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Chapter 5
Multiple-Choice Questions

1. While performing services for their clients, professionals have a duty to provide a level of care
easy which is:
d a. free from judgment errors.
b. superior.
c. greater than average.
d. reasonable.

2. Auditors who fail to exercise due care in their performance of professional services may be
easy liable for:
b a. punitive liability.
b. breach of contract.
c. excess liability.
d. criminal charges.

3. Which of the following may give rise to a business failure?

easy a. An erroneous audit opinion is issued.
b b. Management may make ill-advised business decisions.
c. Auditors may fail to uncover employee fraud.
d. Poorly trained auditors may perform a company’s audit.

4. A(n) _____ failure occurs when an auditor issues an erroneous opinion as the result of an
easy underlying failure to comply with auditing standards.
b a. business
b. audit
c. ethics
d. process

5. The standard of due care to which the auditor is expected to adhere is referred to as the:
easy a. prudent person concept.
a b. common law doctrine.
c. due care concept.
d. vigilant person concept.

6. Auditors may be liable to their clients for:

easy Punitive damages Compensatory damages

a a. Yes Yes
b. No No
c. Yes No
d. No Yes

7. Under the laws of agency, partners of a CPA firm may be liable for the work of others on whom
easy they rely. This would not include:
b a. employees of the CPA firm.
b. employees of the audit client.
c. other CPA firms engaged to do part of the audit work.
d. specialists employed by the CPA firm to provide technical advice on the audit.

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8. “Absence of reasonable care that can be expected of a person in a set of circumstances” defines:
easy a. pecuniary negligence.
d b. gross negligence.
c. extreme negligence.
d. ordinary negligence.

9. An example of a breach of contract would likely include:

easy a. an auditor’s refusal to return the client’s general ledger book until the client paid last
c 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.

10. Privity of contract exists between:

easy a. auditor and the federal government.
c b. auditor and third parties.
c. auditor and client.
d. auditor and client attorney.

11. Audit contracts (engagement letters):

easy a. may be either oral or written.
b b. must be written.
c. must be written and notarized.
d. must be written if the client is regulated by the Securities and Exchange Commission.

12. An individual who is not party to the contract between a CPA and the client, but who is known
easy by both and is intended to receive certain benefits from the contract is known as:
d a. a third party.
b. a common law inheritor.
c. a tort.
d. a third-party beneficiary.

13. Laws that have been developed through court decisions rather than by passage through
easy legislative bodies are:
d a. statutory laws.
b. judicial laws.
c. federal laws.
d. common laws.

14. Laws that have been passed through state legislatures are:
easy a. statutory laws.
a b. judicial laws.
c. federal laws.
d. common laws.

15. The assessment against a defendant of the full loss suffered by a plaintiff regardless of other
easy parties’ liability in the wrongdoing is called:
d a. separate and proportionate liability.
b. shared liability.
c. unitary liability.
d. joint and several liability.

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16. _____ risk represents the possibility that the auditor concludes after conducting an adequate
easy audit that the financial statements were fairly stated when they were actually misstated.
c a. Business
b. Process
c. Audit
d. Failure

17. The assessment against a defendant of that portion of the damage caused by the defendant’s
easy negligence is called:
a a. separate and proportionate liability.
b. joint and several liability.
c. shared liability.
d. unitary liability.

18. In third-party suits, which of the auditor’s defenses contends lack of privity of contract?
easy a. Lack of duty.
a b. Non-negligent performance.
c. Contributory negligence.
d. Absence of causal connections.

19. Which of the following auditor’s defenses usually means non-reliance on the financial
easy statements by the user?
c a. Lack of duty.
b. Non-negligent performance.
c. Lack of causal connections.
d. Contributory negligence.

20. There are a number of things that the AICPA, representing the profession as a whole, can do to
easy reduce the CPA’s exposure to lawsuits. One of them is to:
a a. sanction members for improper conduct and performance.
b. deal only with clients possessing integrity.
c. hire qualified auditors and train and supervise them.
d. perform quality audits.

21. In connection with the audit of financial statements, an independent auditor could be
easy responsible for failure to detect a material fraud if:
b a. statistical sampling techniques were not used on the audit engagement.
b. the auditor planned the audit in a negligent manner.
c. accountants performing important parts of the work failed to discover a close relationship
between the treasurer and the cashier.
d. the fraud was perpetrated by one employee who circumvented the existing internal
controls.

22. Which of the following most accurately describes constructive fraud?

medium a. Absence of reasonable care.
b b. Lack of slight care.
c. Knowledge and intent to deceive.
d. Extreme or unusual negligence without the intent to deceive.

23. Which of the following most accurately describes fraud?

medium a. Absence of reasonable care.
c b. Lack of slight care.
c. Knowledge and intent to deceive.
d. Extreme or unusual negligence without the intent to deceive.

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24. Which of the following is an illustration of liability to clients under common law?
medium a. Client sues auditor for not discovering a theft of assets by an employee.
a b. Bank sues auditor for not discovering that borrower’s financial statements are misstated.
c. Combined group of stockholders sue auditor for not discovering materially misstated
financial statements.
d. Federal government prosecutes auditor for knowingly issuing an incorrect audit report.

25. Which of the following is an illustration of liability under the federal securities acts?
medium a. Client sues auditor for not discovering a theft of assets by an employee.
c b. Bank sues auditor for not discovering that borrower’s financial statements are misstated.
c. Combined group of stockholders sue auditor for not discovering materially misstated
financial statements.
d. auditor sues client for not cooperating during engagement.

26. A third-party beneficiary is one which:

medium a. has failed to establish legal standing before the court.
c 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.

27. If the CPA negligently failed to properly prepare and file a client’s tax return, the CPA may be
medium liable for:
c 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.

28. Historically, most major lawsuits against CPA firms have dealt with:
medium a. disputes over income tax preparation services.
d b. disputes arising in the performance of MAS contracts.
c. disputes over the accuracy of bookkeeping services.
d. audited and unaudited financial statements.

29. “Privileged communication” between client and auditor is:

medium a. available in all federal courts.
c b. not available in any court.
c. available in several states.
d. available for matters involving income taxes only.

30. Which of the following statements is true?

medium
a Gross negligence
may constitute Fraud requires the All fraud should be detected
constructive fraud intent to deceive during audit
a. Yes Yes No
b. No Yes Yes
c. Yes No Yes
d. No No No

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31. Failure of a party to meet its obligations, thereby causing injury to another party to whom a duty
medium was owed, is:
b a. breach of contract.
b. tort action for negligence.
c. constructive fraud.
d. fraud.
32. Tort actions against CPAs are more common than breach of contract actions because:
medium a. there are more torts than contracts.
d b. the burden of proof is on the auditor rather than on the person suing.
c. the person suing need prove only negligence.
d. the amounts recoverable are normally larger.

33. The principal issue to be resolved in cases involving alleged negligence is usually:
medium a. the amount of the damages suffered by plaintiff.
c b. whether to impose punitive damages on defendant.
c. the level of care exercised by the CPA.
d. whether defendant was involved in fraud.

34. In the auditing environment, failure to meet auditing standards is often:

medium a. an accepted practice.
c b. a suggestion of negligence.
c. conclusive evidence of negligence.
d. tantamount to criminal behavior.

35. A common way for a CPA firm to demonstrate its lack of duty to perform is by use of a(n):
medium a. expert witness’ testimony.
b b. audit contract, or engagement letter.
c. management representation letter.
d. confirmation letter.

36. The prudent person concept establishes that:

medium a. the CPA firm is not expected to make only perfect judgments.
a b. an audit in accordance with GAAS is subject to limitations and cannot be relied upon for
complete assurance that all errors and irregularities will be found.
c. the courts do not require that the auditor become the insurer or guarantor of the accuracy
of the statements.
d. all CPAs are considered prudent.

37. To succeed in an action against the auditor, the client must be able to show that:
medium a. the auditor was fraudulent.
d b. the auditor was grossly negligent.
c. there was a written contract.
d. there is a close causal connection between the auditor’s behavior and the damages
suffered by the client.

38. A group typically included as “third parties” in common law is:

medium
a Actual and potential stockholders Employees of client
a. Yes Yes
b. No No
c. Yes No
d. No Yes

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39. The major conclusion of the 1931 Ultramares case was that:
medium
a a. ordinary negligence is insufficient for liability to third parties.
b. ordinary negligence is sufficient for liability to third-party beneficiaries.
c. fraud or gross negligence is sufficient for liability to third parties.
d. auditors have no liabilities to third parties.

40. Under common law, a foreseen user would be treated the same as:
medium
a A primary beneficiary A known third party
a. Yes Yes
b. No No
c. Yes No
d. No Yes

41. A broad interpretation of the rights of third-party beneficiaries holds that users that the auditor
medium should have been able to foresee as being likely users of financial statements have the same
b rights as those with privity of contract. This is known as the concept of:
a. foreseen users.
b. foreseeable users.
c. expected users.
d. four-party contracts.

42. Which of the auditor’s defenses is ordinarily not available when lawsuits are filed by a third
medium party?
b a. Absence of causal connections.
b. Contributory negligence.
c. Non-negligent performance.
d. Lack of duty.

43. According to the principle established by the Restatement of Torts case, foreseen users must be
medium members of:
c a. any potential user group.
b. a legally protected class.
c. a reasonably limited and identifiable user group.
d. a reasonably limited and established user group.

44. The increased litigation under the federal securities laws has resulted from:
medium
c The strict liability
standards imposed on
The availability of CPAs by the securities
class-action litigation laws An excess of attorneys
a. Yes Yes Yes
b. Yes No No
c. Yes Yes No
d. No No No

45. Which of the following statements about the Securities Act of 1933 is not true?
medium a. The amount of the potential recovery is the original purchase price plus punitive damages.
a b. It deals with the information in registration statements and prospectuses.
c. It concerns only the reporting requirements for companies issuing new securities.
d. The only parties that can recover from auditors are original purchasers of securities.

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46. Under the Securities Act of 1933, the auditor’s responsibility for making sure the financial
medium statements were fairly stated extends to:
b a. the date of the financial statements.
b. the date the registration statement becomes effective.
c. the date of the audit report.
d. one year beyond the date of the financial statements.

47. Under the Securities Exchange Act of 1934, which type of organizations is required to submit
medium audited financial statements to the SEC?
a 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.

48. The Securities and Exchange Commission can impose all but which of the following sanctions?
medium a. Suspend a CPA from auditing SEC clients.
d 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.

49. The Foreign Corrupt Practices Act (FCPA) of 1977:

medium a. requires auditors to review and evaluate systems of internal control as a part of an audit.
b 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.

50. (SOX) While the Foreign Corrupt Practices Act of 1977 remains in effect, it has been largely
medium superseded by which of the following?
a a. The Sarbanes-Oxley Act of 2002.
b. The Racketeer Influenced and Corrupt Organization Act.
c. The Federal False Statements Statute.
d. The Federal Mail Fraud Statute.

51. Which of the following is not likely a factor in the increase in the number of lawsuits and sizes
medium of awards to plaintiffs related to auditor behavior?
c 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.

52. Historically, one of the leading case of criminal action against CPAs is the:
medium a. 1136 Tenants case.
b b. United States v. Simon case.
c. Escott et al. v. Bar Chris case, aka Bar Chris.
d. Ultramares Corporation v. Touche case.

53. A major purpose of federal securities regulations is to:

medium a. provide sufficient reliable information to the investing public who purchases securities in
a 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

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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.

54. A CPA is subject to criminal liability if the CPA:

medium a. refuses to turn over requested audit documentation to a client.
c 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.

55. Which of the following best describes a trend in litigation involving CPAs?
medium a. A CPA cannot render an opinion unless the CPA has audited all affiliates of a company.
c 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.

56. Tort actions can be based on which of the following?

medium
a Ordinary negligence Gross negligence
a. Yes Yes
b. No No
c. Yes No
d. No Yes

57. The preferred defense in third-party suits is:

medium a. lack of duty to perform.
b b. non-negligent performance.
c. absence of causal connection.
d. client fraud.

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

59. The Private Securities Litigation Reform Act of 1995 reduced potential damages in securities-
challenging related litigation, but because the act applied only to federal courts, attorneys began taking cases
b 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.

60. One of the changes in auditing procedure which was brought about as a result of the 1136
challenging Tenants case was that auditors were encouraged to begin using:
c a. letters of representation.
b. confirmation letters.
c. engagement letters.
d. billet doux letters.

61. The leading precedent-setting auditing case in third-party liability is:

challenging a. Escott et al. v. Bar Chris Construction Corp.
c b. Hochfelder v. Ernst & Ernst.
c. Ultramares Corporation v. Touche.

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d. United States v. Simon.

62. Under common law, an individual or company that (1) does not have a contract with an auditor,
challenging (2) is known by the auditor in advance of the audit, and (3) will use the auditor’s report to make
d decisions about the client company has:
a. no rights unless an auditor is grossly negligent.
b. no rights unless an auditor is fraudulent.
c. no rights against an auditor.
d. the same rights against an auditor as a client.

63. The basic legal concept which was affirmed in the 1985 New York case, Credit Alliance, was
challenging that:
a 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 longer valid.

64. Which of the following statements about the Securities Act of 1933 is not true?
challenging a. A third party that purchased securities described in the registration statement may sue the
c 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.

65. The most significant audit issue that came as a result of the court decision in the Escott et al. v.
challenging Bar Chris Construction Corporation case in 1968 was:
b 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.

66. Under the federal securities acts, one significant result occurring directly due to the Escott et al.
challenging v. Bar Chris Construction Corporation case was that SAS was changed to require:
a 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.

67. Under the Securities Exchange Act of 1934, most of the litigation against the auditor has been
challenging generated because of the auditor’s involvement with the:
b a. 8-K form.
b. 10-K form.
c. 10-Q form.
d. S-1 form.

68. Section 10 and Rule 10b-5 of the Securities Exchange Act of 1934 are often referred to as:
challenging a. the antifraud provisions.
a b. the new issues provisions.
c. the full-employment act for accountants.
d. the RICO provisions.

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69. In a leading securities law and CPA liabilities case, the U.S. Supreme Court ruled in 1976 in
challenging Hochfelder v. Ernst & Ernst that before CPAs could be held liable for Rule 10b-5 of the
c 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.

70. The similarity that exists in both the United States v. Natelli case (i.e., the National Student
challenging Marketing case of 1975), and the ESM Government Securities v. Alexander Grant & Co. case of
d 1986 is that in each case:
a. a partner in a national CPA firm served prison time.
b. the partners were punished for the shoddy work of their subordinates.
c. a presidential pardon kept them from serving time in prison and allowed them to retain
their CPA licenses.
d. the auditors were not convicted for failing to discover the problem in year 1, but for failing
to disclose the problem when it was discovered in year 2.

71. The Securities and Exchange Commission has authority to:

challenging a. prescribe specific auditing procedures to detect fraud concerning inventories and
c 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.

72. The partnership of Booth & Haynes, CPAs, has been engaged to examine the financial
challenging statements of Paul, Inc., in connection with the registration of Paul’s securities with the
a 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.

73. Gregory & Hedrick, a medium-sized CPA firm, employed Elise as a staff accountant. Elise was
challenging negligent while auditing several of the firm’s clients. Under these circumstances, which of the
d 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 generally
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.

74. The King Surety Company wrote a general fidelity bond covering thefts of assets by the
challenging employees of Wilson, Inc. Thereafter, Cooney, an employee of Wilson, embezzled $17,200 of
b 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

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auditors, Lynch & Merritt, CPAs. Which of the following would be Lynch & Merritt’s best
defense?
a. King is not in privity of contract.
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.
c. Lynch & Merritt were not guilty either of gross negligence or fraud.
d. Lynch & Merritt were not aware of the King-Wilson surety relationship.

75. As a consequence of his failure to adhere to generally accepted auditing standards in the course
challenging of his examination of the Lamp Corp., Harrison, CPA, did not detect the embezzlement of a
c 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.

76. In connection with a public offering of first mortgage bonds by Henson Corp., the bond
challenging underwriter has asked Henson’s CPA to furnish him with a comfort letter giving as much
b assurance as possible relative to Henson’s unaudited financial statements for the three months
ended March 31, 2007.
The CPA had expressed an unqualified opinion on Henson’s financial statements for the year
ended December 31, 2006 and he has performed a limited review of Henson’s financial
statements for the three months ended March 31, 2007. Nothing has come to his attention that
would indicate that the March 31, 2007 statements are not properly presented. Under these
circumstances, the CPA’s response to the underwriter’s request should be to:
a. furnish to the underwriters an opinion that the March 31, 2007 statements are fairly
presented subject to year-end audit adjustments.
b. give negative assurance as to the March 31, 2007 financial statements but disclaim an
opinion on these statements.
c. inform the underwriters that no comfort letter is possible without an audit of the financial
statements for the three months ended March 31, 2007.
d. Furnish to the underwriters an adverse opinion covering financial statements for the three
months ended March 31, 2007.

Essay Questions

77. Distinguish between what is meant by business failure and audit failure.
easy
Answer:
Business failure occurs when a business is unable to repay its debts, the extreme case of
which is filing for bankruptcy. Audit failure occurs when the auditor issues an incorrect
audit report as the result of failing to follow generally accepted auditing standards.

78. Distinguish between ordinary negligence and gross negligence.

easy
Answer:
Ordinary negligence is the absence of reasonable care, whereas gross negligence is the
absence of even slight care that can be expected of a person in a set of circumstances.

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79. Distinguish between audit risk and audit failure.

easy
Answer:
Audit risk is the risk that the auditor will conclude that the financial statements are fairly
stated and issue an unqualified report when, in fact, the financial statements are materially
misstated. An audit failure occurs when the auditor, as a result of his or her failure to
follow GAAS, issues an erroneous audit report.

80. Discuss some of the steps individual practicing auditors can take to minimize their legal
easy 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 them 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.
Seek legal counsel.
Choose a form of organization with limited liability.

81. Distinguish between constructive fraud and fraud.

medium
Answer:
Constructive fraud is the existence of extreme or unusual negligence with no intent to
deceive or do harm. In contrast, fraud involves both knowledge and intent to deceive.

82. There are four major sources of an auditor’s legal liability. One source is liability to the audit
medium client under common law. Briefly summarize the other three sources.

Answer:
The other three sources of auditor’s legal liability are:
Liability to third parties under common law.
Liability to shareholders under federal securities acts.
Criminal liability.

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83. Discuss three major factors that have contributed to the recent increase in the number of
medium 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.
Increasing complexity of auditing and accounting.
Large civil court judgments against CPA firms.
Joint and several liability doctrine which encourages plaintiffs to sue auditors
regardless of fault.
The willingness of CPA firms to settle out of court to avoid costly legal fees and
adverse publicity.
The difficulty courts have in interpreting technical accounting and auditing matters.

84. Distinguish between “joint and several liability” and “separate and proportionate liability.”
medium
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 plaintiff’s loss caused by the defendant’s wrongdoing.

85. Discuss each of the four defenses a CPA firm can normally use when facing legal claims by
medium clients. Which of these defenses is ordinarily not available against third-party suits?

Answer:
Lack of duty. The CPA firm could claim that there was no implied or expressed contract
to perform between the CPA firm and the client.
Nonnegligent performance. The CPA firm could claim that the audit was performed in
accordance with GAAS.
Contributory negligence. The CPA firm could claim that the client’s actions either caused
the loss, or interfered with the auditor’s ability to discover the cause of the loss. This
defense is not available in third-party suits.
Absence of causal connection. The CPA firm could claim that the auditor’s substandard
performance did not cause the damages suffered by the client.

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86. Discuss some of the steps the AICPA and the accounting profession as a whole can and are
medium taking to reduce the practitioner’s exposure to lawsuits.

Answer:
Steps the profession is taking to reduce practitioners’ exposure to lawsuits include:
Research in auditing.
Standard and rule setting and revisions to meet the changing needs of the profession.
Setting requirements to protect auditors.
Establishing peer review requirements.
Opposing lawsuits.
Educating investors and other users of financial statements as to the meaning of the
auditor’s report and the nature of the auditor’s work.
Sanctioning members for improper conduct.
Lobbying for changes in laws.

87. Discuss the sanctions the Securities and Exchange Commission can impose on auditors.
medium
Answer:
The SEC has the power to suspend, temporarily or permanently, practitioners from doing
audits for SEC-regulated companies. The SEC can also require individual CPAs or CPA
firms to have an extensive review of their practices by another CPA firm, to participate in
continuing professional education programs, and to make changes in their practice.

88. Discuss some of the actions that can be taken by individual CPAs to protect themselves from
medium legal liability.

Answer:
Deal only with clients possessing integrity.
Hire qualified personnel and train and supervise them properly.
Follow professional standards.
Maintain independence.
Understand the client’s business.
Perform quality audits.
Document the work properly.
Obtain an engagement letter and a representation letter.
Carry adequate insurance.
Seek legal counsel.
Choose a form of organization with limited liability.
Exercise professional skepticism.

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89. Explain what each of the following terms means:

medium (1) Business failure.
(2) Audit failure.
(3) Audit risk.

Answer:
(1) Business failure occurs when a business is unable to repay its lenders or meet the
expectations of its investors because of economic or business conditions. The
extreme case of business failure is filing for bankruptcy.
(2) Audit failure occurs when the auditor issues an erroneous audit opinion as the result
of a failure to comply with the requirements of generally accepted auditing standards.
(3) Audit risk is the risk that the auditor will conclude that the financial statements are
fairly stated and an unqualified opinion can be issued when, in fact, they are
materially misstated.

90. Three approaches to the application of the foreseen users’ concept are (1) the Credit Alliance
challenging 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 his or her 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 third-party users of the auditor’s work
product must be members of a reasonably limited and identifiable group of users, 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 being likely users of financial statements have the same rights as
those with privity of contract.

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Other Objective Answer Format Questions

91. Match seven of the legal terms (a-j) with the definitions provided below (1-7):
medium
a. Common law
b. Constructive fraud
c. Breach of contract
d. Joint and several liability
e. Ordinary negligence
f. Third-party beneficiary
g. Gross negligence
h. Statutory law
i. Fraud
j. Separate and proportionate liability

h 1. Laws that have been passed by the U.S. Congress and other governmental
units.

e 2. Absence of reasonable care than can be expected of a person in a set of

circumstances.

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

j 4. The assessment against a defendant of the portion of the damage caused by

the defendant’s negligence.

c 5. Failure of one or both parties in a contract to fulfill the requirements of the

contract.

d 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.

b 7. Existence of extreme or unusual negligence even though there was no intent to

deceive or do harm; also termed recklessness.

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92. Match eight of the following terms (a-n) with the definitions provided below (1-8):
medium
a. Foreign Corrupt Practices Act
b. Securities Exchange Act of 1934
c. Securities Litigation Uniform Standards Act of 1998
d. Securities Act of 1933
e. Ultramares doctrine
f. Audit risk
g. Audit failure
h. Standards failure
i. Business failure
j. Absence of causal connection
k. Contributory negligence
l. Lack of duty to perform
m. Private Securities Litigation Reform Act
n. Nonnegligent performance

g 1. A situation in which the auditor issues an erroneous audit opinion as the result
of an underlying failure to comply with the requirements of generally
accepted auditing standards.

b 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.

k 3. An auditor’s legal defense under which the auditor claims that the client failed
to perform certain obligations and that it is the client’s failure to perform those
obligations that brought about the claimed damages.

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

country.

e 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.

c 6. A federal statute designed to cause class-action securities lawsuits to be

addressed in federal district courts.

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

j 8. An auditor’s legal defense under which the auditor contends that the damages
claimed by the client were not brought about by any act of the auditor.

93. The standard of due care to which the auditor is expected to be held is referred to as the prudent
easy person concept.
a a. True
b. False

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94. The Private Securities Litigation Reform Act of 1995 capped damage awards against auditors to
easy the amount of the audit fees charged.
b a. True
b. False

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

96. In a CPA firm operating as a limited liability partnership (LLP), the liability for one partner’s
easy actions does not extend to the firm’s assets.
b a. True
b. False

97. Statutory laws are laws that have been developed through court decisions rather than through
easy the U.S. Congress and other governmental units.
b a. True
b. False

98. One result from the Escott et al. v. Bar Chris case was a greater emphasis being placed on audit
medium staff understanding the client’s business and industry.
a a. True
b. False

99. An example of auditor legal liability to third parties under common law would be the federal
medium government prosecuting an auditor for knowingly issuing an incorrect audit report.
b a. True
b. False

100. The doctrine of joint and several liability is one factor that has contributed to the recent increase
medium in the number of lawsuits against auditors and the size of awards to plaintiffs.
a a. True
b. False

101. Audit risk is the risk there will be an audit failure for a given audit engagement.
medium a. True
b b. False

102. The term “audit failure” refers to the situation when the auditor has followed auditing standards
medium yet still fails to discover that the client’s financial statements are materially misstated.
b a. True
b. False

103. Several states have statutes that permit privileged communication between the client and
medium auditor, allowing a CPA to refuse to testify in state and federal courts.
b a. True
b. False

104. The 1136 Tenants case was a criminal case concerning a CPA’s failure to uncover fraud during
medium a financial statement audit.
b a. True
b. False

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105. Of the three approaches to applying the concept of foreseen users (Credit Alliance approach,
medium restatement of torts approach, and foreseeable user approach), the approach followed by the
b most states is the Credit Alliance approach.
a. True
b. False

106. The only parties who can recover from auditors under the Securities Act of 1933 are original
medium purchasers of securities.
a a. True
b. False

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

108. Companies with securities traded on national and over-the-counter exchanges are required to
medium submit audited financial statements once every three years to the Securities and Exchange
b Commission.
a. True
b. False

109. The same three defenses available to auditors in common law suits by third parties—non-
medium negligent performance, lack of duty, and absence of causal connection—are also available for
a suits under the Securities Exchange Act of 1934.
a. True
b. False

110. The United States Supreme Court has ruled that outside professionals such as accountants who
medium don’t help run corrupt businesses cannot be sued under the provisions of the Foreign Corrupt
b Practices Act.
a. True
b. False

112. The Foreign Corrupt Practices Act of 1977 allows an injured party to seek treble (triple)
medium damages and recovery of legal fees in cases where it can be demonstrated that the defendant
b was engaged in a pattern of fraudulent activity.
a. True
b. False

113. Gross negligence is the existence of extreme or unusual negligence with the intent to deceive.
medium a. True
b b. False

114. The preferred defense in third-party suits is absence of causal connection.

challenging a. True
b b. False

115. The restatement of torts approach to the concept of foreseen users states that any users that the
challenging auditor should have reasonably been able to foresee as being likely users of financial statements
b have the same rights as those with privity of contract.
a. True
b. False

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

117. (SOX) The Sarbanes-Oxley Act of 2002 makes destruction of audit documentation punishable by up to
challenging 10 years in prison.
b a. True
b. False

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