Deck 3: Legal Liability

Question 1

An example of a breach of contract would be

A) 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.
B) an auditor's refusal to return a client's records until the client paid last year's audit fees.
C) a public accounting firm's failure to deliver a tax return on the agreed-upon date because the firm had a backlog of other work that was more lucrative.
D) an auditor's failure to complete the audit by the agreed-upon date because the client's financial records had been destroyed.

Answer 1

C

Question 2

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) joint and several liability.
C) shared liability.
D) unitary liability.

Answer 2

B

Question 3

If the public accountant negligently failed to properly prepare and file a client's tax return, the public accountant can be held liable for

A) the penalties the client owes Canada Customs and Revenue Agency.
B) the penalties and interest the client owes.
C) the penalties and interest, plus the tax preparation fee that the public accountant charged.
D) the penalties and interest, the tax preparation fee, and the amount of tax that was underpaid.

Answer 3

C

Question 4

Danford, a PA, is setting up his accounting firm as a sole practitioner. Which of the following is not an important way that Danford can reduce legal liability with respect to the work completed by his office?

A) participate in the standard-setting process for audit engagements
B) find out when his practice is due for practice inspection
C) hire only qualified personnel and train them well
D) sanction other PAs who engage in improper conduct

Question 5

Pierre, a CPA, was convicted of stealing money from his clients and deliberately preparing personal tax returns that were false. In addition, Pierre will likely

A) need to take additional training courses to upgrade his tax skills.
B) need to defend himself to prove non-negligent performance.
C) be charged with misconduct by his professional institution (or order).
D) have lack of privity with the federal and provincial tax authorities.

Question 6

Many PAs prepare tax returns for individuals and for corporations. Under what circumstances is liability insurance required to cover the preparation of tax returns?

A) When the PA is a member of a professional accounting association.
B) When any number of tax returns are prepared, including no-charge tax returns.
C) When fees are being charged and more than a handful of returns are being prepared.
D) When the bulk of the PA's income comes from preparing tax returns.

Question 7

Conflict between financial statement users and auditors often arises because of the

A) high cost of performing an audit.
B) extremely technical vocabulary auditors use in their reports.
C) placement of the auditor's report in the back of the client's annual report, where it is hard to locate.
D) expectation gap.

Question 8

There are a number of things that a practising auditor can do to reduce liability in lawsuits. One of them is to

A) lobby for changes in laws.
B) carry adequate insurance.
C) establish peer-review requirements.
D) revise auditing standards to meet the changing needs of society.

Question 9

When an auditor issues an erroneous opinion as the result of an underlying failure to comply with the requirements of generally accepted auditing standards, it results in

A) business failure.
B) audit failure.
C) audit risk.
D) business risk.

Question 10

Laws that have been passed through federal or provincial governments are

A) statutory law.
B) judicial law.
C) criminal law.
D) common law.

Question 11

While performing services for their clients, professionals have always had a duty to provide a level of care that is

A) reasonable.
B) greater than average.
C) superior.
D) guaranteed to be free from error.

Question 12

PA has been recently appointed auditor of Foible Ltd., a company that exports high-cost knickknacks. To facilitate the rapid preparation of the financial statements, management had the physical inventory counted in October, rather than at the December year-end. During the inventory count, PA noticed that several of the boxes were labelled with receiving documents from a competitor. PA was told that the new warehouse supervisor worked part-time at the competitor and must have picked up the wrong boxes.
Several employees have sued Foible Ltd. for wrongful dismissal, claiming that they were promised a job that would last at least one year and would be provided with low cost accommodations. They are suing for the balance of the year's wages and are claiming that they were brought into the country under false pretenses. These employees are all from an Eastern-European country. The law firm has responded in a legal letter that this suit is without merit.
During the year, Foible obtained legal services from a firm in which Foible's Chairman of the Board of is a partner. Fees and disbursements for these services for the year were $125 000, a material amount.
During the audit, employees often spoke in a foreign language among themselves before responding to PA. Then one employee would respond after some (often heated) discussion.
Subsequent to the year end, the warehouse supervisor was arrested on criminal charges of theft, and Foible was charged with selling stolen goods. PA was charged as an accomplice to money laundering, as all of the management for Foible were members of a criminal group found to be laundering money from Eastern Europe.
Required:
Discuss the actions that PA could have taken during the engagement to prevent these charges.

Question 13

What are the 6 major factors contributing to the high number of lawsuits against pubic accountants and the high amounts in settlements being awarded to plaintiffs?

Question 14

Amin is distraught. Six months ago, a big-box stereo store opened just down the street from his independent stereo and music business and now he is unable to continue operating his business. Only eight months ago, you issued an unqualified audit opinion on his financial statements that showed the financial results of a well-run, profitable store. Amin's business is experiencing

A) customer expectation gap.
B) audit failure.
C) fiduciary duty.
D) business failure.

Question 15

Small Town Lumberyard Limited (STLL) needed an additional bank loan to finance its operations. To make its financial statements look better, the company overstated its inventory and overstated its accounts payable. The auditors did not detect this deliberate misstatement because they conducted limited tests of inventory and did not confirm accounts payable. Other auditors agreed that the procedures conducted during this audit were inadequate. The auditors of STLL would likely be considered to be

A) guilty of fraud.
B) negligent.
C) contributorily negligent with STLL.
D) guilty of constructive fraud.

Question 16

Most of the major lawsuits against public accounting firms have dealt with

A) audited or unaudited financial statements.
B) disputes over income-tax preparation services.
C) disputes arising in the performance of management consulting services contracts.
D) unaudited financial statements.

Question 17

In rare cases, auditors have been held liable for criminal acts. A criminal conviction against an auditor can result only when it is demonstrated that the auditor

A) was negligent.
B) was grossly negligent.
C) knowingly issued an incorrect auditor's report.
D) caused a financial loss to an innocent third party.

Question 18

A) Describe some of the steps the CPA and the accounting profession as a whole can and are taking to reduce practitioners' exposure to lawsuits.
B) Describe some of the steps individual practising auditors can take to minimize their legal liability.

Question 19

An example of an audit failure is when the

A) auditor issues an erroneous audit opinion as the result of a failure to comply with the requirements of GAAS.
B) audit opinion is qualified.
C) company files for bankruptcy less than 12 months after receiving an unqualified opinion.
D) auditor issues an erroneous audit opinion as the result of an undiscovered fraud that took place in the period being audited.

Question 20

An auditor would be found negligent if he/she

A) relied on a report from management without considering management integrity.
B) relied on a report that contained errors that had been concealed by management.
C) did not consider the expenses from a division due to management intentionally withholding that information.
D) failed to discover a payroll fraud by testing a statistical sample of transactions in the salary expense account.

Question 21

In the auditing environment, failure to meet generally accepted auditing standards is often

A) an accepted practice.
B) a suggestion of negligence.
C) strong evidence of negligence.
D) tantamount to criminal behaviour.

Question 22

A) List the four items a defendant must prove in an action for negligence against a public accountant.
B) Discuss what is meant by the term "expectation gap."

Question 23

Joan talked to the owners of Fancy Clothing Limited before investing. She obtained a copy of their financial statements and saw that profits were low, even considering the fact that the owners had not taken any money for themselves in the current year. However, she decided to invest in the company because she believed her superior knowledge of the clothing industry would turn the business around, resulting in enough profits for all owners. Unfortunately, this did not occur and the company went bankrupt. Joan is suing the auditors because she relied upon the financial statements during her investment decision. What is the auditor's best defence?

A) absence of misstatement
B) contributory negligence
C) non-negligent performance
D) duty of care

Question 24

A bank sues an auditor after having lost a significant amount of money from a loan granted to a client based on the financial statements that contained a material error. The source of the legal liability is

A) known third party liability.
B) client liability.
C) liability under provincial securities law.
D) criminal liability.

Question 25

What rights do secondary investors (i.e. those who purchase shares after an initial offering) have to sue an auditor?

A) Since they are third-party claimants, they would be part of a limited class of known users.
B) They could claim contributory negligence since they had prior information of company results.
C) They can sue under provincial legislation without the need to prove reliance.
D) Since there is absence of causal connection, they would not be able to sue the auditors.

Question 26

PA was engaged by Microcomputer Distributor Limited (MDL) to conduct a review engagement. The financial statements are used primarily by the shareholders, management, and by the bank. Recently, an employee was fired for stealing computer parts, primarily chips and boards that could easily be placed in a pocket. MDL is suing PA because they believed that audit procedures, such as counting inventory, would have detected this fraud. What is PA's best defence?

A) absence of causal connection
B) lack of negligence
C) contributory negligence
D) duty of care not required

Question 27

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

A) the amount of the damages suffered by the plaintiff.
B) whether to impose punitive damages on the defendant.
C) the level of care required.
D) whether the defendant was involved in fraud.

Question 28

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

A) the auditor was grossly negligent.
B) the auditor was fraudulent.
C) there is a close causal connection between the auditor's breach of the standard of due care and the damages suffered by the client.
D) there was a written contract.

Question 29

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

A) statistical sampling techniques were not used on the audit engagement.
B) the auditor planned the work in a hasty and ineffective 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 client employee who circumvented the existing internal controls.

Question 30

The standard of due care to which the auditor is expected to be held is referred to as the

A) prudent person concept.
B) common law doctrine.
C) due care concept.
D) reckless regard doctrine.

Question 31

There are four major sources of auditors' legal liability. Briefly summarize the four sources.

Question 32

According to the CPA Handbook, the auditor's responsibility for failure to detect fraud arises

A) when such failure clearly results from failure to comply with generally accepted auditing standards.
B) whenever the amounts involved are material.
C) only when the examination was specifically designed to detect fraud.
D) only when such failure clearly results from negligence so gross as to sustain an inference of fraud on the part of the auditor.

Question 33

Winston Chang, a PA, conducted the audit of Manra Manufacturing Ltd., a small company that produces a variety of machined parts for the automotive and computer industries. The audit showed that the company produced a small profit after paying the owners of the company a high salary. Manra was purchased by a competitor, Cheblay. Cheblay had hoped to produce efficiencies by combining the two companies but was unable to do so. Cheblay sued Chang because it relied upon the financial statements when purchasing the company's shares, claiming that the machines, which were about fifteen years old, had been overvalued. The machines were recorded at cost, which was below net realizable value. What is the auditor's best defence?

A) contributory negligence
B) absence of negligence
C) duty of care
D) absence of liability

Question 34

The leading precedent-setting case in third-party liability was a 1931 U.S. case, Ultramares v. Touche. What is the key aspect of this case?

A) To succeed, claimants must be foreseeable users of the audited financial statements that are part of the claim process.
B) Ordinary negligence is insufficient for liability to third parties because of lack of privity of contract.
C) The auditor must have actual knowledge of the users of the financial statements to establish privity.
D) There is no general auditor liability to shareholders, since the loss of equity was suffered by the company.

Question 35

Which of the following lawsuits resulted in a decision that shareholders could not sue the auditors for the loss in the value of their shares?

A) Haig v. Bamford et al.(1976)
B) Hercules Management Ltd. v. Ernst & Young (1997)
C) Ultramers Corporation v. Touche (1931)
D) United States v. Anderson (2002)

Question 36

Fabio recently sold his restaurant for $650 000, the value of the net assets as reported on the balance sheet. After the sale, Fabio realized that he could've sold the restaurant for as much as $950 000 as the fair value of the assets was $300 000 higher than what was reported on the balance sheet. Fabio is suing the auditors for his loss. The auditor's best defence is

A) absence of a misstatement.
B) lack of duty.
C) no damages.
D) absence of causal connection.

Question 37

The King Surety Company wrote a general fidelity bond covering defalcations 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, public accountants. Which of the following would be Lynch & Merritt's best defence?

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 negligence or fraud.
D) Lynch & Merritt were not aware of the King-Wilson surety relationship.

Question 38

The Ultramares doctrine is that ordinary negligence is insufficient for liability of auditors to third parties because of the lack of privity of contract between the third party and the auditor. What type of behaviour on the part of an auditor would result in liability to more general third parties according to this doctrine?

A) conducting an audit engagement when a review engagement had been contracted
B) completing work in accordance with a contract that was signed with the client
C) deliberate misstatement of the financial statements by management remaining undetected
D) fraud or constructive fraud with respect to the working papers

Question 39

A common way for a public accounting firm to demonstrate its defence of a lack of duty to perform is by use of a(n)

A) engagement letter.
B) letter of representation.
C) confirmation letter.
D) expert witness.

Question 40

An investor suing an auditor for not discovering that the financial statements of a company were materially misstated is an example of

A) criminal liability.
B) fiduciary duty.
C) third party liability.
D) liability to client under common law.

Question 41

The court ruled that Jones did not rely on the financial statements in his decision to purchase shares of Manumite Limited. Instead, Jones relied upon his discussions with the owners and with financial analysts. This result illustrates

A) absence of negligence.
B) lack of privity.
C) contributory negligence.
D) absence of causal connection.

Question 42

There are a number of things that the CPA, representing the profession as a whole, can do to reduce the practitioner's exposure to lawsuits. One of them is to

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.

Question 43

Individuals who accept fees (or property) and know or are willfully blind to the fact that the property was obtained illegally can be charged with money laundering, a criminal offence. Which of the following techniques will help a PA prevent such charges?

A) Ensure that the financial statements are in accordance with an acceptable reporting framework.
B) Require that clients carefully document the sources of their funds.
C) Carefully assess management integrity.
D) Obtain a detailed letter of representation from management confirming the sources of their funds.

Question 44

One of the lessons learned from accounting scandals such as Enron's is that generally accepted accounting principles (now under an acceptable financial reporting framework) cannot be relied upon exclusively in deciding whether financial statements are fairly presented. Why is this the case?

Question 45

Musical Productions Limited has had declining sales as more and more media are being presented online rather than on CD or DVD. It diversified its business by moving into backup systems, but is still having trouble boosting income.
The audit team was led by Theresa Sanford, who obtained her CPA last year. Theresa had two assistants, Marv and Uhta, who did the work in the accounts receivable and inventory areas. Theresa felt that they did not require supervision, as they had been with the firm for two years and were expected to do well on their professional exams this year. Marv found that the accounts receivable had many old accounts and customers were tough to get hold of. Accordingly, he decided to accept management's representations with respect to the balances. Similarly, Uhta noted that there were still many CDs in inventory that had been there for over three years. Management insisted on recording these at cost. Uhta accepted managements' valuation.
Two months after the audit report was issued, Musical Productions Limited went bankrupt. It was found that many accounts receivable were for fictitious customers and the receiver was only able to obtain five cents on the dollar for the inventory, which was sold as scrap.
The bank is suing the auditors to recover its bank loan, which had been renegotiated based upon the results of the financial statements.
Required:
Will the bank be successful in its suit? Why or why not?

Question 46

Most accounting and auditing professionals agree that when an audit has failed to uncover material misstatements, and the wrong type of audit opinion is issued, the audit firm

A) has failed to follow generally accepted auditing standards (GAAS).
B) deserves to lose the lawsuit.
C) should be asked to defend the quality of the audit.
D) should not be held responsible for the financial loss suffered by others.

Question 47

A bank sues the auditor after making a loan to Klaxxon, a company that went bankrupt. The bank indicates that they relied on the year-end financial statements of Klaxxon to make the lending decision. The bank analyst indicates that the audit opinion was unqualified so he assumed that Klaxxon was a going concern. The auditor defends himself by referring to a note disclosure in the financial statements about the company's economic dependence on one buyer, Dexters Corp. Dexters Corp had experienced some significant financial trouble for the past year and went bankrupt three months after the financial statements of Klaxxon were released. The PA's liability is likely

A) contributory negligence.
B) fraud.
C) breach of contract.
D) gross negligence.

Question 48

A client is suing a PA firm, claiming that the firm is responsible for the losses suffered from a fraud in the payroll department that was not uncovered during the year-end testing done by the auditor. The auditors did indicate to management that controls over payroll calculations and payments were weak, as there was improper segregation of duties. The auditor's best defence is

A) contributory negligence.
B) absence of negligence.
C) absence of causal connection.
D) no damages.

Question 49

You are the auditor of Jehello Incorporated, a public company with a December year end. Your firm has audited Jehello for the past three years. The following issues were documented in the working paper files for the prior year audit:
• The company had incurred expenditures of $400 000 related to the development of a new sound system. The large majority of the costs were related to development of software, hardware, and presentation of the results to customers who participated in focus groups. Management had been optimistic that the new sound system would work well, even though focus group results had been poor. These costs had been fully capitalized.
• About 40% of the company's revenues were from one customer. That contract had been due for renewal on May 15, ten days after the audit report had been issued. Documents on file indicated that the customer seemed likely to renew the contract, although quality control disputes were escalating. On May 14, Jehello was informed that the contract would not be renewed.
Jehello has defaulted on its bank loans and the bank is suing you, saying that the financial statements presented last year were false and misleading.
Required:

A) Which defences should the auditor use?
B) Do you believe that the auditor will lose the suit? Why or why not?

Question 50

Sandra is a new partner at a PA firm. Sandra recently signed a new contract with Gretchen Fabrics to become its auditor. In the process of accepting the client and planning the first year's audit, Sandra did the following:
- Sandra contacted the previous auditor to enquire if there were any reasons not to accept the audit of this client. Unfortunately, the previous auditor was on vacation and did not respond to Sandra before she accepted the client.
- Upon his return, the previous auditor did communicate with Sandra and indicated that the client had aggressive expense deferral policies that they disagreed on. Sandra asked to review the working papers of the previous auditor with regards to these expenses and found them to be right below the materiality threshold.
- Gretchen Fabrics imports most of its fabrics and has two production facilities in Asia. The company therefore has a complex tax structure and many import duties. Since this is not the area of expertise of Sandra, she asked another auditing firm to provide the required audit procedures for the international taxes and duties expense. When selecting the other audit firm, Sandra researched the firm online. She also ensured that they had their professional designation and enquired with the CPA and provincial association if the firm had any complaints or litigation outstanding for malpractice.
- Since the bidding process took time, Sandra had to start the audit almost right after learning she had the winning bid. She did not prepare an engagement letter before starting the work. She does not see this as being a problem since waiting until the audit has begun will provide her with a better idea of what work has to be done and what the engagement letter should include.
Required:
Identify the good and bad steps that Sandra has undertaken in reducing her exposure to legal liability.

Question 51

Bigland and Betton, PAs, is being sued by a bank for potential negligence during an audit engagement that was completed over five years ago. Which of the following actions during that audit engagement will help ensure that the suit is fairly assessed?

A) good quality documentation
B) honest management at the client
C) low employee turnover
D) good employee memory of events

Question 52

Your firm has been the auditor of Chappello Design and Construction Limited for several years. During the current year, a consultant on staff at your firm assisted Chappello in the selection and implementation of a new computer system. The audit staff were not involved in this process.
The new system was an enterprise-wide system that was to be implemented without modification using the direct cut-over approach (the old system was discontinued and the new one continued the next day). Unfortunately, staff had extreme difficulty using the system and discontinued it after two months. During that time, Chappello was unable to document and bill its work for progress billings, and borrowed heavily to continue to pay its employees while work continued. The company reverted to its old system and claims that it has lost hundreds of thousands of dollars in revenues as it was unable to issue quotes and bid on new contracts.
Chappello has sued your firm for negligence with respect to the implementation of the computer system.
Required:
Which defences should the firm use? Support your answer with reasons.

Question 53

Describe each of the six defences a public accounting firm can normally use when facing legal claims by clients.

Question 54

In third party suits, when there is a misstatement in the financial statements, which of the auditor's defences usually means non-reliance on the financial statements by the user?

A) lack of duty
B) non-negligent performance
C) contributory negligence
D) absence of causal connections

Question 55

Enron and Equity Funding are companies that suffered from large frauds by corporate management. One important lesson with respect to such cases is that

A) when a company does really well financially it is important to suspect that such results are always inflated.
B) an investigation of the integrity of management is an important part of deciding upon the extent of audit work.
C) securities and exchange commissions expect auditors to be perfect in their assessment of management.
D) partners and staff should cooperate in preparing working papers that prove the accuracy of the financial statements.