Deck 5: Legal Liability

Question 1

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 1

C

Question 2

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

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

Answer 2

C

Question 3

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

A)ordinary negligence.
B)gross negligence.
C)constructive fraud.
D)fraud.

Answer 3

C

Question 4

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.

Question 5

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

Question 6

The term "audit failure" refers to the situation when the auditor has followed auditing standards yet still fails to discover that the client's financial statements are materially misstated.

Question 7

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)constructive care concept.
D)vigilant person concept.

Question 8

"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.

Question 9

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

Question 10

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

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

Question 11

The expectation gap

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

Question 12

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.

Question 13

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

Question 14

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

A)
B)
C)
D)

Question 15

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 do part of the audit work.
D)specialists employed by the CPA firm to provide technical advice on the audit.

Question 16

In the performance of an audit,a CPA

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

Question 17

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

Question 18

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

A)statutory laws.
B)judicial laws.
C)federal laws.
D)common laws.

Question 19

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.

Question 20

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

A)contract fraud.
B)breach of contract.
C)constructive fraud.
D)criminal neglect.

Question 21

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

Question 22

Which of the following statements is True?

A)
B)
C)
D)

Question 23

Distinguish between constructive fraud and fraud.

Question 24

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

Question 25

Define ordinary negligence,gross negligence,and constructive fraud.

Question 26

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.

Question 27

The laws that have been developed through court decisions are called

A)common laws.
B)criminal laws.
C)statutory laws.
D)civil laws.

Question 28

Which of the following is a True statement regarding CPAs' liability?

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

Question 29

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.

Question 30

Distinguish between "joint and several liability" and "separate and proportionate liability."

Question 31

If the CPA negligently 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.

Question 32

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.

Question 33

Constructive fraud

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

Question 34

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

Question 35

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

Question 36

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

Question 37

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

Question 38

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.

Question 39

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

A)breach of contract.
B)tort action for negligence.
C)constructive fraud.
D)fraud.

Question 40

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

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

Question 41

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

A)the auditor was fraudulent.
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.

Question 42

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

Question 43

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

A)letters of representation.
B)confirmation letters.
C)engagement letters.
D)billet doux letters.

Question 44

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

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

Question 45

In connection with the audit of financial statements,an independent 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 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.

Question 46

Which of the following is a True statement regarding auditors' liability?

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

Question 47

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

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

Question 48

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

A)there are more torts than contracts.
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.

Question 49

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

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

Question 50

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

A)lack of duty
B)nonnegligent performance
C)contributory negligence
D)foreseeable users

Question 51

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

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

Question 52

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

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.

Question 53

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

A)expert witness' testimony.
B)engagement letter.
C)management representation letter.
D)confirmation letter.

Question 54

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

Question 55

The principal issue in cases involving alleged negligence is usually

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

Question 56

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

Question 57

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

Question 58

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

Question 59

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

Question 60

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.

Question 61

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

A)foreseen users.
B)foreseeable users.
C)expected users.
D)four-party contracts.

Question 62

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

Question 63

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

Question 64

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

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

Question 65

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

A)liability to clients
B)liability to third parties under common law
C)civil liability under federal securities law
D)criminal liability

Question 66

The basic legal concept which was affirmed in the 1985 New York case,Credit Alliance,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 longer valid.

Question 67

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

A)absence of causal connections
B)contributory negligence
C)nonnegligent performance
D)lack of duty

Question 68

The major conclusion of the 1931 Ultramares case was that

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

Question 69

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

Question 70

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

Question 71

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

Question 72

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

Question 73

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

A)
B)
C)
D)

Question 74

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

Question 75

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

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.

Question 76

A group typically included as "third parties" in common law is

A)
B)
C)
D)

Question 77

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

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

Question 78

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

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.

Question 79

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

A)a primary beneficiary.
B)an injured party.
C)a foreseen user.
D)a bank.

Question 80

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