Deck 15: Legal Liability

Question 1

Elliot Corp.is interested in purchasing Roger Corp.Prior to the purchase Elliot hired Adam & Co.to audit the financial statements of Roger.During the audit,Adam & Co.failed to discover a fraud that resulted in material misstatements in Roger's financial statements.After the acquisition,the fraud was discovered and Elliot Corp.suffered substantial losses.If Elliot sues Adam & Co.,Elliot must prove that Adam & Co:

A)Acted recklessly or with lack of reasonable grounds for belief.
B)Knew of the instances of fraud.
C)Failed to exercise the appropriate level of professional care.
D)Demonstrated gross negligence.

Answer 1

C

Question 2

Which of the following claims concerning the quality of auditors' work would least likely result in civil liability for damages?

A)Gross negligence amounting to constructive fraud.
B)Failure to investigate possible fraud when other entities in the industry have experienced frauds.
C)Reckless disregard of evidence that the financial statements do not conform to generally accepted accounting principles.
D)Issuing an unqualified auditors' opinion when evidence suggests that the financial statements were not prepared according to generally accepted accounting principles.

Answer 2

B

Question 3

To prevail in an action brought under common law,the plaintiff must show all of the following except:

A)He or she was damaged or suffered a loss
B)The financial statements contained a material misstatement
C)Auditors knew the financial statements contained a material misstatement
D)He or she relied on the financial statements

Answer 3

C

Question 4

If an audit is performed for the benefit of a specific person or organization,that person or organization is known as a(n)

A)Party to the contract
B)Primary beneficiary
C)Foreseeable third party
D)Prime benefactor

Question 5

Lauren hires Humphrey,a CPA,to audit her financial statements.The engagement letter includes a statement acknowledging that audited financial statements are required to be filed with a regulatory body by October 1.Humphrey does not complete the audit until October 5.Lauren is late filing the financial statements and is fined $100,000 by the regulatory body.Lauren would most likely sue Humphrey claiming:

A)Breach of contract.
B)Ordinary negligence.
C)Gross negligence.
D)Constructive fraud.

Question 6

Kerry CPA is the auditor for Sammy Corp.During the audit,Kerry discovers a material misstatement in Sammy's financial statements.Sammy's management tells Kerry that if the misstatement is corrected or if Kerry issues an opinion that indicates there is a material misstatement,Sammy Corp.will likely have to declare bankruptcy and thousands of employees will lose their jobs.Which of the following statements is true if the misstatement is not corrected and Kerry issues an unqualified opinion on Sammy's financial statements?

A)Kerry is liable only to third parties in privity of contract.
B)Kerry is liable only to known users of the financial statements.
C)Kerry is likely liable to any person who suffered a loss as a result of the fraud.
D)Kerry is likely liable to third parties even if the third parties were aware of the fraud and did not rely on the opinion.

Question 7

Which of the following statements is true concerning auditors' responsibilities during the audit?

A)Auditors must exercise the level of care,skill,and judgment expected of a reasonably prudent auditor under the circumstances.
B)Auditors must plan the audit to gather sufficient competent evidence to guarantee the accuracy of the financial statements.
C)Auditors are strictly liable for failures to discover client fraud.
D)Auditors are not liable unless they commit gross negligence or intentionally disregard generally accepted auditing standards.

Question 8

Lauren hires Humphrey,a CPA,to provide an audit of her financial statements.The engagement letter includes a statement acknowledging that audited financial statements will be provided to financial institutions for a loan,but does not name any financial institutions.Humphrey completes the audit and issues an unqualified opinion.Based on the audited financial statements,Key Largo Bank approves the loan to Lauren.Four months later,Lauren files for bankruptcy.Key Largo Bank would most likely sue Humphrey claiming:

A)It was in privity of the contract
B)It was a primary beneficiary
C)It was a foreseen party
D)It was a foreseeable party

Question 9

When bringing suit against auditors under section 10(b)of the Securities Exchange Act of 1934,plaintiffs must allege and prove:

A)The financial statements in the offering registration filing contained a material misstatement.
B)Auditors were aware of material misstatements in the financial statements.
C)Auditors were guilty of ordinary negligence and failed to discover material misstatements in the financial statements.
D)The plaintiffs purchased the specific securities through a public offering and thus have a right to sue.

Question 10

Lauren hires Humphrey,a CPA,to audit her financial statements.The engagement letter includes a statement acknowledging that audited financial statements are needed for a filing with a regulatory body.Humphrey completes the audit and issues an unqualified opinion.Based on the audited financial statements,Key Largo Bank approves a loan to Lauren.Four months later,Lauren files for bankruptcy.Key Largo Bank would most likely sue Humphrey claiming:

A)It was in privity of the contract
B)It was a primary beneficiary
C)It was a foreseen party
D)It was a foreseeable party

Question 11

Auditors should not be liable to any party if they perform services that met the standards of:

A)Ordinary negligence.
B)Regulatory providence.
C)Due care.
D)Good faith.

Question 12

Third-party plaintiffs bringing action under common law need not prove

A)They were damaged or suffered an economic loss.
B)Reliance on the financial statements.
C)The financial statements were direct cause of loss.
D)Breach of contract.

Question 13

At the request of James Company's management,E.G.audited James Company's financial statements and was aware that James' management intended to deliver the financial statements to its 25 shareholders for the purpose of repurchasing their shares for $50 per share (the investors had originally purchased the shares for $5 per share).The audit was conducted in accordance with generally accepted auditing standards and the financial statements were prepared in accordance with generally accepted accounting principles.Later,the shareholders sued the auditors,claiming that if they fully realized the significance of disclosures about the market value of the assets,they could have received $75 per share from James Company.The shareholders' lawsuit will probably fail because:

A)The shareholders did not suffer a loss.
B)The shareholders were not primary beneficiaries of the audit engagement and they have no standing to sue.
C)The shareholders failed to prove lack of appropriate professional care on the part of auditors.
D)The shareholders did not rely properly on the financial statements.

Question 14

An audit failure occurs when

A)A client goes bankrupt or has serious financial difficulty.
B)Auditors fail to conduct the examination in accordance with generally accepted auditing standards,which results in the failure to identify material misstatements in the financial statements.
C)Auditors cannot collect audit fees owed to them by the client.
D)Auditors are sued by a third party.

Question 15

A principle that may reduce or eliminates auditors' liability to clients is:

A)Client's constructive negligence.
B)Client's contributory negligence.
C)Auditors' ordinary negligence.
D)Auditors' gross negligence.

Question 16

Failure to provide any level care in fulfilling a duty owed to another party,including reckless disregard for the truth,is called

A)Breach of contract.
B)Ordinary negligence.
C)Privity.
D)Constructive fraud.

Question 17

Mays bought McCovey Corp.common stock in an offering registered under the Securities Act of 1933.Hart & Co.,CPAs,gave an unqualified opinion on McCovey's financial statements that were included in the registration statement filed with the Securities and Exchange Commission.Mays sued Hart under the provisions of the 1933 Act that deal with omission of facts required to be in the registration statement.Mays must prove that:

A)There was fraudulent activity by Hart.
B)The financial statements contained a material misstatement.
C)Mays relied on Hart's opinion.
D)Mays was in privity with Hart.

Question 18

Lancaster & Co.CPAs is auditing the financial statements of Cooper Corporation.During the course of the audit,Cooper Corporation sent the following memo to the engagement partner: We have requested $1 million worth of products from Ladd Corporation with credit terms of net 30 days.Ladd has requested audited financial statements for its credit decision.We notified Ladd that our annual audit was in process and we would provide the audited financial statements to them as soon as they were completed.
Which of the following statements is true with regards to this memo?
A)The memo is an amendment to the engagement letter and makes Ladd Corporation a primary beneficiary of the audited financial statements.

A)The memo may move Ladd Corporation closer to a primary beneficiary and reposition them as third party with a standing to sue,depending on the jurisdiction of any future lawsuits
B)The memo is only a courtesy and does not alter the terms of the engagement letter or change the nature of Ladd Corporation's standing to sue.
C)The memo is an additional contract placing Ladd in privity of contract.

Question 19

Which of the following parties is most likely to recover against auditors for losses resulting from acts of ordinary negligence?

A)Third parties that auditors should have foreseen could rely on the client's financial statements.
B)The auditors' client.
C)Purchasers and sellers of securities under the Securities Exchange Act of 1934
D)Third parties whose reliance on the client's financial statements was reasonably foreseeable.

Question 20

Lauren hires Humphrey,a CPA,to audit her financial statements.The engagement letter includes a statement acknowledging that audited financial statements will be provided to Key Largo Bank for a loan.Humphrey completes the audit and issues an unqualified opinion.Based on the audited financial statements,Key Largo Bank approves the loan to Lauren.Four months later,Lauren files for bankruptcy.Key Largo Bank would most likely sue Humphrey claiming:

A)It was in privity of the contract
B)It was a primary beneficiary
C)It was a foreseen party
D)It was a foreseeable party

Question 21

Beckler & Associates,CPAs,examined and issued an unqualified opinion on the financial statements of Queen Co.The financial statements contained misstatements that resulted in a material overstatement of Queen's net worth.Queen provided the audited financial statements to Mac Bank in connection with a loan made by Mac to Queen.Beckler knew that the financial statements would be provided to Mac.Queen defaulted on the loan.Mac sued Beckler to recover for its losses associated with Queen's default.Which of the following must Mac prove in order to recover?

A)I only.
B)II only.
C)Both I and II.
D)Neither I nor II.

Question 22

In a common law action against auditors,lack of privity is a viable defense if the plaintiff

A)Is the client's creditor who sues auditors for ordinary negligence.
B)Can prove gross negligence by auditors that amounts to a reckless disregard for the truth.
C)Is the auditors' client.
D)Bases the action upon fraud.

Question 23

Under the liability provisions of section 11 of the Securities Act of 1933,auditors may be liable to any purchaser of a security for certifying materially misstated financial statements that are included in the registration statement.Under section 11,auditors usually will not be liable to the purchaser

A)If auditors can show contributory negligence on the part of the purchaser.
B)If auditors can demonstrate due diligence.
C)Unless the purchaser can prove privity with auditors.
D)Unless the purchaser can prove scienter on the part of auditors.

Question 24

While conducting an audit,Larson Associates,CPAs,failed to detect material misstatements included in its client's financial statements.Larson's unqualified opinion was included with the financial statements in a registration statement and prospectus for a public offering of securities made by the client.Larson knew that its opinion and the financial statements would be used for this purpose.Which of the following statements is correct with regard to a suit against Larson and the client by a purchaser of the securities under section 11 of the Securities Act of 1933?

A)The purchaser must prove that Larson failed to conduct the audit in accordance with generally accepted auditing standards.
B)The purchaser must prove that Larson knew of the material misstatements.
C)Larson will not be liable if it had reasonable grounds to believe the financial statements were accurate.
D)Larson will not be liable if the purchaser did not rely on the financial statements.

Question 25

The Securities Act of 1933

A)Regulates trading in securities.
B)Approves and guarantees investments.
C)Regulates the initial issuance of securities.
D)Regulates the accounting profession.

Question 26

Which of the following factors would not influence third parties' abilities to bring suit against auditors for ordinary negligence under common law?

A)The extent to which the third party relied upon the misstated financial statements and this reliance resulted in their loss.
B)The nature of activity by auditors that resulted in their failure to exercise appropriate levels of professional care.
C)The relationship between the auditors and third party.
D)The jurisdiction in which the action occurred.

Question 27

Foreseeable third parties are best described as

A)Management of the entity.
B)Those third parties that have a direct relationship with auditors through previous contract related to the audit engagement.
C)Those third parties who will rely on the audit and are specifically known by auditors.
D)Those third parties whose decisions normally rely on audited financial statements and opinions on those financial statements.

Question 28

The first significant case under section 11 of the Securities Act of 1933 charging auditors with not conducting a reasonable investigation was

A)Rusch Factors v.Levin
B)United States v.Benjamin
C)Escott v.BarChris Construction Corp.
D)Ernst & Ernst v.Hochfelder

Question 29

Which of the following statements concerning the Ultramares Corp.v.Touche case is not true?

A)This case was brought under common law liability.
B)This case provided a test to determine whether a third party qualified as a primary beneficiary and could bring suit for ordinary negligence.
C)This case established the rights of third parties to bring suits against auditors under common law liability.
D)This case concluded that auditors' liability to third parties would be generally limited to gross negligence or fraud.

Question 30

The restatement of torts is a general legal doctrine that extends liability for ordinary negligence to

A)Foreseeable third parties.
B)Foreseen third parties.
C)Primary beneficiaries.
D)All users of financial statements.

Question 31

While conducting an audit of a public entity,Wallace failed to identify material misstatements in its client's financial statements.Investors then sued Wallace in connection with this audit.Which of the following would not need to be demonstrated in order for the shareholders to successfully bring suit against Wallace?

A)Wallace was in privity with the shareholders.
B)The shareholders relied upon the materially misstated financial statements.
C)Wallace acted with gross negligence in his audit.
D)The reliance on the materially misstated financial statements caused the shareholders' losses.

Question 32

Paula performed the audit of the financial statements of Abdul Company (a nonpublic entity currently not subject to filing requirements under the Securities Act of 1933 or Securities Exchange Act of 1934).Abdul Company is currently considering several alternatives for raising capital,including seeking financing from area banks or an initial public offering of its securities.Which of the following parties would have the lowest likelihood of successfully bringing suit for ordinary negligence against Paula?

A)Abdul Company.
B)Purchasers of Abdul Company's securities in an initial public offering.
C)First State Bank,a bank with whom Abdul Company has not previously done business.
D)Simon Whitaker,a private investor who is considering acquiring Abdul Company.

Question 33

Which of the following would not need to be demonstrated by third parties bringing suit against auditors for losses sustained under the Securities Act of 1933?

A)Auditors were aware of the materially misstated financial statements.
B)Third-party purchasers suffered a loss.
C)The client's financial statements contained a material misstatement.
D)Purchasers would need to demonstrate all of the above.

Question 34

Under the liability provisions of section 11 of the Securities Act of 1933,auditors may be liable to any purchaser of securities for certifying materially misstated financial statements that are included in the registration statement.Under section 11,which of the following must be proven by a purchaser of the security?

A)Reliance on financial statements: Yes; Fraud by auditors: Yes
B)Reliance on financial statements: Yes; Fraud by auditors: No
C)Reliance on financial statements: No; Fraud by auditors: Yes
D)Reliance on financial statements: No; Fraud by auditors: No

Question 35

Typical defenses for auditors in common law actions include all of the following,except

A)The plaintiff was foreseen.
B)The plaintiff contributed to the failure to detect material misstatements.
C)The financial statements were not materially misstated.
D)The audit was conducted in accordance with generally accepted auditing standards.

Question 36

The SEC Rule 10b-5 deals with

A)Fraud in the purchase or sale of securities.
B)Penalties for willfully and knowingly violating the Securities Exchange Act of 1934.
C)The use of the "due diligence" defense to avoid liability.
D)Integrated disclosure system for annual reports.

Question 37

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

A)The plaintiff must prove damages or an economic loss.
B)The plaintiff must prove they read and relied upon the financial statements.
C)Any purchaser of securities may sue auditors.
D)The plaintiff need not prove that the materially misstated financial statements are the direct cause of the loss.

Question 38

Which of the following is not part of the definition of proportionate liability adopted by the Private Securities Litigation Reform Act?

A)The total responsibility for loss is divided among all parties responsible for the loss.
B)Defendants who knowingly committed a violation of securities laws remain jointly and severally liable.
C)The full amount of damages may be recovered from any defendants involved in the action.
D)A solvent defendant's liability may be increased by 50 percent if other defendants are insolvent.

Question 39

While conducting an audit,Larson Associates,CPAs,failed to detect material misstatements included in its client's financial statements.Larson's unqualified opinion was included with the financial statements in a registration statement and prospectus for a public offering of securities made by the client.Larson knew that its opinion and the financial statements would be used for this purpose.In a suit by a purchaser against Larson,Larson's best defense would be that the

A)Audit was conducted in accordance with generally accepted auditing standards.
B)Client was aware of the misstatements.
C)Purchaser was not in privity of contract with Larson.
D)Identity of the purchaser was not known to Larson at the time of the audit.

Question 40

According to Sarbanes-Oxley,accountants performing an audit or review must maintain all engagement documentation for a period of

A)2 years
B)3 years
C)5 years
D)7 years

Question 41

Sleek Corporation is a public corporation whose stock is traded on a national securities exchange.Sleek hired Garson Associates,CPAs,to audit Sleek's financial statements.Sleek needed the audit to obtain bank loans and to make a public stock offering so that Sleek could undertake a business expansion program.
Before the engagement,Fred Hedge,Sleek's president,told Garson's managing partner that the audited financial statements would be submitted to Sleek's banks to obtain the necessary loans.
During the course of the audit,Garson's managing partner found that Hedge and other Sleek officers had embezzled substantial amounts of money from the corporation.These embezzlements threatened Sleek's financial stability.When these findings were brought to Hedge's attention,Hedge promised that the money would be repaid and begged Garson not to disclose the embezzlements.
Hedge also told Garson's managing partner that several friends and relatives of Sleek's officers had been advised about the projected business expansion and proposed stock offering,and had purchased significant amounts of Sleek's stock based on this information.
Garson submitted an unqualified opinion on Sleek's financial statements,which did not include adjustments for or disclosures of the embezzlements and insider stock transactions.The financial statements and auditors' opinion were submitted to the banks Sleek normally does business with,including Knox Bank.Knox,relying on the financial statements and the auditors' report,loaned Sleek $2,000,000.
Sleek's audited financial statements were also included in a registration statement prepared under the provisions of the Securities Act of 1933.The registration statement was filed with the SEC in conjunction with Sleek's public offering of 100,000 shares of its common stock at $100 per share.
An SEC investigation of Sleek disclosed the embezzlements and the insider trading.Trading in Sleek's stock was suspended and Sleek defaulted on the Knox loan.As a result,the following legal actions were taken:
-Knox Bank sued Garson.
-The purchasers of Sleek's stock offering sued Garson.
Required:
a.Would Knox recover from Garson for fraud?
b.Would the purchasers of Sleek's stock offering recover from Garson
1.Under the liability provisions of section 11 of the Securities Act of 1933?
2.Under the antifraud provisions of section 10(b)and Rule 10b-5 of the Securities Exchange Act of 1934?

Question 42

Distinguish between the "due diligence" and the "causation" defenses available to auditors under section 11 of the Securities Act of 1933.

Question 43

Under the Securities Act of 1933,which of the following defenses is related to auditors performing a reasonable investigation of the financial statements?

A)Causation
B)Contributory negligence
C)Due diligence
D)Prudent auditor

Question 44

Which of the following is not a valid defense for auditors' liability to third parties for ordinary negligence under common law?

A)The loss was caused by factors other than the materially misstated financial statements
B)Lack of proper standing (relationship)to bring suit in that jurisdiction.
C)Lack of a privity relationship with auditors
D)Third parties did not rely upon the financial statements

Question 45

Which of the following is the best defense auditors can assert in a suit for common law fraud based on their unqualified opinion on materially misstated financial statements?

A)Contributory negligence on the part of the client.
B)A disclaimer contained in the engagement letter.
C)Lack of privity.
D)Lack of scienter.

Question 46

Charlie Company is headquartered in Wisconsin.Charlie Company's auditors are headquartered in Minnesota.Bob lives in Bloomington,Indiana but works in Chicago,Illinois.Based on a tip from his boss,Bob calls his stockbroker (Jim,who offices in Chicago)and instructs him to purchase 1,000 shares of Charlie Company despite never having requested or reviewed Charlie Company's financial statements.Charlie Company is traded on the New York Stock Exchange and the transaction takes place 15 minutes later on the floor of the exchange.
Charlie Company declared bankruptcy three months later and Bob lost his entire investment.Bob sued Charlie Company's auditors for ordinary negligence.
The trial is scheduled for hearing in Madison,Wisconsin.Before the opening of the trial,the attorney for the auditors objects to the trial being held in Wisconsin,since the transaction between Bob and Jim took place in Illinois.The attorney asks that the trial be moved to Illinois.
Required A.Why would the attorney ask for the trial to be moved?
B.What defense would you raise if you were the auditors' attorney?

Question 47

How does the Securities Act of 1933,which imposes civil liability on auditors for misrepresentations or omissions of material facts in a registration statement,expand auditors' liability to purchasers of securities beyond that of common law?

A)Purchasers only have to prove loss caused by reliance on audited financial statements
B)Privity with purchasers is not a necessary element of proof
C)Purchasers have to prove either fraud or gross negligence as a basis for recovery
D)Auditors are held to a standard of care described as professional skepticism

Question 48

Under the anti-fraud provisions of section 10(b)of the Securities Exchange Act of 1934,auditors may be liable if they acted

A)With ordinary negligence.
B)With independence.
C)Without due diligence.
D)Without good faith.

Question 49

What are the legal liabilities of auditors under common law?

Question 50

Which of the following elements,if present,would support a finding of constructive fraud on the part of auditors?

A)Gross negligence in conducting the engagement.
B)Ordinary negligence in conducting the engagement.
C)Failure to perform the engagement in accordance with the terms in the engagement letter.
D)Actions that demonstrated scienter.

Question 51

To be successful in a civil action under section 11 of the Securities Act of 1933 against auditors for liability for a materially misstated registration statement,the plaintiff must prove the

A)Auditors' intent to deceive: Yes; Plaintiff's reliance on the registration statement: Yes
B)Auditors' intent to deceive: Yes; Plaintiff's reliance on the registration statement: No
C)Auditors' intent to deceive: No; Plaintiff's reliance on the registration statement: Yes
D)Auditors' intent to deceive: No; Plaintiff's reliance on the registration statement: No

Question 52

Sun Corp.approved a merger plan with Cord Corp.One of the determining factors in approving the merger was the financial statements of Cord that were audited by Frank & Co.,CPAs.Sun had engaged Frank to audit Cord's financial statements.While performing the audit,Frank failed to discover certain irregularities that later caused Sun to suffer substantial losses.For Frank to be liable under common law liability,Sun at a minimum must prove that Frank

A)Knew of the irregularities.
B)Failed to exercise the appropriate level of professional care.
C)Demonstrated gross negligence.
D)Acted with scienter.

Question 53

Briefly explain the concept of proportionate liability.Why is the adoption of proportionate liability important to the accounting profession?

Question 54

Which of the following is not a reason that the Class Action Fairness Act of 2005 will benefit auditors in class action lawsuits?

A)Federal courts provide a higher level of scrutiny for class action lawsuits than state courts
B)Federal courts have more resources at their disposal for managing class action lawsuits
C)State courts may discriminate against defendants from other jurisdictions
D)Verdicts in state courts are normally more appropriate to apply to multiple jurisdictions than verdicts in federal courts