Deck 20: Legal Liability Cases

Question 1

During a review engagement, CPA discovers that the gross margin has increased by 20% over the last few years. To avoid potential liability due to possibly misstated financial statements, what should CPA do?

A) Correct the gross margin to be consistent with prior years.
B) Obtain additional information to correct or substantiate the figures.
C) No additional work is required for review engagements.
D) Downgrade the assignment to a compilation engagement.

Answer 1

B

Question 2

When referring to public accountants, what does breach of contract mean?

A) A lawsuit involving a client and an auditor.
B) Services were not performed as agreed.
C) Auditor bills clients for extra services.
D) There is no engagement letter signed by the client.

Answer 2

B

Question 3

An important case that limits the auditor's liability to those third parties of which the auditor had knowledge was ________.

A) Dupuis v. Pan American Mines
B) Hedley Byrne & Co. Ltd. v. Heller & Partners Ltd.
C) Caparo Industries PLC.v. Dickman et al.
D) Haig v. Bamford et al.

Answer 3

C

Question 4

While conducting an audit, Larson Associates CPAs failed to detect a material misstatement 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 for common law negligence, Larson's best defence 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 5

Third-party plaintiffs bringing action under common law need NOT prove ________.

A) they were damaged or suffered a loss
B) reliance on the financial statements
C) the financial statements were direct cause of loss
D) breach of contract

Question 6

In a common law action against an accountant, lack of privity is a viable defence if the plaintiff ________.

A) is the client's creditor who sues the accountant for negligence
B) can prove the presence of gross negligence that amounts to a reckless disregard for the truth
C) is the accountant's client
D) bases the action upon fraud

Question 7

A company whose partners' liability is limited to the capital they have invested in the business is known as a ________.

A) partnership
B) corporation
C) proprietorship
D) limited liability partnership

Question 8

Foreseeable third parties are best described as ________.

A) management of the company
B) those that have direct involvement through a contract
C) those third parties who will rely on the audit and are specifically known by the auditor
D) those third parties who potentially will rely on the audit but are not specifically known by the auditor

Question 9

Under common law, which of the following statements most accurately reflects the liability of a CPA who gives a fraudulent opinion on an audit of a client's financial statements?

A) The CPA is liable only to third parties who are in privity of contract with the CPA.
B) The CPA is liable only to known users of the financial statements.
C) The CPA probably is liable to any person who suffered a loss as a result of the fraud.
D) The CPA probably is liable to the client even if the client was aware of the fraud and did not rely on the opinion.

Question 10

When an auditor is found guilty of a fraudulent misrepresentation, there is liability owed to ________.

A) third parties with privity and contracted parties
B) any party that suffered a loss
C) shareholders only
D) all parties with privity

Question 11

While conducting an audit, Larson & Larson Chartered Professional Accountants failed to detect a material misstatement in its client's financial statements. Larson's unqualified opinion was included with the financial statements in a 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?

A) The purchaser must prove that Larson was negligent in conducting the audit.
B) The purchaser must prove that Larson knew of the material misstatements.
C) Larson will not be liable if they had reasonable grounds to believe the financial statements were accurate.
D) Larson will be liable unless the purchaser did not rely on the financial statements.

Question 12

Which of the following is NOT an element of a successful negligence action against auditors?

A) There must be proof that damage resulted.
B) The plaintiff must be a known user of the financial statements.
C) There must be a legal duty of care to the plaintiff.
D) There must be a reasonable connection between the breach of duty of care and resulting losses.

Question 13

The lessons for accountants that are inherent in the 1136 Tenants' Corporation v. Rothenberg & Co. case include all of the following EXCEPT which one?

A) Engagement letters are as essential for accounting engagements as they are for audit engagements.
B) Regardless of the nature of the engagement, a public accountant should be alert for and should follow up on any unusual items such as missing invoices.
C) Accountants should clearly communicate the extent of their association with financial information.
D) Public accountants cannot be held liable to third parties in non-audit or review engagements.

Question 14

Under the common law, in a lawsuit concerning auditor liability, the primary beneficiary is _______.

A) the recipient of funds when someone dies
B) a party for whose benefit the audit or service is being performed
C) the client
D) the shareholders of the company

Question 15

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

A) Gross negligence in applying generally accepted auditing standards.
B) Ordinary negligence in applying generally accepted accounting principles.
C) Identified third-party users.
D) Scienter.

Question 16

Sun Corp. approved a merger plan with Cord Corp. One of the factors that led to the approval of the merger was the fact that the Cord's financial statements 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 the lawsuit to be successful, Sun must prove that Frank & Co., CPAs ________.

A) knew of the irregularities
B) failed to exercise due care
C) was grossly negligent
D) acted with scienter

Question 17

Beckler & Associates CPAs issued an unqualified opinion on the financial statements of Queen Ltd. 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 the losses associated with Queen's default. Which of the following must Mac prove in order to recover? I. Beckler was negligent in conducting the audit.
II) Mac relied on the financial statements.

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

Question 18

Which of the following statements represents an audit failure?

A) A client goes bankrupt or has serious financial difficulty.
B) An auditor failed to conduct an audit in accordance with GAAS.
C) An auditor cannot collect the audit fees from the client.
D) An auditor is sued by a third party.

Question 19

A CPA may be liable to any purchaser of a security if the CPA issued a clean opinion on materially misstated financial statements. The CPA usually will not be liable to the purchaser ________.

A) if the purchaser is guilty of contributory negligence
B) if the CPA can prove due care in the audit
C) unless the purchaser can prove privity with the CPA
D) unless the purchaser can prove scienter on the part of the CPA

Question 20

To protect themselves, before an engagement letter is submitted to a client, what should an auditor complete to assist in deciding whether to accept a particular client for an engagement?

A) Management letter.
B) Client acceptance checklist.
C) Reliance letter.
D) Limited liability letter.

Question 21

Under common law, a plaintiff who is owed a legal duty of care must prove reliance on misleading statements and damages suffered because of that reliance.

Question 22

A plaintiff, who is a normal trade creditor, can collect damages under common law for negligence from the corporation's auditors.

Question 23

In a common law action against an accountant, all that a plaintiff must prove is that the accountant was negligent, grossly negligent, fraudulent, or otherwise responsible for the damages claimed.

Question 24

The Securities and Exchange Commission in the United States will hold a negligent auditor liable under common law.

Question 25

If a professional accountant is able to reasonably foresee a limited class of potential users for his or her work, liability may then be imposed for ________.

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

Question 26

The OSC in Canada has powers to decide what is GAAP, similar to the SEC in the United States.

Question 27

A defendant accountant will likely first try to argue that it had no privity relationship with the plaintiff.

Question 28

Due professional care occurs when an auditor observes all the rules of conduct for the profession and applies all the standards of the profession.

Question 29

Due professional care implies that the practitioner is conducting his or her work to the highest possible standard and will make no errors.

Question 30

Accountants are liable under the common law for breach of contract if they fail to fulfill their contractual obligations with their clients and for negligence if they fail to exercise due care in the performance of services for their clients

Question 31

Constructive fraud is characterized by an intentional act designed to deceive, mislead or injure the rights of another person.

Question 32

A relationship of direct involvement between parties to a contract is known as privity

Question 33

Auditors are increasingly obligated to report illegal acts to third parties outside the company in which they occurred.

Question 34

Even in a review engagement, the accountant cannot merely accept client-supplied information that appears to be false or misleading.

Question 35

Accountants are not liable for misstatements in compilation or review engagements.

Question 36

A breach of contract suit is a claim that could be brought by a client against an accountant that accounting services were not performed in the manner agreed upon.

Question 37

Primary beneficiaries are third parties who have paid to have an audit performed.

Question 38

Joint and several liability is a doctrine that allows a successful plaintiff to recover the full amount of damage award from the defendants who have money or insurance.

Question 39

A reasonably foreseeable third party would include current shareholders but not lenders.

Question 40

In the London v.General Bank (1895) case, it was held that the auditor takes complete responsibility for detecting fraud in a set of financial statements they are auditing.

Question 41

Some people argue that there is a legal liability crisis for auditors in Canada. Do you agree or disagree? Provide some evidence supporting this argument, and some evidence contradicting this argument.

Question 42

In contrast to its concern for the quality of accounting principles, the SEC's involvement in auditing standards and procedural matters has been minimal since the developments of the McKesson and Robbins affair.

Question 43

What is privity?

Question 44

Sleek Corporation is a public corporation whose stock is traded on several provincial securities exchanges. Sleek engaged Garson & Garson CPAs to audit Sleek's financial statements. Sleek was planning a business expansion program and needed the audit in order to obtain financing through borrowing and making a public stock offering.
Before the engagement began, Fred Hedge, the president of Sleek, 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 that the auditor not disclose the fraud. 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 about the embezzlements and insider stock transactions. The financial statements and audit report were submitted to Sleek's regular banks including Knox Bank. Knox, relying on the financial statements and Garson's report, gave Sleek a $2,000,000 loan. Sleek's audited financial statements were also incorporated into a prospectus. The prospectus filed by Sleek with the OSC offered 100,000 shares of its common stock at $100 per share. An OSC 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:
1. Knox sued Garson.
2. The general public purchasers of Sleek's stock offering sued Garson.
Required:
A. Knox would recover from Garson for fraud. The elements of fraud are:
a. the misrepresentation of a material fact Garson issued an unqualified opinion on misleading financial statements. Garson's opinion did not include adjustments for or disclosures about the embezzlements and insider stock trading.
b. a loss was sustained
c. by Knox as a direct result of Sleek's default on the loan.
A. Would Knox recover from Garson for fraud?
B. The general public purchasers of Sleek's stock offerings would recover from Garson for the same reasons.
a. Under the facts presented, Garson could not establish a due diligence defence because they knew that the prospectus failed to disclose material facts. Garson's knowledge that the prospectus failed to disclose a material fact, such as the insider trading and the embezzlements, is considered a fraudulent action. The omission was material.
b. Garson's action was intentional or, at a minimum, a result of gross negligence or recklessness (scienter).
c. These purchasers relied on Garson's opinion on the financial statements and incurred a loss.
B. Would the general public purchasers of Sleek's stock offerings recover from Garson?

Question 45

What are the legal liabilities of professional accountants under the common law?

Question 46

Negligence is the failure to perform a duty with the requisite standard of care. What are the four elements of negligence and what would be an auditor's defence against them?

Question 47

Who would be considered a reasonably foreseeable third party for an auditor?

Question 48

What is a primary beneficiary?

Question 49

The United States was the first nation to make it illegal to bribe foreign officials. This was implemented through the landmark Foreign Corrupt Practices Act of 1977 (FCPA).