CHAPTER 20

MULTIPLE CHOICE

c 1. Which of the following best describes a trend in litigation involving CPAs?

a. A CPA cannot render an opinion on a company unless the CPA has audited all affiliates of that
company.
b. A CPA may successfully assert as a defense that the CPA had no motive to be part of a fraud.
c. A CPA may be exposed to criminal as well as civil liability.
d. A CPA is primarily responsible for a client's footnotes in an annual report filed with the SEC.
(AICPA ADAPTED)

c 2. As a consequence of failure to adhere to generally accepted auditing standards in the course of an

audit 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. No liability since the ordinary examination cannot be relied on to detect defalcations.
b. No liability because privity of contract is lacking.
c. Liable for losses attributable to her or his negligence.
d. Liable only if it could be proved that he or she was grossly negligent. (AICPA ADAPTED)

b 3. The Apex Surety Company wrote a general fidelity bond covering defalcations by the employees
of Watson, Inc. Thereafter, Grand, an employee of Watson, embezzled $18,999 of company
funds. When his activities were discovered, Apex paid Watson the full amount in accordance
with the terms of the fidelity bond and then sought recovery against Watson's auditors, Kane &
Dobbs, CPAs. Which of the following would be Kane & Dobbs' best defense?
a. Apex is not in privity of contract.
b. The shortages were the result of clever forgeries and collusive fraud that would not be detected by
an examination made in accordance with generally accepted auditing standards.
c. Kane & Dobbs were not guilty of either gross negligence or fraud.
d. Kane & Dobbs were not aware of the Apex-Watson surety relationship. (AICPA ADAPTED)

b 4. Martin Corporation orally engaged Humm & Dawson to audit its year-end financial statements.
The engagement was to be completed within two months after the close of Martin's fiscal year for
a fixed fee of $2,500. Under these circumstances, what obligation is assumed by Humm &
Dawson?
a. None. The contract is unenforceable since it is not in writing.
b. An implied promise to exercise reasonable standards of competence and care.
c. An implied obligation to take extraordinary steps to discover all defalcations.
d. The obligation of an insurer of its work, which is liable without fault. (AICPA ADAPTED)

a 5. One of the most significant aspects of the Continental Vending case was that it
a. Created a more general awareness of the auditor's exposure to criminal prosecution.
b. Extended the auditor's responsibility for financial statements of subsidiaries.
c. Extended the auditor's responsibility for events after the end of the audit period.
d. Defined the auditor's common-law responsibilities to third parties. (AICPA ADAPTED)

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b 6. The 1136 Tenants case was chiefly important because of its emphasis on the legal liability of the
CPA when
a. Performing a review of financial statements.
b. An engagement letter is not obtained.
c. An audit results in a disclaimer of opinion.
d. Preparing letters for underwriters. (AICPA ADAPTED)

d 7. In which of the following statements about a public accounting firm's action is scienter or its
equivalent absent?
a. Reckless disregard for the truth.
b. Actual knowledge of fraud.
c. Intent to gain monetarily by concealing fraud.
d. Performance of substandard auditing procedures. (AICPA ADAPTED)

c 8. Doe and Co., CPAs, issued an unqualified opinion on the 2005 financial statements of Marx
Corp. These financial statements were included in Marx's annual report and form 10K filed with
the SEC. Doe did not detect material misstatements in the financial statements as a result of
negligence in the performance of the audit. Based on the financial statements, Fitch purchased
stock in Marx. Shortly thereafter, Marx became insolvent, causing the price of the stock to
decline drastically. Fitch has commenced legal action against Doe for damages based on Section
10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. Doe's best defense to such an
action would be that
a. Fitch lacks privity to sue.
b. The engagement letter specifically disclaimed all liability to third parties.
c. There is no proof of scienter.
d. There has been no subsequent sale for which a loss can be computed. (AICPA ADAPTED)

b 9. Hall purchased bonds for Eon Corp. in a public offering subject to the Securities Act of 1933.
Kosson and Co., CPAs, rendered an unqualified opinion on Eon's financial statements, which
were included in Eon's registration statement. Kosson is being sued by Hall based on
misstatements contained in the financial statements. In order to be successful, Hall must prove
materiality of Kosson's

Damages Misstatement Scienter

a. Yes Yes Yes
b. Yes Yes No
c. Yes No No
d. No Yes Yes (AICPA ADAPTED)

b 10. Lewis & Clark, CPAs, rendered an unqualified opinion on the financial statements of a company
that sold common stock in a public offering subject to the Securities Act of 1933. Based on a
false statement in the financial statements, Lewis & Clark are being sued by an investor who
purchased shares of this public offering. Which of the following represents a viable defense?
a. The investor has not met the burden of proving fraud or negligence by Lewis & Clark.
b. The investor did not actually rely on the false statement.
c. Detection of the false statement by Lewis & Clark occurred after their examination date.
d. The false statement is immaterial in the overall context of the financial statements.
(AICPA ADAPTED)

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c 11. Gibson is suing Simpson & Sloan, CPAs, to recover losses incurred in connection with Gibson's
transactions in Zebra Corporation securities. Zebra's Annual Form 10-K Report contained
material false and misleading statements in the financial statements audited by Simpson & Sloan.
To recover under the Securities and Exchange Act of 1934, Gibson must, among other things,
establish that
a. All of his past transactions in Zebra securities, both before and after the auditors' report date,
resulted in net losses.
b. The transaction in Zebra securities that resulted in a loss occurred within 90 days of the auditors'
report date.
c. He relied on the financial statements in his decision to purchase or sell Zebra securities.
d. The market price of the stock dropped significantly after Zebra issued corrected financial
statements. (AICPA ADAPTED)

b 12. Humm & Dawson had been engaged to audit the Martin Corporation's financial statements.
Although an engagement letter was not prepared, Martin agreed orally to a fixed fee of $2,500.
Which of the following best describes the obligation assumed by Humm & Dawson?
a. None; the agreement is not in writing.
b. An implied promise to exercise due care.
c. An implied obligation to detect all fraud.
d. An implied obligation to detect all illegal acts. (AICPA ADAPTED)

d 13. Winslow Manufacturing, Inc. sought a $200,000 loan from National Lending Corporation.
National Lending insisted that audited financial statements be submitted before granting credit.
Winslow agreed. An audit was performed by an independent auditor who submitted an audit
report to Winslow that was to be used solely for the purpose of negotiating a loan from National.
National, upon reading the audited financial statements, decided in good faith not to extend the
credit desired. Certain ratios, used routinely by National in reaching credit decisions, were judged
insufficient. Winslow used copies of the audited financial statements to obtain credit elsewhere.
Despite complying with generally accepted auditing standards, the independent auditor failed to
discover a sophisticated embezzlement scheme perpetrated by Winslow's chief financial officer.
The auditor is liable to
a. Third parties who relied on the audited financial statements to extend credit.
b. Winslow to repay the audit fee because National did not extend credit.
c. Winslow for any losses Winslow suffered as a result of failing to discover the embezzlement.
d. None of the parties. (AICPA ADAPTED)

b 14. Which of the following ultimately determines the specific audit procedures necessary to provide
an independent auditor with a reasonable basis for the expression of an opinion?
a. The audit program.
b. The auditor's judgment.
c. Generally accepted auditing standards.
d. The auditor's working papers. (AICPA ADAPTED)

b 15. An auditor who believes that a material irregularity may exist should initially
a. Discuss the matter with those believed to be involved in the perpetration of the material
irregularity.
b. Discuss the matter with a higher level of management.
c. Withdraw from the engagement.
d. Consult legal counsel. (AICPA ADAPTED)

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c 16. Which of the following, if material, would be an irregularity?
a. Mistakes in the application of accounting principles.
b. Clerical mistakes in the accounting data underlying the financial statements.
c. Misappropriation of an asset or groups of assets.
d. Misinterpretations of facts that existed when the financial statements were prepared.
(AICPA ADAPTED)

d 17. When unable to determine the amounts associated with certain illegal acts committed by a client,
the auditor would most likely issue
a. A review opinion with a separate explanatory paragraph.
b. Only an adverse opinion.
c. Either a qualified opinion or an adverse opinion.
d. Either a qualified opinion or a disclaimer of opinion. (AICPA ADAPTED)

c 18. The auditor is most likely to presume that a high risk of irregularities exists if
a. The client is a multinational company that does business in numerous foreign countries.
b. The client does business with several related parties.
c. Inadequate segregation of duties places an employee in a position to perpetrate and conceal thefts.
d. Inadequate employee training results in lengthy EDP exception reports each month.
(AICPA ADAPTED)

a 19. An auditor who finds that the client has committed an illegal act would be most likely to
withdraw from the engagement when the
a. Illegal act affects the auditor's ability to rely on management representations.
b. Illegal act has material financial statement implications.
c. Illegal act has received widespread publicity.
d. Auditor cannot reasonably estimate the effect of the illegal act on the financial statements.
(AICPA ADAPTED)

c 20. The Foreign Corrupt Practices Act requires that

a. Auditors engaged to examine the financial statements of publicly held companies report all illegal
payments to the SEC.
b. Privately held companies devise and maintain an adequate internal control structure.
c. Publicly held companies devise and maintain an adequate internal control structure.
d. U.S. firms doing business abroad report sizable payments to non-U.S. citizens to the Justice
Department. (AICPA ADAPTED)

a 21. Donalds & Company, CPAs, audited the financial statements included in the annual report
submitted by Markum Industries, Inc. to the Securities and Exchange Commission. The audit was
deficient in several respects. Markum is now insolvent and unable to satisfy shareholders' claims.
The shareholders have taken legal action against Donalds under Section 10b and Rule 10b-5 of
the Securities Exchange Act of 1934. Which of the following is Donalds' best defense?
a. Donalds did not intend to deceive, manipulate, or defraud Markum's shareholders.
b. Section 10b does not apply.
c. Donalds was not in privity to the shareholders.
d. The engagement letter specifically disclaimed liability to any third party. (AICPA ADAPTED)

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a 22. A third party sues a public accounting firm for negligence under common law on the basis of
materially false financial statements. Which of the following is the firm's defense?
a. Lack of privity.
b. Lack of reliance.
c. Lack of intent.
d. Contributory negligence. (AICPA ADAPTED)

c 23. Purchasers of securities have brought suit against an independent auditor under the Securities Act
of 1933. The firm will prevail in the suit, even though the firm issued an unqualified opinion on
materially misstated financial statements, if
a. The firm was unaware of the material misstatements.
b. The purchasers had no direct dealings with the auditor.
c. The firm can show that the purchasers did not rely on the financial statements.
d. The firm can show that there was no intent to deceive or manipulate the purchasers.
(AICPA ADAPTED)

a 24. When seeking to recover stock market losses from a public accounting firm on the basis of an
unqualified opinion that accompanied a registration statement, an investor must establish that
a. The audited financial statements were materially misstated.
b. He or she relied on the financial statements.
c. The firm did not act in good faith.
d. If the firm had exercised due care, the material misstatement would have been discovered.
(AICPA ADAPTED)

c 25. An auditor is subject to criminal liability if he or she

a. Refuses to return a client's working papers.
b. Performs an audit negligently.
c. Willfully omits a material fact required to be stated in a registration statement.
d. Willfully breaches a contract with a client. (AICPA ADAPTED)

a 26. If an independent auditor believes that material errors or fraud exist, he or she should
a. Consider the implications and discuss the matter with appropriate levels of management.
b. Make the investigation necessary to determine whether the errors or fraud have, in fact, occurred.
c. Request that management investigate whether the errors or fraud have, in fact, occurred.
d. Consider whether the errors or fraud were the result of a failure by employees to comply with
existing internal controls. (AICPA ADAPTED)

d 27. With respect to errors and fraud, which of the following should be part of an auditor's planning of
the audit engagement?
a. Plan to search for errors or fraud that would have a material or immaterial effect on the financial
statements.
b. Plan to discover errors or fraud that are either material or immaterial.
c. Plan to discover errors or fraud that are material.
d. Plan to consider factors affecting the risk of material misstatement both at the financial
statement and the account balance level. (AICPA ADAPTED)

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d 28. An audit conducted in accordance with generally accepted auditing standards generally should
a. Be expected to provide assurance that illegal acts will be detected when internal control is
effective.
b. Be relied on to disclose violations of truth in lending laws.
c. Include a plan to actively search for illegal acts.
d. Not be relied on to provide assurance that illegal acts will be detected. (AICPA ADAPTED)

c 29. If an auditor believes a client may have committed illegal acts, which of the following actions
should the auditor take?
a. Consult with the client's counsel and the auditor's counsel to determine how the suspected illegal
acts will be communicated to stockholders.
b. Extend auditing procedures to determine whether the suspected illegal acts have a material effect
on the financial statements.
c. Make inquiries of the client's management and obtain an understanding of the circumstances
underlying the acts and of other evidence to determine the effects of the acts on the financial
statements.
d. Notify each member of the audit committee of the board of directors about nature of the acts and
request that they advise an approach to be taken by the auditor. (AICPA ADAPTED)

d 30. If an illegal act is discovered during the audit of a publicly held company, the auditor should
a. Notify the regulatory authorities.
b. Determine who was responsible for the act.
c. Modify the extent of auditing procedures.
d. Report the act to high-level personnel within the client's organization. (AICPA ADAPTED)

d 31. An audit client's board of directors and audit committee refused to take action about an
immaterial illegal act that was brought to their attention by the auditor. Because of their failure to
act, the auditor withdrew from the engagement. The auditor's decision to withdraw was primarily
due to doubts concerning
a. Inadequate financial statement disclosures.
b. Compliance with the Foreign Corrupt Practices Act.
c. Scope limitations resulting from the inaction.
d. Reliance on management's representations. (AICPA ADAPTED)

b 32. Which of the following statements correctly describes the unlawful influence provision of the
Foreign Corrupt Practices Act? The Act applies
a. Only to multinational corporations.
b. To all domestic corporations engaged in interstate commerce.
c. To corporations whose securities are registered under the Securities Exchange Act of 1934.
d. To corporations engaged in foreign commerce. (AICPA ADAPTED)

SHORT ANSWER

1. Compare and contrast common law with statutory law.

Answer:
The source of common law is the written opinions of prior courts within a state (legal precedent),
each state having its own common law. Common law is based in the doctrine of stare decisis,
which is the handing down precedent-setting principles of law to succeeding cases.

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 Statutory law refers to written statutes established by Congress at the federal level and by state
legislatures at the state level. Federal (and state) courts are bound by federal (state) statutes,
unless the statue violates the U.S. (state) constitution.

2. Under common law, clients may bring action against an auditor for breach of contract or for tort.
Explain these two violations of common law.

Answer:
Clients may sue for breach of contract because clients are parties (they are in privity) to an
express or implied contract for audit services. Suits for breach of contract usually allege that an
auditor violated either GAAS or the auditorclient confidential relationship.
A tort is a wrongful act, other than breach of contract, which results in injury to another person.
Suits in tort usually allege negligence, gross negligence, or fraud.

3. Explain the difference between (a) primary beneficiaries, (b) foreseen third parties,
(c) foreseeable third parties.

Answer:
Primary beneficiaries are specifically identified to auditors as the beneficiaries of audit services
the auditor would not have been engaged were it not for the primary beneficiary.
Foreseen third parties are not specifically identified as beneficiaries of audit services, although
the auditor knows their general identity and specific purpose of an audit report.
Foreseeable third parties are parties who have a reasonable need to rely on an entitys financial
statements but, because theyre the furthest removed from a contractual agreement for audit
services, generally enjoy the least favorable position in auditor liability cases.

4. Compare ordinary negligence, gross negligence, and fraud as it pertains to the audit process.

Answer:
Ordinary negligence means a lack of reasonable care when performing services, such as a
departure from one of the generally accepted auditing standards. When used alone, the term
negligence is generally understood to mean ordinary negligence.
Gross negligence is a lack of even minimum care when performing services, such as a reckless
departure from GAAS.
Fraud is an intentional misstatement or omission of a material fact or a theft that results in
another party being deceived and then injured. The operative word is intentional.

5. The extent of an independent auditors liability under either common or statutory law rests on
four essential points. Name and describe the four essential points.

Answer:
The plaintiff sustained a damage or loss.
The audited financial statements were materially misstated.
The plaintiff relied on the financial statements.
The auditors conduct was deficient.

PROBLEMS

1. Complete the chart below illustrating the minimum basis for potential auditor liability and the
burden of proof placed upon the plaintiff as it pertains to specified Securities acts and rules.

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 Plaintiff/Act/Rules
Under 1933 Act Section 11:
Security Purchaser
Under 1934 Act Section
10(b): Rule 10b-5:
Security Purchaser or
Seller
Under 1934 Act Section 18:
Security Purchaser or
Seller
Answer:
Plaintiff/Act/Rules Minimum Basis For
Under 1933 Act Section 11:
Security Purchaser Ordinary Negligence
Under 1934 Act Section
10(b): Rule 10b-5: Gross Negligence or Fraud
Security Purchaser or
Seller
Under 1934 Act Section 18:
Security Purchaser or
Seller
Minimum Basis For Describe The
Potential Auditor Burden of Proof
Liability Placed Upon Plaintiff
Describe The
Potential Auditor Burden of Proof
Liability Placed Upon Plaintiff
Damage or loss
Financial statements
misstated or erroneous
advice
Damage or loss
Financial statements
misstated or erroneous
advice
Reliance
Auditor conduct deficient
Damage or loss
Gross Negligence Financial statements
misstated or erroneous
advice
Reliance
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2. Complete the chart below illustrating the minimum basis for potential auditor liability and the
burden of proof placed upon the defendant as it pertains to specified Securities acts and rules.

Plaintiff/Act/Rules Minimum Basis For Describe The

Potential Auditor Burden of Proof
Liability Placed Upon Defendant

Under 1933 Act Section 11:

Security Purchaser

Under 1934 Act Section

10(b): Rule 10b-5:
Security Purchaser or
Seller

Under 1934 Act Section 18:

Security Purchaser or
Seller

Answer:

Plaintiff/Act/Rules Minimum Basis For Describe The

Potential Auditor Burden of Proof
Liability Placed Upon Defendant

Under 1933 Act Section 11: Lack of reliance or auditor

Security Purchaser Ordinary Negligence conduct not deficient (due
diligence)

Under 1934 Act Section

10(b): Rule 10b-5: Gross Negligence or Fraud No defendant
Security Purchaser or burden of proof
Seller

Under 1934 Act Section 18: Auditor conduct not

Security Purchaser or Gross Negligence deficient (due diligence)
Seller

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