Case 01.

a. What defense should Lauren Yost & Co. use in the suit by Stuart?

Solution: I think Yost and Co. can go for the defense of maintaining auditing standards and
contributory negligence. Stuart Supply Company had committed a complex fraud which was
difficult to find out without using the procedures Yost suggested.

It is not necessary to count every inventory through physical investigation which is situated at
different locations. The president should have followed Yost's suggestion. He has committed
fraud by not following the suggestions. Yost can use his signed statement as evidence.

b. What defense should Lauren Yost & Co. use in the suit by First City National Bank?

Solution: Yost can use Lack of Privity of Contract as a defense in the suit by First City National
Bank. Even though the bank was a known third party, it does not mean that there is any duty to
that party in this complex circumstance.

Another defense Yost can use is that the firm followed every auditing standards in the audit of
inventory, including the employment. As the firm did not discover the fraud that does not
conclude it has responsibility as a CPA firm is unlikely find out such an problem in the course of
an ordinary audit.

c. Is Yost likely to be successful in her defenses?

Solution: Yost is likely to be successful in her defense against the client because of the
contributory negligence. The company is responsible for practicing internal controls. The
president's statement indicates that it was impractical to count all inventories on the same day
and this puts burden on the company for its loss.

It is also unlikely that First City National Bank will be successful in suit. The court is likely to
conclude that Yost followed due care in the performance of her work. The fact that there was
not a count of all inventories on the same date is unlikely to be sufficient for a successful suit.

d. Would the issues or outcome be significantly different if the suit was brought under the
Securities Exchange Act of 1934?

Solution: The issues and outcomes should be essentially the same under the suit brought under
the Securities Exchange Act of 1934. If the suit were brought under Rule 10b-5, it is certainly
unlikely that the plaintiff would be successful because there was no intention to deceive. The
plaintiff would likely be unsuccessful in such a suit.
Case 02:

Will the CPA firm be liable to the creditors who extended the money because of their reliance
on the erroneous financial statements if Newell Corporation should fail to pay them?
Explain.*

Solution: The CPA firm be liable to the creditors who extended the money because of their
reliance on the erroneous financial statements.

A CPA firm will not be liable to third parties for whose benefit its work was performed. One
exceptional rule is fraud. When the financial statements were fraudulently prepared, liability
goes to third parties who used the false information. Fraud can be actual or constructive. In this
case, there was no deliberate falsehood made with the intent to deceive on the part of Small or
the firm. However, it would appear that constructive fraud might be present. Constructive fraud
is found where the auditor's performance is found to be grossly negligent. Small's disregard for
standard auditing procedures would seem to indicate such gross negligence that’s why the firm
is liable to third parties who relied on the financial statements and suffered loss.

Case 03:

a. If Thompson alleges and proves negligence on the part of Doyle and Jensen, she will be
able to recover her loss.

Solution: False. There was no privity of contract between Thompson, Doyle and Jensen,
therefore, ordinary negligence will usually not be sufficient for a recovery.

b. If Thompson alleges and proves constructive fraud (that is, gross negligence on the part of
Doyle and Jensen), she will be able to recover her loss.

Solution: True. If gross negligence is proven, firm will be held liable for losses to third parties.

c. Thompson does not have a contract with Doyle and Jensen.

Solution: True. There was no privity of contract between Thompso, Doyle and Jensen.

d. Unless actual fraud on part of Doyle and Jensen can be shown, Thompson cannot recover.

Solution: False. Gross negligence is actual fraud to determine who may recover from the CPA.

e. Thompson is a third party beneficiary of the contract Doyle and Jensen made with
Regal Jewelry.

Solution: False. Thompson is an unknown third party who will be able to recover damages only
in the case of gross negligence or fraud.
Case 04:
a. Discuss whether you believe Hanover will be found liable to the purchasers of common
stock.

Solution: I don’t believe Hanover is likely to be found liable to the purchasers of the common
stock because there was no knowledge or intent to deceive by the auditor. However, if the
purchasers are original purchasers and are able to bring suit under the Securities Act of 1933,
the plaintiffs will likely succeed because they must only prove the existence of a material error
or omission.

b. Indicate whether you believe First National Bank will be successful in its claim against
Hanover.

Solution: I believe First National Bank will be successful in its claim against Hanover because
Hanover was aware that the financial statements were to be used to obtain financing from the
bank. The audit company is likely to be held responsible for negligence to the bank as a known
third party that relied on the financial statements.

c. Indicate whether you believe the trade creditors will be successful in their claim against
Hanover.*

Solution: I don’t believe the trade creditors will be successful in their claim against Hanover.
Hanover will likely be found not liable to the trade creditors since Hanover was unaware that
the statements would be used by the creditors. They cannot claim gross negligence on the part
of Hanover.

Case 05:

a. Is Chen liable to the bank?

Solution: Chen is definitely liable to the bank because Chen was a direct party to the issuance of
false financial statements. There was material misstatement of fact, knowledge of falsity, intent
that the bank relies on the false statement, actual reliance, and damage to the bank.

Moreover, if the action by the bank is based upon ordinary negligence, the bank may recover as
a third-party beneficiary because it is a primary beneficiary. So the bank will be able to recover
its loss from Smith under either theory.
b. Is Chen liable to the lessor?

Solution: Chen is not liable to the lessor as the lessor was a party to a secret agreement. The
lessor cannot claim based on the financial statements and cannot recover uncollected rents.
Even if the lessor was damaged indirectly, his or her own fraudulent actions led to the loss
which excludes the lessor from obtaining relief.

So Chen is not liable to the lessor for any financial claims.

c. Is there potential for criminal action against Chen?

Solution: There is potential for criminal action against Chen because Chen knew that the
financial statements did not follow generally accepted accounting principles. He willingly
prepared an unqualified report which falls under criminal act because there was a clear
intention to deceive the other party.