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Auditing and Assurance Services, 15e (Arens)

Chapter 5 Legal Liability


Learning Objective 5-1
1) 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.
nswer! "ajor factors include!
# $he growing awareness of the responsibilities of public accountants b% users of financial
statements.
# n increased consciousness on the part of the &ecurities and '(change )ommission
regarding its responsibilit% for protecting investors* interests.
# $he comple(it% of auditing and accounting functions caused b% the increasing size of
businesses+ the globalization of business+ and the comple(ities of business operations.
# Large civil court judgments against ), firms.
# $he tendenc% of societ% to accept lawsuits b% injured parties against an%one who might be
able to provide compensation+ regardless of who was at fault+ coupled with joint and several
liabilit% doctrine.
# $he willingness of ), firms to settle legal problems out of court to avoid costl% legal fees
and adverse publicit%+ rather than pursuing resolution through the judicial process.
# $he difficult% judges and jurors have understanding and interpreting technical accounting and
auditing matters.
# $he global recession and tough economic times result in business failures+ which prompt
sta-eholders to see- restitution from others+ including e(ternal auditors.
$erms! "ajor factors that have contributed to the recent increase in the number of lawsuits
against auditors
Diff! "oderate
Objective! LO 5-1
)&.! /eflective thin-ing s-ills
Learning Objective 5-0
1) 1n) 22222222 failure occurs when an auditor issues an erroneous opinion because it failed to
compl% with re3uirements of auditing standards.
) business
.) audit
)) ethics
D) process
nswer! .
$erms! 4ailure which occurs when an auditor issues an erroneous opinion
Diff! 'as%
Objective! LO 5-0
)&.! /eflective thin-ing s-ills
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0) $he e(pectation gap!
) e(ists between the auditor and the &').
.) e(ists because auditors guarantee the accurac% of the financial statements.
)) often results in unwarranted lawsuits against the auditor.
D) is a legal concept supported b% the federal courts.
nswer! )
$erms! '(pectation gap
Diff! "oderate
Objective! LO 5-0
)&.! /eflective thin-ing s-ills
9) Distinguish between what is meant b% business failure and audit failure.
nswer! .usiness failure occurs when a business is unable to repa% its lenders or meet
e(pectations of its investors because of economic or business conditions+ such as recession+ poor
management decisions+ or une(pected competition in the industr%. udit failure occurs when the
auditor issues an incorrect audit opinion because it failed to compl% with the re3uirements of
auditing standards.
$erms! .usiness failure and audit failure
Diff! 'as%
Objective! LO 5-0
)&.! /eflective thin-ing s-ills
7) udit ris- is the ris- there will be an audit failure for a given audit engagement.
) $rue
.) 4alse
nswer! .
$erms! udit ris-
Diff! "oderate
Objective! LO 5-0
)&.! /eflective thin-ing s-ills
5) $he term :audit failure: refers to the situation when the auditor has followed auditing
standards %et still fails to discover that the client*s financial statements are materiall% misstated.
) $rue
.) 4alse
nswer! .
$erms! udit failure; 4ollowed audit standards and fail to discover material misstatement
Diff! "oderate
Objective! LO 5-0
)&.! /eflective thin-ing s-ills
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Learning Objective 5-9
1) 8n the performance of an audit+ a ),!
) is legall% liable for detecting an immaterial client fraud.
.) must strictl% follow <, for privatel% held clients.
)) must e(ercise constructive professional care in the performance of their audit responsibilities.
D) must e(ercise due professional care in the performance of their audit responsibilities.
nswer! D
$erms! ,erformance of an audit
Diff! 'as%
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
0) 8f an auditor fails to fulfill a certain re3uirement in the contract+ the% ma% be guilt% of!
) contract fraud.
.) breach of contract.
)) constructive fraud.
D) criminal neglect.
nswer! .
$erms! Liabilit% when auditors fail to e(ercise due care
Diff! 'as%
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
9) /ec-lessness in the case of an audit is present if the auditor -new an ade3uate audit was not
done but still issued an opinion+ even though there was no intent to deceive financial statement
users. $his description is the legal term for!
) ordinar% negligence.
.) gross negligence.
)) constructive fraud.
D) fraud.
nswer! )
$erms! Legal term for rec-less in an audit with not intent to deceive
Diff! 'as%
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
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7) $he standard of due care to which the auditor is e(pected to adhere to in the performance of
the audit is referred to as the!
) prudent person concept.
.) common law doctrine.
)) constructive care concept.
D) vigilant person concept.
nswer!
$erms! &tandard of due care
Diff! "oderate
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
5) uditors ma% be liable to their clients if the% are found guilt% of!
)
Ordinar% negligence <ross negligence
=es =es
.)
Ordinar% negligence <ross negligence
>o >o
))
Ordinar% negligence <ross negligence
=es >o
D)
Ordinar% negligence <ross negligence
>o =es
nswer!
$erms! uditor liabilit% to clients
Diff! "oderate
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
?) @nder the laws of agenc%+ partners of a ), firm ma% be liable for the wor- of others on
whom the% rel%. $his would not include!
) emplo%ees of the ), firm.
.) emplo%ees of the audit client.
)) other ), firms engaged to do part of the audit wor-.
D) specialists emplo%ed b% the ), firm to provide technical advice on the audit.
nswer! .
$erms! Laws of agenc%. ,artners of ), firm liable for wor- of others on whom the% rel%
Diff! 'as%
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
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A) :bsence of reasonable care that can be e(pected of a person in a set of circumstances:
defines!
) pecuniar% negligence.
.) gross negligence.
)) e(treme negligence.
D) ordinar% negligence.
nswer! D
$erms! bsence of reasonable care
Diff! 'as%
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
B) n e(ample of a breach of contract would li-el% include!
) an auditor*s refusal to return the client*s general ledger boo- until the client paid last %ear*s
audit fees.
.) a ban-*s claim that an auditor had a dut% to uncover material errors in financial statements that
had been relied on in ma-ing a loan.
)) a ), firm*s failure to complete an audit on the agreed-upon date because the firm had a
bac-log of other wor- which was more lucrative.
D) an auditor*s claim that the client staff is un3ualified.
nswer! )
$erms! .reach of contract
Diff! 'as%
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
C) ,rivit% of contract e(ists between!
) auditor and the federal government.
.) auditor and third parties.
)) auditor and client.
D) auditor and client attorne%.
nswer! )
$erms! ,rivit% of contract
Diff! 'as%
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
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16) n individual who is not part% to the contract between a ), and the client+ but who is
-nown b% both and is intended to receive certain benefits from the contract is -nown as!
) a third part%.
.) a common law inheritor.
)) a tort.
D) a third-part% beneficiar%.
nswer! D
$erms! 8ndividual who is not a part% to the contract between a ), and client+ but who is -nown
Diff! 'as%
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
11) Laws that have been passed b% the @.&. )ongress and other governmental units are!
) statutor% laws.
.) judicial laws.
)) federal laws.
D) common laws.
nswer!
$erms! Laws passed through state legislatures
Diff! 'as%
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
10) $he assessment against a defendant of the full loss suffered b% a plaintiff regardless of the
e(tent to which other parties shared in the wrongdoing is called!
) separate and proportionate liabilit%.
.) shared liabilit%.
)) unitar% liabilit%.
D) joint and several liabilit%.
nswer! D
$erms! ssessment against a defendant of the full loss suffered b% a plaintiff
Diff! 'as%
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
19) $he assessment against a defendant of that portion of the damage caused b% the defendant*s
negligence is called!
) separate and proportionate liabilit%.
.) joint and several liabilit%.
)) shared liabilit%.
D) unitar% liabilit%.
nswer!
$erms! ssessment against a defendant of that portion of the damages
Diff! 'as%
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
17) 4raud occurs when!
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) a misstatement is made and there is both -nowledge of its falsit% and the intent to deceive.
.) a misstatement is made and there is -nowledge of its falsit% but no intent to deceive.
)) the auditor lac-s 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.
nswer!
$erms! 4raud and errors
Diff! 'as%
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
15) Dhich of the following most accuratel% describes constructive fraudE
) bsence of reasonable care
.) Lac- of slight care
)) Fnowledge and intent to deceive
D) '(treme or unusual negligence without the intent to deceive
nswer! D
$erms! Describes constructive fraud
Diff! "oderate
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
1?) Dhich of the following most accuratel% describes fraudE
) bsence of reasonable care
.) Lac- of slight care
)) Fnowledge and intent to deceive
D) '(treme or unusual negligence without the intent to deceive
nswer! )
$erms! Describes fraud
Diff! "oderate
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
1A) third-part% beneficiar% is one which!
) has failed to establish legal standing before the court.
.) does not have privit% of contract and is un-nown to the contracting parties.
)) does not have privit% of contract+ but is -nown to the contracting parties and intended to
benefit under the contract.
D) ma% establish legal standing before the court after a contract has been consummated.
nswer! )
$erms! $hird-part% beneficiar%
Diff! "oderate
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
A
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1B) 8f the ), negligentl% failed to properl% prepare and file a client*s ta( return+ the ), ma%
be liable for!
) the penalties the client owes the 8/&.
.) the penalties and interest the client owes.
)) the penalties and interest the client owes+ plus the ta( preparation fee the ), charged.
D) the penalties and interest+ the ta( preparation fee+ and the amount of ta( that was underpaid.
nswer! )
$erms! Liabilit% when a ), negligentl% failed to properl% prepare and file ta( return
Diff! "oderate
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
1C) )onstructive fraud!
) is also -nown as rec-lessness.
.) re3uires an intent to deceive.
)) involves collusion with the client.
D) is also -nown as breach of contract.
nswer!
$erms! &upport a finding of constructive fraud
Diff! "oderate
Objective! LO 5-9
)&.! nal%tic s-ills
B
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06) Dhich of the following statements is trueE
)
<ross negligence ma%
constitute
constructive fraud
4raud re3uires the
intent to deceive
ll fraud should be
detected during audit
=es =es >o
.)
<ross negligence ma%
constitute
constructive fraud
4raud re3uires the
intent to deceive
ll fraud should be
detected during audit
>o =es >o
))
<ross negligence ma%
constitute
constructive fraud
4raud re3uires the
intent to deceive
ll fraud should be
detected during audit
=es >o =es
D)
<ross negligence ma%
constitute
constructive fraud
4raud re3uires the
intent to deceive
ll fraud should be
detected during audit
>o >o >o
nswer!
$erms! <ross negligence+ fraud+ and constructive fraud
Diff! "oderate
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
01) $he laws that have been developed through court decisions are called!
) common laws.
.) criminal laws.
)) statutor% laws.
D) civil laws.
nswer!
$erms! )ommon law
Diff! 'as%
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
C
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00) <regor% G Hedric-+ a medium-sized ), firm+ emplo%ed 'lise as a staff accountant. 'lise
was negligent while auditing several of the firm*s clients. @nder these circumstances+ which of
the following statements is trueE
) 'lise would have no personal liabilit% for negligence.
.) <regor% G Hedric- is not liable for 'lise*s negligence because ),s are generall% considered
to be independent contractors.
)) <regor% G Hedric- would not be liable for 'lise*s negligence if 'lise disobe%ed specific
instructions in the performance of the audits.
D) <regor% G Hedric- can recover against its insurer on its malpractice polic% even if one of the
partners was also negligent in reviewing 'lise*s wor-.
nswer! D
$erms! uditor negligent while auditing
Diff! )hallenging
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
09) $he legal term for when an auditor issues an audit opinion+ -nowing that an ade3uate audit
was not performed is a!
) breach of contract.
.) tort action for negligence.
)) constructive fraud.
D) fraud.
nswer! )
$erms! 4ailure of part% to meet its obligations+ causing injur% to another part%
Diff! "oderate
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
07) Define ordinar% negligence+ gross negligence+ and constructive fraud.
nswer! Ordinar% negligence is the absence of reasonable care that can be e(pected of a person
is a set of circumstances. 4or auditors+ it is in terms of what other competent auditors would have
done in the same situation.
<ross negligence is the lac- of even slight care+ tantamount to rec-less behavior+ that can be
e(pected of a person in a set of circumstances.

)onstructive fraud is the e(istence of e(treme or unusual negligence even though there was no
intent to deceive or to do harm. 8t is also termed rec-less+ in the case of an audit is present if the
auditor -new an ade3uate audit was not done but still issued an opinion+ even though there was
no intention of deceiving statement users.
$erms! Ordinar% negligence+ gross negligence+ and constructive fraud
Diff! 'as%
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
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05) n important concept in contract law for accountants to understand is the :third-part%
beneficiar% doctrine.: '(plain and give an e(ample.
nswer! third part% who does not have privit% of contract but is -nown to the contracting
parties and is intended to have certain rights and benefits under the contract. '(ample! ban- has
a large loan outstanding at the balance sheet date and re3uires an audit as part of the loan
agreement.
$erms! )ontract law; $hird-part% beneficiar% doctrine
Diff! 'as%
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
0?) Distinguish between constructive fraud and fraud.
nswer! )onstructive fraud is the e(istence of e(treme or unusual negligence even though there
was no intent to deceive or do harm. 8n contrast+ fraud occurs when a misstatement is made and
there is both -nowledge of its falsit% and the intent to deceive.
$erms! )onstructive fraud and fraud
Diff! "oderate
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
0A) Distinguish between :joint and several liabilit%: and :separate and proportionate liabilit%.:
nswer! @nder joint and several liabilit%+ the defendant can be assessed the full loss suffered b%
the plaintiff+ regardless of the e(tent to which other parties shared in the wrongdoing. 8n contrast+
under separate and proportionate liabilit%+ the defendant is assessed that portion of the damage
caused b% the defendant*s negligence.
$erms! Ioint and several liabilit% and separate and proportionate liabilit%
Diff! "oderate
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
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0B) "atch seven of the legal terms 1a-j) with the definitions provided below 11-A)!
a. )ommon law
b. )onstructive fraud
c. .reach of contract
d. Ioint and several liabilit%
e. Ordinar% negligence
f. $hird-part% beneficiar%
g. <ross negligence
h. &tatutor% law
i. 4raud
j. &eparate and proportionate liabilit%
22222222 1. Laws that have been passed b% the @.&. )ongress and other governmental units.
22222222 0. bsence of reasonable care that can be e(pected of a person in a set of
circumstances.
22222222 9. Lac- of even slight care+ tantamount to rec-less behavior that can be e(pected of a
person.
22222222 7. $he assessment against a defendant of that portion of the damage caused b% the
defendant*s negligence.
22222222 5. 4ailure of one or both parties in a contract to fulfill the re3uirements of the contract.
22222222 ?. $he assessment against a defendant of the full loss suffered b% a plaintiff regardless
of the e(tent to which other parties shared in the wrongdoing.
22222222 A. '(istence of e(treme or unusual negligence even though there was no intent to
deceive or do harm; also termed rec-lessness.
nswer!
1. h
0. e
9. g
7. j
5. c
?. d
A. b
$erms! )onstructive fraud; .reach of contract; Ioint and several liabilit%; &eparate and
proportionate liabilit%; <ross negligence; Ordinar% negligence; &tatutor% law
Diff! "oderate
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
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0C) $he standard of due care to which the auditor is e(pected to be held is referred to as the
prudent person concept.
) $rue
.) 4alse
nswer!
$erms! &tandard of due care; ,rudent person concept
Diff! 'as%
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
96) 8n a ), firm operating as a limited liabilit% partnership 1LL,)+ the liabilit% for one partner*s
actions does not e(tend to another partner*s personal assets.
) $rue
.) 4alse
nswer!
$erms! ), firm operating as a limited liabilit% partnership
Diff! 'as%
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
91) 8n a ), firm operating as a limited liabilit% partnership 1LL,)+ the liabilit% for one partner*s
actions e(tends to the firm*s assets.
) $rue
.) 4alse
nswer!
$erms! ), firm operating as a limited liabilit% partnership
Diff! 'as%
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
90) &tatutor% laws are laws that have been developed through court decisions rather than through
the @.&. )ongress and other governmental units.
) $rue
.) 4alse
nswer! .
$erms! &tatutor% laws
Diff! 'as%
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
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99) $he doctrine of joint and several liabilit% is one factor that has contributed to the recent
increase in the number of lawsuits against auditors and the size of awards to plaintiffs.
) $rue
.) 4alse
nswer!
$erms! Doctrine of joint and several liabilit%; )ontributed to increase in lawsuits
Diff! "oderate
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
97) &everal states have statutes that permit privileged communication between the client and
auditor+ allowing a ), to refuse to testif% in state and federal courts.
) $rue
.) 4alse
nswer! .
$erms! ), and privileged communication
Diff! "oderate
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
95) <ross negligence is the e(istence of e(treme or unusual negligence with the intent to
deceive.
) $rue
.) 4alse
nswer! .
$erms! <ross negligence; '(treme or unusual negligence; 8ntent to deceive
Diff! "oderate
Objective! LO 5-9
)&.! /eflective thin-ing s-ills
Learning Objective 5-7
1) $he principal issue in cases involving alleged negligence is usuall%!
) if an an engagement letter was issued.
.) the level of care re3uired.
)) if fraud was committed b% upper-level management.
D) whether the auditor is liable under civil or criminal laws.
nswer! .
$erms! Level of care; >egligence
Diff! 'as%
Objective! LO 5-7
)&.! /eflective thin-ing s-ills
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0) 8n third-part% suits+ which of the auditor*s defenses contends no implied or e(pressed contractE
) Lac- of dut%
.) >on-negligent performance
)) )ontributor% negligence
D) bsence of causal connections
nswer!
$erms! $hird-part% suits; uditor defenses contends lac- of privit% contract
Diff! "oderate
Objective! LO 5-7
)&.! /eflective thin-ing s-ills
9) 8n connection with the audit of financial statements+ an independent auditor could be
responsible for failure to detect a material fraud if!
) statistical sampling techni3ues were not used on the audit engagement.
.) the auditor planned the audit in a negligent manner.
)) accountants performing important parts of the wor- failed to discover a close relationship
between the treasurer and the cashier.
D) the fraud was perpetrated b% one emplo%ee who circumvented the e(isting internal controls.
nswer! .
$erms! 8ndependent auditor could be responsible for failure to detect material fraud
Diff! 'as%
Objective! LO 5-7
)&.! /eflective thin-ing s-ills
7) Dhich of the following is an illustration of liabilit% to clients under common lawE
) )lient sues auditor for not discovering a theft of assets b% an emplo%ee.
.) .an- sues auditor for not discovering that borrower*s financial statements are misstated.
)) )ombined group of stoc-holders sue auditor for not discovering materiall% misstated financial
statements.
D) $he federal government prosecutes the auditor for -nowingl% issuing an incorrect audit
report.
nswer!
$erms! Liabilit% to clients under common law
Diff! "oderate
Objective! LO 5-7
)&.! /eflective thin-ing s-ills
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5) Dhich of the following is an illustration of liabilit% under the federal securities actsE
) client sues the auditor for not discovering a theft of assets b% an emplo%ee.
.) ban- sues the auditor for not discovering that the borrower*s financial statements are
misstated.
)) combined group of stoc-holders sues the auditor for not discovering materiall% misstated
financial statements.
D) $he auditor sues a client for not cooperating during the engagement.
nswer! )
$erms! Liabilit% under federal securities acts
Diff! "oderate
Objective! LO 5-7
)&.! /eflective thin-ing s-ills
?) ), firm normall% uses one or a combination of four defenses when there are legal claims
b% clients. Dhich one of the following is generall% not a defenseE
) Lac- of dut%
.) >onnegligent performance
)) )ontributor% negligence
D) 4oreseeable users
nswer! D
$erms! Defenses when there are legal claims
Diff! "oderate
Objective! LO 5-7
)&.! /eflective thin-ing s-ills
A) $ort actions against ),s are more common than breach of contract actions because!
) there are more torts than contracts.
.) the burden of proof is on the auditor rather than on the person suing.
)) the person suing need prove onl% negligence.
D) the amounts recoverable are normall% larger.
nswer! D
$erms! $ort actions against ),s are more common than breach of contract
Diff! "oderate
Objective! LO 5-7
)&.! /eflective thin-ing s-ills
B) $he principal issue to be resolved in cases involving alleged negligence is usuall%!
) the amount of the damages suffered b% plaintiff.
.) whether to impose punitive damages on defendant.
)) the level of care e(ercised b% the ),.
D) whether defendant was involved in fraud.
nswer! )
$erms! ,rincipal issue to be resolved in cases involving alleged negligence
Diff! "oderate
Objective! LO 5-7
)&.! /eflective thin-ing s-ills
1?
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C) 8n the auditing environment+ failure to meet auditing standards is often!
) an accepted practice.
.) a suggestion of negligence.
)) conclusive evidence of negligence.
D) tantamount to criminal behavior.
nswer! )
$erms! 4ailure to meet auditing standards
Diff! "oderate
Objective! LO 5-7
)&.! /eflective thin-ing s-ills
16) common wa% for a ), firm to demonstrate a lac- of dut% to perform is b% use of a1n)!
) e(pert witness* testimon%.
.) engagement letter.
)) management representation letter.
D) confirmation letter.
nswer! .
$erms! )ommon wa% to demonstrate lac- of dut% to perform
Diff! "oderate
Objective! LO 5-7
)&.! /eflective thin-ing s-ills
11) $o succeed in an action against the auditor+ the client must be able to show that!
) the auditor was fraudulent.
.) the auditor was grossl% negligent.
)) there was a written contract.
D) there is a close causal connection between the auditor*s behavior and the damages suffered b%
the client.
nswer! D
$erms! $o succeed in an action against the auditor+ client must show that
Diff! "oderate
Objective! LO 5-7
)&.! /eflective thin-ing s-ills
10) "atthews G )o.+ ),s+ issued an un3ualified opinion on Dodgers )orporation. "illennium
.an-+ which relied on the audited financial statements+ granted a loan of J066+66+666 to Dodgers
)orporation. Dodgers subse3uentl% defaulted on the loan. $o succeed in an action against
"atthews G )o.+ "illennium .an- must prove that the ban- was!
) in privit% of contract with Dodgers.
.) in privit% of contract with "illennium.
)) free from contributor% negligence.
D) justified in rel%ing on the financial statements in granting the loan.
nswer! D
$erms! Legal action where ban- relied audited financial statements+ granted loan on which
customer defaulted
Diff! )hallenging
Objective! LO 5-7
)&.! nal%tic s-ills
1A
)op%right 5 0617 ,earson 'ducation+ 8nc.
19) One of the changes in auditing procedure which was brought about as a result of the 119?
$enants case was that auditors were encouraged to begin using!
) letters of representation.
.) confirmation letters.
)) engagement letters.
D) billet dou( letters.
nswer! )
$erms! udit procedure brought about b% 119? $enants case
Diff! )hallenging
Objective! LO 5-7
)&.! /eflective thin-ing s-ills
17) $he Fing &uret% )ompan% wrote a general fidelit% bond covering thefts of assets b% the
emplo%ees of Dilson+ 8nc. $hereafter+ )oone%+ an emplo%ee of Dilson+ embezzled J1A+066 of
compan% funds. Dhen the activities were discovered+ Fing paid Dilson the full amount in
accordance with the terms of the fidelit% bond+ and then sought recover% against Dilson*s
auditors+ L%nch G "erritt+ ),s. Dhich of the following would be L%nch G "erritt*s best
defenseE
) Fing is not in privit% of contract.
.) $he shortages were the result of clever forgeries and collusive fraud which would not be
detected b% an e(amination made in accordance with generall% accepted auditing standards.
)) L%nch G "erritt were not guilt% either of gross negligence or fraud.
D) L%nch G "erritt were not aware of the Fing-Dilson suret% relationship.
nswer! .
$erms! Defense in recover% against auditors with emplo%ee theft
Diff! )hallenging
Objective! LO 5-7
)&.! nal%tic s-ills
15) $here are four major sources of an auditor*s legal liabilit%. One source is liabilit% to the audit
client. List the other three sources.
nswer! $he other three sources of auditor*s legal liabilit% are!
# Liabilit% to third parties under common law.
# )ivil liabilit% under federal securities laws.
# )riminal liabilit%.
$erms! &ources of auditor*s legal liabilit%
Diff! "oderate
Objective! LO 5-7
)&.! /eflective thin-ing s-ills
1B
)op%right 5 0617 ,earson 'ducation+ 8nc.
1?) Discuss each of the four defenses a ), firm can normall% use when facing legal claims b%
clients. Dhich of these defenses is ordinaril% not available against third-part% suitsE
nswer! Lack of duty. $he ), firm claims that there was no implied or e(pressed contract.
Non-negligent performance. $he ), firm claims that the audit was performed in accordance
with auditing standards.

Contributory negligence. $he ), firm claims that the client*s own actions resulted in the loss
that is the basis for the damages+ or interfered with the conduct of the audit in such a wa% that
prevented that auditor from discovering the cause of the loss. $his defense is not available in
third-part% suits.
Absence of causal connection. $he ), firm claims that the auditor*s failure to follow auditing
standards did not cause the damages suffered b% the client.
$erms! 4our defenses a ), firm can normall% use when facing legal claims b% clients
Diff! "oderate
Objective! LO 5-7
)&.! /eflective thin-ing s-ills
1A) n e(ample of auditor legal liabilit% to third parties under common law would be the federal
government prosecuting an auditor for -nowingl% issuing an incorrect audit report.
) $rue
.) 4alse
nswer! .
$erms! Legal liabilit% to third parties under common law
Diff! "oderate
Objective! LO 5-7
)&.! /eflective thin-ing s-ills
1B) $he 1136 Tenants case was a criminal case concerning a ),*s failure to uncover fraud
during a financial statement audit.
) $rue
.) 4alse
nswer! .
$erms! 119? $enants case
Diff! "oderate
Objective! LO 5-7
)&.! /eflective thin-ing s-ills
1C) "an% litigation e(perts believe that a well written engagement letter significantl% reduces the
li-elihood of adverse legal actions.
) $rue
.) 4alse
nswer!
$erms! 'ngagement letter
Diff! 'as%
Objective! LO 5-7
)&.! /eflective thin-ing s-ills
1C
)op%right 5 0617 ,earson 'ducation+ 8nc.
Learning Objective 5-5
1) financial institution sues the audit firm for failure to discover that a borrower*s financial
statements are materiall% misstated. $his is an e(ample of which of the following legal liabilit%
conceptsE
) Liabilit% to clients
.) Liabilit% to third parties under common law
)) )ivil liabilit% under federal securities law
D) )riminal liabilit%
nswer! .
$erms! Legal liabilit% in audit of financial statements that are materiall% misstated
Diff! 'as%
Objective! LO 5-5
)&.! /eflective thin-ing s-ills
0) Dhich of the following auditor*s defenses usuall% means nonreliance on the financial
statements b% the userE
) Lac- of dut%
.) >onnegligent performance
)) bsence of causal connections
D) )ontributor% negligence
nswer! )
$erms! uditor defenses which means non-reliance on the financial statements
Diff! 'as%
Objective! LO 5-5
)&.! nal%tic s-ills
06
)op%right 5 0617 ,earson 'ducation+ 8nc.
9) group t%picall% included as :third parties: in common law is!
)
ctual and potential stoc-holders 'mplo%ees of client
=es =es
.)
ctual and potential stoc-holders 'mplo%ees of client
>o >o
))
ctual and potential stoc-holders 'mplo%ees of client
=es >o
D)
ctual and potential stoc-holders 'mplo%ees of client
>o =es
nswer!
$erms! $hird-parties in common law
Diff! "oderate
Objective! LO 5-5
)&.! /eflective thin-ing s-ills
7) $he major conclusion of the 1C91 Ultramares case was that!
) ordinar% negligence is insufficient for liabilit% to third parties.
.) third parties must file criminal charges+ not civil charges+ against the auditor.
)) fraud or gross negligence is sufficient for liabilit% to third parties.
D) auditors have no liabilities to third parties.
nswer!
$erms! "ajor conclusion of 1C91 @ltramares case
Diff! "oderate
Objective! LO 5-5
)&.! /eflective thin-ing s-ills
01
)op%right 5 0617 ,earson 'ducation+ 8nc.
5) @nder common law+ a foreseen user would be treated the same as!
)
primar% beneficiar% -nown third part%
=es =es
.)
primar% beneficiar% -nown third part%
>o >o
))
primar% beneficiar% -nown third part%
=es >o
D)
primar% beneficiar% -nown third part%
>o =es
nswer!
$erms! 4oreseen user under common law treated the same as
Diff! "oderate
Objective! LO 5-5
)&.! /eflective thin-ing s-ills
?) broad interpretation of the rights of third-part% beneficiaries holds that users that the auditor
should have been able to foresee as being li-el% users of financial statements have the same
rights as those with privit% of contract. $his is -nown as the concept of!
) foreseen users.
.) foreseeable users.
)) e(pected users.
D) four-part% contracts.
nswer! .
$erms! /ights of third-part% beneficiaries; ,rivit% of contract
Diff! "oderate
Objective! LO 5-5
)&.! /eflective thin-ing s-ills
A) Dhich of the auditor*s defenses is ordinaril% not available when lawsuits are filed b% a third
part%E
) bsence of causal connections
.) )ontributor% negligence
)) >on-negligent performance
D) Lac- of dut%
nswer! .
$erms! uditor defenses not available when lawsuits filed b% a third part%
Diff! "oderate
Objective! LO 5-5
)&.! /eflective thin-ing s-ills
00
)op%right 5 0617 ,earson 'ducation+ 8nc.
B) ccording to the principle established b% the estatement of Torts case+ foreseen users must be
members of!
) an% potential user group.
.) a legall% protected class.
)) a reasonabl% limited and identifiable user group.
D) a reasonabl% limited and established user group.
nswer! )
$erms! ,rinciple established b% /estatement of $orts; 4oreseen users must be members
Diff! "oderate
Objective! LO 5-5
)&.! /eflective thin-ing s-ills
C) 8n an action against a ), in a jurisdiction that follows the @ltramares doctrine+ lac- of
privit% is a viable defense provided the plaintiff!
) is the client*s creditor who sued the ), for negligence.
.) can prove gross negligence.
)) violated the &ecurities ct of 1C99.
D) violated the &ecurities ct of 1C97.
nswer!
$erms! @ltramares doctrine; Lac- of privit% is viable defense
Diff! "oderate
Objective! LO 5-5
)&.! /eflective thin-ing s-ills
16) @nder common law+ an individual or compan% that 11) does not have a contract with an
auditor+ 10) is -nown b% the auditor in advance of the audit+ and 19) will use the auditor*s report
to ma-e decisions about the client compan% has!
) no rights unless an auditor is grossl% negligent.
.) no rights unless an auditor is fraudulent.
)) no rights against an auditor.
D) the same rights against an auditor as a client.
nswer! D
$erms! )ommon law third-part% rights
Diff! )hallenging
Objective! LO 5-5
)&.! nal%tic s-ills
09
)op%right 5 0617 ,earson 'ducation+ 8nc.
11) $he basic legal concept which was affirmed in the 1CB5 >ew =or- case+ Credit Alliance+ was
that!
) the auditor*s defense of privit% of contract is still valid against third parties.
.) the auditor is liable for ordinar% negligence to specificall% foreseen third parties.
)) the auditor is liable for ordinar% negligence to reasonabl% foreseeable third parties.
D) the auditor*s defense of contributor% negligence is no longer valid.
nswer!
$erms! .asic legal concept affirmed in 1CB5 case+ )redit lliance
Diff! )hallenging
Objective! LO 5-5
)&.! nal%tic s-ills
10) s a conse3uence of his failure to adhere to generall% accepted auditing standards in the
course of his e(amination of the Lamp )orp.+ Harrison+ ),+ did not detect the embezzlement of
a material amount of funds b% the compan%*s controller. s a matter of common law+ to what
e(tent would Harrison be liable to the Lamp )orp. for losses attributable to the theftE
) He would have no liabilit%+ since the ordinar% e(amination cannot be relied upon to detect
thefts of assets b% emplo%ees.
.) He would have no liabilit% because privit% of contract is lac-ing.
)) He would be liable for losses attributable to his negligence.
D) He would be liable onl% if it could be proven that he was grossl% negligent.
nswer! )
$erms! @nder common law+ e(tent of liabilit% where auditor failed to adhere to generall%
accepted auditing standards in e(amination of client and failed to detect emplo%ee embezzlement
Diff! )hallenging
Objective! LO 5-5
)&.! nal%tic s-ills
19) $he preferred defense in third part% suits is!
) lac- of dut% to perform.
.) nonnegligent performance.
)) absence of causal connection.
D) client fraud.
nswer! .
$erms! ,referred defense in third-part% suits
Diff! "oderate
Objective! LO 5-5
)&.! /eflective thin-ing s-ills
07
)op%right 5 0617 ,earson 'ducation+ 8nc.
17) $hree approaches to the application of the foreseen users* concept are 11) the )redit Alliance
approach+ 10) the restatement of torts approach+ and 19) the foreseeable user approach.
&ummarize each of these three approaches.
nswer! $he Credit Alliance approach upholds the concept of privit% of contract established b%
the Ultramares Corporation !. Touc"e case. @nder this approach+ for an auditor to be liable to
third parties+ the auditor 11) must -now and intend that the wor- product would be used b% the
third-part% for a specific purpose+ and 10) the -nowledge and intent must be evidenced b% the
auditor*s conduct.
@nder the restatement of torts approach+ foreseen users must be members of a reasonabl% limited
and identifiable group of users that have relied on the ),*s wor-+ such as creditors+ even though
those persons were not specificall% -nown to the ), at the time the wor- was done.
@nder the foreseeable user approach+ an% users that the auditor should have reasonabl% been able
to foresee as li-el% users of the client*s financial statements have the same rights as those with
privit% of contract.
$erms! $hree approaches to the application of foreseen users* concepts; )redit lliance
approach; /estatement of torts approach; foreseeable user approach
Diff! )hallenging
Objective! LO 5-5
)&.! /eflective thin-ing s-ills
15) lthough there is confusion caused b% the differing views of liabilit% to third parties under
common law+ the movement is clearl% awa% from the foreseeable user approach.
) $rue
.) 4alse
nswer!
$erms! )redit lliance approach; /estatement of torts approach; 4oreseeable user approach
Diff! "oderate
Objective! LO 5-5
)&.! /eflective thin-ing s-ills
1?) $he restatement of torts approach to the concept of foreseen users states that an% users that
the auditor should have reasonabl% been able to foresee as being li-el% users of financial
statements have the same rights as those with privit% of contract.
) $rue
.) 4alse
nswer! .
$erms! /estatement of torts approach; 4oreseen users; ,rivit% of contract
Diff! )hallenging
Objective! LO 5-5
)&.! /eflective thin-ing s-ills
05
)op%right 5 0617 ,earson 'ducation+ 8nc.
1A) $he Credit Alliance approach to the concept of foreseen users states that to be liable to third
parties+ an auditor 11) must -now and intend that the wor- product would be used b% the third-
part% for a specific purpose+ and 10) the -nowledge and intent must be evidenced b% the auditor*s
conduct.
) $rue
.) 4alse
nswer!
$erms! )redit lliance approach; 4oreseen users; Liabilit% to third parties
Diff! )hallenging
Objective! LO 5-5
)&.! /eflective thin-ing s-ills
Learning Objective 5-?
1) n ade3uate s%stem of internal control for &') registrants was originall% re3uired b% the!
) &arbanes-O(le% ct of 0660.
.) &ecurities ct of 1C99.
)) 4oreign )orrupt ,ractices ct of 1CAA.
D) &ecurities ct of 1C97.
nswer! )
$erms! /e3uired an ade3uate s%stem of internal control for &') registrants
Diff! 'as%
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
0?
)op%right 5 0617 ,earson 'ducation+ 8nc.
0) $he increased litigation under the federal securities laws has resulted from!
)
$he availabilit% of class-
action litigation
$he strict liabilit% standards
imposed on ),s b% the
securities laws n e(cess of attorne%s
=es =es =es
.)
$he availabilit% of class-
action litigation
$he strict liabilit% standards
imposed on ),s b% the
securities laws n e(cess of attorne%s
=es >o >o
))
$he availabilit% of class-
action litigation
$he strict liabilit% standards
imposed on ),s b% the
securities laws n e(cess of attorne%s
=es =es >o
D)
$he availabilit% of class-
action litigation
$he strict liabilit% standards
imposed on ),s b% the
securities laws n e(cess of attorne%s
>o >o >o
nswer! )
$erms! 8ncreased litigation under federal securities law resulted from
Diff! "oderate
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
9) @nder the &ecurities ct of 1C99+ the auditor*s responsibilit% for ma-ing sure the financial
statements were fairl% stated e(tends to!
) the date of the financial statements.
.) the date the registration statement becomes effective.
)) the date of the audit report.
D) one %ear be%ond the date of the financial statements.
nswer! .
$erms! &ecurities ct of 1C99; uditor responsibilit% for ma-ing sure financial statements were
fairl% stated e(tends
Diff! "oderate
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
0A
)op%right 5 0617 ,earson 'ducation+ 8nc.
7) @nder the &ecurities '(change ct of 1C97+ which t%pe of organization is re3uired to submit
audited financial statements to the &')E
) 'ver% compan% with securities traded on national and over-the-counter e(changes
.) 'ver% corporation
)) 'ver% compan% issuing new securities
D) 'ver% corporation which is chartered b% a state government
nswer!
$erms! &ecurities ct of 1C97; Organizations re3uired to submit audited financial statements
Diff! "oderate
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
5) $he &ecurities and '(change )ommission can impose all but which of the following
sanctionsE
) &uspend a ), from auditing &') clients.
.) ,rohibit a ), from accepting new &') clients for a period of time.
)) /e3uire a ), to participate in continuing-education programs and ma-e changes in their
practice.
D) /evo-e a ), license.
nswer! D
$erms! &ecurities and '(change )ommission can impose sanctions
Diff! "oderate
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
?) $he 4oreign )orrupt ,ractices ct 14),) of 1CAA!
) re3uires auditors to review and evaluate s%stems of internal control as a part of an audit.
.) re3uires &') registrants to maintain a reasonabl% complete and accurate set of records and an
ade3uate s%stem of internal control.
)) re3uires auditors to review client*s internal control s%stem in a manner which is thorough
enough to judge whether client meets the re3uirements of the 4),.
D) re3uires auditors to file a report with the &') if client*s internal control s%stem is inade3uate.
nswer! .
$erms! 4oreign )orrupt ,ractices ct of 1CAA
Diff! "oderate
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
0B
)op%right 5 0617 ,earson 'ducation+ 8nc.
A) Dhile the 4oreign )orrupt ,ractices ct of 1CAA remains in effect+ its internal control
provisions have been largel% superseded b% which of the followingE
) $he &arbanes-O(le% ct of 0660
.) $he /ac-eteer 8nfluenced and )orrupt Organization ct
)) $he 4ederal 4alse &tatements &tatute
D) $he 4ederal "ail 4raud &tatute
nswer!
$erms! 4oreign )orrupt ,ractices ct of 1CAA; 8nternal control provisions
Diff! "oderate
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
$opic! &OK
B) Dhich of the following is an accurate statement regarding recent actions brought against
accountants b% clients and third partiesE
) Litigants will first see- state remedies because of the availabilit% of class-action litigation.
.) <ross negligence b% the auditor must be proven under the &ecurities cts of 1C99 and 1C97.
)) $he greatest growth in ), liabilit% litigation bas been under the federal securities laws.
D) $he amount of damages that plaintiffs can receive is greater under common law than under
the federal securities laws.
nswer! )
$erms! 4actor in increase in number of lawsuits and sizes of awards
Diff! "oderate
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
C) major purpose of federal securities regulations is to!
) provide sufficient reliable information to the investing public who purchase securities in the
mar-etplace.
.) establish the 3ualifications for accountants who are members of the profession.
)) eliminate incompetent attorne%s and accountants who participate in the registration of
securities to be offered to the public.
D) provide a set of uniform standards and tests for accountants+ attorne%s+ and others who
practice before the &ecurities and '(change )ommission.
nswer!
$erms! "ajor purpose of federal securities regulations
Diff! "oderate
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
0C
)op%right 5 0617 ,earson 'ducation+ 8nc.
16) $he 0610 news of a massive alleged briber% scheme involving Dal-"art has brought charges
against the compan% under the!
) &ecurities ct of 1C99.
.) &ecurities ct of 1C97.
)) 4oreign )orrupt ,ractices ct of 1CAA.
D) &arbanes-O(le% ct of 0660
nswer! )
$erms! 4oreign )orrupt ,ractices ct of 1CAA
Diff! "oderate
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
11) Dhich of the following statements about the &ecurities ct of 1C99 is not trueE
) third part% that purchased securities described in the registration statement ma% sue the
auditor for material misrepresentations or omissions in the audited financial statements.
.) third part% user does not have the burden of proof that heLshe relied on the financial
statements.
)) third part% user has the burden of proof that the auditor was either negligent or fraudulent in
doing the audit.
D) third part% user does not have the burden of proof that the loss was caused b% the
misleading statements.
nswer! )
$erms! &ecurities ct of 1C99
Diff! )hallenging
Objective! LO 5-?
)&.! nal%tic s-ills
10) $he most significant audit issue that came as a result of the court decision in the #scott et al.
!. $ar C"ris Construction Corporation case in 1C?B was!
) the court*s reaffirmation that the burden of proof was on the plaintiff to prove the auditor was
negligent.
.) the affirmation of the increased auditor*s responsibilit% when performing an &-1 review+ a
review of events subse3uent to the balance sheet+ for registration statements.
)) the increased auditor responsibilit% when associated with unaudited financial statements.
D) the court*s refusal to allow the percentage-of-completion method of accounting for revenues.
nswer! .
$erms! &ignificant audit issue from 'scott et al v. .ar )hris )onstruction )orporation case in
1C?B
Diff! )hallenging
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
96
)op%right 5 0617 ,earson 'ducation+ 8nc.
19) @nder the federal securities acts+ one significant result occurring directl% due to the #scott et
al. !. $ar C"ris Construction Corporation case was that && was changed to re3uire!
) greater emphasis on subse3uent events procedures.
.) new standards for unaudited statements.
)) a broader definition of third part% beneficiaries.
D) more companies to file annual reports with the &').
nswer!
$erms! &ignificant result from 'scott et al v. .ar )hris )onstruction )orporation case
Diff! )hallenging
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
17) @nder the &ecurities '(change ct of 1C97+ most of the litigation against the auditor has
been generated because of the auditor*s involvement with the!
) B-F form.
.) 16-F form.
)) 16-M form.
D) &-1 form.
nswer! .
$erms! &ecurities '(change ct of 1C97
Diff! )hallenging
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
15) &ection 16 and /ule 16b-5 of the &ecurities '(change ct of 1C97 are often referred to as!
) the antifraud provisions.
.) the new issues provisions.
)) the full emplo%ment act for accountants.
D) the /8)O provisions.
nswer!
$erms! &ecurities '(change ct of 1C97 &ection 16 and /ule 16b-5
Diff! )hallenging
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
91
)op%right 5 0617 ,earson 'ducation+ 8nc.
1?) 8n a leading securities law and ), liabilities case+ the @.&. &upreme )ourt ruled in 1CA? in
%oc"felder v. #rnst & #rnst that before ),s could be held liable for /ule 16b-5 of the
&ecurities '(change ct of 1C97+ what would be re3uired to be shown to the court was the
auditor*s!
) ordinar% negligence.
.) gross negligence.
)) -nowledge and intent to deceive.
D) financial gain at the e(pense of the plaintiff.
nswer! )
$erms! &ecurities '(change ct of 1C97 /ule 16b-5; @.&. &upreme )ourt ruled in 1CA? in
Hochfelder v. 'rnst G 'rnst
Diff! )hallenging
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
1A) @nder the &ecurities ct of 1C99!
) an% part% who relies on the compan%*s audited financial statements can recover from the
auditors.
.) third-part% users must prove that the auditor was negligent.
)) the burden of proof is on the defendant.
D) auditors face potential legal e(posure for information contained in the 4orm 16-M.
nswer! )
$erms! &ecurities and '(change )ommission
Diff! "oderate
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
1B) $he partnership of .ooth G Ha%nes+ ),s+ has been engaged to e(amine the financial
statements of ,aul+ 8nc.+ in connection with the registration of ,aul*s securities with the &ecurities
and '(change )ommission. @nder these circumstances+ which of the following statements is
trueE
) .ooth G Ha%nes is assuming much greater third-part% liabilit% than it assumes on
engagements under common law.
.) 8f its e(amination is not fraudulent+ .ooth G Ha%nes ma% issue an appropriate disclaimer to
the financial statements and thereb% avoid liabilit%.
)) .ooth G Ha%nes must incorporate if the% wish to practice before the &').
D) .ooth G Ha%nes must be a large interstate firm if the% wish to practice before the &').
nswer!
$erms! ),s engaged to e(amine financial statements in connection with registration of
securities with the &ecurities and '(change )ommission
Diff! "oderate
Objective! LO 5-?
)&.! nal%tic s-ills
90
)op%right 5 0617 ,earson 'ducation+ 8nc.
1C) Discuss the sanctions the &ecurities and '(change )ommission can impose on auditors.
nswer! $he &') has the power in certain circumstances to sanction or suspend practitioners
from doing audits for &') companies. $he &')*s /ules of ,ractice permit them to temporaril%
or permanentl% den% a ), or ), firm from being associated with financial statements of
public companies+ either because of lac- of appropriate 3ualifications or having engaged in
unethical or improper professional conduct.
8n recent %ears+ the &') has temporaril% suspended a number of individual ),s from doing an%
audits of &') clients. 8t has also prohibited a number of ), firms from accepting an% new &')
clients for a period. 8n some cases+ the &') has re3uired an e(tensive review of a major ),
firm*s practices b% another ), firm+ or made ), firms ma-e changes in their practices.
8ndividual ),s and their firms have also been re3uired to participate in continuing education
programs. &anctions such as these are published b% the &') and are often reported in the
business press+ ma-ing them a significant embarrassment to those involved.
$erms! &anctions the &ecurities and '(change )ommission can impose on auditors
Diff! "oderate
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
06) One result from the #scott et al. !. $ar C"ris case was a greater emphasis being placed on
audit staff understanding the client*s business and industr%.
) $rue
.) 4alse
nswer!
$erms! /esult from 'scott et al. v. .ar )hris
Diff! "oderate
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
01) $he onl% parties who can recover from auditors under the &ecurities ct of 1C99 are original
purchasers of securities.
) $rue
.) 4alse
nswer!
$erms! &ecurities ct of 1C99
Diff! "oderate
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
99
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00) @nder the &ecurities ct of 1C99+ a third part% plaintiff does not have the burden of proof
that he or she relied on the financial statements or that the auditor was negligent or fraudulent in
doing the audit. /ather+ the plaintiff need onl% prove that the audited financial statements
contained a material misrepresentation or omission.
) $rue
.) 4alse
nswer!
$erms! &ecurities ct of 1C99; .urden of proof
Diff! "oderate
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
09) )ompanies with securities traded on national and over-the-counter e(changes are re3uired to
submit audited financial statements once ever% three %ears to the &ecurities and '(change
)ommission.
) $rue
.) 4alse
nswer! .
$erms! &ecurities ct )ommission; &ecurities traded on national e(changes
Diff! "oderate
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
07) $he same three defenses available to auditors in common lawsuits b% third parties
nonnegligent performance+ lac- of dut%+ and absence of causal connectionNare also available for
suits under the &ecurities '(change ct of 1C97.
) $rue
.) 4alse
nswer!
$erms! &ecurities ct of 1C97; Defenses available to auditors in common law suits b% third
parties
Diff! "oderate
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
05) $he @nited &tates &upreme )ourt has ruled that outside professionals such as accountants
who don*t help run corrupt businesses cannot be sued under the provisions of the 4oreign )orrupt
,ractices ct.
) $rue
.) 4alse
nswer! .
$erms! @nited &tates &upreme )ourt; 4oreign )orrupt ,ractices ct
Diff! "oderate
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
97
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0?) $he &arbanes-O(le% ct re3uires the )'O and )4O of a public compan% to certif% the
annual and 3uarterl% financial statements filed with the ,)O..
) $rue
.) 4alse
nswer! .
$erms! &arbanes-O(le% ct
Diff! "oderate
Objective! LO 5-?
)&.! /eflective thin-ing s-ills
Learning Objective 5-A
1) 8n which case were auditors prosecuted for filing false financial statements for a client with
the governmentE
) United 'tates !. Natelli
.) United 'tates !. 'imon
)) #scott et al. !. $ar C"ris
D) #'( )o!ernment 'ecurities !. Ale*ander )rant & Co.
nswer! .
$erms! )ase where auditors were prosecuted for filing false financial statements
Diff! "oderate
Objective! LO 5-A
)&.! /eflective thin-ing s-ills
0) ), is subject to criminal liabilit% if the ),!
) refuses to turn over re3uested audit documentation to a client.
.) performs an audit in a negligent manner.
)) is -nowingl% involved with false financial statements.
D) willfull% breaches a contract with a client.
nswer! )
$erms! ), subject to criminal liabilit%
Diff! "oderate
Objective! LO 5-A
)&.! /eflective thin-ing s-ills
9) )ritical lessons learned after anal%zing major criminal cases against auditors include the fact
that!
) the partner+ but not the audit staff+ must be independent.
.) transactions with related parties are an indication of fraud.
)) an investigation of the integrit% of management is an important part of deciding whether to
accept a new client.
D) accounting principles can be relied on e(clusivel% in deciding if the financial statements are
fairl% presented.
nswer! )
$erms! ),s held liable for criminal activit% and federal laws; 8nfamous cases
Diff! "oderate
Objective! LO 5-A
)&.! /eflective thin-ing s-ills
95
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7) $he &arbanes-O(le% ct of 0660 ma-es it a felon% to destro% or create documents to impede
or obstruct a federal investigation. $hose provisions were adopted following which of the
following legal casesE
) United 'tates !. Natelli
.) United 'tates !. Andersen
)) #'( )o!ernment 'ecurities !. Ale*ander )rant & Co.
D) United 'tates !. 'imon
nswer! .
$erms! &imilarit% between @nited &tates v. >atelli case 1i.e.+ the >ational &tudent "ar-eting
case of 1CA5)+ and the '&" <overnment &ecurities v. le(ander <rant G )o. case of 1CB?
Diff! "oderate
Objective! LO 5-A
)&.! nal%tic s-ills
5) ),s can be held liable for criminal activit% under both state and federal laws. 8nfamous cases
have involved United 'tates !s. Natelli and #'( )o!ernment 'ecurities !. Ale*ander )rant and
Co. Discuss what occurred and prepare a summar% of the court findings.
nswer! NatelliNtwo auditors were convicted of criminal liabilit% under the 1C97 act for
certif%ing financial statements of >ational &tudent "ar-eting )orporation that contained
inade3uate disclosures.
#'(Nmanagement revealed to the partner in charge of the audit of '&" that the previous %ear*s
financial statements contained a material misstatement. /ather than compl%ing with the
profession and firm standards+ the partner agreed to sa% nothing in the hope that management
would wor- its wa% out of the problem during the current %ear. $he partner was convicted of
criminal charges for his role in sustaining the fraud
$erms! ),s held liable for criminal activit% and federal laws; 8nfamous cases
Diff! "oderate
Objective! LO 5-A
)&.! /eflective thin-ing s-ills
?) $he &arbanes-O(le% ct of 0660 ma-es destruction of audit documentation punishable b% up
to 16 %ears in prison.
) $rue
.) 4alse
nswer! .
$erms! &arbanes-O(le% ct of 0660; Destruction of audit documentation punishable
Diff! )hallenging
Objective! LO 5-A
)&.! /eflective thin-ing s-ills
$opic! &OK
9?
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Learning Objective 5-B
1) Dhich of the following resulted in a federal law passed in 1CC5 that significantl% reduced
potential damages in securities-related litigationE
) ,rivate &ecurities Litigation /eform ct
.) ,ublic &ecurities Damages and &ettlements ct
)) /ac-eteer 8nfluenced and )orrupt Organization ct
D) @.&. &ecurities )laims /eform ct
nswer!
$erms! 4ederal law passed in 1CC5 significantl% reduced potential damages
Diff! )hallenging
Objective! LO 5-B
)&.! /eflective thin-ing s-ills
0) 8n order to protect themselves from legal liabilit%+ it is important that ),s!
) are organized as sole-proprietors.
.) accept client representations.
)) understand the client*s business.
D) use engagement letters+ not representation letters.
nswer! )
$erms! ,rotecting individual ),s from legal liabilit%
Diff! )hallenging
Objective! LO 5-B
)&.! /eflective thin-ing s-ills
9) Discuss at least 9 steps the 8), and the accounting profession as a whole can and are
ta-ing to reduce the practitioner*s e(posure to lawsuits.
nswer! &teps the profession is ta-ing to reduce practitioners* e(posure to lawsuits include!
# &et standards and revise them the meet the changing needs of auditing.
# Oppose lawsuits.
# 'ducate investors and other users of financial statements as to the meaning of the opinion of
the auditors and the nature of the auditor*s wor-.
# &anction members for improper conduct and performance.
# Lobb% for changes in laws.
$erms! &teps the 8), and accounting profession ta-ing to reduce practitioner*s e(posure to
lawsuits
Diff! "oderate
Objective! LO 5-B
)&.! /eflective thin-ing s-ills
9A
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7) "atch eight of the following terms 1a-n) with the definitions provided below 11-B)!
a. 4oreign )orrupt ,ractices ct
b. &ecurities '(change ct of 1C97
c. &ecurities Litigation @niform &tandards ct of 1CCB
d. &ecurities ct of 1C99
e. Ultramares doctrine
f. udit ris-
g. udit failure
h. &tandards failure
i. .usiness failure
j. bsence of causal connection
-. )ontributor% negligence
l. Lac- of dut% to perform
m. ,rivate &ecurities Litigation /eform ct
n. >onnegligent performance
22222222 1. situation in which an incorrect audit opinion is issued because it failed to compl%
with the re3uirements of auditing standards.
22222222 0. federal statute dealing with companies that trade securities on national and over-
the-counter e(changes. uditors are involved because the annual reporting re3uirements include
audited financial statements.
22222222 9. n auditor*s legal defense under which the auditor claims that the client*s own
actions either resulted in the loss that is the basis for damages or interfered with the conduct of
the audit in such a wa% that prevented the auditor from discovering the cause of the loss.
22222222 7. federal statute that ma-es it illegal to offer a bribe to an official of a foreign
countr%.
22222222 5. common-law approach to third-part% liabilit% in which ordinar% negligence is
insufficient for liabilit% to third parties+ because of the lac- of privit% of contract between the
third-part% and the auditor unless the third-part% is a primar% beneficiar%.
22222222 ?. federal statute designed to significantl% reduce the potential damages in federal
securities-related litigation b% providing for proportionate liabilit% in most cases.
22222222 A. n auditor*s legal defense under which the auditor claims that the audit was
performed in accordance with generall% accepted auditing standards.
22222222 B. n auditor*s legal defense under which the auditor claims that the failure to follow
auditing standards did not cause the damages suffered b% the client.
9B
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nswer!
1. g
0. b
9. -
7. a
5. e
?. c
A. n
B. j
$erms! udit failure; &ecurities '(change ct of 1C97; )ontributor% negligence; 4oreign
)orrupt ,ractices ct; &ecurities Litigation @niform &tandards ct of 1CCB; @ltramares doctrine;
>onnegligent performance; bsence of causal connection
Diff! "oderate
Objective! LO 5-0+ LO 5-7+ LO 5-5+ LO 5-? and LO 5-B
)&.! /eflective thin-ing s-ills
5) Discuss some of the steps individual practicing auditors can ta-e to minimize their legal
liabilit%.
nswer! $here are man% steps individual practitioners can ta-e to minimize legal liabilit%
including!
# Deal onl% with clients possessing integrit%.
# Hire 3ualified personnel and train and supervise them properl%.
# 4ollow the standards of the profession.
# "aintain independence.
# @nderstand the client*s business.
# ,erform 3ualit% audits.
# Document the wor- properl%.
# Obtain an engagement letter and a representation letter.
# "aintain confidential relations.
# )arr% ade3uate insurance.
# )onsult with e(perienced legal counsel.
# )hoose a form of organization that provides some form of legal liabilit% protection to
owners.
# '(ercise professional s-epticism.
$erms! &teps auditors can ta-e to minimize legal liabilit%
Diff! 'as%
Objective! LO 5-9 and LO 5-B
)&.! /eflective thin-ing s-ills
9C
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?) $he ,rivate &ecurities Litigation /eform ct of 1CC5 capped damage awards against auditors
to the amount of the audit fees charged.
) $rue
.) 4alse
nswer! .
$erms! ,rivate &ecurities Litigation /eform ct of 1CC5
Diff! 'as%
Objective! LO 5-B
)&.! /eflective thin-ing s-ills
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