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Flashcards in Ch 1 Ethics/Professional/Legal Responsibilities Deck (61)
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1

A CPA who fraudulently performs an audit of a corporation's financial statements will:

A.
probably be liable to any person who suffered a loss as a result of the fraud.

B.
be liable only to the corporation and to third parties who are members of a class of intended users of the financial statements.

C.
probably be liable to the corporation even though its management was aware of the fraud and did not rely on the financial statements.

D.
be liable only to third parties in privity of contract with the CPA.

A.
probably be liable to any person who suffered a loss as a result of the fraud.

A CPA who fraudulently performs an audit of a corporation's financial statements will probably be liable to any person who suffered a loss as a result of the fraud.

The remaining answer choices are an attempt to confuse you with the issue of the Ultramares rule. Recall that the Ultramares decision dealt with a case of a CPA who was negligent as opposed to fraudulent in the conduct of the audit. The Ultramares court ruled that third parties who are not in privity of contract with the accountants cannot sue for negligence (though they can sue for gross negligence).

2

According to the standards of the profession, which of the following sources of information should a CPA consider before signing a client's tax return?

I. Information actually known to the CPA from the tax return of another client
II. Information provided by the client that appears to be correct based on the client's returns from prior years
A.
I only

B.
II only

C.
Both I and II

D.
Neither I nor II

C.
Both I and II

Before signing a client's tax return, a CPA may rely in good faith without verification upon information provided by the client. However, the CPA should not ignore the implications of other information which has come to his or her attention. This would include information known to the CPA from the tax return of another client. The consideration of this information does not violate any rules regarding confidentiality.

3

When CPAs fail in their duty to carry out their contracts for services, liability to clients may be based on:

I. breach of contract.
II. strict liability.
A.
Both A and B

B.
Only A

C.
Neither A or B

D.
Only B

B.
Only A

A CPA may be held liable to clients for fraud, negligence, or breach of contract. Strict liability does not require a finding of fault. Common law has generally required some finding of fault in application to CPAs.

4

The IRS requested client records from a CPA who does not have possession or control of the records. According to Treasury Circular 230, the CPA must:

A.
notify the IRS of the identity of any person who, according to the CPA’s belief, could have the records.

B.
require the client to submit the records to the IRS or withdraw from the engagement.

C.
obtain the records from the client and submit them to the IRS.

D.
contact all third parties associated with the records, such as banks and employers, to obtain the requested records for submission to the IRS.

A.
notify the IRS of the identity of any person who, according to the CPA’s belief, could have the records.

Pursuant to Treasury Circular 230, Section 10.20(a), “A practitioner must, on a proper and lawful request by a duly authorized officer or employee of the Internal Revenue Service, promptly submit records or information in any matter before the Internal Revenue Service unless the practitioner believes in good faith and on reasonable grounds that the records or information are privileged.”

In addition, “Where the requested records or information are not in the possession of, or subject to the control of, the practitioner or the practitioner’s client, the practitioner must promptly notify the requesting Internal Revenue Service officer or employee and the practitioner must provide any information that the practitioner has regarding the identity of any person who the practitioner believes may have possession or control of the requested records or information.”

Hence, the CPA must notify the IRS of the identity of any person who, according to the CPA’s belief, could have the records.

5

The ability to transfer licensing credential from one state to another is controlled by state boards and reciprocity is not guaranteed. Individuals seeking a particular state's licensing credential must present:

A.
a form attesting to the fact that the candidate is licensed elsewhere.

B.
authorization for release of score information.

C.
letters of recommendation from the prior jurisdiction.

D.
a letter of intent to transfer between states.

B.
authorization for release of score information.

The correct answer is to present an authorization for release of score information. This rule is not hard and fast, as it is essential to check each state's rules and regulations. Since the CPA Examination is uniform in all jurisdictions, the scoring is uniform and will be accepted in all locations. The major differences are in experience required to receive a license. However, most states do provide a procedure for this process.

6

The mission of the Financial Accounting Standards Board (FASB) is to:

A.
establish local rules of accountancy.

B.
enforce IRS rules and regulations.

C.
govern accounting provided by governmental agencies.

D.
improve financial standards for nongovernmental entities.

D.
improve financial standards for nongovernmental entities.

The FASB's Mission Statement recognizes that their mission is to improve the accounting standards that apply to nongovernmental entities. The FASB plays an integral role in the regulation of the accounting industry as it applies to CPAs and other financial professionals. The FASB's major function is to establish accounting and reporting requirements for large, publicly held corporations.

7

The AICPA has made the FASAB the organization that will establish GAAP principles for:

A.
state and local CPAs.

B.
state agencies.

C.
international agencies.

D.
federal reporting entities.

D.
federal reporting entities.

Federal reporting entities will be required to follow the rules established by the Federal Accounting Standards Advisory Board (FASAB) when reporting to the public or other agencies.

8

Ivor and Associates, CPAs, audited the financial statements of Jaymo Corp. As a result of Ivor's negligence in conducting the audit, the financial statements included material misstatements. Ivor was unaware of this fact. The financial statements and Ivor's unmodified opinion were included in a registration statement and prospectus for an original public offering of stock by Jaymo. Thorp purchased shares in the offering. Thorp received a copy of the prospectus prior to the purchase but did not read it. The shares declined in value as a result of the misstatements in Jaymo's financial statements becoming known. Under which of the following Acts is Thorp most likely to prevail in a lawsuit against Ivor?

A.
Securities Act of 1933 (Section 11)

B.
Securities Exchange Act of 1934 (Section 10(b), Rule 10b-5)

C.
Both the Securities Act of 1933 (Section 11) and the Securities Exchange Act of 1934 (Section 109(b), Rule 10b-5)

D.
Neither the Securities Act of 1933 nor the Securities Exchange Act of 1934

A.
Securities Act of 1933 (Section 11)

Under Section 11 of the Securities Act of 1933, the plaintiff need only show that misstated material information was contained in the prospectus prior to the public offering. Section 10(b)/Rule 10b-5 requires reliance by the purchaser and knowledge of the falsity (scienter) on the part of the CPA.

9

Professional rules and ethics for CPA tax practitioners that are merely advisory, rather than having formal administrative authority, include which of the following sources?

A.
AICPA Code of Professional Conduct

B.
AICPA Statements on Responsibilities in Tax Practice

C.
Internal Revenue Code

D.
Treasury Department Practice Rules (Circular 230)

B.
AICPA Statements on Responsibilities in Tax Practice

The AICPA Statements on Responsibilities in Tax Practice (SRTP) were issued from 1964 to 1977. On October 31, 2000, the AICPA replaced the SRTP with Statements on Standards for Tax Services (SSTS). Since the SSTS are now the enforceable tax practice standards, the SRTP are merely advisory.

10

Which of the following bodies promulgates standards for audits of federal financial assistance recipients?

A.
Governmental Accounting Standards Board

B.
Financial Accounting Standards Board

C.
Government Accountability Office

D.
Governmental Auditing Standards Board

C.
Government Accountability Office

The Government Accountability Office (GAO) is a federal agency and has power by law to promulgate standards for audits of federal financial assistance recipients. Because of its position, the GAO is also active in releasing reports concerning audits, Congressional testimony, and the like.

None of the other boards specified is a federal agency that has such power.

11

In a common law action against an accountant, lack of privity is a viable defense in most jurisdictions 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.

A.
is the client's creditor who sues the accountant for negligence.

Privity of contract is the existence of a contractual relationship between the accountant and the client. Therefore, there is no lack of privity defense in an action brought by the client. In most cases privity is a required element of any lawsuit by an aggrieved party against the accountant. However, privity is not required if the accountant has been guilty of fraud or gross negligence.

A client's creditor (a third party) suing for mere negligence does not have privity with the accountant and does not fall within either of the mentioned exceptions, and therefore lack of privity of contract is a viable defense against such a lawsuit (under the Ultramares doctrine).

However, recently, many jurisdictions apply the Foreseeable Third-Party Beneficiary Rule, which holds the auditor liable for simple negligence to all third parties who can reasonably be foreseen to rely on the audited financial statements. In such circumstances, the client's creditor could be a foreseeable third-party beneficiary and lack of privity would not be a valid defense against suit for negligence.

12

According to the profession's ethical standards, a CPA would be considered independent in which of the following instances?

A.
A client leases part of an office building from the CPA, resulting in a material indirect financial interest to the CPA.

B.
The CPA has a material direct financial interest in a client, but transfers the interest into a blind trust.

C.
The CPA owns an office building and the mortgage on the building is guaranteed by a client.

D.
The CPA belongs to a client country club in which membership requires the acquisition of a pro rata share of equity.

D.
The CPA belongs to a client country club in which membership requires the acquisition of a pro rata share of equity.

ET Section 191.034 indicates that if membership in a client social club, such as a country club, is basically only for social purposes and the CPA does not serve on the board of directors, then independence would not be violated.

The other answer alternatives, according to ET Section 191, are impairments of independence:

A client leases part of an office building from the CPA, resulting in a material indirect financial interest to the CPA.
The CPA has a material direct financial interest in a client, but transfers the interest into a blind trust.
The CPA owns an office building and the mortgage on the building is guaranteed by a client.

13

Which of the following pairs of elements must a client prove to hold an accountant liable for common-law negligence?

A.
Freedom from contributory negligence and privity

B.
Breach of the accountant’s duty of care and loss

C.
Willful misrepresentation and breach of the accountant’s duty of care

D.
Scienter and a violation of GAAP

B.
Breach of the accountant’s duty of care and loss

An accountant has a liability due to client’s negligence when:

the accountant breached duty owed of an average, reasonable accountant; and
damages or losses resulted from the breach.

14

The quarterly data required by SEC Regulation S-K has been omitted. Which of the following statements must be included in the auditor's report?

A.
The auditor was unable to review the data.

B.
The company's internal control provides an adequate basis to complete the review.

C.
The company has not presented the selected quarterly financial data.

D.
The auditor will review the selected data during the review of the subsequent quarterly financial data.

C.
The company has not presented the selected quarterly financial data.

An independent auditor of registration filings under federal securities statutes is responsible to certify that he has reasonable grounds to believe that statements involved with the registration are true and that there was no omission to state a material fact required to be stated or necessary to make the statements not misleading.

Management has ultimate responsibility for the accuracy of the information filed with the SEC, but the Securities Act of 1933 extends the responsibility for any false or misleading statements to accountants.

This means that if management omits required quarterly data, the auditor is required to disclose the omission in the report.

15

Kar, CPA, is a staff auditor participating in the audit engagement of Fort, Inc. Which of the following circumstances impairs Kar's independence?

A.
During the period of the professional engagement, Fort gives Kar tickets to a football game worth $75.

B.
Kar owns stock in a corporation that Fort's 401(k) plan also invests in.

C.
Kar's friend, an employee of another local accounting firm, prepares Fort's tax returns.

D.
Kar's sibling is an internal auditor employed part-time by Fort.

D.
Kar's sibling is an internal auditor employed part-time by Fort.

Auditor independence is a crucial issue in the professional world today. According to the AICPA, Kar is a “covered member” since Kar is part of the engagement performing the audit. We must now dissect the question's answers.

Kar's sibling, who is an internal auditor employed “part time” by Fort, Inc., is a problem. It is probable that the sibling could have an “influence” over the firm's operating or financial policies, or even over the financial statements or their contents. While it is true that the sibling is a part-time employee, the fact that such sibling is in such a position of possible “influence” is overriding. While an internal auditor does not make policy directly, an internal auditor may well influence such policy by recommendations and the like. As such, there is enough influence to consider the person to be in an “oversight role,” which could affect independence. This is the best answer choice.

A covered member may receive a “token gift” from a client. It is presumed that a $75, one-time football game ticket gift is a token gift, particularly if the client already had the tickets in their possession. Therefore, this answer is incorrect.

A quick reading of this scenario might give you the wrong impression—notice that Kar owns stock in a corporation that the Fort Corporation's 401(k) plan also invests in. It is not Fort, Inc., stock. It is also not Kar's 401(k) plan. If you did not read carefully, you might assume that this was Fort, Inc., stock owned by Kar's 401(k), which would be prohibited. Accordingly, this answer is incorrect.

As to the friend that prepares the corporate tax return, there is no prohibition in being friends with people with whom you do not work. There is no sibling relationship. There should be no ability to influence the audit or the tax return. This is one area that might receive more review in the future, but for now it is not prohibited.

16

A CPA prepares income tax returns for a client. After the client signs and mails the returns, the CPA discovers an error. According to Treasury Circular 230, the CPA must:

A.
document the error in the workpapers.

B.
prepare an amended return within 30 days of the discovery of the error.

C.
promptly advise the client of the error.

D.
promptly resign from the engagement and cooperate with the successor accountant.

C.
promptly advise the client of the error.

When an error is found in a return that has previously been filed with the IRS, the CPA must promptly notify the client of the error. After notification, the CPA should be available to file an amended return to correct the error, if agreed to by the client.

17

A violation of the profession's ethical standards least likely would have occurred when a CPA:

A.
purchased another CPA's accounting practice and based the price on a percentage of the fees accruing from clients over a 3-year period.

B.
received a percentage of the amounts invested by the CPA's audit clients in a tax shelter with the clients' knowledge and approval.

C.
had a public accounting practice and also was president and sole stockholder of a corporation that engaged in data processing services for the public.

D.
formed an association—not a partnership—with two other sole practitioners and called the association “Adams, Betts, and Associates.”

A.
purchased another CPA's accounting practice and based the price on a percentage of the fees accruing from clients over a 3-year period.

ET Section 101.01 notes that a CPA shall be independent in performing professional services. Furthermore, the Professional Ethics Executive Committee (PEEC) looks at the risk involved when establishing its evaluative process concerning independence, so this assessment will determine whether the risk is acceptable or not. Purchase of an accounting practice and the method of valuing the purchase do not violate independence or any other ethical rule. This is a common method of valuing a practice for sale.

The other answer choices involve situations that compromise the ethical position of the CPA, possibly resulting in a violation:

The CPA has a direct financial interest in the clients. (ET 101.02A1)
Whenever a CPA in public practice also has a direct interest in a corporation offering accounting services to the public, the possibility of lack of independence must be carefully monitored. Thus, while this option does not always result in a violation, the high possibility removes it from being considered the “least likely.” (ET 101.05 and 505.02)
Use of the name “Associates” is not permitted because it might mislead the public into thinking a true partnership exists (ET 591.269). Thus, a violation of ET Section 505, “Name of Practice,” would occur.

18

The AICPA Principles of Professional Conduct provide that those who set out to deliver accounting services as a CPA will hold themselves out as:

A.
public servants for the greater good.

B.
professionals.

C.
individuals that will honor the public trust.

D.
None of the answer choices are correct.

C.
individuals that will honor the public trust.

ET Section 0.300.030 (“The Public Interest”) provides that those who accept membership will do so only as long as they honor the public trust.

19

In which of the following types of action, brought against a CPA who issues an audit report containing an unmodified opinion on materially misstated financial statements, may a plaintiff prevail without proving reliance on the audit report?

A.
An action for common law fraud

B.
An action for common law breach of contract

C.
An action brought under Section 11 of the Securities Act of 1933

D.
An action brought under Rule 10b-5 of the Securities Exchange Act of 1934

C. An action brought under Section 11 of the Securities Act of 1933

A plaintiff does not have to prove reliance on materially misstated financial statements under Section 11 of the Securities Act of 1933.

20

Complaints can be filed against CPAs in most jurisdictions through online reporting sites or the state site itself. Reporting a violation requires that the person reporting:

A.
has an attorney file the complaint.

B.
lists his or her name for verification of the complaint.

C.
file the appropriate complaint form.

D.
None of the answer choices are correct.

D.
None of the answer choices are correct.

None of the answer choices are requirements for reporting a violation. Each jurisdiction sets its own standards for the filing of complaints, but generally, any method of filing with the state board of accountancy will suffice. In Texas, for example, a simple letter is appropriate and it is not necessary to include your name. (Texas Occupations Code, Chapter 901 (Public Accountancy Act))

21

Under the common law, which of the following defenses, if used by a CPA, would best avoid liability in an action for negligence brought by a client?

A.
The client was contributorily negligent.

B.
The client was comparatively negligent.

C.
The accuracy of the CPA’s report was not guaranteed.

D.
The CPA’s negligence was not the proximate cause of the client’s losses.

D.
The CPA’s negligence was not the proximate cause of the client’s losses.

Under common law, CPAs are liable to their clients for failure to exercise due professional care. Accordingly, ordinary negligence is a sufficient degree of misconduct to hold CPAs liable for damages caused to their clients. The CPA will not be held liable if losses are not the result of the CPA’s negligence. If the CPA’s negligence did not cause the losses, there would be no liability to the CPA.

Defenses available to the CPA include the following:

The CPA was not negligent or fraudulent.
Contributory negligence of the client caused the loss.
The CPA adhered to GAAS and planned audit examination to search for material fraud.
The error was immaterial.
The proximate cause of loss was not the erroneous financial statements.

22

To which of the following parties may a CPA partnership provide its working papers without either the client's consent or a lawful subpoena?

A.
The IRS: Yes; The FASB: Yes

B.
The IRS: Yes; The FASB: No

C.
The IRS: No; The FASB: Yes

D.
The IRS: No; The FASB: No

D.
The IRS: No; The FASB: No

Generally, clients must be asked whether their materials can be released to other parties. Here, however, the question's proper answer hinges on other matters.

Though the FASB is a governing board for accounting standards, it has neither the inherent ability nor the power to require CPAs to provide copies of working papers to the board. It is not a licensing (or regulatory) board, such as a state board of public accountancy.

The IRS has tremendous and broad administrative powers, particularly in criminal matters, yet it must still follow the law and follow due process procedures. The key to understanding this part of the question is the lack of a lawful subpoena being noted as having been issued. Once a subpoena has been issued, compliance will be necessary. Notice, however, that a third party, the judiciary, has independently reviewed the IRS's materials and determined that probable cause or other appropriate justification is present to issue the subpoena. Unlike an attorney, a CPA does not have absolute privilege, although tax workpapers have some limited privilege. It is not clear here whether such requested records are tax or other working paper

23

The Financial Accounting Standards Board (FASB) structure is such that it is:

A.
tied directly to governmental agencies.

B.
independent of all other business and professional organizations.

C.
not able to reach all accountants equally.

D.
operated in a manner that is consistent with government policy.

B.
independent of all other business and professional organizations.

FASB is independent of all other business and professional organizations. It is part of a larger structure that helps to achieve consistent standards and improve financial accounting standards.

24

The National Association of State Boards of Accountancy (NASBA) is in place to establish standards for providers of continuing professional education (CPE) units throughout the country. The organization also works to:

A.
establish uniform rules of accountancy for all 54 U.S. Boards.

B.
require CPE program sponsors to provide program-level content.

C.
provide background checks on candidates.

D.
promulgate rules surrounding continuing education.

B.
require CPE program sponsors to provide program-level content.

State boards dictate the rules and expectations of licensure within their individual jurisdictions, so the NASBA is tasked with monitoring CPE programs for accuracy and content. Keep in mind that not every jurisdiction has the same education requirements, so it is essential to check with each locale in order to determine what is necessary and what is not.

25

An accountant will be liable for damages under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 only if the plaintiff proves that:

A.
the accountant was negligent.

B.
there was a material omission.

C.
the security involved was registered.

D.
the security was part of an original issuance.

B.
there was a material omission.

Rule 10b-5 specifically makes it unlawful to make an untrue statement or omit a material fact. It covers any instrumentality of interstate commerce, so it would not matter whether the security was registered or part of an original issuance. In the Supreme Court case Hochfelder, the court held that simple negligence is not enough to hold a CPA responsible. Scienter, the intent to deceive, manipulate, or defraud, must be proved to hold the CPA responsible.

26

To be successful in a civil action under Section 11 of the Securities Act of 1933 concerning liability for a misleading registration statement, the plaintiff must prove:

A.
the defendant's intent to deceive.

B.
the plaintiff's reliance on the registration statement.

C.
both the defendant's intent to deceive and the plaintiff's reliance on the registration statement.

D.
neither the defendant's intent to deceive nor the plaintiff's reliance on the registration statement.

D.
neither the defendant's intent to deceive nor the plaintiff's reliance on the registration statement.

To win a civil case under Section 11 of the Securities Act of 1933, the plaintiff does not have to prove that the defendant had intent to deceive nor that the plaintiff had relied on the registration statement. Section 11 of the Securities Act of 1933 imposes a civil liability on all issues, underwriters, etc. for any material errors or misrepresentations in the registration statements regardless of whether an investor actually relied on the statement or not. Such broad liability serves to create a strong incentive on the part of management to avoid any “mistakes” and it ensures that all parties preparing a registration statement will review all documents carefully.


27

Which of the following statements is true about the IRS?

A.
The IRS promulgates the rules governing CPAs as they practice before the IRS.

B.
The IRS follows the rules set forth by the individual state boards of accountancy.

C.
The IRS uses the rules provided by the AICPA when determining professional rules surrounding CPAs.

D.
None of the answer choices are true statements.

A.
The IRS promulgates the rules governing CPAs as they practice before the IRS.

The IRS determines what rules CPAs that practice in front of them will follow. While it is true that numerous other regulatory agencies, including state boards of accountancy, provide insight and overview, when it comes to practicing in front of the IRS, the IRS has the final word.

28

A company engaged a CPA to perform the annual audit of its financial statements. The audit failed to reveal an embezzlement scheme by one of the employees. Which of the following statements best describes the CPA's potential liability for this failure?

A.
The CPA's adherence to generally accepted auditing standards (GAAS) may prevent liability.

B.
The CPA will not be liable if care and skill of an ordinary reasonable person was exercised.

C.
The CPA may be liable for punitive damages if due care was not exercised.

D.
The CPA is liable for any embezzlement losses that occurred before the scheme should have been detected.

A.
The CPA's adherence to generally accepted auditing standards (GAAS) may prevent liability.

When performing an audit, a CPA must exercise the level of care, skill, and judgment expected of a reasonably prudent CPA under the circumstances. This statement includes the standard that CPAs are held to in performing audits.

CPAs do not have strict liability for discovering fraud. If fraud is discovered in the audit, the CPA must disclose this to the client.

CPAs are liable to their clients if they are negligent in performing the audit.

29

Which of the following would be considered to impair a CPA's independence while performing extended audit services?

A.
Confirming of accounts receivable

B.
Performing a separate evaluation of a client's internal control

C.
Reporting to the board of directors or audit committee on behalf of management or the individual responsible for the internal audit function

D.
Performing a separate evaluation of the client's ongoing monitoring activities

C.
Reporting to the board of directors or audit committee on behalf of management or the individual responsible for the internal audit function

Interpretation 101-3 of Rule 101 generally notes that a member's performance of extended audit services would not be considered to impair independence with respect to a client for which the member is also providing services requiring independence, provided the member or his or her firm does not act or does not appear to act in a capacity equivalent to a member of client management or as an employee.

A member's independence would not be impaired by the performance of separate evaluations of the effectiveness of a client's internal control, including separate evaluations of the client's ongoing monitoring activities. Also, performing procedures which are considered extensions of the member's audit scope applied in an audit of the client's financial statements, such as confirming of accounts receivable, would not impair independence.

However, reporting to the board of directors or audit committee on behalf of management or the individual responsible for the internal audit function, would be an activity that would impair independence.

30

Under the liability provisions of Section 11 of the Securities Act of 1933, which of the following must a plaintiff prove to hold a CPA liable?

I. The misstatements contained in the financial statements certified by the CPA were material.
II. The plaintiff relied on the CPA's unmodified opinion.
A.
I only

B.
II only

C.
Both I and II

D.
Neither I nor II

A. I only

Section 11 deals with the civil liability for damages related to registration statements that are filed with the SEC. Generally, the accountant will be liable if the accountant prepared any financial statements that “contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading” (15 USC 77k(a)) (Emphasis added).

The reliance on an unmodified statement, for purposes of this liability section, is not enough. There must have been material facts—either misstated or omitted—in the filing statement. Note that defendants may assert a due diligence defense. The defendant must prove that, after reasonable investigation, there were reasonable grounds to believe that there were no omissions of material facts or any untrue statements.

31

A CPA works for a large petrochemical company. The CPA has chosen not to file his personal federal tax return for the last three years. The CPA:

A.
may be disciplined by his employer.

B.
has no ethical exposure to anyone other than himself, although he is subject to IRS scrutiny.

C.
may not be disciplined by the AICPA or his state society as he is not in public practice.

D.
has committed an act discreditable to the profession.

D.
has committed an act discreditable to the profession.

The CPA, while an employee of industry, nevertheless is bound by the AICPA rules of professional conduct. A common misperception is that the various rules of professional conduct have no applicability to the member in industry. This is simply false. The answer is that the CPA has committed an act discreditable to the profession as outlined in ET Section 501, “Acts discreditable to the profession,” Interpretation 501-7, “Failure to File Tax Return or Pay Tax Liability.” Accordingly, the CPA may be disciplined by the state board or AICPA for committing an act discreditable to the profession.

32

In Year 6, an IRS agent completed an examination of a corporation's Year 5 tax return and proposed an adjustment that will result in an increase in taxable income for each of Years 1 through 5. All returns were filed on the original due date. The proposed adjustment relates to the disallowance of corporate jet usage for personal reasons. The agent does not find the error to be fraudulent or substantial in nature. Which of the following statements regarding this adjustment is correct?

A.
The adjustment is improper because an agent may only propose adjustments to the year under examination.

B.
The adjustment is proper because there is no statute of limitations for improperly claiming personal expenses as business expenses.

C.
The adjustment is proper because it relates to a change in accounting method, which can be made retroactively irrespective of the statute of limitations.

D.
The adjustment is improper because the statute of limitations has expired for several years of the adjustment.

D.
The adjustment is improper because the statute of limitations has expired for several years of the adjustment.

Generally, the statute of limitations for the period to question tax returns is three years after the date the return is filed or the due date, whichever is later. In the case described, only Year 5 and Year 4 are clearly at risk, and Year 3 may be depending on the date the audit is completed. The time may be extended if the return is fraudulent or if unreported income is greater than 25% of the gross income reported. Neither of these conditions is present.

IRC Sec 6501(a) and (e)

33

According to the standards of the profession, which of the following activities may be required in exercising due care?

A.
Consulting with experts

B.
Obtaining specialty accreditation

C.
Both consulting with experts and obtaining specialty accreditation

D.
Neither consulting with experts nor obtaining specialty accreditation

A.
Consulting with experts

The standards of the profession provide that an accountant may be required to consult with an expert in order to carry out the job in a competent fashion. The obtaining of specialty accreditation is generally not required.

34

When performing an audit, a CPA will most likely be considered negligent when the CPA fails to:

A.
detect all of a client's fraudulent activities.

B.
include a negligence disclaimer in the client engagement letter.

C.
warn a client of known internal control weaknesses.

D.
warn a client's customers of embezzlement by the client's employees.

C.
warn a client of known internal control weaknesses.

A CPA will be guilty of simple negligence if he or she fails to warn a client of known internal control problems. This is based upon the CPA's general obligation to carry out professional duties with the same skill and judgment possessed by the average CPA. There is no obligation to detect all of a client's fraudulent activities or to warn customers of the client that some of the client's employees may be guilty of embezzlement. Negligence disclaimers in engagement letters are inappropriate and probably not legally enforceable.

35

A company engaged a CPA to perform the annual audit of its financial statements. The audit failed to reveal an embezzlement scheme by one of the employees. Which of the following statements best describes the CPA's potential liability for this failure?

A.
The CPA's adherence to generally accepted auditing standards (GAAS) may prevent liability.

B.
The CPA will not be liable if care and skill of an ordinary reasonable person was exercised.

C.
The CPA may be liable for punitive damages if due care was not exercised.

D.
The CPA is liable for any embezzlement losses that occurred before the scheme should have been detected.

A.
The CPA's adherence to generally accepted auditing standards (GAAS) may prevent liability.

When performing an audit, a CPA must exercise the level of care, skill, and judgment expected of a reasonably prudent CPA under the circumstances. This statement includes the standard that CPAs are held to in performing audits.

CPAs do not have strict liability for discovering fraud. If fraud is discovered in the audit, the CPA must disclose this to the client.

CPAs are liable to their clients if they are negligent in performing the audit.

36

Which of the following would be considered to impair a CPA's independence while performing extended audit services?

A.
Confirming of accounts receivable

B.
Performing a separate evaluation of a client's internal control

C.
Reporting to the board of directors or audit committee on behalf of management or the individual responsible for the internal audit function

D.
Performing a separate evaluation of the client's ongoing monitoring activities

C.
Reporting to the board of directors or audit committee on behalf of management or the individual responsible for the internal audit function

Interpretation 101-3 of Rule 101 generally notes that a member's performance of extended audit services would not be considered to impair independence with respect to a client for which the member is also providing services requiring independence, provided the member or his or her firm does not act or does not appear to act in a capacity equivalent to a member of client management or as an employee.

A member's independence would not be impaired by the performance of separate evaluations of the effectiveness of a client's internal control, including separate evaluations of the client's ongoing monitoring activities. Also, performing procedures which are considered extensions of the member's audit scope applied in an audit of the client's financial statements, such as confirming of accounts receivable, would not impair independence.

However, reporting to the board of directors or audit committee on behalf of management or the individual responsible for the internal audit function, would be an activity that would impair independence.

37

Rules of accountancy differ from state to state and are difficult to understand. Where can a candidate find information that will allow him or her to maintain licensure records and view requirements for multiple jurisdictions?

A.
Each state will list requirements for all state licensing programs.

B.
The National Clearinghouse of CPAs

C.
The Federal CPA Exam Center

D.
NASBA tools for accounting compliance

D.
NASBA tools for accounting compliance

Each state has different rules and regulations as they apply to licensing requirements, but the NASBA Tools for Accounting Compliance (www.nasbatools.com) allow a candidate to view a CPE registry, compile credentials in one convenient location, and search jurisdictional requirements.

38

Thorp, CPA, was engaged to audit Ivor Co.'s financial statements. During the audit, Thorp discovered that Ivor's inventory contained stolen goods. Ivor was indicted and Thorp was subpoenaed to testify at the criminal trial. Ivor claimed accountant-client privilege to prevent Thorp from testifying.

Which of the following statements is correct regarding Ivor's claim?

A.
Ivor can claim an accountant-client privilege only in states that have enacted a statute creating such a privilege.

B.
Ivor can claim an accountant-client privilege only in federal courts.

C.
The accountant-client privilege can be claimed only in civil suits.

D.
The accountant-client privilege can be claimed only to limit testimony to audit subject matter.

A.
Ivor can claim an accountant-client privilege only in states that have enacted a statute creating such a privilege.

The “accountant-client” privilege does not generally exist, although some states have adopted statutes providing for such a privilege. The accountant in this case could successfully claim the accountant-client privilege only in those states that have adopted a statute creating such a privilege. The privilege does not apply in federal court or federal administrative agencies. While a limited privilege exists in a noncriminal tax matter, this fact situation does not allow a consideration of that very limited privilege.

39

According to the ethical standards of the profession, a CPA's independence would most likely be impaired if the CPA:

A.
accepted any gift from a client.

B.
became a member of a trade association that is a client.

C.
contracted with a client to supervise the client's office personnel.

D.
served, with a client bank, as a co-fiduciary of an estate or trust.

C.
contracted with a client to supervise the client's office personnel.

Under the AICPA Code of Professional Conduct, the Independence Rule (ET 1.200.001) prohibits a CPA from acting in essence as a member of management. Supervising the client's office personnel would violate this rule.

40

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

A.
Gross negligence in applying generally accepted auditing standards

Gross negligence (constructive fraud) is the extreme, flagrant, or reckless departure from the standards of due care and competence in performing or reporting upon professional engagements. There need not be actual intent to deceive (scienter). Ordinary negligence is a lesser offence than gross negligence. There is no necessity to identify any third-party users.

41

Under the ethical standards of the profession, which of the following business relationships would generally not impair an auditor's independence?

A.
Promoter of a client's securities

B.
Member of a client's board of directors

C.
Client's general counsel

D.
Advisor to a client's board of trustees

D.
Advisor to a client's board of trustees

Independence is the ability to act with integrity and objectivity. Independence and the appearance of independence are required for attest services so that the auditor's professional judgment is not impaired.

The AICPA Code of Professional Conduct uses seven categories to review whether a situation can cause a threat to independence. These threats are:

self-review (auditing the auditor's own work),
advocacy (promoting a client's interests),
adverse interest (taking action against the attest client such as litigation),
familiarity (having a close or long-standing relationship with the attest client),
undue influence (client attempting to coerce the auditor),
financial self-interest (directly benefiting due to a financial interest in the client), and
management participation (taking on the role of management).
A CPA would be considered to be an advocate of the client if he were promoting the client's securities or acting as the client's general counsel. Independence would be impaired if the CPA acted as a member of the client's board of directors, which is the equivalent of management participation. CPAs are permitted to advise the client's board of trustees without impairing independence.

42

Which of the following acts constitute(s) grounds for a tax preparer penalty?

I. Without the taxpayer's consent, the tax preparer disclosed taxpayer income tax return information under an order from a state court.
II. At the taxpayer's suggestion, the tax preparer deducted the expenses of the taxpayer's personal domestic help as a business expense on the taxpayer's individual tax return.
A.
I only

B.
II only

C.
Both I and II

D.
Neither I nor II

B.
II only

Taxpayer return information may be disclosed without penalty if the information is (1) to a tax processor to file electronically, (2) for peer review of the preparer, (3) for administrative order by a state agency or state court order. Preparers are subject to a $1,000 penalty for a willful attempt to understate tax liability or a reckless or intentional disregard of the rules and regulations.

The rules and regulations clearly do not permit a deduction for a taxpayer's personal domestic help as a business expense.

43

Under the position taken by a majority of the courts, to which third parties will an accountant who negligently prepares a client's financial report be liable?

A.
Only those third parties in privity of contract with the accountant

B.
All third parties who relied on the report and sustained injury

C.
Any foreseen or known third party who relied on the report

D.
Any third party whose reliance on the report was reasonably foreseeable

C.
Any foreseen or known third party who relied on the report

If the financial reports are primarily for the benefit of a third party, the CPA may be held liable. The third party may be considered a party to the contract.

44

Under the provisions of Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, which of the following activities must be proven by a stock purchaser in a suit against a CPA?

A. Intentional conduct by the CPA designed to deceive investors
B. Negligence by the CPA
A.
I only

B.
II only

C.
Both I and II

D.
Neither I nor II

A. Intentional conduct by the CPA designed to deceive investors

Under the Securities Exchange Act of 1934, the CPA can be held liable to investors in certain circumstances. The United States Supreme Court, in Hochfelder (1976), ruled that such liability will attach only if scienter can be proven.

Scienter is a deliberate act intended to deceive, manipulate, or defraud. Thus, simple negligence is not sufficient to impose liability on the CPA under this interpretation of the statute.

45

A CPA prepared a tax return that involved a tax shelter transaction that was disclosed on the return. In which of the following situations would a tax return preparer penalty not be applicable?

A.
There was substantial authority for the position.

B.
It is reasonable to believe that the position would more likely than not be upheld.

C.
There was a reasonable possibility of success for the position.

D.
There was a reasonable basis for the position.

B.
It is reasonable to believe that the position would more likely than not be upheld.

A CPA should not recommend to a client that a position be taken with the tax treatment of an item on a return unless the CPA has a firm belief that the position has a realistic possibility of being sustained by the IRS or the courts if challenged. The definition of “realistic possibility” is “the position will more likely than not be upheld”; the mathematical approach is “the chances of the position being upheld must be better than one out of two.”

46

Hark, CPA, failed to follow generally accepted auditing standards in auditing Long Corp.'s financial statements. Long's management had told Hark that the audited statements would be submitted to several banks to obtain financing. Relying on the statements, Third Bank gave Long a loan. Long defaulted on the loan. In a jurisdiction applying the Ultramares decision, if Third sues Hark, Hark will:

A.
win because there was no privity of contract between Hark and Third.

B.
lose because Hark knew that banks would be relying on the financial statements.

C.
win because Third was contributorily negligent in granting the loan.

D.
lose because Hark was negligent in performing the audit.

A.
win because there was no privity of contract between Hark and Third.

In a jurisdiction applying the Ultramares decision, if Third Bank sues Hark CPA, Hark will win because there was no privity of contract between Hark and Third. The key term is the Ultramares decision, referring to the landmark case of Ultramares Corporation v. Touche. In this case, the accountants were found guilty of negligence in performing an audit.

However, the court held that the accountant had no liability to third parties for ordinary negligence even though liability to third parties could be imposed for fraud or gross negligence. Many courts still follow the Ultramares rule that since there is no privity between a third-party user of an audited financial statement and the CPA firm, there is no cause of action by the third party against the CPA firm for negligence.

The Ultramares court ruled that even if a CPA firm knows that the audited financial statements are to be used by a creditor to make lending decisions, the third-party user lacks privity with the CPA firm and cannot recover for negligence.

47

A CPA will be liable to a tax client for damages resulting from all of the following actions, except:

A.
failing to timely file a client's return.

B.
failing to advise a client of certain tax elections.

C.
refusing to sign a client's request for a filing extension.

D.
neglecting to evaluate the option of preparing joint or separate returns that would have resulted in a substantial tax savings for a married client.

C.
refusing to sign a client's request for a filing extension.

A CPA will be liable to a tax client for damages from:

failing to timely file a client's return,
failing to advise a client of certain tax deductions, and
neglecting to evaluate the option of preparing joint or separate returns that would have resulted in substantial tax savings for a married client.

48

Dart Corp. engaged Jay Associates, CPAs, to assist in a public stock offering. Jay audited Dart's financial statements and gave an unmodified opinion, despite knowing that the financial statements contained misstatements. Jay's opinion was included in Dart's registration statement. Larson purchased shares in the offering and suffered a loss when the stock declined in value after the misstatements became known.

If Larson succeeds in the Section 11 suit against Dart, Larson would be entitled to:

A.
damages of three times the original public offering price.

B.
rescind the transaction.

C.
monetary damages only.

D.
damages, but only if the shares were resold before the suit was started.

C.
monetary damages only.

If Larson succeeds in the Section 11 suit against Dart (issuer), the investor would be entitled to monetary damages only.

Section 11 of the Securities Act of 1933 does not provide for treble damages or for rescission. There is also no requirement that the shares be resold before the suit is started.

49

A CPA assists a taxpayer in tax planning regarding a transaction that meets the definition of a tax shelter as defined in the Internal Revenue Code. Under the AICPA Statements on Standards for Tax Services (SSTS), the CPA should inform the taxpayer of the penalty risks unless the transaction, at the minimum, meets which of the following standards for being sustained if challenged?

A.
More likely than not

B.
Not frivolous

C.
Realistic possibility

D.
Substantial authority

A.
More likely than not

“More likely than not” is now the standard for judging the chances of a position being accepted by the IRS and the courts. “More likely than not” can also be stated as “better than one chance out of two.”

50

To which of the following parties may a CPA partnership provide its working papers, without being lawfully subpoenaed or without the client's consent?

A.
The IRS

B.
The FASB

C.
Any surviving partner(s) on the death of a partner

D.
A CPA before purchasing a partnership interest in the firm

C.
Any surviving partner(s) on the death of a partner

Without a subpoena or client consent, a CPA partnership may provide its working papers only to surviving partners on the death of a partner or under a review of the CPA's professional practice under AICPA or State CPA Society or Board of Accountancy authorization. In most other cases, including the IRS and a CPA purchasing a partnership interest in the firm, a subpoena or the client's consent is required.

The FASB should have no reason to need access to a practitioner's working papers.

51

The partnership of Rodgers & Higgs, CPAs, performed audits of Alt Corp., a publicly traded company, for the past several years. After issuing the current year's audit report, the CFO of Alt confessed to having committed fraud against Alt. Under which of the following statutes would the investors most likely bring suit against Rodgers & Higgs?

A.
Securities Act of 1933, if they can prove ordinary negligence

B.
Securities Act of 1933, if they can prove gross negligence

C.
Securities Exchange Act of 1934, if they can prove ordinary negligence

D.
Securities Exchange Act of 1934, if they can prove scienter

D.
Securities Exchange Act of 1934, if they can prove scienter

Investors would most likely bring suit against Rodgers & Higgs under the Security Exchange Act of 1934, if they can prove scienter.

As stated in Black’s Law Dictionary, the term “scienter” is used in pleading an allegation setting out the defendant’s previous knowledge of the cause, which led to the injury complained of, or rather the defendant's previous knowledge of a state of facts that it was his duty to guard against, and his omission to do that has led to the injury complained of. The term is frequently used to signify the defendant’s guilty knowledge.

In this case, the accounting firm should have found the fraud being committed by the chief financial officer.

52

Which of the following facts must be proven for a plaintiff to prevail in a common-law negligent misrepre­sentation action?

A.
The defendant made the misrepresentations with a reckless disregard for the truth.

B.
The plaintiff justifiably relied on the misrepresentations.

C.
The misrepresentations were in writing.

D.
The misrepresentations concerned opinion.

B.
The plaintiff justifiably relied on the misrepresentations.

In the Ultramares case, a third party who proves gross negligence will be able to prove that the CPA is guilty of fraud. Gross negligence is a deceit that involves a misrepresentation of a material fact, with lack of reasonable ground for belief, relied upon by another, which causes damage to that party.

53

A client suing a CPA for negligence must prove each of the following factors except:

A.
breach of duty of care.

B.
proximate cause.

C.
reliance.

D.
injury.

C.
reliance.

To establish negligence, a client must show that:
the CPA owed a legal duty,
the CPA breached that duty,
the CPA's action was the proximate cause of the resulting injury to the client, and the CPA's actions caused the damage or loss.

The client does not have to prove reliance on the CPA's advice.

54

Cable Corp. orally engaged Drake & Co., CPAs, to audit its financial statements. Cable’s management informed Drake that it suspected the accounts receivable were materially overstated. Though the finan­cial statements Drake audited included a materially overstated accounts receivable balance, Drake issued an unmodified opinion. Cable used the financial statements to obtain a loan to expand its operations. Cable defaulted on the loan and incurred a substantial loss. If Cable sues Drake for negligence in failing to discover the overstatement, Drake’s best defense would be that Drake did not:

A.
have privity of contract with Cable.

B.
sign an engagement letter.

C.
perform the audit recklessly or with an intent to deceive.

D.
violate generally accepted auditing standards in performing the audit.

D.
violate generally accepted auditing standards in performing the audit.

Under general legal liability, a CPA must not perform work negligently and therefore must exercise due care. There is no legal requirement that there be an engagement letter. A finding of negligence does not require reckless behavior or the intent to deceive. Privity does not have to be considered; Cable and Drake do not need a relationship for the agreement. However, a CPA’s responsibility is defined by generally accepted auditing standards (GAAS). Defenses to legal actions concerning the lack of due care include the fact that the CPA adhered to GAAS. The failure to follow GAAS would be considered a lack of due care.

55

Under the liability provisions of Section 11 of the Securities Act of 1933, a CPA may be liable to any purchaser of a security for certifying materially misstated financial statements that are included in the security's registration statement.

Under Section 11, which of the following must be proven by a purchaser of the security?

A.
Reliance on the financial statements

B.
Fraud by the CPA

C.
Both reliance on the financial statements and fraud by the CPA

D.
Neither reliance on the financial statements nor fraud by the CPA


D.
Neither reliance on the financial statements nor fraud by the CPA

Under Section 11 of the Securities Act of 1933, the purchaser of a security may have a cause of action against the CPA if the associated financial statements are materially misleading. The purchaser need not prove reliance on the financial statements nor must the purchaser prove fraud (or even negligence) by the CPA.

Section 11 shifts the burden of proof from the plaintiff to the defendant—the CPA must prove innocence by establishing one of the permitted defenses.

56

Which of the following statements best describes whether a CPA has met the required standard of care in conducting an audit of a client's financial statements?

A.
The client's expectations with regard to the accuracy of audited financial statements

B.
The accuracy of the financial statements and whether the statements conform to generally accepted accounting principles

C.
Whether the CPA conducted the audit with the same skill and care expected of an ordinarily prudent CPA under the circumstances

D.
Whether the audit was conducted to investigate and discover all acts of fraud

C. Whether the CPA conducted the audit with the same skill and care expected of an ordinarily prudent CPA under the circumstances

A CPA meets the required standard of care in conducting an audit of a client's financial statements by exercising the same skill and care expected of an ordinarily prudent CPA under the same or similar circumstances. This is the standard of professional conduct below which liability may result. Client expectations, accuracy of the financial statements, and whether or not the audit was conducted to find fraud are irrelevant. The key concept is due professional care, the standard of care required of a CPA.

57

Joe is the trustee of a trust set up for his father. Under the Internal Revenue Code, when Joe prepares the annual trust tax return, IRS Form 1041, he:

A.
must obtain the written permission of the beneficiary prior to signing as a tax return preparer.

B.
is not considered a tax return preparer.

C.
may not sign the return unless he receives additional compensation for the tax return.

D.
is considered a tax return preparer because his father is the grantor of the trust.

B.
is not considered a tax return preparer.

An individual may represent a member of their immediate family before the IRS. Since Joe is the trustee of a trust set up for his father, he is representing his father.

Circular 230 allows individuals who are not CPAs, attorneys, or enrolled agents to engage in limited practice before the IRS.

58

Under the “Ultramares” rule, to which of the following parties will an accountant be liable for negligence?

A.
Parties in privity of contract

B.
Foreseen parties

C.
Both parties in privity and foreseen parties

D.
Neither parties in privity nor foreseen parties

A.
Parties in privity of contract

The Ultramares rule derives from the case of Ultramares Corporation v. Touche (N.Y. 1931). In that case, the court held that a CPA's liability for negligent acts extended only to those parties with whom the CPA was in privity of contract, unless the victim could prove gross negligence or fraud. While some states have expanded the liability of the CPA to include “foreseeable” parties (parties who the accountant knew would use the work product), this is not the holding of the Ultramares case.

59

Which of the following would not be considered to impair a CPA's independence while performing extended audit services?

A.
Analyzing fluctuations in account balances if the extent of such testing exceeds that required by generally accepted auditing standards

B.
Determining which, if any, recommendations for improving the internal control system should be implemented

C.
Approving or being responsible for the overall internal audit work plan, including the determination of the internal audit risk and scope

D.
Preparing source documents on transactions

A. Analyzing fluctuations in account balances if the extent of such testing exceeds that required by generally accepted auditing standards

Interpretation 101-3 of Rule 101 generally notes that a member's performance of extended audit services would not be considered to impair independence with respect to a client for which the member is also providing services requiring independence, provided the member or his or her firm does not act or does not appear to act in a capacity equivalent to a member of client management or as an employee.

Among the examples of activities that if performed as part of an extended audit service would be considered to impair a member's independence are:
determining which, if any, recommendations for improving the internal control system should be implemented.
approving or being responsible for the overall internal audit work plan, including the determination of the internal audit risk and scope, project priorities, and frequency of performance of audit procedures.
preparing source documents on transactions.

However, performing procedures that are generally of the type considered to be extensions of the member's audit scope applied in the audit of the client's financial statements, such as confirming of accounts receivable and analyzing fluctuations in account balances, would not impair independence. This is the case even if the extent of such testing exceeds that required by generally accepted auditing standards.

60

According to the AICPA Statements on Standards for Tax Services, which of the following factors should a CPA consider in choosing whether to provide oral or written advice to a client?

A.
Whether the client will seek a second opinion

B.
The tax sophistication of the client

C.
The likelihood that current tax litigation will impact the advice

D.
The client's business acumen

B.
The tax sophistication of the client

The advice given should serve the taxpayer's needs adequately. Oral advice should be documented if the taxpayer seems to not truly understand the consequences of the tax implication. The CPA is not required to follow a standard on documenting oral or written communications.

61

Which of the following is the best defense a CPA firm can assert in a suit for common law fraud based on its unmodified opinion on materially false financial statements?

A.
Contributory negligence on the part of the client

B.
A disclaimer contained in the engagement letter

C.
Lack of privity

D.
Lack of scienter

D.
Lack of scienter

The essential element of “common law fraud” is an intent to defraud or deceive. Another expression for an intent to defraud is “scienter.” Thus, if a CPA is sued for fraud, a good defense would be proof that there was a lack of “scienter.”