Ch 4 - Auditor's Legal Liability

Question 1

The burden of proof to recover losses from the auditors under the Securities Exchange Act of 1934 is generally considered to be:

The same as the Securities Act of 1933.

Greater than the Securities Act of 1933.

Less than the Securities Act of 1933.

Indeterminate in relation to the Securities Act of 1933.

Answer 1

Greater than the Securities Act of 1933.

Question 2

Under which act (or acts) may criminal charges against a CPA be filed?

Answer 2

The Securities Act of 1933 & the Securities Act of 1934

Question 3

A CPA issued an unqualified opinion on the financial statements of a company that sold common stock in a public offering subject to the Securities Act of 1933. Based on a misstatement in the financial statements, the CPA is being sued by an investor who purchased shares of this public offering. Which of the following represents a viable defense?

The investor did not actually rely upon the false statement.

The investor has not proved fraud or negligence by the CPA.

The CPA detected the false statement after the audit date.

The false statement is immaterial in the overall context of the financial statements.

Answer 3

The false statement is immaterial in the overall context of the financial statements.

Question 4

In a common law action against an accountant, lack of privity is a viable defense if the plaintiff:

Is the client’s creditor who sues the accountant for negligence.

Is the accountant’s client.

Bases the action upon fraud.

Can prove the presence of gross negligence that amounts to a reckless disregard for the truth.

Answer 4

Is the client’s creditor who sues the accountant for negligence.

Question 5

An auditor knew that the purpose of her audit was to render reasonable assurance on financial statements that were to be used for the application for a loan; the auditor did not know the identity of the bank that would eventually give the loan. Under the foreseeable third party approach, the auditor is generally liable to the bank which subsequently grants the loan for:

Either ordinary or gross negligence.

Lack of good faith.

Lack of due diligence.

Gross negligence, but not ordinary negligence.

Answer 5

Either ordinary or gross negligence.

Question 6

The most frequent trigger of a lawsuit against an auditor is a…

Answer 6

“Big R” Restatement

Question 7

The right to sue is also known as…

Answer 7

Standing (need a body of law)

Question 8

How does the Plaintiff “win” the lawsuit?

Answer 8

by finding a source of law which supports their claim for damages

& proving detailed points required by that source of law.

Question 9

How does the Defendant “win” the lawsuit?

Answer 9

Defendant wins if the Plaintiff fails to prove any of the detailed points required by the law.

Question 10

How can the auditor lower their chances of going to court and/or paying damages in court?

(6 ways)

Answer 10

1. Improve audit quality
2. Buy malpractice insurance
3. Report more conservatively
4. Lobby for legal reform
5. Be More Selective in the Type of Clients Selected
6. Avoid Parts of the Audit Market/Industry

Question 11

We want auditors to suffer the consequences of doing a bad audit to motivate them to do better and malpractice insurance contradicts this

Answer 11

Moral Hazard

Question 12

____________________ creates Opportunity Costs for investors.

Answer 12

Reporting more conservatively

Question 13

What two ways to lower auditor risk of being sued are associated with engagement risk?

Answer 13

1. Being more selective of types of audit clients
2. Avoiding certain industries

Question 14

What is the “best” defense for auditors?

Answer 14

That they conducted the audit “according to the relevant standards”

Question 15

The higher (inappropriately high) understanding of the auditor’s responsibilities that the general public has VS the responsibilities the auditor actually has

Answer 15

Expectations Gap

Question 16

How do auditors deal with the Expectations Gap?

Answer 16

Auditor’s lawyers have to spend valuable court time educating the judge/jury on what the auditors’ responsibilities (by standards) actually are

Question 17

Who makes up the largest number of lawsuits against the auditor?

Answer 17

Clients

Question 18

T/F: The dollar amounts associated with clients suing auditors tend to be large.

Answer 18

False; dollar amounts tend to be small

Question 19

What two sources of Common Law are available to clients for gaining standing?

Answer 19

1. Law of Torts/Negligence
2. Breach of Contract

Question 20

T/F: The specific items that the Plaintiff/Client has to prove are the same whether they are using Breach of Contract or Law of Torts Common Law.

Answer 20

True

Question 21

What 4 notions does the client/3rd party have to prove?

Answer 21

1. Duty
2. Breach of duty
3. Loss
4. Proximate cause

Question 22

The auditor has a duty to avoid Ordinary/Gross Negligence under the _________ (law of torts/breach of contract).

Answer 22

Law of Torts

Question 23

The Plaintiff/Client has to prove all 4 points to get damages out of the auditor based on the ________________.

Answer 23

Preponderance of the Evidence

Question 24

Auditors will often focus their defense on attacking which notion?

Answer 24

The Breach of Duty notion

Question 25

Investors and creditors who put money into/lent money to the audit client

Answer 25

3rd parties

Question 26

Which type of lawsuits produce huge damages and media attention, but are less frequent?

Answer 26

3rd party lawsuits

Question 27

What source of Common Law is available to 3rd parties for gaining standing?

Answer 27

1. Law of Torts (Breach of Contract is not available because auditor did not sign a contract with the 3rd party)

Question 28

T/F: Clients can sue for gross negligence.

Answer 28

False; only 3rd parties can

Question 29

T/F: Auditors always have a duty to 3rd Parties to avoid Gross Negligence and Ordinary Negligence

Answer 29

False; always gross but not always ordinary (depends on state)

Question 30

Duty to a 3rd Party to avoid Ordinary Negligence if: 1. The audit is done for the primary benefit (sales/loans) of the 3rd Party. 2. The auditor knows the identity of the 3rd Party.

Answer 30

Primary Beneficiaries Approach

Question 31

Duty to a 3rd Party to avoid Ordinary Negligence if: 1. The audit is done for the primary benefit of the 3rd Party. 2. The auditor does NOT need to know the identity of the 3rd Party.

Answer 31

Foreseen 3rd Parties Approach (think: seen = no)

Question 32

Auditor has a duty to avoid Ordinary Negligence to any 3rd Party they could reasonably foresee using the financial statements

Answer 32

Foreseeable 3rd Parties Approach (think: reasonably foresee = foreseeABLE)

Question 33

Which approach is best for the auditor? Which is worst?

Answer 33

Best: Primary Beneficiaries Approach Worst: Foreseeable 3rd Parties Approach

Question 34

What approach does Arizona use?

Answer 34

Foreseen 3rd Parties Approach (most common for states)

Question 35

The location of the _______ (Plaintiff/Defendant) determines the jurisdiction of the lawsuit

Answer 35

Plaintiff

Question 36

Which approach will Plaintiff's lawyers argue for?

Answer 36

state with Foreseeable 3rd Parties Approach

Question 37

2 Statutory laws that create civil liability for the auditor?

Answer 37

1. Securities Act of 1933 2. Securities Act of 1934

Question 38

Statutory Law passed by the US Congress to regulate various aspects of securities trading in the US; created the SEC, requires companies to file audited financial statements annually; creates Civil Liability for auditors

Answer 38

Securities Act of 1934

Question 39

Statutory Law passed by the US Congress to regulate various aspects of Initial Public Offerings (IPOs).

Answer 39

Securities Act of 1933

Question 40

The Securities Act of ____ (1933/1934) was the biggest regulatory change in auditing/securities trading in the US, ever

Answer 40

1934

Question 41

What 4 notions does the Plaintiff have to prove for the Securities Act of 1934?

Answer 41

1. They sustained a loss 2. They relied on financial statements (cause) 3. FS were misleading (breach of duty) 4. Intent to defraud (breach of duty)

Question 42

Good Faith defense implicitly disproves which notion?

Answer 42

Scienter / Intent to defraud

Question 43

T/F: Both the Securities Acts of 1933 & 1934 create civil liability for auditors.

Answer 43

True

Question 44

What 2 notions does the Plaintiff have to prove for the Securities Act of 1933?

Answer 44

1. Loss 2. Registration statement was misleading

Question 45

The defendant conducted the audit with Due Diligence is a good defense for the Securities Act of ____ (1933/1934)?

Answer 45

1933

Question 46

The burden of proof shifts (partially) to the Defendant under the Securities Act of ____ (1933/1934).

Answer 46

1933 (have to disprove proximate cause & breach of duty)

Question 47

T/F: The liability of the auditor drastically increases when auditing IPO FS versus normal FS.

Answer 47

True

Question 48

Each Defendant is only responsible for their proportion of the damages & other Defendants are NOT forced to make up the missing $

Answer 48

Proportionate Liability

Question 49

Any Defendant may be forced to pay ALL of the damages regardless of how at fault they are; if any Defendant(s) are unable to pay their portion, the court will collect the missing damages from the remaining Defendants.

Answer 49

Joint and Several Liability

Question 50

For Joint and Several Liability, the Plaintiff will get all their damages unless all Defendants are _______.

Answer 50

insolvent

Question 51

Which liability/damage is worse for the auditor?

Answer 51

Joint and Several Liability

Question 52

Hiring a big auditor comes with the benefit that someone (the big auditor) will have enough money in the bank to pay out damages if there are problems with the accounting.

Answer 52

Insurance Value

Question 53

T/F: Arizona is a Proportionate Liability state.

Answer 53

True

Question 54

T/F: There are no criminal anti-fraud/deceptive practices laws in the US targeted specifically to the auditor, but many automatically apply to the auditor.

Answer 54

True

Question 55

Rule that prohibits “material misrepresentations and misleading omissions in connection with the purchase or sale of securities.”

Answer 55

Rule 10B-5 (of the Securities Act of 1934 )

Question 56

laws that govern securities trading inside a particular state; forbid intentional fraud

Answer 56

Blue Sky Laws

Question 57

T/F: Rule 10B-5 does NOT require Scienter/Intent.

Answer 57

False; DOES require intent to deceive

Question 58

Consequences for auditors if found guilty?

Answer 58

fine based on the defrauded amount & up to 25 years in prison.

Question 59

Employees _____ (are/are not) personally liable for frauds they participate in

Answer 59

ARE

Question 60

T/F: Employees are not personally liable for negligence so long as they are acting within the scope of employment

Answer 60

True

Question 61

T/F: If you exceed/act outside your job description, then it’s possible you may be held personally liable.

Answer 61

True

Question 62

T/F: Class lawsuits are the most frequent/common kind of lawsuit.

Answer 62

False; clients are

Question 63

In __________ (proportionate/joint and several) liability, each defendant is liable for 100% of damages.

Answer 63

Joint and several