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Flashcards in Ch 5 - Legal Liability Deck (49):
1

Laws that have been developed through court decisions rather than through government statutes

Common Law

2

Laws that have been passed by the US Congress and other governmental units. The Securities Acts of 1933 and 1934 and Sarbanes-Oxley Act of 2002 are important kinds of this type of law affecting auditors.

Statutory Law

3

The assessment against a defendant of the full loss suffered by a plaintiff, regardless of the extent to which other parties shared in the wrongdoing. For example, if management intentionally misstates financial statements, an auditor can be assessed the entire loss to shareholders if the company is bankrupt and management is unable to pay.

Joint and several liability

4

The assessment against a defendant of that portion of the damage caused by the defendant's negligence. For example, if the courts determine that an auditor's negligence in conducting an audit was the cause of 30% of a loss to a defendant, only 30% of the aggregate damage will be assessed to the CPA firm.

Separate and proportionate liability

5

Name the source of liability for the following example of potential claim:

Client sues the auditor for not discovering a material fraud during the audit.

Liability to clients

6

Name the source of liability for the following example of potential claim:

Bank sues auditor for not discovering that a borrower's financial statements are materially misstated.

Liability to third parties under common law

7

Name the source of liability for the following example of potential claim:

Combined group of stockholders sues auditor for not discovering materially misstated financial statements.

Civil liability under federal securities laws

8

Name the source of liability for the following example of potential claim:

Federal government prosecutes auditor for knowingly issuing an incorrect audit report

Criminal liability

9

What is the most common source of lawsuits against CPAs?

clients

10

What three reasons can a lawsuit be for?

1) Breach of contract
2) Tort for negligence
3) Both of these

11

Which are more common, tort actions or breach of contract lawsuits?

tort actions

because the amount recoverable under them are normally larger than under breach of contract.

12

Of the following defenses against client suits, which is the best one to have?

1) Lack of duty to perform
2) Non-negligent performance
3) Contributory negligence
4) Absence of casual connection

2) Non-negligent performance

13

This defense against a client suit means that a CPA firm claims that there was no implied or expressed contract.

Lack of duty to perform
(importance of the engagement letter)

14

This defense against a client suit means that the CPA firm claims that the audit was performed in accordance with auditing standards. Even if there were undiscovered misstatements, the auditor is not responsible if the audit was conducted properly.

Non-negligent performance

15

This defense against a client suit exists when the auditor claims 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 way that prevented the auditor from discovering the cause of the loss.

Contributory negligence

16

This defense against a client suit...to succeed in an action against the auditor, the client must be able to show that there is a close causal connection between the auditor's failure to follow auditing standards and the damages suffered by the client. In defense of such litigation, the auditor would attempt to refute any connection.

Absence of Causal Connection

17

Name 6 third party types that an auditor could be liable to under common law.

1) Actual and potential stockholders
2) Vendors
3) Bankers
4) Other creditors
5) Employees
6) Customers

18

True or False.
A CPA may be liable if a loss was incurred by the claimant due to reliance on misleading financial statements.

True

19

What court case is the following describing?

The creditors of an insolvent corporation relied on the audited financials and subsequently sued the accountants alleging that they were guilty of negligence and fraudulent misrepresentation. The court held that the accountants had been negligent but ruled that accountants would not be liable to 3rd parties for honest blunders beyond the bounds of the original contract unless they were primary beneficiaries.

Ultramares doctrine

20

Parties who have a relationship that is established by a contract are said to have ________________.

Privity of contract

21

Which of the following relates to the definition of Third Party user and related example?

Auditor knows and intents that user will use audit report.

ex. Auditor is aware of bank loan agreement that requires audited financial statements.

1) Primary beneficiary
2) Forseen user
3) Foreseeable user

1) Primary beneficiary

22

Which of the following relates to the definition of Third Party user and related example?

Reasonably limited and identifiable group of users who have relied on the auditor's work.

ex. Bank or trade creditors when the auditor is aware that the client has provided audited financial statements to such users.

1) Primary beneficiary
2) Forseen user
3) Foreseeable user

2) Forseen user

23

Which of the following relates to the definition of Third Party user and related example?

An unlimited class of users that the auditor should have reasonably been able to foresee as being likely users of the financial statements.

1) Primary beneficiary
2) Forseen user
3) Foreseeable user

3) Foreseeable user

24

What are three reasons that there is a growth in CPA liability?

1) Availability of class action litigation
2) Can obtain significant damages
3) Strict liability standards

25

What are five responses the CPA profession has given to legal liability?

1) Standard and rule setting
2) Oppose lawsuits
3) Education of users
4) Sanction of members
5) Lobby for changes in laws

26

What are some things that CPAs can do to protect themselves against legal liability?

1) Deal only with clients possessing integrity
2) Maintain independence
3) Understand the client's business
4) Perform quality audits
5) Document the work properly
6) Exercise professional skepticism
7) Hire qualified personnel
8) Carry adequate insurance
9) Choose business form that provides limited liability

27

What is a situation in which the auditor issues an incorrect audit opinion as the result of an underlying failure to comply with the requirements of auditing standards.

Audit failure

28

What is the risk that the auditor will conclude after conducting an adequate audit that the financial statements are fairly stated and an unqualified opinion can therefore be issued when, in fact, they are materially misstated.

Audit risk

29

A federal statute that makes it illegal to offer a bribe to an official of a foreign country for the purpose of exerting influence and obtaining or retaining business and that requires US companies to maintain reasonably complete and accurate records and an adequate system of internal control.

Foreign Corrupt Practices Act of 1977

30

A federal law passed in 1995 that significantly reduced potential damages in securities-related litigation.

Private Securities Litigation Reform Act of 1995

31

commission of an act with knowledge or intent to deceive

scienter

32

a federal statute dealing with companies that register and sell securities to the public; under the statute, third parties who are original purchasers of securities may recover damages from the auditor if the financial statements are misstated, unless the auditor proves that the audit was adequate or that the third party's loss was caused by factors other than misleading financial statements.

Securities Act of 1933

33

a federal statute dealing with companies that trade securities on national and over-the-counter exchanges; auditors are involved because the annual reporting requirements include audited financial statements.

Securities Exchange Act of 1934

34

A common law approach to third-party liability, established in 1931 in the case of Ultramares Corporation v. Touche, in which ordinary negligence is insufficient for liability to third parties because of the lack of privity of contract between the third party and the auditor, unless the third party is a primary beneficiary.

Ultramares doctrine

35

Sharp, CPA, was engaged by Peters & Sons, a partnership, to give an opinion on the financial statements that were to be submitted to several prospective partners as part of a planned expansion of the firm. Sharp's fee was fixed on a per diem basis. After a period of intensive work, Sharp completed about half of the necessary field work. Then, because of unanticipated demands on his time by other clients, Sharp was forced to abandon the work. The planned expansion of the firm failed to materialize because the prospective partners lost interest when the audit report was not promptly available. Sharp offered to complete the task at a later date. This offer was refused. Peters & Sons suffered damages of $400,000 as a result. Under the circumstances, what is the probable outcome of a lawsuit between Sharp and Peters & Sons?

1) Sharp will be compensated for the reasonable value of the services actually performed.
2) Peters & Sons will recover damages for breach of contract.
3) Peters & Sons will recover both punitive damages and damages for breach of contract.
4) Neither Sharp nor Peters & Sons will recover against the other.

2) Peters & Sons will recover damages for breach of contract.

36

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

1) is the client's creditor who sues the accountant for negligence.
2) can prove the presence of gross negligence that amounts to a reckless disregard for the truth
3) is the accountant's client
4) bases the action upon fraud

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

37

The 1136 Tenants case was important chiefly because of its emphasis on the legal liability of the CPA when associated with

1) an SEC engagement
2) an audit resulting in a disclaimer of opinion
3) letters for underwriters
4) unaudited financial statements

4) unaudited financial statements

38

Major, Major & Sharpe, CPAs, are the auditors of MacLain Technologies. In connection with the public offering of $10 million of MacLain securities, Major expressed an unqualified opinion as to the financial statements. Subsequent to the offering, certain misstatements were revealed. Major has been sued by the purchasers of the stock offered pursuant to the registration statement that included the financial statements audited by Major. In the ensuing lawsuit by the MacLain investors, Major will be able to avoid liability if

1) the misstatements were caused primarily by MacLain
2) it can be shown that at least some of the investors did not actually read the audited financial statements
3) it can prove due diligence int he audit of the financial statements by MacLain.
4) MacLain had expressly assumed any liability in connection with the public offering

3) it can prove due diligence int he audit of the financial statements by MacLain.

39

Under the 1933 Securities Act, which of the following must be proven by the purchaser of the security?

Reliance on the Financial Statements...Fraud by the CPA

1) Yes...Yes
2) Yes...No
3) No...Yes
4) No...No

4) No...No

40

Donaldson & Company, CPAs, audited the financial statements included in the annual report submitted by Markum Securities, Inc., to the SEC. The audit was improper in several respects. Markum is now insolvent and unable to satisfy the claims of its customers. The customers have instituted legal action against Donalds based on Section 10b and Rule 10b-5 of the Securities Exchange Act of 1934. Which of the following is likely to be Donald's best defense?

1) Section 10b does not apply to them
2) They did not intentionally certify false financial statements
3) They were not in privity of contract with the creditors
4) Their engagement letter specifically disclaimed any liability to any party that resulted from Markum's fraudulent conduct.

2) They did not intentionally certify false financial statements

41

Which of the following statements about the Securities Act of 1933 is not true?

1) The third-party user does not have the burden of proof that she/he relied on the financial statements

2) The third party has the burden of proof that the auditor was either negligent or fraudulent in doing the audit.

3) The third party user does not have the burden of proof that the loss was caused by the misleading financial statements.

4) The auditor will not be liable if he or she can demonstrate due diligence in performing the audit.

2) The third party has the burden of proof that the auditor was either negligent or fraudulent in doing the audit.

42

A third party lacking privity will often be successful in bringing a claim against the auditor if they can demonstrate _____ or _____.

fraud or gross neglignece

43

Under the Ultramares doctrine, an auditor is generally not liable for _____to third parties lacking _____.

ordinary negligence
privity of contract

44

The auditor will use a defense of _____ in a suit brought under the 1933 Securities Act.

due diligence

45

Under the 1933 Act, plaintiffs do not have to demonstrate _____, but need merely demonstrate the existence of a _____.

reliance on the financial statements
material error or omission

46

After passage of the Private Securities Litigation Reform Act, auditors generally have _____liability in federal securities cases.

separate and proportionate

47

The broadest class of third parties under common law is known as _____.

foreseen users

48

Based on the ruling in Hochfelder v Ernst & Ernst, an auditor generally must have knowledge and _____ to be found guilty of a violation of Rule 10b-5 of the 1934 Act.

intent to deceive

49

_____ is generally only available as a defense in suits brought by clients.

contributory negligence