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Flashcards in Professional and Legal Responsibilities Deck (74):
1

Tory researched a position that her tax client wished to take and concluded in good faith that there was a 25% chance that the IRS would sustain the position if it reviewed it. Which of the following is true?

  1. Tory may sign a return taking this position with or without disclosure.
  2. Tory may sign a return taking this position, but she should disclose it.
  3. Tory may take the position, even if it involves a tax shelter transaction.
  4. All of the above.

Tory may sign a return taking this position, but she should disclose it.  Because the position meets the "reasonable basis" test, but not the "substantial authority" test, Tory may sign a return taking this position only if she discloses it.

2

Which of the following bodies ordinarily would have the authority to suspend or revoke a CPA's license to practice public accounting?

  • The SEC.
  • The AICPA.
  • A state CPA society.
  • A state board of accountancy.

A state board of accountancy.  

While certain types of punishments may be meted out by the SEC, the AICPA, and state CPA societies, only a state board of accountancy truly has the power to revoke a CPA's license to practice public accountancy. Nonetheless, the SEC may, for example, prevent an accountant from appearing before it or doing any attest work for a public company.

The AICPA may revoke an accountant's membership, as may a state CPA society. But only the state board of accountancy may revoke a license to practice.

3

When an ethics complaint carrying national implications arises, which entity typically handles it?

  • SEC.
  • PCAOB.
  • State CPA society.
  • AICPA.

AICPA.  The AICPA handles ethical complaints with national implications.  The State's will handle more regional lower profile issues.  

4

What is JEEP?

JEEP is the Joint Ethics Enforcement Program that divides ethics complaints and investigations between the AICPA and state societies.

5

Which of the following statements is generally correct regarding the liability of a CPA who negligently gives an opinion on an audit of a client's financial statements?

  • The CPA is only liable to those third parties who are in privity of contract with the CPA.
  • The CPA is only liable to the client.
  • The CPA is liable to anyone in a class of third parties who the CPA knows will rely on the opinion.
  • The CPA is liable to all possible foreseeable users of the CPA's opinion.

There are three general viewpoints regarding an accountant's liability to third parties.

  1. One view requires privity of contract for a third party to recover.
  2. Another view allows all reasonably foreseeable users of an accountant's report to sue.
  3. But the majority view, known as the Restatement view, limits an accountant's liability to a limited class of actually foreseen users.

This question obviously asks the student to apply the majority (Restatement) view.

6

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?

  • The CPA's adherence to generally accepted auditing standards (GAAS) may prevent liability.
  • The CPA will not be liable if care and skill of an ordinary reasonable person was exercised.
  • The CPA may be liable for punitive damages if due care was not exercised.
  • The CPA is liable for any embezzlement losses that occurred before the scheme should have been detected.

The CPA's adherence to generally accepted auditing standards (GAAS) may prevent liability.  If a CPA adhered to GAAS, he or she acted according to professional standards and likely was not careless so as to create negligence-based liability.

2nd choice is incorrect because CPAs doing audits are held to professional standards and must obviously do a better job than the "ordinary reasonable person" off the street.

7

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?

  • Only those third parties in privity of contract with the accountant.
  • All third parties who relied on the report and sustained injury.
  • Any foreseen or known third party who relied on the report.
  • Any third party whose reliance on the report was reasonably foreseeable.

Any foreseen or known third party who relied on the report.  Although the AICPA lists this as the correct answer, it is poorly worded. The majority view is the Restatement "limited class" approach, which generally allows recovery by third parties where the CPA had prior knowledge of the existence of a limited class of potential users (but not necessarily of their individual identities) and of the general purpose of their use of the audit. Prior knowledge is the key, so mere foresee ability is not enough, although this answer implies the contrary.

8

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:

  • Win because there was no privity of contract between Hark and Third.
  • Lose because Hark knew that banks would be relying on the financial statements.
  • Win because Third was contributorily negligent in granting the loan.
  • Lose because Hark was negligent in performing the audit.

Win because there was no privity of contract between Hark and Third.  The Ultramares rule is applied in only a few jurisdictions. It normally allows recovery by a third party only if there was privity of contract between the accountant and third party.

B is incorrect...normally, Hark will lose if he has this knowledge, because the bank is then a foreseeable user. However, under the Ultramares rule, which is applied in only a few jurisdictions, recovery is normally allowed by a third party only if there was privity of contract between the accountant and third party.

9

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

  • Contributory negligence on the part of the client.
  • A disclaimer contained in the engagement letter.
  • Lack of privity.
  • Lack of scienter.

Lack of scienter.  Scienter involves whether or not a person or company has a "guilty mind." One of the requirements of fraud is an intent to deceive. Therefore, if a firm did not intentionally make a misrepresentation and has no "guilty mind," no fraud has occurred.

10

Which of the following elements, if present, would support a finding of constructive fraud on the part of a CPA?

  • Gross negligence in applying generally accepted auditing standards.
  • Ordinary negligence in applying generally accepted accounting principles.
  • Identified third party users.
  • Scienter.

Gross negligence in applying generally accepted auditing standards. Fraud usually involves intentional deception. This question, however, asks about a close cousin of fraud -- constructive fraud. In a constructive fraud case, gross negligence (sometimes referred to as recklessness) acts as a substitute for intentional deception. Ordinary negligence or carelessness is not serious enough to act as a substitute for intent.

11

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 unqualified 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:

  • Have privity of contract with Cable.
  • Sign an engagement letter.
  • Perform the audit recklessly or with an intent to deceive.
  • Violate generally accepted auditing standards in performing the audit.

Violate generally accepted auditing standards in performing the audit.  In a negligence case, the plaintiff must show that the CPA did not use reasonable care or did not act as a reasonable CPA in the circumstances. If Drake can show that he followed GAAS in preparing the report, it is strong evidence that he acted reasonably. It is not an absolute defense, but it tends to show that he did what other accountants would have done in the same situation.

12

Which of the following is a correct statement about the circumstances under which a CPA firm may or may not disclose the names of its clients without the clients' express permission?

  • A CPA firm may disclose this information if the practice is limited to bankruptcy matters, so that prospective clients with similar concerns will be able to contact current clients.
  • A CPA firm may disclose this information if the practice is limited to performing asset valuations in anticipation of mergers and acquisitions.
  • A CPA firm may disclose this information unless disclosure would suggest that the client may be experiencing financial difficulties.
  • A CPA firm may not disclose this information because the identity of its clients is confidential information.

A CPA firm may disclose this information unless disclosure would suggest that the client may be experiencing financial difficulties.

Generally, the mere name of clients is not confidential information. Therefore, unless the accountant knows (or has reason to know, given the circumstances) that the client wishes to keep its identity as a client confidential, this information may be disclosed. An accountant would have reason to know there was a problem if disclosure of the client's name informed the world that the client was experiencing financial difficulties.

13

In accordance with the AICPA Statements on Standards for Tax Services, if after having provided tax advice to a client there are legislative changes which affect the advice provided, the CPA:

  • Is obligated to notify the client of the change and the effect thereof.
  • Is obligated to notify the client of the change and the effect thereof if the client was not advised that the advice was based on existing laws which are subject to change.
  • Cannot be expected to notify the client of the change unless the obligation is specifically undertaken by agreement.
  • Cannot be expected to have knowledge of the change.

Cannot be expected to notify the client of the change unless the obligation is specifically undertaken by agreement.

After providing tax advice to a client, the CPA cannot be expected to notify the client of any subsequent legislative changes which affect the advice previously provided. If, however, the obligation for the subsequent notification is specifically undertaken by agreement, the CPA is expected to notify the client of any such changes.

14

Even in circumstances where disclosure on a tax return is not required, the CPA may choose to make a disclosure.  Such choice may not be made if the intent is to

  • Avoid preparer negligence penalties.
  • Avoid allegations of fraud.
  • Invalidate the preparer’s declaration.
  • Disclose a position that might be viewed as contrary to the Internal Revenue Code.

Invalidate the preparer’s declaration. 

A position that is viewed as contrary to the Internal Revenue Code is required to be disclosed. Some nonrequired disclosures may be in the client’s and the CPA’s best interests to avoid negligence penalties and fraud allegations.  However, with regard to the preparer’s declaration, the CPA is required to sign it without modification. Therefore, no disclosure should be made with the intent to invalidate the preparer’s declaration.

15

An accountant compiled the unaudited financial statements for Taylor Company, a nonissuer company.   The financial statements contained a material misstatement that was not discovered in the compilation.   The accountant issued a report that stated that the financial statements were fairly stated based on the limited evidence that he collected.  Which of the following is true about the accountant’s liability to a third party who relies on the financial statements?

  • The accountant will not likely be held liable because the report indicated that limited evidence was collected.
  • The accountant will not likely be held liable because he only compiled the financial statements.
  • The accountant will likely be held liable because an appropriately worded report was not issued.
  • The accountant will likely be held liable because in compiling the financial statements he should have detected the misstatement.

The accountant will likely be held liable because an appropriately worded report was not issued. The report overstated the accountant's level of work.

The accountant may be liable in these types of engagements if:

  • Failure to mark each page, “unaudited,” or “See Accountant’s Compilation Report,” or “See Accountant’s Review Report.”
  • Failure to issue a disclaimer of opinion, or an appropriately worded compilation or review report.
  • Failure to follow appropriate AICPA Statements on Standards for Accounting and Review Services.
  • Failure to inform client of any discovery of indications of major issues.  For example, circumstances indicating presence of fraud.

16

Common law fraud of accountant is established by following elements:

  1. Misrepresentation of material fact or accountant’s expert opinion
  2. Scienter, shown by either
    1. Intent to mislead with accountant’s knowledge of falsity, or
    2. Reckless disregard of the truth
  3. Reasonable or justifiable reliance by injured party
  4. Actual damages

17

Liability to client for fraud, gross negligence, or constructive fraud

  1. Elements of Common Law Fraud must be proven (see separate card)
  2. Called constructive fraud or gross negligence if when proving the four elements of CLF, reckless disregard of the truth is established instead of knowledge of falsity
  3. Contributory negligence of client is not a defense available for accountant in cases of fraud, constructive fraud, or gross negligence
  4. Privity of contract is not required for plaintiff to prove fraud, constructive fraud, or gross negligence
  5. Punitive damages may be added to actual damages for fraud, constructive fraud, or gross negligence

18

A CPA partnership may, without being lawfully subpoenaed or without the client’s consent, make client workpapers available to

  • An individual purchasing the entire partnership.
  • The IRS.
  • The SEC.
  • Any surviving partner(s) on the death of a partner.

Any surviving partner(s) on the death of a partner. The ownership of a CPA’s working papers is custodial in nature. The CPA is required to preserve confidentiality of the client’s affairs with limited exceptions. The CPA may make working papers available to the client since this will not violate the confidentiality owed to the client. In the case of an audit of a partnership, all of the partners are clients, including any surviving partner(s) on the death of a partner. Answers A, B, and C are incorrect because these are not clients of the CPA.

19

In a jurisdiction having an accountant-client privilege statute, to whom may a CPA turn over workpapers without a client’s permission?

  • Purchaser of the CPA’s practice.
  • State tax authorities.
  • State court.
  • State CPA society quality control panel.

State CPA society quality control panel. In a jurisdiction having an accountant-client privilege statute, the CPA generally may not turn over workpapers without the client’s permission. It is allowable to do so, however, for use in a quality review under AICPA authorization or to be given to the state CPA society quality control panel.

20

Treasury Department Circular 230

Provides regulations regarding practice before the Internal Revenue Service.

  • Merely preparing tax returns for others does not constitute practice before the IRS.
  • preparing and filing documents, corresponding and communicating with the IRS, rendering written advice with respect to any entity, transaction, plan or arrangement, and representing a client at conferences, hearings, and meetings
  • limited to CPAs, attorneys, enrolled agents (EAs) and for limited purposes enrolled actuaries, and enrolled retirement plan agents.  Enrollment as an EA, actuary, or retirement plan agent is granted if the individual demonstrates special competence in tax by passing an IRS Enrollment Examination.  Additionally, certain former employees of the IRS may be granted the right to practice as an enrolled agent

21

Hall purchased Eon Corp. bonds in a public offering subject to the Securities Act of 1933.  Kosson and Co., CPAs, rendered an unqualified opinion on Eon’s financial statements, which were included in Eon’s registration statement.  Kosson is being sued by Hall based upon misstatements contained in the financial statements.  In order to be successful, Hall must prove:

  • Damages?
  • Materiality of Misstatement?
  • Kosson's Scienter?

  • Damages = YES
  • Materiality of Misstatement = YES
  • Kosson's Scienter = NO

Under the 1933 Act, the plaintiff must prove that damages were incurred and that there was a material misstatement or omission in the registration statement. The 1933 Act does not require the establishment of scienter (intent to deceive or reckless disregard of the truth) on the part of the CPA.

22

Auditors who audit financial statements under Federal Securities Exchange Act of 1934 are required to establish procedures to?

Note - the Private Securities Litigation Reform Act of 1995 amended both:

  1. Securities Act of 1933, and
  2. Securities Exchange Act of 1934  

  • Detect material illegal acts,
  • Identify material related-party transactions, and
  • Evaluate ability of firm to continue as going concern.

23

The Ultramares decision is a leading case that helps define when a CPA is liable to different parties.  If a CPA has committed negligence, under this decision the CPA is liable to which of the following parties?

  1. The client.
  2. Third-party beneficiaries.
  3. Foreseeable third parties.

1 and 2 only.  Under the Ultramares case, the CPA is liable to those parties for negligence that were in privity of contract with the CPA. These parties include the client and other parties that were intended in the contract to be benefited in the contract.

24

An auditor is responsible for reviewing for material subsequent events that may affect the financial statements contained in a Form S-1 filed with the SEC until

  • The last day of fieldwork.
  • The effective date of the registration statement.
  • The date of the audit report.
  • The date the form is filed with the SEC.

The auditor is responsible for reviewing for material subsequent events through the effective date of the registration statement.

This is referred to as an S-1 review when made for a registration statement under securities regula­tions.

EXAMPLE:  An accountant performed an audit and later performed an S-1 review to review events subsequent to the balance sheet date.  The accountant did not detect certain material events during this S-1 review even though there was sufficient evidence to make the accountant suspicious.  Further investigation was required to avoid li­ability.

25

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, 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?

  1. More likely than not.
  2. Not frivolous.
  3. Realistic possibility.
  4. Substantial authority.

More likely than not. When providing professional services that include tax planning, a member CPA should determine and comply with any applicable standards for reporting and disclosing tax return positions. When recommending a tax return position, a member should, when relevant, advise the taxpayer regarding the potential penalty consequences of the tax return position and the opportunity, if any, to avoid such penalties through disclosure. Statement on Standards for Tax Services No. 1 indicates a member should determine and comply with the standards, if any, that are imposed by the applicable taxing authority with respect to recommending a tax return position. In this case, IRC Sec. 6694 provides for a tax preparer penalty if the understatement of a taxpayer's tax liability is due to an unreasonable position. Additionally, Sec. 6694(a)(2)(C) provides that if the position is in respect to a tax shelter, the position will be considered unreasonable unless it is reasonable to believe that the position would be more likely than not sustained on its merits.

26

Sharp & Co., CPAs, was engaged by Radar Corp. to audit its financial statements. Sharp issued an unqualified opinion on Radar’s financial statements. Radar has been accused of making negligent misrepresentations in the financial statements which Wisk relied upon when purchasing Radar stock. Sharp was not aware of the misrepresentations nor was it negligent in performing the audit. If Wisk sues Sharp for damages based upon Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, Sharp will

  1. Lose, since the statements contained negligent misrepresentations.
  2. Lose, since Wisk relied upon the financial statements.
  3. Prevail, since some element of scienter must be proved.
  4. Prevail, since Wisk was not in privity of contract with Sharp.

Prevail, since some element of scienter must be proved.  In an action brought under the Securities Exchange Act of 1934, Section 10(b) and Rule 10b-5 the plaintiff (Wisk) must prove that damages were incurred as a result of the act, that there was a material misstatement or omission, that s/he relied upon the financial information, and that scienter exists. Scienter is generally defined as the knowledge of or the intent to deceive, defraud, or manipulate. Thus, Sharp will prevail if Wisk is unable to prove that Sharp had knowledge of the misrepresentations or that Sharp had intended to deceive or defraud (scienter).

27

Lawson, a CPA, discovers material noncompliance with a specific Internal Revenue Code (IRC) requirement in the prior year return of a new client.  Which of the following actions should Lawson take?

  1. Wait for the statute of limitations to expire.
  2. Discuss the requirements of the IRC with the client and recommend that client amend the return.
  3. Contact the IRS and discuss courses of action.
  4. Contact the prior CPA and discuss the client's exposure.

Discuss the requirements of the IRC with the client and recommend that client amend the return.

28

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?

  1. The misstatements contained in the financial statements certified by the CPA were material.
  2. The plaintiff relied on the CPA’s unqualified opinion.

I Only

Under Section 11 of the Securities Act of 1933, the plaintiff must prove damages and that the financial statements certified by the CPA contained misstatements or omissions of facts that were material. The plaintiff need not prove reliance on the financial statements certified.

29

A CPA firm fails to complete the audit of a publicly traded company because the firm determines that it does not have sufficient competent personnel.  As a result, the client’s Form 10-K is not filed on a timely basis.  The company will likely be entitled to damages from the firm for

  1. Breach of contract under common law.
  2. Negligence under the Securities Exchange Act of 1934.
  3. Breach of contract under the Securities Exchange Act of 1934.
  4. Negligence under the appropriate state securities act.

Breach of contract under common law. The relationship between the client and the CPA is that of an employer and an independent contractor.  A CPA may be held liable to a client if the accountant fails to perform substantially as agreed under contract (the engagement letter).

30

The Internal Revenue Code provisions dealing with tax return preparation

  1. Require tax return preparers who are neither attorneys nor CPAs to pass a basic qualifying examination.
  2. Apply to all tax return preparers whether they are compensated or uncompensated.
  3. Apply to a CPA who prepares the tax returns of the president of a corporation the CPA audits, without charging the president.
  4. Only apply to preparers of individual tax returns.

Apply to a CPA who prepares the tax returns of the president of a corporation the CPA audits, without charging the president.

The Internal Revenue Code provisions dealing with tax return preparation apply to preparers. A preparer is defined as an individual or firm who prepares returns for compensation. The compensation can be implied or explicit. This is an example of implied compensation.

Preparer—an individual who prepares for compensation, or who employs one or more persons to prepare for compensation, an income tax return, or a substantial portion of return.

  1. Preparer need not be enrolled to practice before the Internal Revenue Service.
  2. Compensation—must be received and can be implied or explicit (e.g., a person who does neighbor’s return and receives a gift has not been compensated.  Accountant who prepares individual return of the president of a company, for which he performs the audit, for no additional fee as part of a prior agreement has been compensated [implied])

31

Dexter and Co., CPAs, issued an unqualified opinion on the 2012 financial statements of Bart Corp. Late in 2010, Bart determined that its treasurer had embezzled over $1,000,000. Dexter was unaware of the embezzlement. Bart has decided to sue Dexter to recover the $1,000,000. Bart’s suit is based upon Dexter’s failure to discover the missing money while performing the audit. Which of the following is Dexter’s best defense?

  1. That the audit was performed in accordance with GAAS.
  2. Dexter had no knowledge of the embezzlement.
  3. The financial statements were presented in conformity with GAAP.
  4. The treasurer was Bart’s agent and as such had designed the internal controls which facilitated the embezzlement.

That the audit was performed in accordance with GAAS. 

The final objective of an external financial audit is to express an opinion as to the fairness of the financial statements in accordance with GAAP. In meeting this objective, the CPA must adhere to GAAS. At no time during the audit does the CPA assure that all material errors or irregularities will be detected. Therefore, if Dexter and Co. prove that the audit was performed in accordance with GAAS, they will not be held liable to Bart for their failure to detect the treasurer’s embezzlement. Note, however, that if Bart could establish a lack of reasonable care on the part of Dexter in performance of the audit, Dexter would be held responsible if the irregularity would have been discovered in an audit performed with average professional care and skill.

32

A preparer of a tax return may incur penalties under the Internal Revenue Code in all of the following cases except where the taxpayer

  1. Substantially overvalues property donated to a charitable organization.
  2. Claims a substantial deduction for unpaid expenses incurred by a cash basis taxpayer.
  3. Claims a substantial deduction for a loss resulting from an accidental fire.
  4. Takes a position at variance with the Internal Revenue Code and a US Supreme Court decision on the specific point.

Claims a substantial deduction for a loss resulting from an accidental fire.

A preparer of a tax return would not incur penalties under the Internal Revenue Code where the taxpayer reduces his/her liability by justifiably claiming a deduction for a substantial loss (e.g., a loss resulting from an accidental fire).

Preparer Penalties:

A preparer is subject to a penalty equal to the greater of $1,000, or 50% of the income derived (or to be derived) by the preparer with respect to the return or refund claim if any part of an understatement of liability with respect to the return or claim is due to an undisclosed position on the return or refund claim for which there is not substantial authority.

Substantial authority exists if the weight of authorities supporting the position is substantial in relation to the weight of those that take a contrary position.  The substantial authority standard may require at least a 40% probability of being sustained on its merits.

33

Ways to Avoid Preparer Penalty

  1. An adequate disclosure of the questionable position on the return or refund claim, and
  2. A showing that there was a reasonable basis for the position.  The reasonable basis standard may require at least a 20% probability of being sustained on its merits.

A higher more likely than not standard applies if the position is with respect to a tax shelter as defined in Sec. 6662 (d)(2)(C)(ii) or a reportable transaction to which Sec. 6662A applies.  This standard requires a more than 50% probability of being sustained on its merits.

The penalty can also be avoided if the preparer can show there was a reasonable cause for the understatement and that the return preparer acted in good faith.

34

If an accountant detects that an employee of the audited firm has committed a material illegal act, the accountant should

  1. Report this to the employee’s immediate supervisor.
  2. Report this to the firm’s board of directors or audit committee.
  3. Report this to the Securities Exchange Commission.
  4. Urge the employee to report the crime to the appropriate manager.

Report this to the firm’s board of directors or audit committee.

Under the Private Securities Litigation Reform Act, the auditor should report the possible illegal act to the board of directors or the audit committee. Then, if remedial steps are not taken by senior management or the board, additional steps are taken.

35

An accountant performed an audit and later performed a review of events subsequent to the balance sheet date (S-1 Review). The accountant performed the audit without negligence or fraud. For which of the following, if any, can the accountant be held liable in the S-1 Review?

  1. Fraud but not negligence.
  2. Negligence but not fraud.
  3. Either fraud or negligence or both.
  4. Neither fraud nor negligence.

Either fraud or negligence or both.

Even though the accountant was not liable for the work in the regular audits, the accountant can be held liable for either fraud or negligence or both in the S-1 Review whenever the facts are present to support them. This is true even though the S-1 Review is not a full audit.

36

Which of the following circumstances is a defense to an accountant’s liability under Section 11 of the Securities Act of 1933 for misstatements and omissions of material facts contained in a registration statement?

  1. The absence of scienter on the part of the accountant.
  2. The absence of privity between purchasers and the accountant.
  3. Due diligence on the part of the accountant.
  4. Nonreliance by purchasers on the misstatements.

Due diligence on the part of the accountant.

Because under Section 11 of the Securities Act of 1933, the accountant must establish due diligence to avoid liability.  Remember, scienter is a defense under the 1934 Act!

  • Plaintiff need not prove reliance on financial statements unless security was purchased at least 12 months after effective date of registration statement
  • Plaintiff need not prove negligence or fraud

37

In preparing a client’s current year individual income tax return, a tax practitioner discovers an error in the prior year’s return.  Under the rules of practice prescribed in Treasury Circular 230, the tax practitioner

  1. Is barred from preparing the current year’s return until the prior year error is rectified.
  2. Must advise the client of the error.
  3. Is required to notify the IRS of the error.
  4. Must file an amended return to correct the error.

Must advise the client of the error.

A tax practitioner generally has a duty to inform the client upon discovering an error in the client’s previously filed tax return. A tax practitioner is not barred from preparing the current year’s return and has no obligation to notify the IRS of the error. It is the client’s decision whether or not to file an amended return to correct the error.

38

Alex Stone, CPA, prepared Ray Pym’s 2012 federal income tax return.  Pym advised Stone that he had paid doctors’ bills of $15,000 during 2012, when in fact Pym had paid only $3,000 of bills. Based on Pym’s representations, Stone properly computed the medical expense deduction, with consequent understatement of tax liability of more than $5,000.  Pym’s total tax liability shown on the return was $40,000.  Stone had no reason to doubt the accuracy of Pym’s figures, although Stone did not request documentation for the expenses claimed; but he was assured by Pym that sufficient corroborative evidence of these expenses existed.  In connection with Stone’s preparation of Pym’s 2012 return, Stone is

  1. Not subject to any IRS penalty or interest.
  2. Not subject to any IRS penalty, but is liable for interest on the underpayment of tax.
  3. Subject to the negligence penalty.
  4. Subject to the penalty for willful understatement of tax liability.

Not subject to any IRS penalty or interest.

As long as the preparer of a tax return exercises due professional care in the performance of his duties, he will not incur penalties for an understatement of the taxpayer’s tax liability. In this situation, the facts specify that "Stone had no reason to doubt the accuracy of Pym’s figures." Since there is no evidence of negligence or willful misconduct on Stone’s part, he is not subject to any IRS penalty or interest.

A CPA may in good faith rely without verification upon information furnished by the client or by third parties, and is not required to audit, examine, or review books, records, or documents in order to independently verify the taxpayer’s information.

  1. However, the CPA should not ignore implications of information furnished and should make reasonable inquires if information appears incorrect, incomplete, or inconsistent.
  2. When feasible, the CPA should refer to the client’s past returns.

39

Ritz Corp. wished to acquire the stock of Stale, Inc. In conjunction with its plan of acquisition Ritz hired Fein, CPA, to audit the financial statements of Stale. Based on the audited financial statements and Fein’s unqualified opinion, Ritz acquired Stale. Within 6 months, it was discovered that the inventory of Stale had been overstated by $500,000. Ritz commenced an action against Fein. Ritz believes that Fein failed to exercise the knowledge, skill, and judgment commonly possessed by CPAs in the locality, but is not able to prove that Fein either intentionally deceived it or showed a reckless disregard for the truth. Ritz also is unable to prove that Fein had any knowledge that the inventory was overstated. Which of the following two causes of action would provide Ritz with proper bases upon which Ritz would most likely prevail?

  1. Negligence and breach of contract.
  2. Negligence and gross negligence.
  3. Negligence and fraud.
  4. Gross negligence and breach of contract.

Negligence and breach of contract.

Ritz would most likely prevail on an action brought for negligence and breach of contract due to its belief that Fein failed to exercise the knowledge, skill, and judgment commonly possessed by CPAs. The accountant’s common law liability to a client can be based upon a breach of contract, negligence, or fraud. A breach occurs when the accountant fails to perform as agreed under the contract. The duties required under a contract can be either express or implied. An express duty is delineated in the contract. All contracts carry the implied duty to perform in a nonnegligent manner. In order to bring an action against the accountant for negligence the client must prove that the accountant did not act with the same degree of skill or judgment possessed by an average accountant.

40

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

  1. Breach of duty of care.
  2. Proximate cause.
  3. Reliance.
  4. Injury.

Reliance.

The elements needed by a plaintiff to prove negligence against a defendant (including a CPA) are proof of the standard of due care, breach of that standard of due care, injury, and cause including both cause-in-fact and proximate cause. This answer is correct because reliance is not a requirement that a plaintiff must prove in a lawsuit based on negligence.

41

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

  1. Bases his action upon fraud.
  2. Is the accountant’s client.
  3. Is a creditor of the client who sues the accountant for negligence.
  4. Can prove the presence of gross negligence which amounts to a reckless disregard for the truth.

Is a creditor of the client who sues the accountant for negligence.

In a common-law action against an accountant, the lack of privity is a viable defense if the plaintiff is a creditor of the client who sues the accountant for negligence. Parties are not considered to have privity of contract with the accountant when the undertaking of the audit was not for their express purpose.

42

According to Treasury Department Circular 230, a practitioner may not

  1. Inform a client of how to avoid penalties by making disclosures to the IRS.
  2. Rely on good faith without verification of information furnished by the client.
  3. Negotiate a federal tax refund check issued to a client by the government.
  4. Inform a client of any penalties that are likely to apply to a position taken on a return.

Negotiate a federal tax refund check issued to a client by the government.

Duties and Restrictions Relating to Practice Before the IRS

  1. A practitioner must promptly submit records or information in any matter before the IRS unless the practitioner believes in good faith and on reasonable grounds that the records or information are privileged.
  2. A practitioner must, at the request of a client, promptly return the client’s records.  The client’s records include all documents and electronic media provided to the practitioner.  The existence of a dispute over fees generally does not allow the practitioner to retain records.
  3. A practitioner who becomes aware that a client has not complied with the revenue laws or has made an error in or omission from any return must advise the client promptly of the fact of such noncompliance, error, or omission, and must advise the client of the consequences under the law of such noncompliance, error, or omission.
  4. A practitioner must exercise due diligence in preparing returns and documents relating to IRS matters, as well as in determining the correctness of oral and written representations to clients and the Department of the Treasury.  A practitioner may rely on the work product of another person if the practitioner used reasonable care in engaging, supervising, training, and evaluating the person.
  5. A practitioner may not charge an unconscionable fee and generally may not charge a contingent fee for preparing an original return.  However, a contingent fee may be charged in connection with the IRS’s examination of an original tax return, or an amended return or claim for refund or credit.  Also, a contingent fee may be charged for services rendered in connection with any judicial proceeding arising under the Code.
  6. A practitioner may publish the availability of a written fee schedule including fixed fees for specific routine services, hourly rates, range of fees for specific services, and the fee charged for an initial consultation.  The practitioner may charge no more than the published fees for at least 30 days after the last date on which the fee schedule was published.
  7. A practitioner may not use any form of public communication or private solicitation containing a false, fraudulent, or coercive statement or claim, nor a misleading or deceptive statement or claim.  Enrolled agents may not utilize the word “certified” or imply an employer/employee relationship with the IRS.
  8. Tax advisors should provide clients with the highest quality representation concerning Federal tax issues by adhering to best practices in providing advice and in preparing or assisting in the preparation of a submission to the IRS.
  9. A practitioner who prepares returns may not endorse nor negotiate any Federal tax refund check issued to a client by the government.

43

A CPA firm was negligent in the audit of financial statements contained in a Form 10-K filed with the SEC.  If an injured third party decided to file suit against the CPA, it would most likely be filed under

  1. Common law.
  2. The Securities Act of 1933.
  3. The Securities Exchange Act of 1934.
  4. The Racketeer Influenced and Corrupt Organization Act.

The Securities Exchange Act of 1934.

Securities Exchange Act of 1934 regulates the trading of securities of issuer companies, including the information contained in periodic reports (e.g., Form 10-Ks).

Note that Common Law covers NON-ISSUERS.

44

Clark, a professional tax return preparer, prepared and signed a client’s 2012 federal income tax return that resulted in a $600 refund.  Which one of the following statements is correct with regard to an Internal Revenue Code penalty Clark may be subject to for endorsing and cashing the client’s refund check?

  1. Clark will be subject to the penalty if Clark endorses and cashes the check.
  2. Clark may endorse and cash the check, without penalty, if Clark is enrolled to practice before the Internal Revenue Service.
  3. Clark may endorse and cash the check, without penalty, because the check is for less than $1,000.
  4. Clark may endorse and cash the check, without penalty, if the amount does not exceed Clark’s fee for preparation of the return. 

Clark will be subject to the penalty if Clark endorses and cashes the check.

Under Internal Revenue Code Section 6695(f) any person who is an income tax return preparer who endorses or otherwise negotiates any check which is issued to another taxpayer shall pay a penalty of $500.

45

A tax preparer has advised a company to take a position on its tax return.  The tax preparer believes that there is a 75% possibility that the position will be sustained if audited by the IRS.  If the position is not sustained, an accuracy-related penalty and a late-payment penalty would apply.  What is the tax preparer’s responsibility regarding disclosure of the penalty to the company?

  1. The tax preparer is responsible for disclosing both penalties to the company.
  2. The tax preparer is responsible for disclosing only the accuracy-related penalty to the company.
  3. The tax preparer is responsible for disclosing only the late-payment penalty to the company.
  4. The tax preparer has no responsibility for disclosing any potential penalties to the company, because the position will probably be sustained on audit.

The tax preparer is responsible for disclosing both penalties to the company.

According to Statement on Standards for Tax Services 1, Tax Return Positions, when recommending a tax return position or when preparing or signing a tax return on which a tax return position is taken, a member should, when relevant, advise the taxpayer regarding potential penalty consequences of such tax return position and the opportunity, if any, to avoid such penalties through disclosure.

46

Sharp, an accountant, is auditing XYZ Corporation pursuant to the Federal Securities Exchange Act of 1934.  Under the Private Securities Litigation Reform Act, she is required to establish procedures to accomplish which of the following?

  • I.Identify material related-party transactions.
  • II.Detect material illegal acts.
  • III.Evaluate the ability of the firm to continue as a going concern.
  1. I only.
  2. II only.
  3. I and II only.
  4. I, II, and III.

ALL THREE.

Auditors who audit financial statements under the Federal Securities Exchange Act of 1934 are required to establish procedures under the Private Securities Litigation Reform Act to accomplish all three.

47

Under the liability provisions of Section 18 of the Securities Exchange Act of 1934, for which of the following actions would an accountant generally be liable?

  1. Negligently approving a reporting corporation’s incorrect internal financial forecasts.
  2. Negligently filing a reporting corporation’s tax return with the IRS.
  3. Intentionally preparing and filing with the SEC a reporting corporation’s incorrect quarterly report.
  4. Intentionally failing to notify a reporting corporation’s audit committee of defects in the verification of accounts receivable.

Intentionally preparing and filing with the SEC a reporting corporation’s incorrect quarterly report.

Under the liability provisions of Section 18 of the Securities Exchange Act of 1934, an accountant is generally liable when s/he prepares and files intentionally an incorrect quarterly report with the SEC. Therefore, this answer is correct.

48

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

  • Breach of contract
  • Strict liability

  • Breach of contract = YES
  • Strict liability = NO

When a CPA fails to carry out his/her obligations under a contract for services, the CPA may be held liable based on breach of contract but not strict liability. The theory of strict liability is used in some product liability cases but is not applicable when deciding the liability of the CPA.

49

What defense must an accountant establish to be absolved from civil liability under Section 18 of the Securities Exchange Act of 1934 for false or misleading statements made in reports or documents filed under the Act?

  1. Lack of gross negligence.
  2. Exercise of due care.
  3. Good faith and lack of knowledge of the statement's falsity.
  4. Lack of privity with an injured party.

Good faith and lack of knowledge of the statement's falsity.

The auditor's required defense is that he or she acted in good faith and did not have knowledge of the statement's falsity.

50

Which of the following statements is correct regarding disclosure of client working papers prepared by a CPA?

  1. Working papers may not be transferred to another accountant without the client's permission.
  2. Working papers may not be turned over to a CPA quality review team without the client's permission.
  3. Working papers may not be disclosed under a federal court subpoena without the client's permission.
  4. Working papers may not be disclosed to any third parties without the client's permission.

Working papers may not be transferred to another accountant without the client's permission.

Accountant's working papers

  • Consist of evidence, notes, computations, etc. that accountant accumulates when doing professional work for client.
  • Working papers are owned by accountant unless there is agreement to the contrary.
  • Ownership is essentially custodial in nature and it serves two purposes:
    • To preserve confidentiality of client information. Without client consent, an accountant cannot allow transmission of information in working papers to another party. However, an accountant must produce working papers upon being given an enforceable subpoena, or if agreeing to provide access to working papers to a government agency is part of the agreement with the client.
      • Subpoenas should be limited in scope and for a specific purpose.
      • The accountant may challenge a subpoena as being too broad and unreasonably burdensome.

51

Which of the following is not an acceptable manner of designating that an estimated figure was used in preparing a federal income tax return?

  1. State expressly that an amount has been estimated.
  2. Use a round amount.
  3. Use an amount suggested in a treasury department guideline.
  4. Modify the tax preparer’s declaration on the return before signing the tax return.

Modify the tax preparer’s declaration on the return before signing the tax return.

Use of Estimates

  • Where data is missing (e.g., result of a fire, computer failure), estimates of the missing data may be made by the client.
  • A CPA may prepare a tax return using estimates if it is impracticable to obtain exact data, and the estimated amounts are reasonable.
  • An estimate should not imply greater accuracy than actually exists (e.g., estimate $1,000 rather than $999.32).

52

Under the Private Securities Litigation Reform Act, the defendants have what type of liability?

  1. Proportionate to their degree of fault for unknowing conduct.
  2. Joint and several liability for unknowing conduct.
  3. Equal shares of liability.
  4. Strict liability for unknowing or knowing conduct.

Proportionate to their degree of fault for unknowing conduct.

The Reform Act changes the rule on joint and several liability so that each defendant is liable for his/her proportionate degree of fault for unknowing conduct.

53

According to Treasury Department Circular 230, a tax practitioner must promptly submit records or information in any matter before the IRS unless:

  1. The practitioner believes in good faith and on reasonable grounds that the records or information are privileged.
  2. The practitioner believes that the records or information would be incriminating to the client.
  3. The practitioner believes the client would not want the records or information provided.
  4. The practitioner believes the records and information may not be relevant.

The practitioner believes in good faith and on reasonable grounds that the records or information are privileged.

A practitioner must promptly submit records or information in any matter before the IRS unless the practitioner believes in good faith and on reasonable grounds that the records or information are privileged.

54

Able, CPA, was engaged by Wedge Corp. to audit Wedge’s financial statements.  Wedge intended to use the audit report to obtain a $10 million loan from Care Bank.  Able and Wedge’s president agreed that Able would give an unqualified opinion on Wedge’s financial statements in the audit report even though there were material misstatements in the financial statements.  Care refused to make the loan.  Wedge then gave the audit report to Ranch to encourage Ranch to purchase $10 million worth of Wedge common stock.  Ranch reviewed the audit report and relied on it to purchase the stock.  After the purchase, Able’s agreement with Wedge’s president was revealed.  As a result, Wedge stock lost half its value and Ranch sued Able for fraud.  What will be the result of Ranch’s suit?

  1. Ranch will win because Able intentionally gave an unqualified opinion on Wedge's materially misstated financial statements.
  2. Ranch will win because Able is strictly liable for errors made in auditing Wedge's financial statements.
  3. Ranch will lose because Ranch is not a foreseen user of Able's audit report.
  4. Ranch will lose because Ranch is not in privity with Able.

Ranch will win because Able intentionally gave an unqualified opinion on Wedge's materially misstated financial statements.

Knowingly issuing an unqualified opinion on materially misstated financial statements is fraud.

55

An investor purchased shares of stock in a stock offering under the Securities Act of 1933.  The financial statements included in the registration statement contained material misstatements.  As a result, the investor incurred a significant loss on the securities.  What must the investor prove to possibly recover losses from the CPA firm that audited the financial statements contained in the registration statement?

  1. Losses, reliance on the financial statements, and negligence on the part of the CPA.
  2. Losses and reliance on the financial statements.
  3. Losses and the financial statements were materially misstated.
  4. Losses and negligence on the part of the CPA.

  1. Losses and
  2. the financial statements were materially misstated.

The plaintiff need only prove that he or she had losses and the financial statements were misleading. The burden of proof is then shifted to the CPA to prove due diligence.

56

Petty Corp. made a public offering subject to the Securities Act of 1933.  In connection with the offering, Ward & Co., CPAs, rendered an unqualified opinion on Petty’s financial statements included in the SEC registration statement.  Huff purchased 500 of the offered shares.  Huff has brought an action against Ward under Section 11 of the Securities Act of 1933 for losses resulting from misstatements of facts in the financial statements included in the registration statement. Ward’s weakest defense would be that

  1. Huff knew of the misstatements when Huff purchased the stock.
  2. Huff’s losses were not caused by the misstatements.
  3. Ward was not in privity of contract with Huff.
  4. Ward conducted the audit in accordance with GAAS.

Ward was not in privity of contract with Huff.

Under the 1933 Act, a CPA can be held liable to a purchaser of registered securities if damages are incurred by the purchaser and if the financial statements contained in the registration statement contain a material misstatement of a fact or omit a material fact. The fact that the purchaser is not in privity of contract with the CPA is not a valid defense for the CPA.

57

In preparing Tint’s 2012 individual income tax return, Boe, CPA, took a $3,000 deduction for unreimbursed travel and entertainment expenses, which Tint stated he paid in 2012.  Boe had no reason to believe that documentation of the travel and entertainment expenses was inadequate or nonexistent. In order to avoid the preparer’s negligence penalty, Boe

  1. May rely solely on Tint’s statement as to the amount of deduction.
  2. Must be advised by Tint that the documentation exists.
  3. Must examine the documentation.
  4. Must maintain copies of the documentation in its file.

Must be advised by Tint that the documentation exists.

In order to avoid the negligence penalty, a preparer of a tax return must exercise due professional care in the discharge of his duties. If Boe is advised by Tint that the documentation exists and if, as the facts state, "Boe has no reason to believe that documentation of the travel and entertainment expenses is inadequate or nonexistent," then there is no evidence of negligence on Boe’s part and he will not be liable for the preparer’s negligence penalty.

58

Stewart, CPA, was engaged to complete the audit of Wilson Company.  In performing the audit Stewart made a mistake in judgment regarding some evidence.  As a result an embezzlement of funds by an employee was not discovered.  The mistake did not rise to the level of negligence.  Which of the following statements is true regarding Stewart’s liability in this case?

  1. Stewart likely will not be held liable.
  2. Stewart likely will be held liable for breach of contract.
  3. Stewart likely will be held liable for making an untrue statement.
  4. Stewart likely will be held liable for failure to use due care.

Stewart likely will not be held liable.

A CPA will not be held liable if negligence cannot be proved.

59

If an auditor detects possible illegal activity in the course of an audit, s/he has which duty under the Private Securities Litigation Reform Act?

  1. To inform the audit committee or the board of directors.
  2. To inform the Federal Bureau of Investigation.
  3. To inform the Justice Department.
  4. To inform the shareholders.

To inform the audit committee or the board of directors.

If auditor detects possible illegal activity, must inform audit committee or board of directors

  • If senior management or board fails to take remedial action and if illegal activities are material so that departure from standard audit report or auditor resignation is indicated, auditor shall report this to board of directors

60

Management of Tyler Company, a nonpublic company, materially misstated the company’s financial statements that were audited by Ted & Ted, CPAs.  Ted & Ted was negligent in the performance of the audit and failed to detect the misstatements.  In reliance on the audited financial statements, Second Bank extended a loan in the amount of $500,000, and Tyler Company went bankrupt and was unable to repay any of the loan.  Assume that Ted & Ted is determined to be 40% responsible for Second Bank’s losses and management of Tyler Company is determined to be 60% liable.  Which of the following is not true regarding this situation?

  1. In a state that has adopted joint and several liability, Ted & Ted may be required to pay the entire $500,000 in damages.
  2. In a state that has adopted joint liability, Ted & Ted may be required to pay the entire $500,000 in damages.
  3. In a state that has adopted several liability, Ted & Ted will likely be required to pay only $200,000 in damages.
  4. In a state that has adopted several liability, Ted & Ted will likely be required to pay the entire $500,000 but would be able to try to recover $300,000 from management.

In a state that has adopted several liability, Ted & Ted will likely be required to pay the entire $500,000 but would be able to try to recover $300,000 from management.

In a state that has adopted several liability, Ted & Ted would be required to pay only their share, $200,000.

  • Joint liability.  In a state that applies joint liability, both the accountant and management are liable up to the full amount of the obligation.   If management has no funds, the entire amount may be collected from the accountant.
  • Several liability.  In a state that applies several (proportionate liability), the accountant and management are only obligated to pay their respective share of the damages based on the degree of responsibility for the losses.
  • Joint and several liability.  In a state that applies joint and several liability, each of the parties are responsible for the full amount of the obligation but may seek to get reimbursement from the other parties.  Most state courts apply joint and several liability.

61

The preparer of a federal income tax return signs a preparer’s declaration which states:

  • Under penalties of perjury, I declare that I have examined this return and accompanying schedules…and to the best of my knowledge and belief, they are true, correct, and complete.

A CPA who signs this declaration as preparer for a client’s tax return warrants that

  1. Information furnished by the client was relied upon in preparing the tax return unless it appeared incorrect or incomplete.
  2. Information furnished by the client was examined in accordance with generally accepted auditing standards.
  3. All available evidence in support of material assertions on the tax return was examined in accordance with generally accepted auditing standards.
  4. All available evidence in support of material assertions on the tax return was documented in the CPA’s working papers.

Information furnished by the client was relied upon in preparing the tax return unless it appeared incorrect or incomplete.

A CPA may rely on information furnished by the client. The CPA is not required to examine or review documents or other evidence supporting the client’s information, although the CPA is required to make reasonable inquiries where the information as presented appears to be incorrect or incomplete.

62

Sharp & Co., CPAs, was engaged by Radar Corp. to audit its financial statements. Sharp issued an unqualified opinion on Radar’s financial statements. Radar has been accused of making negligent misrepresentations in the financial statements which Wisk relied upon when purchasing Radar stock. Sharp was not aware of the misrepresentations nor was it negligent in performing the audit. If Wisk sues Sharp for damages based upon Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, Sharp will

  1. Lose, since the statements contained negligent misrepresentations.
  2. Lose, since Wisk relied upon the financial statements.
  3. Prevail, since some element of scienter must be proved.
  4. Prevail, since Wisk was not in privity of contract with Sharp.

Prevail, since some element of scienter must be proved.

In an action brought under the Securities Exchange Act of 1934, Section 10(b) and Rule 10b-5 the plaintiff (Wisk) must prove that damages were incurred as a result of the act, that there was a material misstatement or omission, that s/he relied upon the financial information, and that scienter exists. Scienter is generally defined as the knowledge of or the intent to deceive, defraud, or manipulate. Thus, Sharp will prevail if Wisk is unable to prove that Sharp had knowledge of the misrepresentations or that Sharp had intended to deceive or defraud (scienter).

63

Jay, CPA, gave an unqualified opinion on Nast Power Co.’s financial statements.  Larkin bought Nast bonds in a public offering subject to the Securities Act of 1933.  The registration statement filed with the SEC included Nast’s financial statements.  Larkin sued Jay for misstatements contained in the financial statements under the provisions of Section 11 of the Securities Act of 1933. To prevail, Larkin must prove

  • Scienter
  • Reliance

Neither.

For a purchaser of stock to successfully sue under Section 11 of the Securities Act of 1933, s/he must prove that damages were incurred and that there was a material misstatement or omission in the financial statements included in the registration statement. The plaintiff does not need to prove negligence or scienter. Also, the plaintiff need not prove reliance on the financials (unless the securities were purchased after the CPA firm issued an income statement covering at least 12 months subsequent to the effective date of the registration statement).

64

Which one of the following, if present, would support a finding of constructive fraud on the part of a CPA?

  1. Privity of contract.
  2. Intent to deceive.
  3. Reckless disregard.
  4. Ordinary negligence.

Reckless disregard.

Constructive fraud requires the following elements:

  1. misrepresentation of a material fact,
  2. reckless disregard for the truth,
  3. reasonable reliance by the injured party, and
  4. injury.

Therefore, if reckless disregard is present, it would support a finding of constructive fraud on the part of a CPA.

65

While the AICPA cannot revoke a CPA’s right to practice, it is important for CPAs to follow AICPA rules because

  1. A CPA must be a member of the AICPA to practice in more than one state.
  2. Most state boards of accountancy have rules that mirror the AICPA rules.
  3. The AICPA investigates ethics violations for most accounting regulatory bodies.
  4. PCAOB standards and rules are the same as AICPA rules.

Most state boards of accountancy have rules that mirror the AICPA rules.

The CPA may still practice public accounting using valid license issued by state

  1. Violation of state board code, however, can result in revocation of CPA certificate and loss of ability to practice public accounting.  State board codes generally mirror the AICPA Code of Professional Conduct.
  2. Any member who departs from rulings or interpretations has burden justifying it in any dis­ciplinary proceedings.
  3. A member of the AICPA may be expelled or suspended without hearing for any of the following:
  • The member’s CPA certificate or license or permit to practice is revoked by state as a disciplinary measure.
  • The member is convicted of a crime punishable by imprisonment for more than one year.
  • The member files or aids in filing a fraudulent tax return for client or self.
  • The member intentionally fails to file his or her required tax return.

66

In accordance with the AICPA Statements on Standards for Tax Services, where a question on a federal income tax return has not been answered, the CPA should sign the preparer’s declaration only if

  1. The CPA can provide reasonable support for this omission upon examination by IRS.
  2. The information requested is significant, but is not available.
  3. The question is not applicable to the taxpayer.
  4. Reasonable grounds exist for not answering the question.

Reasonable grounds exist for not answering the question.

Statement on Standards for Tax Services No. 2 requires CPAs to make sure that a reasonable effort has been made to answer questions on a tax return before the CPA signs the return. If a taxpayer leaves a question unanswered and reasonable grounds exist for not answering the question, the preparer need not provide an explanation for the omission.

67

A member would be in violation of the Standards for Tax Services if the member recommends a return position under which of the following circumstances?

  1. It does not meet the realistic possibility standard but there is a reasonable basis for the position and it is disclosed on the return.
  2. It might result in penalties and the member advises the taxpayer and discusses avoiding such penalties through disclosing the position.
  3. It does not meet the realistic possibility standard but the member feels the return has a minimal likelihood for examination by the IRS.
  4. It meets the realistic possibility standard based on the well-reasoned opinion of the taxpayer's attorney.

It does not meet the realistic possibility standard but the member feels the return has a minimal likelihood for examination by the IRS.

With respect to tax return positions, a CPA

  1. Should not recommend a position unless there is a realistic possibility of it being sustained administratively or judicially on its merits if challenged.
  2. Should not prepare or sign a tax return if the CPA knows the return takes a position that the CPA could not recommend under (1) above.
  3. Notwithstanding (1) and (2), a CPA may recommend a position for which there is a reasonable basis so long as the position is adequately disclosed on the return or claim for refund. A position may have a reasonable basis if there is at least a 20% probability of success.
  4. Should advise the client of the potential penalty consequences of any recommended tax position.

68

Lewis & Clark, CPAs, rendered 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 false statement in the financial statements, Lewis & Clark are being sued by an investor who purchased shares of this public offering. Which of the following represents a viable defense?

  1. The investor has not met the burden of proving fraud or negligence by Lewis and Clark.
  2. The investor did not actually rely upon the false statement.
  3. Detection of the false statement by Lewis and Clark occurred after their examination date.
  4. The false statement is immaterial in the overall context of the financial statements.

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

Section II of the Securities Act of 1933 makes it unlawful for a registration statement to contain an untrue material fact or to omit a material fact. Under the 1933 Act, the plaintiff must prove damages were incurred and that there was a material misstatement or omission in the financial statements included in the registration statement. Thus, proving that the false statement is immaterial is a viable defense. Other viable defenses are the due diligence defense, proving that the plaintiff knew the financial statements were incorrect when the investment was made, and proving the loss was caused by factors other than the misstatement or omission.

69

The Ultramares decision is a leading case that helps define when a CPA is liable to different parties.  If a CPA has committed negligence, under this decision the CPA is liable to which of the following parties?

  • I.The client.
  • II.Third-party beneficiaries.
  • III.Foreseeable third parties.

  • I.The client. - YES
  • II.Third-party beneficiaries. - YES
  • III.Foreseeable third parties. - NO

Under the Ultramares case, the CPA is liable to those parties for negligence that were in privity of contract with the CPA. These parties include the client and other parties that were intended in the contract to be benefited in the contract.

70

Burt, CPA, issued an unqualified opinion on the financial statements of Midwest Corp. These financial statements were included in Midwest’s annual report and Form 10-K filed with the SEC. As a result of Burt’s reckless disregard for GAAS, material misstatements in the financial statements were not detected. Subsequently, Davis purchased stock in Midwest in the secondary market without ever seeing Midwest’s annual report or Form 10-K. Shortly thereafter, Midwest became insolvent and the price of the stock declined drastically. Davis sued Burt for damages based on Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. Burt’s best defense is that

  1. There has been no subsequent sale for which a loss can be computed.
  2. Davis did not purchase the stock as part of an initial offering.
  3. Davis did not rely on the financial statements or Form 10-K.
  4. Davis was not in privity with Burt.

Davis did not rely on the financial statements or Form 10-K.

A suit for damages based on Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 requires proof (1) that plaintiff suffered damages, (2) there was a material misstatement or omission in information released by the firm, (3) that the plaintiff relied on financial information, and (4) existence of scienter. Thus, proving that Davis did not rely on the financial statement or Form 10-K will be the CPA’s best defense.

71

Holly Corp. engaged Yost & Co., CPAs, to audit the financial statements to be included in a registration statement Holly was required to file under the provisions of the Securities Act of 1933. Yost failed to exercise due diligence and did not discover the omission of a fact material to the statements. A purchaser of Holly’s securities may recover from Yost under Section 11 of the Securities Act of 1933 only if the purchaser

  1. Brings a civil action within 1 year of the discovery of the omission and within 3 years of the offering date.
  2. Proves that the registration statement was relied on to make the purchase.
  3. Proves that Yost was negligent.
  4. Establishes privity of contract with Yost.

Brings a civil action within 1 year of the discovery of the omission and within 3 years of the offering date.

A purchaser of securities may recover losses from the CPA firm that failed to discover the omission of a fact material to the statements under the Securities Act of 1933. The statute of limitations for this civil action is 1 year from the discovery of the omission and 3 years from the offering date.

72

Which of the following laws does not have provisions for criminal liability by auditors?

  1. The Securities Act of 1933.
  2. The Securities Exchange Act of 1934.
  3. The Racketeer Influenced and Corrupt Organization Act.
  4. Common Law.

Common Law

Common law deals with civil liability although many states have codified common law and added criminal provisions.

73

Tax return preparers can be subject to penalties under the Internal Revenue Code for failure to do any of the following, except

  1. Sign a tax return as a preparer.
  2. Disclose a conflict of interest.
  3. Provide a client with a copy of the tax return.
  4. Keep a record of returns prepared.

Disclose a conflict of interest.

Tax return preparers can be subject to penalties for failing to sign a tax return as preparer, failing to provide a client with a copy of the tax return, and failing to keep a record of returns prepared or copies of the returns. A tax return preparer would not be subject to penalty for failing to disclose a conflict of interest.

Additional penalties may be imposed on preparers if they fail to fulfill the following requirements (unless failure is due to reasonable cause):

  1. Preparer must sign returns done for compensation.
  2. Preparer must provide a copy of the return or refund claim to the taxpayer no later than when the preparer presents a copy of the return to the taxpayer for signing.
  3. Returns and claims for refund must contain the social security number of preparer and identification number of preparer's employer or partnership (if any).
  4. Preparer must either keep a list of those for whom returns were filed with specified information, or copies of the actual returns, for three years.
  5. Employers of return preparers must retain a listing of return preparers and place of employment for three years.
  6. Preparer must not endorse or negotiate a refund check issued to a taxpayer.
  7. Preparer must not disclose information furnished in connection with the preparation of a tax return, unless for quality or peer review, or under an administrative order by a regulatory agency.

74

In general, the third-party (primary) beneficiary rule as applied to a CPA’s legal liability in conducting an audit is relevant to which of the following causes of action against a CPA?

  • Fraud
  • Constructive fraud
  • Negligence

  • Fraud - NO
  • Constructive fraud - NO
  • Negligence - YES

A third-party (primary) beneficiary of audited financial statements is one specifically intended by the CPA and the client to be the primary user of the financial statements. The CPA will be liable for negligence to a third party only if it can be established that the party was intended to be the primary beneficiary. Since a CPA is generally liable to all third parties, including foreseen and foreseeable third parties, for fraud and constructive fraud, the third-party (primary) beneficiary rule is relevant only in those cases based on negligence.