REVIEW QUESTIONS
5-1 (OBJECTIVE 5-1) Lawsuits against CPA firms continue to increase. State your opinion of the positive and negative effects of the increased litigation on CPAs and on society.
5-2 (OBJECTIVE 5-2) Distinguish between audit risk and audit failure. Why is there at least some level of audit risk on every audit engagement?
5-3 (OBJECTIVE 5-3) How does the prudent person concept affect the liability of the auditor?
5-4 (OBJECTIVES 5-1, 5-8) Discuss why many CPA firms have willingly settled lawsuits out of court. What are the implications to the profession?
5-5 (OBJECTIVES 5-3, 5-4) What is meant by contributory negligence? Under what conditions will this likely be a successful defense?
5-6 (OBJECTIVE 5-4) A common type of lawsuit against CPAs is for the failure to detect a fraud. State the auditor’s responsibility for such discovery. Give authoritative support for your answer.
5-7 (OBJECTIVE 5-4) Explain how an engagement letter might affect an auditor’s liability to clients under common law.
5-8 (OBJECTIVE 5-5) Is the auditor’s liability under common law affected if the third party was unknown rather than known? Explain.
5-9 (OBJECTIVE 5-6) Contrast the auditor’s liability under the Securities Act of 1933 with that under the Securities Exchange Act of 1934.
5-10 (OBJECTIVES 5-4, 5-5, 5-6, 5-7) Distinguish among the auditor’s potential liability to the client, liability to third parties under common law, civil liability under the securities laws, and criminal liability. Describe one situation for each type of liability in which the auditor can be held legally responsible.
5-11 (OBJECTIVE 5-6) What potential sanctions does the SEC have against a CPA firm?
5-12 (OBJECTIVE 5-7) How did the Sarbanes–Oxley Act of 2002 increase criminal liability for auditors?
5-13 (OBJECTIVE 5-8) In what ways can the profession positively respond to and reduce liability in auditing?
MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS
5-14 (OBJECTIVES 5-4, 5-5) The following questions concern CPA firms’ liability under common law. Choose the best response.
a. 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.
b. 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.
c. If a CPA recklessly departs from the standards of due care when conducting an audit, the CPA will be liable to third parties who are unknown to the CPA based on
(1) negligence.
(2) gross negligence.
(3) strict liability.
(4) criminal deceit.
5-15 (OBJECTIVE 5-6) The following questions deal with liability under the 1933 and 1934 securities acts. Choose the best response.
a. 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 in the audit of the financial statements of MacLain.
(4) MacLain had expressly assumed any liability in connection with the public offering.
b. Donalds & 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 Donalds’ 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.
c. A CPA audited the financial statements included in a registration statement for an issuance of securities to the public. If the financial statements contained an omission that caused a purchaser of the securities to sustain damages, the
(1) Securities and Exchange Act of 1934 applies.
(2) purchaser must prove that (s)he was damaged by the omission, but not negligence, privity or reliance.
(3) CPA will be liable only for gross negligence.
(4) due diligence defense is not available to the CPA.
MULTIPLE CHOICE QUESTIONS FROM BECKER CPA EXAM REVIEW
5-16 (OBJECTIVES 5-3, 5-5, 5-6) The following questions concern CPA firms’ liability under
common law or statutory law. Choose the best response.
a. Which of the following elements is required to be proven by the plaintiff to hold an accountant liable for gross negligence but not for actual fraud?
(1) Misrepresentation of a material fact
(2) Intention to deceive
(3) Intention to induce client’s reliance on the misrepresentation
(4) Reckless action
b. One of the elements that a plaintiff must prove to hold a CPA who signs off on financial statements in a registration statement liable for misstatements in the financial statements under Section 11 of the 1933 Act is that the
(1) plaintiff relied on the
misrepresentation.
(2) CPA intended to deceive.
(3) plaintiff suffered a loss.
(4) CPA was negligent.
c. Under the Ultramares rule, an accountant that negligently prepares a client’s financial report will be liable to
(1) clients and any person or limited foreseeable class of persons who the CPA knows will be relying on the CPA’s work.
(2) persons in privity of contract with the CPA and intended third parties.
(3) clients and any third party that foreseeably relied on the accountant’s report.
(4) the client only.
DISCUSSION QUESTIONS AND PROBLEMS
5-17 (OBJECTIVES 5-3, 5-4, 5-5, 5-6) Following are eight statements with missing terms involving auditor legal liability.
1. ________________ is generally only available as a defense in suits brought by clients.
2. Under the Ultramares doctrine, an auditor is generally not liable for ___________________ to third parties lacking ___________________.
3. A third party lacking privity will often be successful in bringing a claim against the auditor if they can demonstrate ___________________ or ___________________.
4. The broadest class of third parties under common law is known as _______________.
5. Under the 1933 Act, plaintiffs do not have to demonstrate ___________________, but need merely demonstrate the existence of a(n) ___________________.
6. The auditor will use a defense of ___________________ in a suit brought under the 1933 Securities Act.
7. 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.
8. After passage of the Private Securities Litigation Reform Act, auditors generally have ___________________ liability in federal securities cases.
Terms
a. Due diligence g. Intent to deceive
b. Reliance on the financial statements h. Privity of contract
c. Fraud i. Gross negligence
d. Ordinary negligence j. Foreseen users
e. Separate and proportionate k. Material error or omission
f. Contributory negligence
For each of the 11 blanks in statements 1 through 8, identify the most appropriate term.
No term can be used more than once.
5-18 (OBJECTIVES 5-3, 5-7) The following independent scenarios describe auditor behavior on an audit engagement.
1. The audit engagement partner, Marc Johnson, recently received a subpoena for work- papers related to an audit engagement on which his audit firm has been named as a defendant. Marc asked the staff auditor to remove and discard two memos from the workpaper files documenting communication between the engagement partner and the CFO regarding the goodwill impairment analysis.
2. Chad Lewis is the lead audit partner on the audit engagement of a publicly traded company. Chad followed auditing standards on the audit engagement and issued an unqualified opinion. It was subsequently discovered that the financial statements contained a material misstatement that had been undetected by the management of the company and by the audit team.
3. Maria Marquez, CPA, is a sole proprietor. She recently accepted a new audit client who was applying for a bank loan and needed to present audited financial statements to the bank. Maria was not able to complete the audit engagement by herself, so she hired several college students to assist her. The students completed the audit procedures without much guidance, and Maria issued an unmodified opinion on the client’s financial statements.
4. On a recent audit engagement, the client firm neglected to inform the audit firm that a significant percentage of inventory was stored at an outside warehouse. As a result, the auditors did not observe the physical inventory count for that inventory, which represented 20 percent of the client’s inventory balance. The auditors were able to satisfy themselves that the inventory existed through alternative procedures, and issued an unmodified opinion on the financial statements as a whole.
5. Melissa Louis is the lead engagement partner on a publicly traded company. The company’s CEO recently approached Melissa and informed her that they had identified a material misstatement in the prior year’s financial statements, which had been audited by Melissa’s firm and submitted to the SEC. The CEO suggested they correct the misstatement by recording a journal entry in the current year for half of the amount of the misstatement, and in the following year for the remaining half. Melissa agreed to this plan to avoid a public announcement of a restatement and a potential lawsuit, since the amount of the journal entries recorded in the current and subsequent years would be considered immaterial to the financial statements.
For each of the scenarios listed above, discuss whether the auditor’s behavior would be considered nonnegligence, ordinary negligence, gross negligence, constructive fraud, fraud, or criminal behavior.
5-19 (OBJECTIVES 5-2, 5-3) The following are five independent situations.
1. Joanie Brogan is a partner in an audit firm that operates as a limited liability partnership (LLP). The firm has been sued for an alleged audit failure related to an audit engagement handled by a different partner in the firm. While Brogan had no involvement in the engagement, she is concerned that the plaintiff may successfully sue her seeking restitution from her personal assets.
2. A lawsuit has been filed against Carter Hockaday, CPA, charging him with constructive fraud in the audit of Broughton Company’s financial statements. Hockaday has examined all the audit documentation in his files and reviewed all relevant auditing standards. He is convinced that his audit fully complies with standards of the profession but is uncertain what he should use as his primary defense tactic.
3. West Camera Co. filed for bankruptcy in January 2018. A recent blog suggested that West’s external auditors should be sued for failing to include a going concern explanatory paragraph in the firm’s opinion on the financial statements issued before the bankruptcy, even though the fair presentation of the financial statements is not being disputed.
4. The audit firm Weaver and Jones, LLP, received a subpoena for its documentation related to the audit of Westbrook Corporation’s financial statements. The firm has refused to respond, alleging that the documentation is considered privileged communication between the firm and its client.
5. Spencer Cullen, CPA, is a defendant in a lawsuit alleging that Cullen should be held legally liable for gross negligence for a fraud involving the valuation of securities included in the financial statements of one of his clients. Cullen was uncertain how to establish a correct valuation for the securities and decided to rely on the price estimation supplied by management.
Analyze each situation and provide your assessment of the potential resolution of each scenario, including potential liability for the auditor or audit firm involved.
5-20 (OBJECTIVES 5-4, 5-5) Lauren Yost & Co., a medium-sized CPA firm, was engaged to audit Stuart Supply Company. Several staff were involved in the audit, all of whom had attended the firm’s in-house training program on effective auditing methods. Throughout the audit, Yost spent most of her time in the field planning the audit, supervising the staff, and reviewing their work.
A significant part of the audit entailed verifying the physical count, cost, and summarization of inventory. Inventory was highly significant to the financial statements, and Yost knew the inventory was pledged as collateral for a large loan to First City National Bank. In reviewing Stuart’s inventory count procedures, Yost told the president she believed the method of counting inventory at various locations on different days was highlyundesirable. The president stated that it was impractical to count all inventory on the same day because of personnel shortages and customer preference. After considerable discussion, Yost agreed to permit the practice if the president signed a statement that no other method was practical. The CPA firm had at least one person at each site to audit the inventory count procedures and actual count. There were more than 40 locations.
Eighteen months later, Yost found out that the worst had happened. Management below the president’s level had conspired to materially overstate inventory as a means of covering up obsolete inventory and inventory losses resulting from mismanagement. The misstatement occurred by physically transporting inventory at night to other locations after it had been counted in a given location. The accounting records were inadequate to uncover these illegal transfers.
Both Stuart Supply Company and First City National Bank sued Lauren Yost & Co.
Answer the following questions, setting forth reasons for any conclusions stated:
a. What defense should Lauren Yost & Co. use in the suit by Stuart?
b. What defense should Lauren Yost & Co. use in the suit by First City National Bank?
c. Is Yost likely to be successful in her defenses?
d. Would the issues or outcome be significantly different if the suit was brought under the Securities Exchange Act of 1934?
5-21 (OBJECTIVE 5-5) The CPA firm of Bigelow, Barton, and Brown was expanding rapidly.
Consequently, it hired several junior accountants, including a man named Small. The partners of the firm eventually became dissatisfied with Small’s productivity and warned him they would be forced to discharge him unless his output increased significantly.
At that time, Small was engaged in audits of several clients. He decided that to avoid being fired, he would reduce or omit some of the standard auditing procedures listed in audit programs prepared by the partners. One of the CPA firm’s clients, Newell Corporation, was in serious financial difficulty and had adjusted several of the accounts being audited by Small to appear financially sound. Small prepared fictitious audit documentation in his home at night to support purported completion of auditing procedures assigned to him, although he in fact did not examine the adjusting entries. The CPA firm rendered an unmodified opinion on Newell’s financial statements, which were grossly misstated. Several creditors, relying on the audited financial statements, subsequently extended large sums of money to Newell Corporation.
Will the CPA firm be liable to the creditors who extended the money because of their reliance on the erroneous financial statements if Newell Corporation should fail to pay them? Explain.*
5-22 (OBJECTIVES 5-3, 5-5) Doyle and Jensen, CPAs, audited the accounts of Regal Jewelry, Inc., a corporation that imports and deals in fine jewelry. Upon completion of the audit, the auditors supplied Regal Jewelry with 20 copies of the audited financial statements. The firm knew in a general way that Regal Jewelry wanted that number of copies of the auditor’s report to furnish to banks and other potential lenders.
The balance sheet in question was misstated by approximately $800,000. Instead of having a $600,000 net worth, the corporation was insolvent. The management of Regal Jewelry had doctored the books to avoid bankruptcy. The assets had been overstated by $500,000 of fictitious and nonexisting accounts receivable and $300,000 of nonexisting jewelry listed as inventory when in fact Regal Jewelry had only empty boxes. The audit failed to detect these fraudulent entries. Thompson, relying on the audited financial statements, loaned Regal Jewelry $200,000. She seeks to recover her loss from Doyle and Jensen.
State whether each of the following is true or false and give your reasons:
a. If Thompson alleges and proves negligence on the part of Doyle and Jensen, she will be able to recover her loss.
b. If Thompson alleges and proves constructive fraud (that is, gross negligence on the part of Doyle and Jensen), she will be able to recover her loss.
c. Unless actual fraud on the part of Doyle and Jensen can be shown, Thompson cannot recover her loss.
d. Thompson is a third-party beneficiary of the contract Doyle and Jensen made with Regal Jewelry.*
5-23 (OBJECTIVES 5-5, 5-6) In order to expand its operations, Gibson Corp. raised $5 million in a public offering of common stock, and also negotiated a $2 million loan from Citizens National Bank. In connection with this financing, Gibson engaged Horton & Co., CPAs, to audit Gibson’s financial statements. Horton knew that the sole purpose of the audit was so that Gibson would have audited financial statements to provide to Citizens National Bank and the purchasers of the common stock. Although Horton conducted the audit in conformity with its audit program, Horton failed to detect material acts of embezzlement committed by Gibson Corp.’s president. Horton did not detect the embezzlement because of its inadvertent failure to exercise due care in designing the audit program for this engagement.
After completing the engagement, Horton issued an unqualified opinion on Barton’s financial statements. The financial statements were relied upon by the purchasers of the common stock in deciding to purchase the shares. In addition, Citizens National Bank approved the loan to Gibson based on the audited financial statements. Within 60 days after the sale of the common stock and the issuance of the loan, Gibson was involuntarily petitioned into bankruptcy. Because of the president’s embezzlement, Gibson became insolvent and defaulted on the loan from the bank. Its common stock became virtually worthless. Actions have been brought against Horton by
• the purchasers of the common stock, who have asserted that Horton is liable for damages under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934.
• Citizens National Bank, based upon Horton’s negligence.
• trade creditors who extended credit to Gibson based upon Horton’s negligence.
a. Discuss whether you believe Horton will be found liable to the purchasers of common stock.
b. Indicate whether you believe Citizens National Bank will be successful in its claim against Horton.
c. Indicate whether you believe the trade creditors will be successful in their claim against Horton.*
5-24 (OBJECTIVE 5-6) Under Section 11 of the Securities Act of 1933 and Section 10(b), Rule 10b-5, of the Securities Exchange Act of 1934, a CPA may be sued by a purchaser of registered securities. The following items relate to what a plaintiff who purchased securities must prove in a civil liability suit against a CPA.
The plaintiff security purchaser must allege or prove
1. a monetary loss occurred.
2. material misstatements were included in a filed document.
3. reliance on the financial statements.
4. privity with the CPA.
5. the CPA had scienter (knowledge and intent to deceive).
6. lack of due diligence by the CPA.
For each of the items 1 through 6 listed above, indicate whether the statement must be proven under
a. Section 11 of the Securities Act of 1933 only.
b. Section 10(b) of the Securities Exchange Act of 1934 only.
c. both Section 11 of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934.
d. neither Section 11 of the Securities Act of 1933 nor Section 10(b) of the Securities Exchange Act of 1934.*
5-25 (OBJECTIVES 5-1, 5-2, 5-6) Taylor Bean & Whitaker Mortgage Corp. (Taylor Bean) was a Florida mortgage lender. Once one of the nation’s largest privately held mortgage companies, the company collapsed in 2009 after a multibillion dollar mortgage fraud unraveled.
The downfall of Taylor Bean also triggered the collapse of Colonial Bank in one of the largest bank failures in U.S. history. The SEC charged Lee Farkas, the former chairman of Taylor Bean, and several other officers of the company with conspiring to sell more than $1.5 billion worth of fabricated or impaired mortgage securities to Colonial Bank. The fraudulent scheme occurred from March 2002 until August 2009, when Taylor Bean filed for bankruptcy. The SEC charged Theresa Kelly, a former operations supervisor at Colonial Bank’s mortgage warehouse lending division, with being an active participant in the fraud scheme.
The bankruptcy trustee for Taylor Bean sued PricewaterhouseCoopers (PwC), which had served as Colonial Bank’s auditor, for $5.5 billion in damages, claiming that PwC was negligent in not detecting the fraud. Although PwC was Colonial Bank’s auditor, Colonial Bank and Taylor Bean had a close relationship. Most lawsuits related to the 2008 global financial crisis ended in settlements, and Taylor Bean’s auditor, Deloitte LLP, settled in 2013 for an undisclosed amount. The 2016 civil trial involving PwC was supposed to last six weeks. However, after three weeks, PwC settled with the bankruptcy trustee in a confidential settlement for an undisclosed amount.
a. Most of the auditor litigation related to the 2008 financial crisis resulted in settlements. Why do you think most audit firms settled rather than going to trial?
b. The case involving PwC and Taylor Bean was one of the few cases that actually went to trial. Why do you think PwC initially decided to go to trial? Why do you think the firm settled halfway through the trial?
c. The trustee that sued PwC alleged that they were negligent in failing to uncover the fraud. To what extent should auditors be held responsible for failing to detect fraud?
Does it matter that PwC was Colonial Bank’s auditor, and not the auditor for Taylor Bean?
5-26 (OBJECTIVE 5-6) Gordon & Groton, CPAs, were the auditors of Bank & Company, a brokerage firm and member of a national stock exchange. Gordon & Groton audited and reported on the financial statements of Bank, which were filed with the Securities and Exchange Commission.
Several of Bank’s customers were swindled by a fraudulent scheme perpetrated by Bank’s president, who owned 90 percent of the voting stock of the company. The swindled customers were invited to invest in a special investment syndicate. The syndicate did not exist; Bank’s president stole the funds and provided fictitious investment statements to the investors. Bank’s president committed the fraud by directing that all correspondence from customers be received directly by him. Gordon & Groton were unaware of this policy regarding customer correspondence, and did not participate in the fraudulent scheme or know of its existence.
The customers are suing Gordon & Groton, under the antifraud provisions of Section 10b and Rule 10b-5 of the Securities Exchange Act of 1934, for aiding and abetting the fraudulent scheme of the president. The customers’ suit for fraud is predicated exclusively on the nonfeasance of the auditors in failing to conduct a proper audit, thereby failing to discover the fraudulent scheme.
Answer the following questions, including your reasoning in reaching your conclusion:
a. Do you believe the auditors were negligent in conducting the audit?
b. What is the probable outcome of the lawsuit?
5-27 (OBJECTIVE 5-6) The SEC Enforcement Division investigates possible violations of securities laws; recommends SEC action when appropriate, either in a federal court or before an administrative law judge; and negotiates settlements. Litigation Releases, which aredescriptions of SEC civil and selected criminal suits in the federal courts, are posted on the SEC website (www.sec.gov/litigation/litreleases.shtml). Find Litigation Release No. 23765, dated March 3, 2017.
a. What is the nature of the complaint underlying LR No. 23765?
b. How was the fraud underlying the complaint detected?
c. The litigation release does not discuss the role of the auditor. Given the nature of the fraud, do you believe the auditor will be found liable if sued under the 1934 Securities Act?
Required
Based on AICPA question paper, American Institute of Certified Public Accountants.
CASE
5-28 (OBJECTIVES 5-5, 5-6) Part 1. Whitlow & Company is a brokerage firm registered under the Securities Exchange Act of 1934. The act requires such a brokerage firm to file audited financial statements with the SEC annually. Mitchell & Moss, Whitlow’s CPAs, performed the annual audit for the year ended December 31, 2019, and rendered an unqualified opinion, which was filed with the SEC along with Whitlow’s financial statements. During 2019, Charles, the president of Whitlow & Company, engaged in a huge embezzlement scheme that eventually bankrupted the firm. As a result, substantial losses were suffered by customers and shareholders of Whitlow & Company, including Thaxton, who had recently purchased several shares of stock of Whitlow & Company after reviewing the company’s 2019 audit report. Mitchell & Moss’s audit was deficient; if they had complied with auditing standards, the embezzlement would have been discovered. However, Mitchell & Moss had no knowledge of the embezzlement, nor can their conduct be categorized as reckless.
Answer the following questions, setting forth reasons for any conclusions stated:
a. What liability to Thaxton, if any, does Mitchell & Moss have under the Securities Exchange Act of 1934?
b. What theory or theories of liability, if any, are available to Whitlow & Company’s customers and shareholders under common law?
Part 2. Jackson is a sophisticated investor. As such, she was initially a member of a small group that was going to participate in a private placement of $1 million of common stock of Clarion Corporation. Numerous meetings were held between management and the investor group. Detailed financial and other information was supplied to the participants.
Upon the eve of completion of the placement, it was aborted when one major investor withdrew. Clarion then decided to offer $2.5 million of Clarion common stock to the public pursuant to the registration requirements of the Securities Act of 1933. Jackson subscribed to $300,000 of the Clarion public stock offering. Nine months later, Clarion’s earnings dropped significantly, and as a result, the stock dropped 20 percent beneath the offering price. In addition, the Dow Jones Industrial Average was down 10 percent from the time of the offering.
Jackson sold her shares at a loss of $60,000 and seeks to hold all parties liable who participated in the public offering, including Clarion’s CPA firm of Allen, Dunn, and Rose.
Although the audit was performed in conformity with auditing standards, there were some relatively minor misstatements. The financial statements of Clarion Corporation, which were part of the registration statement, also contained minor misleading facts. It is believed by Clarion and Allen, Dunn, and Rose that Jackson’s asserted claim is without merit.
Answer the following questions, setting forth reasons for any conclusions stated:
a. If Jackson sues under the Securities Act of 1933, what will be the basis of her claim?
b. What are the probable defenses that might be asserted by Allen, Dunn, and Rose in light of these facts?
