ch03 - Maintaining Professional Responsibility Regulation and Legal Liability.pdf

Maintaining Professional Responsibility: Regulation and Legal Liability MULTIPLE CHOICE: 1.

A CPA firm studies its personnel advancement experience to ascertain whether individuals meeting stated criteria are assigned increased degrees of responsibility. This is evidence of the firm's adherence to prescribed standards of a. Supervision and review. b. Continuing professional education. c. Professional development. d. Quality control. ANSWER:

2.

Which one of the following, if present, would support a finding of constructive fraud on the part of a CPA? a. Privity of contract. b. Intent to deceive. c. Reckless disregard. d. Ordinary negligence.

ANSWER: 3.

C

The CPA firm of Knox and Knox has been subpoenaed to testify and produce its correspondence and workpapers in connection with a lawsuit brought by a third party against one of their clients. Knox considers the subpoenaed documents to be privileged communication and therefore seeks to avoid admission of such evidence in the lawsuit. Which of the following is correct? a. Federal law recognizes such a privilege if the accountant is a Certified Public Accountant. b. The privilege is available regarding the workpapers since the CPA is deemed to own them. c. The privileged communication rule as it applies to a CPA/client relationship is the same as that of attorney-client. d. In the absence of a specific statutory provision, the law does not recognize the existence of the privileged communication rule between a CPA and his client. ANSWER:

4.

D

D

Of the following statements, which best distinguishes ordinary negligence from gross negligence? a. Failure to detect material errors, whether internal control is strong or weak, suggests gross negligence.

20

Chapter 3 Maintaining Professional Responsibility b. c. d.

Failure to exercise reasonable care denotes ordinary negligence, whereas failure to exercise minimal care indicates gross negligence. Gross negligence is most probable when the auditor fails to detect errors that occurred under conditions of strong internal control. The more material the undetected error the greater the likelihood of ordinary negligence.

ANSWER: 5.

A

The limitation of auditor liability under contract law is known as a. b. c. d.

Privity of contract. Contributory liability. Statutory liability. Common law liability.

ANSWER: 7.

B

On July 1, 2002, Kent purchased common stock of Salem Corp. in an offering subject to the Securities Act of 1933. Mane & Co., CPAs, rendered an unqualified opinion on the financial statements of Salem which were included in Salem's registration statement filed with the SEC on March 1, 2002 Kent has commenced an action against Mane based on the Securities Act of 1933 provisions dealing with omissions of facts required to be stated in the registration statement. Which of the following elements of a cause of action under the Securities Act of 1933 must be proved by Kent? a. Kent relied upon Mane's opinion. b. Kent was the initial purchaser of the stock and gave value for it. c. Mane's omission was material. d. Mane acted negligently or fraudulently. ANSWER:

6.

21

A

Under the Securities Act of 1933, the registration of securities which are offered to the public in interstate commerce is a. Directed toward preventing the marketing of securities which pose serious financial risks to the prospective investor. b. Not required unless the issuer is a corporation. c. Mandatory unless the cost to the issuer is "prohibitive" as defined in the SEC regulations. d. Required unless there is an applicable exemption.

22

Chapter 3 Maintaining Professional Responsibility

ANSWER: 8.

The auditor's defense of contributory negligence is most likely to prevail when a. b.

Third party injury has been minimal. The auditor fails to detect fraud resulting from management override of the control structure. The client is privately held as contrasted with a public company. Undetected errors have resulted in materially misleading financial statements.

c. d.

ANSWER: 9.

B

A plaintiff wishes to recover damages from the issuer for losses resulting from material misstatements in a securities registration statement. In order to be successful, one of the elements the plaintiff must prove is that the a. Plaintiff was in privity of contract with the issuer or that the issuer knew of the plaintiff. b. Plaintiff acquired the securities. c. Issuer acted negligently. d. Issuer acted fraudulently.

ANSWER: 11.

B

The objective of quality control mandates that a public accounting firm should establish policies and procedures for professional development which provide reasonable assurance that all entry-level personnel a. Prepare working papers which are standardized in form and content. b. Have the knowledge required to enable them to fulfill responsibilities assigned. c. Will advance within the organization. d. Develop specialties in specific areas of public accounting. ANSWER:

10.

D

B

A basic objective of a CPA firm is to provide professional services that conform with professional standards. Reasonable assurance of achieving this basic objective is provided through a. A system of peer review. b. Continuing professional education. c. A system of quality control. d. Compliance with generally accepted reporting standards.

23

Chapter 3 Maintaining Professional Responsibility

ANSWER: 12.

Mix and Associates, CPAs, issued an unqualified opinion on the financial statements of Glass Corp. for the year ended December 31, 2002. It was determined later that Glass' treasurer had embezzled $300,000 from Glass during 2002. Glass sued Mix because of Mix's failure to discover the embezzlement. Mix was unaware of the embezzlement. Which of the following is Mix's best defense? a. The audit was performed in accordance with GAAS. b. The treasurer was Glass' agent and, therefore, Glass was responsible for preventing the embezzlement. c. The financial statements were presented in conformity with GAAP. d. Mix had no actual knowledge of the embezzlement. ANSWER:

13.

A

Which of the following is not a condition for membership in the Division for CPA Firms? a. Participating in peer review. a. Employing only CPAs. b. Conforming to specified continuing professional education requirements. c. Maintaining adequate levels of liability insurance.

ANSWER: 14.

C

B

Gold, CPA, rendered an unqualified opinion on the 2000 financial statements of Eastern Power Co. Egan purchased Eastern bonds in a public offering subject to the Securities Act of 1933. The registration statement filed with the SEC included the financial statements. Gold is being sued by Egan under Section 11 of the Securities Act of 1933 for the misstatements contained in the financial statements. To prevail, Egan must prove Scienter No No Yes Yes

a. b. c. d. ANSWER: 15.

Reliance No Yes No Yes

A

The Rusch Factors and Rhode Island Hospital Trust cases further defined the doctrine of privity by stating that

24

Chapter 3 Maintaining Professional Responsibility a. b. c. d.

Stockholders, as owners of the company, are also parties to the contract between auditor and client. Privity extends to primary third party beneficiaries known by the auditor to be relying on the financial statements. The doctrine of privity is broken when management intentionally misrepresents financial position and/or results of operations. Privity extends to third parties only in cases involving auditor negligence.

ANSWER: 16.

In connection with the element of professional development, a CPA firm's system of quality control should ordinarily provide that all personnel a. b. c. d.

Have the knowledge required to enable them to fulfill responsibilities assigned. Possess judgment, motivation, and adequate experience. Seek assistance from persons having appropriate level of knowledge, judgment, and authority. Demonstrate compliance with peer review directives.

ANSWER: 17.

A

In the case of Fischer v. Kletz (Yale Express), the auditors were charged with fraud for failing to inform users of nonexistent accounts receivable. Although the case was settled out of court, it did encourage the profession to issue a Statement on Auditing Standards relating to a. b. c. d.

Related party transactions. Auditor responsibility for detecting illegal acts. Audit risk assessment. Subsequent discovery of facts existing at the date of the audit report.

ANSWER: 18.

B

D

Accounting firms should establish quality control procedures for professional development in order to provide reasonable assurance that d. Persons promoted possess the appropriate characteristics to perform competently. b. Personnel will have the knowledge required to fulfill responsibilities assigned. c. The extent of supervision and review in a given instance will be appropriate.

Chapter 3 Maintaining Professional Responsibility d.

Association with a client whose management lacks integrity will be minimized.

ANSWER: 19.

D

Gleam is contemplating a common law action against Moore & Co. CPAs, based upon fraud. Gleam loaned money to Lilly & Co. relying upon Lilly's financial statements which were audited by Moore. Gleam's action will fail if a. Gleam shows only that Moore failed to meticulously follow GAAS. b. Moore can establish that they fully complied with the statute of frauds. c. The alleged fraud was in part committed by oral misrepresentations and Moore pleads the parol evidence rule. d. Gleam is not a third party beneficiary in light of the absence of privity. ANSWER:

21.

B

The factor that distinguishes constructive fraud from actual fraud is a. Materiality. b. Quality of internal control. c. Type of error or irregularity. d. Intent. ANSWER:

20.

25

A

In the Continental Vending Machine Corporation case, the court argued that a footnote appearing in the company's annual report was confusing and misleading. As a result, the accounting profession a. Encouraged practitioners to carry adequate liability insurance. b. Issued a Statement on Auditing Standards defining related party transactions and assigning auditor responsibility for detecting material related party transactions and determining that the economic substance of such transactions is properly reflected in the financial statements. c. Issued a Statement on Auditing Standards requiring auditor presence at the client's physical inventory taking and auditor confirmation of customer accounts receivable. d. More clearly defined "privity of contract" between auditor and client. ANSWER:

B

26

22.

Chapter 3 Maintaining Professional Responsibility Working papers prepared by a CPA in connection with an audit engagement are owned by the CPA, subject to certain limitations. The rationale for this rule is to a. Protect the working papers from being subpoenaed. b. Provide the basis for excluding admission of the working papers as evidence because of the privileged communication rule. c. Provide the CPA with evidence and documentation which may be helpful in the event of a lawsuit. d. Establish a continuity of relationship with the client whereby indiscriminate replacement of CPAs is discouraged. ANSWER:

23.

Mead Corp. orally engaged Dex & Co., CPAs, to audit its financial statements. The management of Mead informed Dex that it suspected that the accounts receivable were materially overstated. Although the financial statements audited by Dex did, in fact, include a materially overstated accounts receivable balance, Dex issued an unqualified opinion. Mead relied on the financial statements in deciding to obtain a loan from City Bank to expand its operations. City relied on the financial statements in making the loan to Mead. As a result of the overstated accounts receivable balance, Mead has defaulted on the loan and has incurred a substantial loss. If Mead sues Dex for negligence in failing to discover the overstatement, Dex's best defense would be that a. No engagement letter had been signed by Dex. b. The audit was performed by Dex in accordance with generally accepted auditing standards. c. Dex was not in privity of contract with Mead. d. Dex did not perform the audit recklessly or with an intent to deceive. ANSWER:

24.

C

B

Dickens, a CPA firm's personnel partner, periodically studies the CPA firm's personnel advancement experience to ascertain whether individuals meeting stated criteria are assigned increased degrees of responsibility. This is evidence of the CPA firm's adherence to prescribed a. Standards of due professional care. b. Quality control standards. c. Supervision and review standards. d. Reporting standards. ANSWER:

B

Chapter 3 Maintaining Professional Responsibility 25.

West & Co., CPAs, was engaged by Sand Corp. to audit its financial statements. West issued an unqualified opinion on Sand's financial statements. Sand has been accused of making negligent misrepresentations in the financial statements, which Reed relied upon when purchasing Sand stock. West was not aware of the misrepresentations nor was it negligent in performing the audit. If Reed sues West for damages based upon Section 10(b) and rule 10b-5 of the Securities Exchange Act of 1934, West will a. Lose, because Reed relied upon the financial statements. b. Lose, because the statements contained negligent misrepresentations. c. Prevail, because some element of scienter must be proved. d. Prevail, because Reed was not in privity of contract with West. ANSWER:

26.

C

A CPA establishes quality control policies and procedures for deciding whether to accept a new client or continue to perform services for a current client. The primary purpose for establishing such policies and procedures is a. To enable the auditor to attest to the integrity or reliability of a client. b. To comply with the quality control standards established by regulatory bodies. c. To lessen the exposure to litigation resulting from failure to detect irregularities in client financial statements. d. To minimize the likelihood of association with clients whose management lacks integrity. ANSWER:

27.

27

D

Which of the following statements is correct concerning corporations subject to the reporting requirements of the Securities Exchange Act of 1934? a. The annual report (form 10-K) need not include audited financial statements. b. The annual report (form 10-K) must be filed with the SEC within 20 days of the end of the corporation's fiscal year. c. A quarterly report (form 10-Q) need only be filed with the SEC by those corporations that are also subject to the registration requirements of the Securities Act of 1933. d. A monthly report (form 8-K) must be filed with the SEC

28

Chapter 3 Maintaining Professional Responsibility after the end of any month in which a materially important event occurs. ANSWER:

28.

In a common law action against an accountant, the lack of privity is a viable defense if the plaintiff a. Bases his action upon fraud. b. Is the accountant's client. c. Is a creditor of the client who sues the accountant for negligence. d. Can prove the presence of gross negligence which amounts to a reckless disregard for the truth. ANSWER:

29.

D

Tulip Corp. is a registered and reporting corporation under the Securities Exchange Act of 1934. As such it a. Can offer and sell its securities to the public without the necessity of registering its securities pursuant to the Securities Act of 1933. b. Cannot make a tender offer for the equity securities of another registered and reporting corporation without the consent of the SEC. c. Must file annual reports (Form 10-K) with the SEC. d. Must distribute a copy of the annual report (Form 10-K) to each of its shareholders. ANSWER:

31.

C

Donn & Co. is considering the sale of $11 million of its common stock to the public in interstate commerce. In this connection, Donn has been correctly advised that registration of the securities with the SEC is a. Not required if the states in which the securities are to be sold have securities acts modeled after the federal act and Donn files in those states. b. Required in that it is necessary for the SEC to approve the merits of the securities offered. c. Not required if the securities are to be sold through a registered brokerage firm. d. Required and must include audited financial statements as an integral part of its registration. ANSWER:

30.

D

C

A CPA firm issues an unqualified opinion on financial statements not prepared in accordance with GAAP. The CPA firm will have acted with scienter in all the following circumstances except where the firm

Chapter 3 Maintaining Professional Responsibility a. b. c. d.

Intentionally disregards the truth. Has actual knowledge of fraud. Negligently performs auditing procedures. Intends to gain monetarily by concealing the fraud.

ANSWER: 32.

b. c. d.

Failure to detect material errors under conditions of weak internal control. Failure to detect collusive fraud perpetrated by members of middle management. Failure to detect collusive fraud perpetrated by members of top management. Failure to detect errors occurring outside the internal control structure.

ANSWER:

A

The registration of a security under the Securities Act of 1933 provides an investor with a. A guarantee by the SEC that the facts contained in the registration statement are accurate. b. An assurance against loss resulting from purchasing the security. c. Information on the principal purposes for which the offering's proceeds will be used. d. Information on the issuing corporation's trade secrets. ANSWER:

34.

C

Which of the following conditions suggests auditor negligence? a.

33.

29

C

The principal purpose of the registration requirements of the Securities Act of 1933 is to a. Prevent public offerings of securities in which management fraud or unethical conduct is suspected. b. Provide the SEC with the information necessary to determine the accuracy of the facts presented in the financial statements. c. Assure that investors have adequate information upon which to base investment decisions. d. Provide the SEC with the information necessary to evaluate the financial merits of the securities being offered. ANSWER:

C

30

Chapter 3 Maintaining Professional Responsibility

COMPLETION: 35.

A committee formed in 1999 to “focus on the problem of managed earnings, cookie-jar reserves, purchased R&D writeoffs, and abuse of the materiality concept” is known as the __________ __ _______ _____________. ANSWER:

36.

A disparity between users' and CPAs' perceptions of auditor responsibility is referred to as the . ANSWER:

37.

.

SCIENTER

Auditor liability under the Securities acts is referred to as liability. ANSWER:

43.

INCORPORATED BY REFERENCE

The legal term for "intent to deceive" is ANSWER:

42.

ORDINARY NEGLIGENCE

Given the Securities Exchange Act of 1934 and the concept of "integrated disclosure", information may be ____________ ___ in Form 10-K. ANSWER:

41.

CONSTRUCTIVE FRAUD

The primary difference between contractual liability to clients and civil liability to third parties is that, under civil liability, the auditor is not liable to third parties for . ANSWER:

40.

SECURITIES AND EXCHANGE COMMISSION

is defined as negligence so flagrant as to border on deceit. ANSWER:

39.

EXPECTATION GAP

Ultimate authority to set accounting and auditing standards rests with the . ANSWER:

38.

PANEL ON AUDIT EFFECTIVENESS

STATUTORY

In responding to an underwriter's request for a __________ _________, the auditor will likely apply certain limited procedures to the financial data arising subsequent to the most recent audit.

Chapter 3 Maintaining Professional Responsibility

ANSWER: 44.

31

COMFORT LETTER

In the Ernst and Ernst v. Hochfelder case, the U.S. Supreme Court held that auditors are not liable for under Rule 10B-5 of the Securities Exchange Act of 1934, but only for . ANSWER:

NEGLIGENCE, SCIENTER (FRAUD)

MATCHING: 45.

Match each of the responsibilities enumerated below with the bodies charged with that responsibility. a. b. c. d. e. f. g. h.

State board of accountancy SEC Practice Section Public Oversight Board Securities and Exchange Commission AICPA Quality Control Standards Board Independence Standards Board Emerging Issues Task Force Panel on Audit Effectiveness

____ 1. Oversee peer review for public companies. ____ 2. Issue a guideline for reviewing accounting firm personnel for promotion. ____ 3. Issue recommendations directed toward improving the quality of independent audits. ____ 4. Recommend that the executive committee of the SEC Practice Section sanction a member for failing to comply with the Section’s peer review standards. ____ 5. Issue a standard prohibiting an accounting firm from accepting an accounting service engagement from an audit client on the basis that performing both types of service might impair objectivity. ____ 6. Review prospectus and registration statement of company contemplating an initial public offering. ____ 7. Revoke license of member for committing a discreditable act. ____ 8. Monitor FASB deliberations concerning the proper

32

Chapter 3 Maintaining Professional Responsibility accounting treatment to be applied to derivatives.

SOLUTION: 1. 2. 3. 4. 5. 6. 7. 8.

b e h c f d a g

ESSAY 46.An auditor is sued for negligence by the stockholders of an audit client. The auditor had issued an unqualified opinion on the client’s financial statements. It was later determined that the statements were materially distorted due to errors and fraud. Required: a. Under what conditions, in common law may an auditor be held liable to third parties for negligence? b. Describe two approaches for differentiating between ordinary negligence and gross negligence. Cite examples to support your approaches. c.

Who will prevail in the present case?

SOLUTION: a. The doctrine of privity states that auditors are liable to third parties for fraud but not for negligence. Subsequent court decisions, such as Ultramares v. Touche, however, have construed gross negligence as constructive fraud. Auditors, therefore, may be held liable to injured third parties for gross negligence, but not for ordinary negligence. In addition, privity may extend to specifically identified third parties known by the auditor to be relying on the audited financial statements. b. Two approaches to distinguishing ordinary negligence from gross negligence are materiality and internal control. Performing an audit with due care should permit the auditor to detect a material misstatement not cleverly concealed. For example, an inventory extension error (price x quantity) that overstates the ending inventory by 25 percent and results in a material overstatement of net income should be detected in the ordinary course of the audit. Errors or fraud perpetrated because of weak internal controls are more likely to be detected by the auditor than

Chapter 3 Maintaining Professional Responsibility

33

errors or fraud perpetrated outside the existing system of internal control. For example, material misstatements caused by classification errors related to repairs and maintenance expenditures versus property, plant, and equipment additions may occur because the persons charged with determining the appropriate accounts to be debited have not been adequately trained. This constitutes an internal control weakness; and the auditors should have detected the weakness and modified their substantive audit testing accordingly. Contrast this with a material misstatement caused by management intentionally overriding existing internal control for the purpose of inflating earnings. As part of the scheme, documentation supporting fictitious sales may have been fabricated. Under these conditions, the prudent auditor is less likely to detect the fraud. c. To prevail in the present case, the plaintiffs must demonstrate that the auditor was grossly negligent and must also prove that the plaintiffs were injured by the auditors’ negligence. 47. A. How does the level of quality maintenance within the accounting profession impact the expectations gap? Cite examples in your answer. B. What is the alternative to self-regulation? Cite two measures the profession has taken in recent years to meet the challenges posed by the threat of a widening expectations gap? SOLUTION: The goal of self-regulation within the accounting profession is to maintain the quality of accounting services at a level that will satisfy the users of these services. The expectations gap is the disparity between users’ and CPAs’ perceptions of the quality of these services. Therefore, a decline in either the quality of services rendered by CPAs or users’ perceptions of quality causes a widening of the expectations gap. Such diminishments occur, for example, when courts find auditors negligent in the performance of audits or when the financial press reports incidents of alleged audit failures. Cases involving Phar Mor, Lincoln Savings and Loan, Crazy Eddie, and Miniscribe can be cited as illustrations. CPA consulting services for audit clients impair the appearance of independence, and is another means for widening the expectations gap and undermining the perceived effectiveness of self-regulation. The alternative to self-regulation is external regulation by the SEC or a similar public body. One must remember that the SEC already has the authority granted by the securities acts to regulate the accounting profession, but has declined to fully exercise that authority. If the expectations gap were to widen

34

Chapter 3 Maintaining Professional Responsibility

significantly, however, and self-regulation is perceived to be ineffective, the SEC may well decide to actively pursue its regulatory powers. To meet the challenges posed the threat of a widening expectations gap and more external regulation, the profession, in recent years, has: 1. Assigned the auditor responsibility for planning the audit to provide reasonable assurance of detecting material financial statement errors and fraud; 2. Required auditors to evaluate the ability of each audit client to continue as a going concern; 3. Encouraged clients to appoint audit committees to monitor internal control and arbitrate disputes between management and the external auditors; 4. Issued a new SAS that provides more explicit guidance to auditors for detecting fraud and communicating the findings to management and the board of directors; 5. Created an Independence Standards Board to actively pursue issues involving auditor independence 48. For each of the following capsule cases, determine the outcome and provide the rationale to support your conclusion. 1. A group of stockholders is suing a CPA for failing to detect a material misappropriation of customer cash receipts by the controller of a company in which the group has invested. The fraud occurred because the controller had access to cash as well as the accounting records. The fraud was concealed by not recording the receipts. To conceal the overstatement of accounts receivable, the controller inflated sales returns and allowances and wrote off some of the accounts as uncollectible. The CPA failed to detect the fraud in the course of the audit. 2. The management of a large manufacturer of exercise equipment inflated net assets and net earnings by 1)recording fictitious sales and fabricating the underlying documentation; 2)debiting operating expenses to several construction projects in progress; and 3) inflating inventories by not recording sales returns and including the inventory at full cost, and inflating various inventory unit costs. These frauds were detected by IRS auditors after the company’s check for payment of income taxes “bounced.” The independent auditors did not discover the misrepresentation, and the new management is now suing them for failure to detect the fraud. 3. A CPA failed to detect a misrepresentation fraud perpetrated by an audit client. The fraud was material in its impact on the financial statements and was effected by debiting operating expenses and manufacturing overhead to work orders for various construction projects underway. The projects did not

Chapter 3 Maintaining Professional Responsibility

35

exist and the CPA examined a client-prepared analysis of the work orders rather than the work orders themselves. Moreover, the CPA did not ask to inspect any of the projects. An action alleging negligence was brought against the CPA by the bank that granted a loan to the company on the basis of the audited financial statements. The inflated earnings figure resulting from the misrepresentation was an integral part of the decision to grant the loan. The CPA had rendered an unqualified opinion on the financial statements. This was the first year the company had been audited. In past years, the CPA had performed only a review of the company’s financial statements; but this year the company requested an audit as part of the bank’s conditions for processing the loan application. SOLUTION: 1. The stockholders need to prove gross negligence by the CPA, inasmuch as they are not privy to the contract between the CPA and the client. The CPA appears to have been grossly negligent in this case. First, the fraud was facilitated by internal control weaknesses - the controller had access to cash as well as to accounting records. The CPA should have noted the weakness in assessing internal control and modified substantive audit programs accordingly. Further investigation of the accounts receivable write-offs, including contacting customers whose accounts had been written off, should have enabled the auditor to detect the fraud. In summary, this is a material fraud perpetrated within the system of internal control, and failure to detect is evidence of gross negligence. 2. The auditors appear not to be negligent in this case. Like Cenco v. Seidman & Seidman, the fraud was perpetrated by top management, was cleverly concealed, and was effected by overriding internal control. As the court stated in that case, “auditors cannot be expected to detect misstatements when management has turned the entity into an ‘engine of fraud.’” 3. The CPA will probably lose in this case. Although not grossly negligent, privity will likely be extended to the bank because the CPA knew the bank was the primary beneficiary of the audited financial statements. Negligence may be inferred by the fact that the auditor did not examine the work orders and did not inspect any of the additions.