1. In connection with a public offering of first mortgage bonds by DuMond Corp., the bond underwriter has asked DuMond's CPA to furnish him with a comfort letter giving as much assurance as possible relative to DuMond's unaudited financial statements for the three months ended March 31, 2000.
The CPA had expressed an unqualified opinion on DuMond's financial statements for the year ended December 31, 1999; he has performed a limited review of DuMond's financial statements for the three months ended March 31, 2000. Nothing has come to his attention that would indicate that the March 31, 2000 statements are not properly presented. Under these circumstances, the CPA's response to the underwriter's request should be to
a. furnish to the underwriters an opinion that the March 31, 2000 statements are fairly presented subject to year-end audit adjustments.
b. give negative assurance as to the March 31, 2000 financial statements but disclaim an opinion on these statements.
c. inform the underwriters that no comfort letter is possible without an audit of the financial statements for the three months ended March 31, 2000.
d. Furnish to the underwriters an adverse opinion covering financial statements for the three months ended March 31, 2000.
2. As a consequence of his failure to adhere to generally accepted auditing standards in the course of his examination of the Lamp Corp, Harrison, CPA, did not detect the embezzlement of a material amount of funds by the company's controller. As a matter of common law, to what extent would Harrison be liable to the Lamp Corp. for losses attributable to the theft?
a. He would have no liability, since the ordinary examination cannot be relied upon to detect thefts of assets by employees.
b. He would have no liability because privity of contract is lacking.
c. He would be liable for losses attributable to his negligence.
d. He would be liable only if it could be proven that he was grossly negligent.
3. The King Surety Company wrote a general fidelity bond covering thefts of assets by the employees of Wilson, Inc. Thereafter, Cooney, an employee of Wilson, embezzled $17,200 of company funds. When the activities were discovered, King paid Wilson the full amount in accordance with the terms of the fidelity bond, and then sought recovery against Wilson's auditors, Lynch & Merritt, CPAs. Which of the following would be Lynch & Merritt's best defense?
a. King is not in privity of contract.
b. The shortages were the result of clever forgeries and collusive fraud which would not be detected by an examination made in accordance with generally accepted auditing standards.
c. Lynch & Merritt were not guilty either of gross negligence or fraud.
d. Lynch & Merritt were not aware of the King-Wilson surety relationship.
4. Spring & Summers, a medium-sized CPA firm, employed Winters as a staff accountant. Winters was negligent while auditing several of the firm's clients. Under these circumstances, which of the following statements is true?
a. Winters would have no personal liability for negligence.
b. Spring & Summers is not liable for Winters' negligence because CPAs are generally considered to be independent contractors.
c. Spring & Summers would not be liable for Winters' negligence if Winters disobeyed specific instructions in the performance of the audits.
d. Spring & Summers can recover against its insurer on its malpractice policy even if one of the partners was also negligent in reviewing Winters' work.
5. The partnership of Crown & Roe, CPAs, has been engaged to examine the financial statements of Woods, Inc., in connection with the registration of Woods' securities with the Securities and Exchange Commission.
a. The firm of Crown & Roe, CPAs is assuming much greater third-party liability than it assumes on engagements under common law.
b. If its examination is not fraudulent, Crown & Roe may issue an appropriate disclaimer to the financial statements and thereby avoid liability.
c. Crown and Roe must incorporate if they wish to practice before the SEC.
d. Crown and Roe must be a large interstate firm if they wish to practice before the SEC.
6. The Securities and Exchange Commission has authority to
a. prescribe specific auditing procedures to detect fraud concerning inventories and accounts receivable of companies engaged in interstate commerce.
b. deny lack of privity as a defense in third-party actions for gross negligence against the auditors of public companies.
c. determine accounting principles for the purpose of financial reporting by companies offering securities to the public.
d. require a change of auditors of governmental entities after a given period of years as a means of ensuring auditor independence.
7. The similarity which exists in both the United States v. Natelli case, aka National Student Marketing case of 1975, and the ESM Government Securities v. Alexander Grant & Co. case of 1986 is that in each case
a. a partner in a national CPA firm served prison time.
b. the partners were punished for the shoddy work of their subordinates.
c. a presidential pardon kept them from serving time in prison and allowed them to retain their CPA licenses.
d. the auditors were not convicted for failing to discover the problem in year 1, but for failing to disclose the problem when it was discovered in year 2.
8. Which one of the following statements about the Racketeer Influenced and Corrupt Organization Act (RICO) is not correct?
a. The plaintiff must demonstrate that the auditor's conduct was beyond ordinary negligence.
b. The auditor must be able to demonstrate that his/her conduct was not beyond ordinary negligence.
c. The act allows an injured party to seek treble damages and recovery of legal fees.
d. It must be demonstrated that the defendant was engaged in a "pattern of racketeering activity," which means at least two acts of racketeering in a ten-year period.
9. In a leading securities law and CPA liabilities case, the U.S. Supreme Court ruled in 1976 in Hochfelder v. Ernst & Ernst that before CPAs could be held liable for Rule 10b-5 of the Securities Exchange Act of 1934, what would be required to be shown to the court was the auditor's
a. ordinary negligence.
b. gross negligence.
c. knowledge and intent to deceive.
d. financial gain at the expense of the plaintiff.
10. One of the changes in auditing procedure which was brought about as a result of the 1136 Tenants case was that the AICPA now recommends that
a. letters of representation be used on all engagements.
b. confirmation letters be used on all jobs.
c. engagement letters be used on all jobs.
d. billet doux letters be used on all jobs.
11. Which one of the following statutes is not a relevant federal law affecting auditors?
a. The 1933 and 1934 securities acts.
b. The Racketeer Influenced and Corrupt Organization Act.
c. The Federal False Statements Statute.
d. The Federal Mail Fraud Statute.
12. One of the changes in auditing which was brought about as a result of the 1136 Tenants case was
a. the Accounting and Review Services Committee was given the power to set guidelines for audited statements.
b. the Auditing Standards Board has eliminated from their SASs all references to unaudited statements.
c. an AICPA recommendation that CPA firms should not engage in write- up work.
d. an AICPA recommendation that CPAs engaged in write-up work should not perform any audit procedures.
13. The leading case of criminal action against CPAs is the
a. 1136 Tenants case.
b. United States v. Simon case, aka Continental Vending.
c. Escott et al. v. Bar Chris case, aka Bar Chris.
d. Ultramares Corporation v. Touche case.
14. If specific information comes to an auditor's attention that implies the existence of possible illegal acts that could have a material, but indirect effect on the financial statements, the auditor should next
a. apply audit procedures specifically directed to ascertaining whether an illegal act has occurred.
b. seek the advice of an informed expert qualified to practice law as to possible contingent liabilities.
c. report the matter to an appropriate level of management at least one level above those involved.
d. discuss the evidence with the client's audit committee, or others with equivalent authority.
15. The leading precedent-setting auditing case in third-party liability is
a. Escott et al. v. Bar Chris Construction Corp.
b. Hochfelder v. Ernst & Ernst.
c. Ultramares Corporation v. Touche.
d. United States v. Simon.
16. A major purpose of federal securities regulations is to
a. provide sufficient information to the investing public who purchases securities in the marketplace.
b. establish the qualifications for accountants who are members of the profession.
c. eliminate incompetent attorneys and accountants who participate in the registration of securities to be offered to the public.
d. provide a set of uniform standards and tests for accountants, attorneys, and others who practice before the Securities and Exchange Commission.
17. Under common law, an individual or company that (1) does not have a contract with an auditor, (2) is known by the auditor in advance of the audit, and (3) will use the auditor's report to make decisions about the client company
a. has no rights unless auditor is grossly negligent.
b. has no rights unless auditor is fraudulent.
c. has no rights against auditor.
d. has the same rights against auditor as client has.
18. A CPA is subject to criminal liability if the CPA
a. refuses to turn over the working papers to the client.
b. performs an audit in a negligent manner.
c. willfully omits a material fact required to be stated in a financial statement.
d. willfully breaches the contract with the client.
19. The basic legal concept which was affirmed in the 1985 New York case, Credit Alliance, was that
a. the auditor's defense of privity of contract is still valid against third parties.
b. the auditor is liable for ordinary negligence to specifically foreseen third parties.
c. the auditor is liable for ordinary negligence to reasonably foreseeable third parties.
d. the auditor's defense of contributory negligence is no longer valid.
20. Which of the following best describes a trend in litigation involving CPAs?
a. A CPA cannot render an opinion on a company unless the CPA has audited all affiliates of that company.
b. A CPA may not successfully assert as a defense that the CPA had no motive to be part of a fraud.
c. A CPA may be exposed to criminal as well as civil liability.
d. A CPA is primarily responsible for a client's footnotes in an annual report filed with the SEC.
21. Which of the following statements about the Securities Act of 1933 is not true?
a. Any third party that purchased securities described in the registration statement may sue the auditor for material misrepresentations or omissions in the audited financial statements.
b. The third-party user does not have the burden of proof that he/she relied on the financial statements.
c. The third-party user does have the burden of proof that the auditor was either negligent or fraudulent in doing the audit.
d. The third-party user does not have the burden of proof that the loss was caused by the misleading statements.
22. Generally, the decision to notify parties outside the client's organization regarding an illegal act is the responsibility of the
a. independent auditor.
b. internal auditors.
c. management.
d. outside legal counsel.
23. The most significant audit issue that came as a result of the court decision in the Escott et al. v. Bar Chris Construction Corporation case in 1968 was
a. the court's reaffirmation that the burden of proof was on the plaintiff to prove the auditor was negligent.
b. the affirmation of the increased auditor's responsibility when performing an S-1 review, a review of events subsequent to the balance sheet, for registration statements.
c. the increased auditor responsibility when associated with unaudited financial statements.
d. the court's refusal to allow the percentage-of-completion method of accounting for revenues.
24. An auditor's examination performed in accordance with generally accepted auditing standards generally should
a. be expected to provide assurance that illegal acts will be detected where internal control is effective.
b. be relied upon to disclose violations of truth-in-lending laws.
c. encompass a plan to search actively for illegalities which relate to operating aspects.
d. not be relied upon to provide assurance that illegal acts will be detected.
25. Under the federal securities acts, one significant result occurring directly due to the Escott et al. v. Bar Chris Construction Corporation case was that SAS was changed to require
a. greater emphasis on subsequent events procedures.
b. new standards for unaudited statements.
c. a broader definition of third-party beneficiaries.
d. more companies to file annual reports with the SEC.
26. When management refuses to disclose illegal activities which were identified by the independent auditor, the independent auditor may be charged with violating the AICPA Code of Professional Conduct for
a. withdrawing from the engagement.
b. issuing a disclaimer of opinion.
c. failure to uncover the illegal activities during prior audits.
d. reporting these activities to the audit committee.
27. Under the Securities Exchange Act of 1934, most of the litigation against the auditor has been generated because of the auditor's involvement with the
a. 8-K form.
b. 10-K form.
c. 10-Q form.
d. S-1 form.
28. Which of the following resulted in a federal law passed in 1995 that significantly reduced potential damages in securities-related litigation?
a. Private Securities Litigation Reform Act.
b. Public Securities Damages and Settlements Act.
c. Racketeer Influenced and Corrupt Organization Act.
d. U.S. Securities Claims Reform Act.
29. Section 10 and Rule 10b-5 of the Securities Exchange Act of 1934 are often referred to as
a. the antifraud provisions.
b. the new issues provisions.
c. the full-employment act for accountants.
d. the RICO provisions.
30. Privity of contract exists between
a. auditor and client.
b. auditor and third parties.
c. auditor and the Securities and Exchange Commission.
d. all three above.
31. In connection with the examination of financial statements, an independent auditor could be responsible for failure to detect a material fraud if
a. statistical sampling techniques were not used on the audit engagement.
b. the auditor planned the work in a hasty and inefficient manner.
c. accountants performing important parts of the work failed to discover a close relationship between the treasurer and the cashier.
d. the fraud was perpetrated by one client employee, who circumvented the existing internal controls.
32. Which of the following statements is true?
a. Gross negligence may constitute constructive fraud.
b. Constructive fraud is also termed recklessness.
c. Fraud requires the intent to deceive.
d. All three above are true.
33. Under common law, a foreseen user would be treated the same as
a. a primary beneficiary.
b. the client.
c. a known third party.
d. all of the above.
34. The Foreign Corrupt Practices Act (FCPA) of 1977
a. requires auditors to review and evaluate systems of internal control as a part of doing the audit.
b. requires SEC registrants under the 1934 Act to maintain a reasonably complete and accurate set of records and an adequate system of internal control.
c. requires auditors to review client's internal control system in a manner which is thorough enough to judge whether client meets the requirements of the FCPA.
d. requires auditors to file a report with the SEC if client's internal control system is inadequate.
35. An example of a breach of contract would be
a. a CPA firm's failure to deliver a tax return on the agreed-upon date because the firm had a backlog of other work which was more lucrative.
b. a bank's claim that an auditor had a duty to uncover material errors in financial statements that had been relied on in making a loan.
c. an auditor's refusal to return client's general ledger book until client paid last year's audit fees.
d. an auditor's failure to complete the audit by the agreed-upon date because client's financial records had been confiscated by the Internal Revenue Service.
36. There are a number of things that the AICPA, representing the profession as a whole, can do to reduce the practitioner's exposure to lawsuits. One of them is to
a. sanction members for improper conduct and performance.
b. deal only with clients possessing integrity.
c. hire qualified auditors and train and supervise them.
d. perform quality audits.
37. The existence of extreme or unusual negligence, even though there was no intent to deceive or do harm, is
a. fraud.
b. gross fraud.
c. ordinary fraud.
d. constructive fraud.
38. The major conclusion of the 1931 Ultramares case was that
a. ordinary negligence is insufficient for liability to third parties.
b. ordinary negligence is sufficient for liability to third-party beneficiaries.
c. fraud or gross negligence is sufficient for liability to third parties.
d. all three of the above.
39. As a result of a 1993 U.S. Supreme Court decision, outside professionals such as accountants can't be sued under the provisions of RICO
a. unless they are grossly negligent.
b. if they don't help run the client's business.
c. if they help run the client's business.
d. if they are enrolled to practice before the SEC.
40. Which of the following sanctions is not available to the Securities and Exchange Commission?
a. Suspending the CPA from doing audits of SEC clients.
b. Prohibiting the CPA from accepting new SEC clients for six months.
c. Requiring the CPA to participate in continuing-education programs and make changes in their practice.
d. Revoking the CPA license.
41. A group not included under the common law rubric of "third parties" would be
a. actual and potential stockholders.
b. bankers and other creditors of client.
c. employees of client.
d. none of the above; that is, all would be included.
42. "Privileged communication" between client and auditor allows the auditor to refuse to testify in
a. federal courts.
b. all state courts.
c. several states.
d. all income tax cases, but no audit cases.
43. Which of the following auditor's defenses, when used in a third-party lawsuit, usually means non-reliance on the financial statements by the user?
a. Lack of duty.
b. Non-negligent performance.
c. Absence of causal connections.
d. Contributory negligence.
44. "Absence of reasonable care that can be expected of a person in a set of circumstances" is the definition of
a. ordinary negligence.
b. gross negligence.
c. constructive fraud.
d. fraud.
45. Under the laws of agency, partners of a CPA firm may be liable for the work of others on whom they rely. This would not include
a. employees of the CPA firm.
b. employees of the client.
c. other CPA firms engaged to do part of the work.
d. specialists called upon to provide technical information to the CPA firm.
46. In third-party suits, which of the auditor's defenses contends lack of privity of contract?
a. Lack of duty.
b. Non-negligent performance.
c. Contributory negligence.
d. Absence of causal connections.
47. Most of the major lawsuits against CPA firms have dealt with
a. disputes over income tax preparation services.
b. disputes arising in the performance of MAS contracts.
c. disputes over the accuracy of bookkeeping services.
d. audited and unaudited financial statements.
48. To succeed in an action against the auditor, the client must be able to show that
a. the auditor was fraudulent.
b. the auditor was grossly negligent.
c. there was a written contract.
d. there is a close causal connection between the auditor's breach of the standard of due care and the damages suffered by the client.
49. Under the Securities Exchange Act of 1934, which of the following organizations are required to submit audited financial statements to the SEC?
a. Every company with securities traded on national and over-the-counter exchanges.
b. Every corporation.
c. Every company issuing new securities.
d. Every corporation which is chartered by a state government.
50. Auditors are not liable to their clients for
a. errors of judgment.
b. negligence.
c. bad faith.
d. dishonesty.
51. The assessment against a defendant of that portion of the damage caused by the defendant's negligence is called
a. separate and proportionate liability.
b. joint and several liability.
c. shared liability.
d. unitary liability.
52. If the CPA negligently failed to properly prepare and file a client's tax return, the CPA can be held liable for
a. the penalties which client owes the IRS.
b. the penalties and interest which client owes.
c. the penalties and interest, plus the tax preparation fee which the CPA charged.
d. the penalties and interest, the tax preparation fee, and the amount of tax which was underpaid.
53. The prudent person concept establishes in law that
a. the CPA firm is not expected to be infallible.
b. an audit in accordance with GAAS is subject to limitations and cannot be relied upon for complete assurance that all errors and irregularities will be found.
c. the courts do not require that the auditor become the insurer or guarantor of the accuracy of the statements.
d. all three of the above are true.
54. Under the Securities Act of 1933, the auditor's responsibility for making sure the financial statements were fairly stated is extended to
a. the date of the financial statements.
b. the date the registration statement becomes effective.
c. the date of the audit report.
d. one year beyond the date of the financial statements.
55. Which of the following statements about the Securities Act of 1933 is not true?
a. It concerns only the reporting requirements for companies issuing new securities.
b. It deals with the information in registration statements and prospectuses.
c. The amount of the potential recovery is the original purchase price plus punitive damages.
d. The only parties that can recover from auditors under the 1933 act are original purchasers of securities.
56. A common way for a CPA firm to demonstrate its defense of a lack of duty to perform is by use of a(n)
a. expert witness' testimony.
b. engagement letter.
c. letter of representation.
d. confirmation letter.
57. Most accounting and auditing professionals agree that when an audit has failed to uncover material misstatements, and the wrong type of audit opinion is issued, the audit firm
a. has failed to follow generally accepted auditing standards (GAAS).
b. deserves to lose the lawsuit.
c. should be asked to defend the quality of the audit.
d. should not be held responsible for the financial loss suffered by others.
58. The assessment against a defendant of the full loss suffered by plaintiff regardless of the extent to which other parties shared in the wrongdoing is called
a. separate and proportionate liability.
b. shared liability.
c. unitary liability.
d. joint and several liability.
59. The standard of due care to which the auditor is expected to be held is referred to as the
a. prudent person concept.
b. common law doctrine.
c. due care concept.
d. reckless regard doctrine.
60. When the auditor issues an erroneous opinion as the result of an underlying failure to comply with the requirements of generally accepted auditing standards, it results in
a. business failure.
b. audit failure.
c. audit risk.
d. all of the above.
61. Laws that have been passed through state governments are
a. statute law.
b. judicial law.
c. federal law.
d. common law.
62. According to Statement on Auditing Standards No. 1, the auditor's responsibility for failure to detect fraud arises
a. whenever the amounts involved are material.
b. only when such failure clearly results from negligence so gross as to sustain an inference of fraud on the part of the auditor.
c. when such failure clearly results from failure to comply with generally accepted auditing standards.
d. only when the examination was specifically designed to detect fraud.
63. In the auditing environment, failure to meet generally accepted auditing standards is often
a. an accepted practice.
b. a suggestion of negligence.
c. conclusive evidence of negligence.
d. tantamount to criminal behavior.
64. The increased litigation under the federal securities laws has resulted from
a. the expanded availability of class-action litigation.
b. the relative ease of obtaining massive recovery from defendants.
c. the strict liabilities standards imposed on CPAs by the securities laws.
d. all three of the above.
65. Which of the auditor's four defenses is ordinarily not available in third-party lawsuits?
a. Absence of causal connections.
b. Contributory negligence.
c. Non-negligent performance.
d. Lack of duty.
66. Tort actions against CPAs are more common than breach of contract actions because
a. the amounts recoverable are normally larger.
b. the burden of proof is on the auditor rather than on the person suing.
c. the person suing need prove only negligence.
d. there are more torts than contracts.
67. Which of the following is an illustration of liability to client under the common law?
a. Client sues auditor for not discovering a theft of assets by an employee.
b. Bank sues auditor for not discovering that borrower's financial statements are misstated.
c. Combined group of stockholders sue auditor for not discovering materially misstated financial statements.
d. Federal government prosecutes auditor for knowingly issuing an incorrect audit report.
68. An individual who is not party to the contract between CPA and client, but who is known by both and is intended to receive certain benefits from a contract, is
a. a third party.
b. a common law inheritor.
c. a tort.
d. a third-party beneficiary.
69. Society's increasing acceptance of lawsuits against anyone who might be able to provide compensation, regardless of fault, coupled with the joint and several liability doctrine, is a concept of liability referred to as
a. no-fault.
b. compensation-regardless.
c. deep-pockets.
d. mutual liability.
70. An arrangement which offers the injured party a potential gain when the lawsuit is successful but minimal loss when it is unsuccessful is
a. the public defender's office.
b. the contingent-fee basis.
c. no-fault insurance.
d. liability insurance.
71. Laws that have been developed through court decisions rather than by passage through governmental agencies are
a. statute law.
b. judicial law.
c. federal law.
d. common law.
72. Which of the following is an illustration of liability under the federal securities acts?
a. Client sues auditor for not discovering a theft of assets by an employee.
b. Bank sues auditor for not discovering that borrower's financial statements are misstated.
c. Combined group of stockholders sue auditor for not discovering materially misstated financial statements.
d. Federal government prosecutes auditor for knowingly issuing an incorrect audit report.
73. The principal issue to be resolved in cases involving alleged negligence is usually
a. the amount of the damages suffered by plaintiff.
b. whether to impose punitive damages on defendant.
c. the level of care required to be exercised.
d. whether defendant was involved in fraud.
74. The greatest growth in CPA liability litigation has been
a. caused by clients.
b. caused by third parties under common law.
c. under the federal securities law.
d. under the AICPA's Code of Professional Conduct.
75. While performing services for their clients, professionals have a duty to provide a level of care which is
a. free from judgment errors.
b. superior.
c. greater than average.
d. reasonable.
76. Audit contracts
a. may be oral.
b. must be in writing.
c. must be in writing and notarized.
d. must be in writing if the client is supervised by the Securities and Exchange Commission.
77. In rare cases auditors have been held liable for criminal acts. A criminal conviction against an auditor can result only when it is demonstrated that the auditor
a. intended to deceive or harm others.
b. caused a financial loss to an innocent third party.
c. was negligent.
d. was grossly negligent.
78. Failure of a party to meet its obligations, thereby causing injury to another party to whom a duty was owed, is
a. breach of contract.
b. tort action for negligence.
c. constructive fraud.
d. fraud.
79. A broad interpretation of the rights of third-party beneficiaries holds that users that the auditor should have been able to foresee as being likely users of financial statements have the same rights as those with privity of contract. This is known as the concept of
a. foreseen users.
b. foreseeable users.
c. forcible users.
d. four-party contracts.
80. Explain what each of the following terms means:
(1) Business failure.
(2) Audit failure.
(3) Audit risk.
81. Discuss each of the four defenses a CPA firm can normally use when facing legal claims by clients. Which of these defenses is ordinarily not available against third-party suits?
ANSWERS
1 - 10. b, c, b, d, a, c, d, b, c, c
11 - 20. b, b, b, a, c, a, d, c, a, c
21 - 30. c, c, b, d, a, b, b, a, a, a
31 - 40. b, d, d, b, a, a, d, a, b, d
41 - 50. d, c, c, a, b, a, d, d, a, a
51 - 60. a, c, a, b, c, b, c, d, a, b
61 - 70. a, c, c, d, b, a, a, d, c, b
71 - 79. d, c, c, c, d, a, a, b, b
80. (1) Business failure occurs when a business is unable to repay its lenders or meet the expectations of its investors because of economic or business conditions. The extreme case of business failure is filing for bankruptcy.
(2) Audit failure occurs when the auditor issues an erroneous audit opinion as the result of a failure to comply with the requirements of generally accepted auditing standards.
(3) Audit risk is the risk that the auditor will conclude that the financial statements are fairly stated and an unqualified opinion can be issued when, in fact, they are materially misstated.
81. Lack of duty. The CPA firm could claim that there was no implied or expressed contract to perform between the CPA firm and the client.
Nonnegligent performance. The CPA firm could claim that the audit was performed in accordance with GAAS.
Contributory negligence. The CPA firm could claim that the client's actions either caused the loss, or interfered with the auditor's ability to discover the cause of the loss. This defense is not available in third-party suits.
Absence of causal connection. The CPA firm could claim that the auditor's substandard performance did not cause the damages suffered by the client.