110/4141 MCQ Flashcards
A client suing a CPA for negligence must prove each of the following factors except:
breach of duty of care.
proximate cause.
reliance.
injury.
reliance.
To establish negligence, a client must show that:
- the CPA owed a legal duty,
- the CPA breached that duty,
- the CPA’s action was the proximate cause of the resulting injury to the client, and
- the CPA’s actions caused the damage or loss.
- The client does not have to prove reliance on the CPA’s advice.
In a lawsuit against a CPA (Certified Public Accountant) for negligence, the client must establish several critical elements to prove their case. These elements typically include:
Duty of Care: The client must prove that the CPA owed them a duty of care. This means that the CPA had a responsibility to act with the same level of care, skill, and diligence that a reasonably competent CPA would use in similar circumstances.
Breach of Duty of Care: The client must demonstrate that the CPA breached this duty of care. A breach occurs when the CPA fails to meet the standard of care expected of them, such as making errors in financial statements or tax filings.
Causation: The client must show causation, which includes both actual cause (the CPA’s breach of duty directly caused the harm) and proximate cause (the harm was a foreseeable result of the CPA’s actions).
Injury: The client must prove that they suffered an actual injury or loss as a result of the CPA’s negligence. This could be financial loss, damage to reputation, or other harms.
Reliance: The client must often demonstrate reliance on the CPA’s advice or work. This means showing that the injury or loss occurred because the client relied on the inaccurate, negligent, or improper work of the CPA.
From the options you provided, the one factor that a client does NOT need to prove in a lawsuit against a CPA for negligence is:
Reliance: While reliance is crucial in cases involving fraud or misrepresentation, in a pure negligence lawsuit, the focus is more directly on the breach of duty, causation, and injury. However, this might vary depending on the specific legal standards of the jurisdiction and the nature of the claim (e.g., negligence vs. fraudulent misrepresentation).
In typical negligence claims, reliance is less about proving as a separate factor and more integrated into the overall narrative of how the professional’s failure directly led to the client’s loss. Therefore, while reliance is important in the broader sense of proving a case against a CPA, it is not always listed as a separate, standalone element like duty of care, breach of duty, causation, and injury.
A company engaged a CPA to perform an audit of the company’s financial statements for year 2 in order to apply for a bank loan. After the bank made the loan, it was discovered that the company’s assets had been materially overstated. The overstatement was not discovered as part of the CPA’s audit procedures. If the company defaulted on the loan and the case occurred in a jurisdiction that follows the Restatement rule, then the CPA could have liability to which of the following?
The bank, but not the company
Neither the bank nor the company
Both the bank and the company
The company, but not the bank
I think the answer is “the bank, but not the company” because the Restatement Rule states third parties may be able to sue if the CPA knew or should have known that the third party would rely on the financial statements or audits in making a decision. The company is not a third party and the company would not have suffered damages. Let’s see if I am correct.
Nope. I am wrong. AGAIN.
Both the bank and the company
Under the Restatement of Torts, the defendant is liable to possible foreseen users that only have to be identified by their class (e.g., creditors). In this case, because the auditor knew the audit was to obtain a bank loan, the auditor could have liability to the bank providing the loan as a foreseeable user of the financial statements in addition to the known user, the company.
A CPA could be liable to a tax client for damages resulting from all of the following actions, except:
failing to timely file a client’s return.
failing to advise a client of certain tax elections.
refusing to sign a client’s request for a filing extension.
neglecting to evaluate the option of preparing joint or separate returns that would have resulted in a substantial tax savings for a married client.
refusing to sign a client’s request for a filing extension.
A CPA could be liable to a tax client for damages from:
failing to timely file a client’s return,
failing to advise a client of certain tax deductions, and
neglecting to evaluate the option of preparing joint or separate returns that would have resulted in substantial tax savings for a married client.
A CPA firm issues an unmodified 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:
intends to gain monetarily by concealing fraud.
negligently performs auditing procedures.
has actual knowledge of fraud.
intentionally disregards the truth.
negligently performs auditing procedures.
The CPA firm will have acted with scienter in all the following circumstances, except where the firm negligently performs auditing procedures. The key concept is the term “scienter.” Scienter means that the party had knowledge and acted with evil intent or deliberate motive.
My words: If they were negligent, then they would not have scienter. They would have only recklessly disregarded the truth if they were negligent.
CHATGPT4: Scienter refers to a legal term that denotes knowledge on the part of a person or entity that they were engaging in improper or fraudulent conduct. It implies a level of intent or recklessness regarding the wrongful act, especially in the context of securities fraud and certain types of litigation under U.S. law. Scienter is associated with the intent to deceive, manipulate, or defraud.
When a CPA firm issues an unmodified (or clean) opinion on financial statements that were not prepared in accordance with Generally Accepted Accounting Principles (GAAP), it can be considered to have acted with scienter if it knowingly, recklessly, or with intent, disregarded the non-compliance with GAAP. However, the circumstances under which the CPA firm would not be considered to have acted with scienter include:
Negligently performs auditing procedures: If a CPA firm negligently performs its auditing procedures, it means the firm failed to exercise the appropriate level of care and diligence expected in the performance of its professional duties. Negligence does not involve the intentional or knowing commission of a wrongful act. Instead, it involves a failure to act with the prudence and care that a reasonable person or entity would exercise under similar circumstances. In this context, if the CPA firm did not intentionally issue an unmodified opinion on financial statements not prepared in accordance with GAAP but did so due to a failure to adequately perform its auditing procedures, it would not necessarily have acted with scienter, because there was no intent to deceive or knowledge of wrongdoing.
The key difference here is between intentional or reckless behavior (scienter) and negligent behavior (lack of due care). While both can result in significant consequences for the CPA firm and potentially lead to legal or regulatory actions, scienter involves a more culpable state of mind that typically results in more severe penalties. Negligence, while still a serious issue, suggests a lower level of culpability because it lacks the element of intent or knowledge of wrongdoing.
A CPA quickly prepares the financial statements for WSA Co. without noticing that an asset was inadvertently overstated on the balance sheet by 10%. An investor who had purchased stock in WSA based on the financial statements lost $10,000 as a result of the investment. The investor claims that WSA committed fraud. Which of the following is true concerning whether fraud was committed?
Fraud was committed because the balance sheet is misstated.
Fraud was not committed because the investor’s damages are not material.
Fraud was committed because the reliance was placed on the statements by the investor.
Fraud was not committed because the misstatement was due to negligence.
Fraud was not committed because the misstatement was due to negligence.
The elements of fraud are:
- misrepresentation (false representation, concealment, or nondisclosure),
- knowledge of falsity (scienter),
- intent to defraud (i.e., to induce reliance),
- justifiable reliance, and
- resulting damage.
Although the elements of justifiable reliance and resulting damage are present, there was no intent by the auditors to defraud. The facts specifically show that the auditors “without noticing” and “inadvertently” overstated the balance of the assets by 10%. This is not fraud due to the lack of intent, but it may be considered negligence.
A CPA who fraudulently performs an audit of a corporation’s financial statements will:
probably be liable to any person who suffered a loss as a result of the fraud.
be liable only to the corporation and to third parties who are members of a class of intended users of the financial statements.
probably be liable to the corporation even though its management was aware of the fraud and did not rely on the financial statements.
be liable only to third parties in privity of contract with the CPA.
probably be liable to any person who suffered a loss as a result of the fraud.
A CPA who fraudulently performs an audit of a corporation’s financial statements will probably be liable to any person who suffered a loss as a result of the fraud.
The remaining answer choices are an attempt to confuse you with the issue of the Ultramares rule. Recall that the Ultramares decision dealt with a case of a CPA who was negligent as opposed to fraudulent in the conduct of the audit. The Ultramares court ruled that third parties who are not in privity of contract with the accountants cannot sue for negligence (though they can sue for gross negligence).
A CPA who prepares clients’ federal income tax returns for a fee must
A File certain required notices and powers of attorney with the IRS before preparing any returns
B Keep a completed copy of each return for a specified period of time
C Receive client documentation supporting all travel and entertainment expenses deducted on the return
D Indicate the CPA’s federal identification number on a tax return only if the return reflects tax due from the taxpayer
Keep a completed copy of each return for a specified period of time
A CPA who prepares a client’s federal income tax return for a fee must keep a copy of the completed return for three years or a penalty may be assessed. It is not necessary for a tax return preparer to file notices and powers of attorney in connection with return preparation. A preparer is not required to receive client documentation supporting all travel and entertainment expenses. A preparer must furnish a preparer ID number on all returns prepared for a fee.
A CPA will most likely be negligent when the CPA fails to:
correct errors discovered in the CPA’s previously issued audit reports.
detect all of a client’s fraudulent activities.
include a negligence disclaimer in the CPA’s engagement letter.
warn a client’s customers of embezzlement by the client’s employees.
A CPA will most likely be negligent when the CPA fails to correct errors discovered in the CPA’s previously issued audit reports.
The failure to detect all of a client’s fraudulent activities is a standard that goes beyond the typical audit engagement. A CPA’s failure to include a negligence disclaimer in the CPA’s engagement letter does not suggest that the CPA has failed to exercise ordinary due care in fulfilling the audit.
A CPA has no duty to warn a client’s customers of embezzlement on the part of the client’s employees.
A CPA, while employed as an employee in a securities company, prepares misleading financial records for the company at his superior’s directive. He knows what the correct entry should be, yet does not make the correct entry, although the actual making of such an entry is under his control. The CPA has chosen to look the other way due to his superior’s orders. Which of the choices listed is the best answer concerning the CPA’s responsibilities?
The CPA has no responsibility since he prepared the materials under the orders of his superior. The superior has the responsibility.
The CPA has responsibility only if he has not documented his objection.
The CPA is a bad person and should be fired since he made incorrect entries.
The CPA is responsible for the accuracy of the financial records he prepares.
The CPA is responsible for the accuracy of the financial records he prepares.
The CPA certainly could document his objections in writing, but he is still ethically bound to prepare correct financial records. See ET Section 1.400.040, “Negligence in the Preparation of Financial Statements or Records.”
The CPA is responsible for the accuracy of the financial records he or she prepares. An ethical violation is committed if the CPA:
- makes, or permits or directs another to make, materially false and misleading entries in the financial statements or records of an entity,
- fails to correct an entity’s financial statements that are materially false and misleading when the member has the authority to record an entry, or
- signs, or permits or directs another to sign, a document containing materially false and misleading information.
See also ET Section 1.130.020 (“Subordination of Judgment”). The AICPA Integrity and Objectivity Rule (ET 1.100.001) prohibits a member from knowingly misrepresenting facts or subordinating his or her judgment when performing professional services. Under this rule, if a member and his or her supervisor have a disagreement or dispute relating to the preparation of financial statements or the recording of transactions, the member should take the following steps to ensure that the situation does not constitute a subordination of judgment:
The member should consider whether (a) the entry or the failure to record a transaction in the records, or (b) the financial statement presentation or the nature or omission of disclosure in the financial statements, as proposed by the supervisor, represents the use of an acceptable alternative and does not materially misrepresent the facts. If, after appropriate research or consultation, the member concludes that the matter has authoritative support and/or does not result in a material misrepresentation, the member need do nothing further.
If the member concludes that the financial statements or records could be materially misstated, the member should make his or her concerns known to the appropriate higher level(s) of management within the organization (for example, the supervisor’s immediate superior, senior management, the audit committee or equivalent, the board of directors, the company’s owners). The member should consider documenting his or her understanding of the facts, the accounting principles involved, the application of those principles to the facts, and the parties with whom these matters were discussed.
If, after discussing his or her concerns with the appropriate person(s) in the organization, the member concludes that appropriate action was not taken, he or she should consider his or her continuing relationship with the employer. The member also should consider any responsibility that may exist to communicate to third parties, such as regulatory authorities or the employer’s (former employer’s) external accountant. In this connection, the member may wish to consult with his or her legal counsel.
The member should at all times be cognizant of his or her obligations under ET Section 2.130.030 (“Obligation of a Member to His or Her Employer’s External Accountant”).
Authorities
ET 1.130.020
ET 1.400.040
ET 2.130.030
An accounting firm was hired by a company to perform an audit. The company needed the audit report in order to obtain a loan from a bank. The bank lent $500,000 to the company based on the auditor’s report. Fifteen months later, the company declared bankruptcy and was unable to repay the loan. The bank discovered that the accounting firm failed to discover a material overstatement of assets of the company. Which of the following statements is correct regarding a suit by the bank against the accounting firm? The bank:
can sue the accounting firm for the loss of the loan because of negligence.
cannot sue the accounting firm because of the statute of limitations.
can sue the accounting firm for the loss of the loan because of the rule of privilege.
cannot sue the accounting firm because there was no privity of contact.
can sue the accounting firm for the loss of the loan because of negligence.
Negligence is defined as the failure to do what an ordinary, reasonable, prudent CPA would do in similar circumstances. In this example, the CPA has the responsibility under generally accepted auditing standards (GAAS) to detect a material misstatement in the financial statements. If the CPA recklessly certified financial statements without taking proper procedures to determine whether or not the financial statements were in fact true, then the bank may be able to prove gross negligence. The CPA also knew that the bank would be relying on the audited financial statements (the audit was primarily for the purpose of obtaining the loan). This makes the CPA liable to the bank for negligence.
The Ultramares rule is that a third party proving gross negligence does not need privity of contract or a direct contractual relationship with the CPA to recover damages. The rule of privilege refers to the attorney-client privilege. Under common law, there is no privilege that an accountant or client may invoke to prevent disclosures. The statute of limitations for negligence suits varies by state. The injury occurred 15 months after the loan was made, which is not an excessive amount of time. Regardless, the length of time expired is not the main point of the question.
Beckler & Associates, CPAs, audited and gave an unmodified opinion on the financial statements of Queen Co. The financial statements contained misstatements that resulted in a material overstatement of Queen’s net worth. Queen provided the audited financial statements to Mac Bank in connection with a loan made by Mac to Queen. Beckler knew that the financial statements would be provided to Mac. Queen defaulted on the loan. Mac sued Beckler to recover for its losses associated with Queen’s default. Which of the following must Mac prove in order to recover?
Beckler was negligent in conducting the audit.
Mac relied on the financial statements.
I only
II only
Both I and II
Neither I nor II
Both I and II
This question deals with the concept of professional liability of the CPA to a foreseeable third-party beneficiary. Under this concept, the CPA can be held liable to a third party who can be foreseen as a user of the financial statements under ordinary common law negligence and lack of due professional care in the performance of the audit.
In order to recover from Beckler, Mac Bank must prove that the financial statements contained a material misrepresentation (given), that the user suffered damage (the default—given), and both:
Beckler was negligent in conducting the audit and
Mac relied on the financial statements.
Beckler & Associates, CPAs, audited and gave an unmodified opinion on the financial statements of Queen Co. The financial statements contained misstatements that resulted in a material overstatement of Queen’s net worth. Queen provided the audited financial statements to Mac Bank in connection with a loan made by Mac to Queen. Beckler knew that the financial statements would be provided to Mac. Queen defaulted on the loan. Mac sued Beckler to recover for its losses associated with Queen’s default. Which of the following must Mac prove in order to recover?
I. Beckler was negligent in conducting the audit.
II. Mac relied on the financial statements.
A I only
B II only
C Both I and II
D Neither I nor II
Both I and II
In order to prove negligence under common law, Mac must prove the following:
(1) a duty of care existed;
(2) that duty of care was breached;
(3) the injury was proximately caused by the defendant’s breach of the duty of care;
and (4) the plaintiff suffered an injury.
Item I corresponds to the second element— “duty of care.”
Item II corresponds to the third element— “proximate cause.”
Thus, both items I and II are necessary in order for Mac to recover.
The plaintiff must prove reliance: Information in the Financial Statements was relied upon and was the proximate cause of the harm to the plaintiff.
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 unmodified 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:
sign an engagement letter.
have privity of contract with Cable.
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.
Under general legal liability, a CPA must not perform work negligently and therefore must exercise due care. There is no legal requirement that there be an engagement letter. A finding of negligence does not require reckless behavior or the intent to deceive. Privity does not have to be considered; Cable and Drake do not need a relationship for the agreement. However, a CPA’s responsibility is defined by generally accepted auditing standards (GAAS). Defenses to legal actions concerning the lack of due care include the fact that the CPA adhered to GAAS. The failure to follow GAAS would be considered a lack of due care.
Complaints can be filed against CPAs in most jurisdictions through online reporting sites or the state site itself. Reporting a violation requires that the person reporting:
has an attorney file the complaint.
lists his or her name for verification of the complaint.
file the appropriate complaint form.
None of the answer choices are correct.
None of the answer choices are correct.
None of the answer choices are requirements for reporting a violation. Each jurisdiction sets its own standards for the filing of complaints, but generally, any method of filing with the state board of accountancy will suffice. In Texas, for example, a simple letter is appropriate and it is not necessary to include your name. (Texas Occupations Code, Chapter 901 (Public Accountancy Act))
Ford & Co., CPAs, issued an unmodified opinion on Owens Corp.’s financial statements. Relying on these financial statements, Century Bank lent Owens $750,000. Ford was unaware that Century would receive a copy of the financial statements or that Owens would use them to obtain a loan. Owens defaulted on the loan. To succeed in a common-law fraud action against Ford, Century must prove, in addition to other elements, that Century was:
free from contributory negligence.
in privity of contract with Ford.
justified in relying on the financial statements.
in privity of contract with Owens.
justified in relying on the financial statements.
Contributory negligence would be a defense that Ford could use as a defense to blame Owens, not Century.
Defenses for a CPA include: Contributory negligence of the client caused the loss. (CPA was not negligent; adhered to prof standards; error was immaterial; proximate cause of loss was not the CPA’s error)
Privity refers to a contractual or near-contractual relationship. Century did not have a contractual relationship with Ford or with Owens.
In some jurisdictions, privity has been replaced with the third-party beneficiary rules. One of those rules is the foreseen class of users rule. Under the foreseen class of users rule as applied by some courts, a bank may recoup loan losses by proving that the CPA was negligent if the bank relied on the audited financial statements.
Generally, what are the terms of IRC Section 7525?
The terms include the various state law privileges.
The terms are limited to the words of the statute.
The terms mirror the common-law privilege extended to lawyers/clients.
The terms extend to a taxpayer’s communication with any person regarding her taxes.
The terms must necessarily be limited to the words of the statute. The common-law attorney/client privilege grew through the years without being written down. State privileges vary and so cannot limit the federal statute. The IRC Section 7525 privilege protects communication between a client or potential client and a CPA, attorney, enrolled agent, or enrolled actuary for the sole purpose of seeking and providing tax advice.
Reference
4142.05
Authorities
IRC 7525
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:
lose because Hark was negligent in performing the audit.
win because there was no privity of contract between Hark and Third.
win because Third was contributorily negligent in granting the loan.
lose because Hark knew that banks would be relying on the financial statements.
win because there was no privity of contract between Hark and Third.
Ultramares states you have to have privity to win. Later rules state you do not.
In a jurisdiction applying the Ultramares decision, if Third Bank sues Hark CPA, Hark will win because there was no privity of contract between Hark and Third. The key term is the Ultramares decision, referring to the landmark case of Ultramares Corporation v. Touche. In that litigation, the accountants were found guilty of negligence in performing an audit.
However, the court held that the accountants had no liability to third parties for ordinary negligence even though liability to third parties could be imposed for fraud or gross negligence. Many courts still follow the Ultramares rule that since there is no privity between a third-party user of an audited financial statement and the CPA firm, there is no cause of action by the third party against the CPA firm for negligence.
The Ultramares court ruled that even if a CPA firm knows that the audited financial statements are to be used by a creditor to make lending decisions, the third-party user lacks privity with the CPA firm and cannot recover for negligence.
