Chapter 27 - Professional Liability and Accountability

Question 1

auditor

Answer 1

• an accountant qualified to perform audits (systematic inspections) of a business’s financial records

Question 2

defalcation

Answer 2

• the misuse of funds

Question 3

due diligence

Answer 3

• a required standard of care that certain professionals, such as accountants, must meet to avoid liability for securities violations

Question 4

fraud

Answer 4

• any misrepresentation, either by misstatement or omission of a material fact, knowingly made with the intention of deceiving another and on which a reasonable person would and does rely to his or her detriment

Question 5

generally accepted accounting principles (GAAP)

Answer 5

• the conventions, rules, and procedures that define accepted accounting practices at a particular time
• the source of the principles is the Financial Accounting Standards Board

Question 6

generally accepted auditing standards (GAAS)

Answer 6

• standards concerning an auditor’s professional qualities and the judgement exercised by him or her in the performance of an examination and report
• the source of the standards is the American Institute of Certified Public Accountants

Question 7

International Finance Reporting Standards (IFRS)

Answer 7

• a set of global accounting standards created by the International Accounting Standards Board (IASB) that are being phased in by companies in the United States
• The Securities and Exchange Commission is working towards a convergence between the IASB and the U.S. accounting standards
• having uniform accounting rules that apply to all nations makes sense in a global economy

Question 8

negligence

Answer 8

• the failure to exercise that standard of care that a reasonable person would exercise in similar circumstances

Question 9

working papers

Answer 9

• the various documents used and developed by an accountant during an audit
• working papers include notes, computations, memoranda, copies, and other papers that make up the work product of an accountant’s services to a client

Question 10

SAMPLE TEST QUESTIONS

1. Rochelle, an accountant, enters into a contract to provide services to Sky Transport, Inc. Rochelle does not finish the work within the contract’s deadline. Sky Transport pays a penalty for the missed deadline and hires Turbo to complete the job. Rochelle is most likely liable for :
   a. nothing
   b. Sky Transport’s penalty and the cost to hire Turbo
   c. Sky Transport’s penalty only
   d. the cost to hire Turbo only

Answer 10

ANSWER :
(B)
CORRECT :
(B) Sky Transport’s penalty and the cost to hire Turbo

Question 11

SAMPLE TEST QUESTIONS

2. Ricardo, an accountant, contracts to conduct an audit for Sensei Sushi Restaurants. In performing the audit, Ricardo fails to detect certain misconduct. Ricardo is most likely :
   a. liable if the audit would have revealed the misconduct
   b. liable if Ricardo issues a specifically qualified opinion
   c. not liable if Ricardo generally disclaims any liability
   d. not liable if the misconduct was due to Sensei Sushi’s negligence

Answer 11

ANSWER :
(B)
CORRECT :
(A) liable if the audit would have revealed misconduct

Question 12

SAMPLE TEST QUESTIONS

3. Nguyen Imports, Inc., accuses Ogilvie, an accountant, of committing defalcation.This is :
   a. embezzlement
   b. general misconduct
   c. professional negligence
   d. misrepresentation of professional expertise

Answer 12

ANSWER :
(A)
CORRECT :
(A) embezzlement

Question 13

SAMPLE TEST QUESTIONS

4. Norman is an accountant. Norman’s violation of generally accepted accounting principles and generally accepted auditing standards :
   a. does not indicate that Norman was negligent
   b. is prima facie evidence that Norman was negligent
   c. precludes Norman from raising any defense against a negligence claim
   d. is embarrassing but will never subject Norman to liability

Answer 13

ANSWER :
(B)
CORRECT :
(B) is prima facie evidence that Norman was negligent

Question 14

SAMPLE TEST QUESTIONS

5. Delaney is an accountant charged with negligence by Estimation & Valuation Services Inc., a client. Delaney may successfully defend against the claim if he can show that :
   a. scienter was lacking
   b. he complied with all International Financial Reporting Standards
   c. the negligence was not the proximate cause of the client’s losses
   d. the negligence was only contributory

Answer 14

ANSWER :
(C)
CORRECT :
(C) the negligence was not the proximate cause of the client’s losses

Question 15

SAMPLE TEST QUESTIONS

6. Edward, an attorney, allows a statute of limitations to lapse on a claim by Fabrication Company, a client. Edward :
   a. can be held liable for malpractice
   b. has violated an ethical standard but cannot be held liable
   c. is subject to criminal penalties under the statute of limitations
   d. will be automatically disbarred

Answer 15

ANSWER :
(B)
CORRECT :
(A) can be held for malpractice

Question 16

SAMPLE TEST QUESTIONS

7. Ezra, an accountant, intentionally misstates a material fact to mislead Fruit Packing, Inc., a client. Fruit Packing justifiably relies in the misstatement to its detriment. Ezra is most likely liable for :
   a. actual fraud
   b. constructive fraud
   c. destructive fraud
   d. virtual fraud

Answer 16

ANSWER :
(A)
CORRECT :
(A) actual fraud

Question 17

SAMPLE TEST QUESTIONS

8. Commerce Bank files a suit against Drake, it’s former accountant, alleging constructive fraud. Drake may be held liable :
   a. if Commerce Bank cannot prove actual fraud
   b. if Drake was grossly negligent in the performance of his duties
   c. only if Drake acted with fraudulent intent
   d. only if Drake impersonated someone who could be liable for fraud

Answer 17

ANSWER :
(B)
CORRECT :
(B) if Drake was grossly negligent in the performance of his duties

Question 18

SAMPLE TEST QUESTIONS

9. Everett is an accountant whose claims include Finance & Capital, Inc. Under the Ultramares rule, Everett is negligent in his work for Finance & Capital, he could be liable to Finance & Capital and :
   a. any third party
   b. no third party
   c. third parties who are foreseen users of the work
   d. third parties who are reasonably foreseeable users of the work

Answer 18

ANSWER :
(D)
CORRECT :
(B) no third party

Question 19

SAMPLE TEST QUESTIONS

10. Gift Basket Company’s liabilities exceed its assets. Gift Basket hires Hill & Dale, an accounting firm, to prepare a balance sheet. Through Hill & Dale’s negligent omissions, the sheet shows a net worth. Investment Bank relies on the balance sheet to make a loan to Gift Basket. When Gift Basket defaults, the bank files a suit against Hill & Dale. Under the Restatement rule, Hill & Dale is most likely :
    a. liable because Hill & Dale owed a duty of care to Gift Basket
    b. liable because Hill & Dale owed a duty to any foreseeable user
    c. liable if Hill & Dale knew that the bank would rely on the balance sheet
    d. not liable because Hill & Dale and the bank were not in privity

Answer 19

ANSWER :
(C)
CORRECT :
(C) liable if Hill & Dale knew that the bank would rely on the balance sheet

Question 20

SAMPLE TEST QUESTIONS

11. April is an accountant whose clients include Bistro Restaurants, Inc. If April is negligent in her work for Bistro, most courts would hold her liable to Bistro and :
    a. any third party
    b. no third party
    c. third parties who are foreseen users of the work
    d. third parties who are reasonably foreseeable users of the work

Answer 20

ANSWER :
(D)
CORRECT :
(C) third parties who are foreseen users of the work

Question 21

SAMPLE TEST QUESTIONS

12. Craig is an accountant whose clients include Deep Excavation Corporation. Elbert is Craig’s attorney. Under the common law and by statute in many states, working papers that Craig develops when preparing financial reports for Deep Excavation are owned by :
    a. Craig
    b. Deep Excavation
    c. Elbert
    d. no one - the papers must be destroyed immediately after use

Answer 21

ANSWER :
(A)
CORRECT :
(A) Craig

Question 22

SAMPLE TEST QUESTIONS

13. Hadley, an accountant, accumulates working papers while performing an audit for Ilene. After the audit, these documents be,one to :
    a. Hadley, with Ilene having a right of access to the papers
    b. Ilene, with Hadley having a right of access to the papers
    c. neither Hadley nor Ilene - the papers must be disposed of
    d. the Public Company Accounting Oversight Board

Answer 22

ANSWER :
(A)
CORRECT :
(A) Hadley, with Ilene having a right of access to the papers

Question 23

SAMPLE TEST QUESTIONS

14. Root & Branch is a Registered Public Accounting Firm. Root & Branch performs auditing services for Sales & Service Company. Under the Sarbanes-Oxley Act of 2002, at the same time, for the same company, Root & Branch can also provide :
    a. bookkeeping and other services related to accounting records and financial statements
    b. none of the choices
    c. appraisal and valuation services
    d. financial systems design and implementation

Answer 23

ANSWER :
(B)
CORRECT :
(B) none of the choices

Question 24

SAMPLE TEST QUESTIONS

15. Odell, an accountant, prepares for Prontos Tacos Corporation a financial statement that omits a material fact. The financial statement is included in Prontos Taco’s registration statement, Diana reads. Diana buys Prontos Tacos stock. Under Section 11 of the Securities Act of 1933, for Odell to be liable for the omission, Diana must show that she :
    a. relied on the omission
    b. suffered a loss on the stock
    c. knew about the omission before making her purchase
    d. is a sophisticated investor

Answer 24

ANSWER :
(A)
CORRECT :
(B) suffered a loss on the stock

Question 25

SAMPLE TEST QUESTIONS

16. Cathy is an accountant with Discount Retail Corporation. Ethan buys Discount Retail stock and loses money on the investment. To recover from Cathy under Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5, Ethan must prove :
    a. only the purchase and sale of a security
    b. fraud, reliance, materiality, and lack of knowledge about securities
    c. fraud, reliance, materiality, and incompetence
    d. fraud, reliance, materiality, causation, and scienter

Answer 25

ANSWER :
(D)
CORRECT :
(D) fraud, reliance, materiality, causation, and scienter

Question 26

SAMPLE TEST QUESTIONS

17. Randy, an accountant, includes a false statement in a report for Social Media Marketing, Inc., that is filed with the Securities and Exchange Commission. When Theo buys stock in Social Media Marketing and loses money on the investment, he files a suit against Randy, alleging fraud under the 1934 Securities Exchange Act. To avoid liability, Randy can show that she :
    a. intended to defraud Social Media Marketing, not Theo
    b. intended to profit on stock trades generally, not only Theo’s
    c. is an otherwise competent accountant
    d. was not aware her statement was false

Answer 26

ANSWER :
(D)
CORRECT :
(D) was not aware her statement was false

Question 27

SAMPLE TEST QUESTIONS

18. Reed prepares federal corporate income tax returns for Shopping Malls, Inc., and other firms. Under the Internal Revenue Code, with respect to an understatement of a client’s tax liability, Reed may be liable for :
    a. negligent or willful misconduct
    b. no misconduct
    c. only negligent misconduct
    d. only willful misconduct

Answer 27

ANSWER :
(D)
CORRECT :
(A) negligent or willful misconduct

Question 28

SAMPLE TEST QUESTIONS

19. Beck is an accountant who prepares her clients’ tax returns. Cole is not an accountant, but he also prepares tax returns for clients. Under the Internal Revenue Code, liability for preparing a false return may be imposed on :
    a. Beck and Cole
    b. Beck only
    c. Cole only
    d. none of the choices

Answer 28

ANSWER :
(A)
CORRECT :
(A) Beck and Cole

Question 29

SAMPLE TEST QUESTIONS

20. Diderot’s accountant is Esteban and his attorney is Figaro. All states protect, as privileged information, Diderot’s communications with :
    a. Esteban and Figaro
    b. Esteban only
    c. Figaro only
    d. none of the choices

Answer 29

ANSWER :
(C)
CORRECT :
(C) Figaro only

Question 30

Liability for Breach of Contract

Answer 30

• a professional owes a duty to his or her client to honor the terms of their contract and to perform the contract within the stated time period
• if the professional fails to perform as agreed in the contract, then he or she has breached the contract, and the client has the right to recover damages from the professional
• damages include expenses incurred by the client to hire another professional to provide contracted-for services and any other reasonable and foreseeable losses that arise from the professional’s breach

Question 31

Liability for Negligence

Answer 31

• to establish negligence, the plaintiff must prove four elements : duty, breach, causation, and damages which often focus on the standard of cars exercised by the professional
• all professional are subject to the standards of conduct and the ethical codes established by their profession, by state statutes, and by judicial decisions
• in performing their contracts, professional’s must exercise the established standards of care, knowledge, and judgement generally accepted by members of their professional group
• accountants have the expertise and experience necessary to establish and maintain accurate financial record, and to design, control, and audit record-keeping systems
• they also prepare reliable statements that reflect an individuals or a business’s financial status, give tax advice, and prepare tax returns
• a violation of GAAP and GAAS is considered prima facie evidence of negligence on the part of the accountant
• compliance, however, does not necessarily relieve an accountant from potential legal liability
• Discovering Improperties :
  
  • an accountant is not require to discover every impropriety, defalcation, or fraud in a client’s books, however, if an impropriety goes undiscovered because of the accountant’s negligence or failure to perform an express or implied duty, the accountant will be liable for any resulting losses suffered by the client
• an accountant who uncovers suspicious financial transactions and fails to investigate the matter fully or to inform the client if the discovery can be held liable to the client for resulting loss
• Audits, Qualified Opinions, and Disclaimers
  
  • the purpose of an audit it to provide the auditor with evidence to support an opinion on the reliability of the business’s financial statements
  • in issuing an opinion letter, an auditor may qualify the opinion or include a disclaimer
  • in a disclaimer, the auditor basically is stating that he or she does not have sufficient information to issue an opinion
• Defenses to Negligence
  
  • if an accountant is found guilty of negligence, the client can collect damages for losses that arose from the accountant’s negligence
  • an accountant facing a negligence claim has several possible defenses including :
    1. The accountant was not negligent.
    2. If the accountant was negligent, this negligence was not the proximate cause of the client’s losses
    3. The client was also negligent

Question 32

Liability for Fraud

Answer 32

• Fraud involves the following elements :
  1. A misrepresented of a material fact.
  2. An intent to deceive.
  3. Justifiable reliance by the innocent party on the misrepresentation.
  4. To obtain damages, an actual injury to the innocent party
• A professional may be held liable for actual fraud when :
  1. He or she intentionally misstates a material fact to mislead a client
  2. The client is injured as a result of justifiably relying on the misstated fact

Question 33

Potential Liability to Third Parties

Answer 33

• traditionally, an accountant or other professional owed a duty only to those with whom he or she had a direct contractual relationship- that is, those with whom he or she was in privity of contract
• investors, shareholders, creditors, corporate managers and directors, and regulatory agencies rely on the opinions of auditors (accountants) when making decisions
• the Ultramares Rule :
  
  • the traditional rule regarding an accountant’s liability to third parties based on the privity of contract
  • was restated and somewhat modified in a 1985 New York case, Credit Alliance Corp vs. Arthur Anderson & Co.
  • the court held that if a third party has a sufficiently close relationship or nexus (link or connection) with an accountant, the Ultramares privity requirement may be satisfied without the establishment of an accountant-client relationship and the rule enunciated in this case is often referred to as the “near privity” rule
• The Restatement Rule
  
  • states that accountant’s are subject to liability for negligence not only to there clients but also to foreseen, or known, users of their reports of financial statements
  • under this rule, an accountant’s liability extends to :
    1. Persons for whose benefit and guidance the accountant intends to supply the information of knows that the recipient intends to apply it.
    2. Persons whom the accountant intends the information to influence or knows that the recipient so intends.

Question 34

The “Reasonably Foresseable Users” Rule

Answer 34

• small number of courts hold accountants liable to any users whose reliance on an accountant’s statements or reports was reasonably foreseeable
• this standard has been criticized as extending liability too far and exposing accountants to massive liability

Question 35

Liability of Attorneys to Third Parties

Answer 35

• attorneys may be held liable under the common law to third parties who rely on legal opinions to their detriment
• generally, an attorney is not liable to a nonclient unless the attorney has committed fraud or malicious conduct

Question 36

The Sarbanes-Oxley Act of 2002

Answer 36

• imposes a number of strict requirements on both domestic and foreign public accounting firms
• requirements apply to firms that provide auditing services to companies (“issuers”) whose securities are sold to public investors
• increased government oversight of public accounting practices by creating the Public Company Accounting Oversight Board, which reports to the Securities and Exchange Commission
• in performing an audit for a client, an accountant accumulates various working papers
• Section 802(a)(1) provides that accountant must maintain working papers relating to an audit or review for five years - subsequently increased to seven years - from the end of the fiscal period in which the audit or review concluded
  
  • a knowing violation of this requirement will subject the accountant to a fine, imprisonment for up to ten years, or both

Question 37

Potential Liability of Accountants under Securities Laws

Answer 37

• The Securities Act of 1933
  
  • requires registration statements to be filed with the Securities and Exchange Commission (SEC) prior to an offering of securities
  • Section 11 : imposes civil liability in accountants for misstatements and omissions of material facts in registration statements; imposes a duty to use due diligence in preparing financial statements included in the filed registration statements
  • to avoid liability the accountant must show that he or she :
    1. Conducted a reasonable investigation
    2. Had reasonable grounds to believe and did believe, at the time the registration statement became effective, that the statements therein were true and that there was no omission of a material fact that would be misleading
• Section 12 (12)
  
  • imposes civil liability for fraud in relation to offerings or sales of securities
  • liability is based on communication to an investor, whether orally or in the written prospectus, of an untrue statement or omission of a material fact
  • penalties include fines up to $10,000, imprisonment up to five years, or both
  • the SEC is authorized to seek an injunction against a willful violator to prevent further violations
• Securities Exchange Act of 1934
  
  • an accountant may be found liable for fraud
  • an accountant does not have to prove due diligence to escape liability
• Section 18
  
  • imposes civil liability on an accountant who makes or causes to be made in any application, report, or document a statement that at the time and in light of the circumstances was false or misleading with respect to any material fact
  • Good Faith Defense : an accountant will be liable for violating Section 18 if he or she acted in good faith in preparing the financial statement
  • to demonstrate good faith, an accountant must show that he or she had no knowledge that the financial statement was false or misleading and that he or she lacked any intent to deceive, manipulate, defraud, or seek unfair advantage over another party
• Section 10(b) and SEC rule 10b-5
  
  • the scope of these antifraud provisions is very broad and allows private parties to bring civil actions against violators
  • Section 10(b) makes in unlawful for any person, including an accountant, to use, in connection with the purchase or sale of any security, any manipulative or deceptive device or plan that is counted to SEC rules and regulations
  • further makes it unlawful for any person, by use of any means or instrumentality of interstate commerce, to do the following :
    1. Employ any device, scheme, or strategy to defraud
    2. Make any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances, not misleading
    3. Engage in any act, practice, or course of business that operates or would operate as a fraud or deceit on any person, in connection with the purchase or sale of any security
  • for a plaintiff to succeed to recovering damages under these antifraud provisions, he or she must prove intent (scienter) to commit the fraudulent or deceptive act. Ordinary negligence is not enough
• Private Securities Litigation Reform Act of 1995
  
  • imposed a statutory obligation on accountants
  • an auditor must use adequate procedures in an audit to detect any illegal acts of the company being audited
  • if something illegal is detected, the auditor must disclose it to the company’s board of directors, the audit committee, or the SEC, depending on the circumstances
  • the act provides that, in most situations, a party is liable only for the proportion of the damages for which he or she is responsible; in other words, the parties are subject to proportionate liability rather than joint and several liability
  • made it a crime to aid and abet a violator of the Securities Exchange Act of 1934

Question 38

Criminal Liability of Accountants

Answer 38

• most states make it a crime to :
  1. Knowingly certify false reports
  2. Falsify, alter, or destroy books of the account
  3. Obtain property or credit through the use of false financial statements
• willful violations of the Securities Act of 1933 and the Securities Exchange Act of 1934 face imprisonment for p to five years and/or a fine of up to $10,000 under 1933 act and imprisonment for up to ten years and a fine of $100,000 under the 1934 act
• under the Sarbanes-Oxley Act of 2002, if an accountant’s false or misleading certified audit statement is used in a securities filing, the accountant may be held criminally liable; fined up to $5 million, imprisoned for up to twenty years, or both
• Internal Revenue Code
  
  • made it felony to aid or assist in preparation of a false tax return
  • violators are punishable by a fine of $100,000 ($500,000 for a corporation’s return) and imprisonment for up to three years
  • penalty of $250 per tax return is levied on tax preparers for negligent understatement of the client’s tax liability (for willful understatement a penalty of $1,000 is imposed)

Question 39

Confidentiality and Privilege

Answer 39

• attorney-client relationships
  
  • protected by law
• accountant client relationships
  
  • privileged by state staute
  • communication may not be revealed even in court or in court-sanctioned proceedings without the client’s permission but most states don’t follow regulation