Chapter 4

Question 1

Breach of contract

Answer 1

Failure of one or both parties to a contract to perform in accordance with the contract’s provisions. A public accounting firm might be sued for breach of contract, for example, if the firm failed to perform the engagement in accordance with the engagement letter. Negligence on the part of the CPAs also constitutes breach of contract.

Question 2

Common law

Answer 2

Unwritten law that has developed through court decisions; it represents judicial interpretation of a society’s concept of fairness. For example, the right to sue a person for fraud is a common law right.

Question 3

Comparative negligence

Answer 3

A concept used by certain courts to allocate damages between negligent parties based on the degree to which each party is at fault. The allocation of damages is referred to as proportionate liability.

Question 4

Compilation of financial statements

Answer 4

The preparation of financial statements by CPAs based on representations of management, with the expression of no assurance concerning the statements’ compliance with generally accepted accounting principles.

Question 5

Constructive fraud

Answer 5

Performing duties with such recklessness that persons believing the duties to have been completed carefully are being misled. It differs from fraud in that constructive fraud does not involve knowledge of misrepresentations within the financial statements.

Question 6

Contributory negligence

Answer 6

Negligence on the part of the plaintiff that has contributed to his or her having incurred a loss. Contributory negligence may be used as a defense, because the court may limit or bar recovery by a plaintiff whose own negligence contributed to the loss.

Question 7

Credit Alliance Corp. v. Arthur Andersen & Co.

Answer 7

A common law decision by the New York Court of Appeals (New York’s highest court) stating that auditors must demonstrate knowledge of reliance on the financial statements by a third party for a particular purpose to be held liable for ordinary negligence to that party. Basically, this case upheld the Ultramares v. Touche & Co. rule.

Question 8

Defendant

Answer 8

The party against which damages and suit are brought by the plaintiff.

Question 9

Due diligence

Answer 9

A public accounting firm’s contention that its audit work was adequate to support its opinion on financial statements included in a registration statement filed with the SEC under the Securities Act of 1933.

Question 10

Engagement letter

Answer 10

A written contract summarizing the contractual relationship between the CPAs and the client. The engagement letter typically specifies the scope of professional services to be rendered, expected completion dates, and the basis for determination of the CPAs’ fee. Engagement letters are discussed more fully in

Question 11

Ernst & Ernst v. Hochfelder

Answer 11

A landmark case in which the U.S. Supreme Court decided that auditors could not be held liable under the Securities Exchange Act of 1934 for ordinary negligence.

Question 12

Error

Answer 12

An unintentional misstatement of financial statements or omission of an amount or a disclosure.

Question 13

Fraud

Answer 13

Misrepresentation by a person of a material fact, known by that person to be untrue or made with reckless indifference as to whether the fact is true, with intent to deceive and with the result that another party is injured.

Question 14

Gross negligence

Answer 14

Lack of even slight care, indicative of a reckless disregard for one’s professional responsibilities. Substantial failures on the part of an auditor to comply with generally accepted auditing standards might be interpreted as gross negligence.

Question 15

Joint and several liability

Answer 15

A legal concept that holds a class of defendants jointly responsible for losses attributed to the class as well as liable for any share of losses that cannot be collected from those unable to pay their share. Thus, a financially responsible defendant may be required to pay losses attributed to defendants that do not have the ability to pay.

Question 16

Negligence

Answer 16

Violation of a legal duty to exercise a degree of care that an ordinarily prudent person would exercise under similar circumstances. Also referred to as ordinary or simple negligence.

Question 17

Plaintiff

Answer 17

The party claiming damages and bringing suit against the defendant.

Question 18

Ponzi scheme

Answer 18

A swindle in which a quick return on an initial investment is paid out of funds of new investors to lure the victims into bigger risks. This is named for Charles Ponzi, who in 1919 convinced people he could make them a 50 percent profit in 45 days by an international trading scam. Old investors were paid off with cash from new investors. Ultimately such schemes collapse and the newest investors lose their investment because there is no actual appreciation of assets involved.

Question 19

Precedent

Answer 19

A legal principle that evolves from a common law court decision and then serves as a standard for future decisions in similar cases.

Question 20

Proportionate liability

Answer 20

A method of allocating damages to each group that is liable according to that group’s pro rata share of any damages recovered by the plaintiff. For example, if the plaintiff was awarded a total of $1,000,000 and the CPAs were found to bear 40 percent of the responsibility for the damages, the CPAs would be assessed $400,000.

Question 21

Proximate cause

Answer 21

Damage to another is directly attributable to a wrongdoer’s act. The issue of proximate cause may be raised as a defense in litigation. Even though a public accounting firm might have been negligent in rendering services, it will not be liable for the plaintiff’s loss if its negligence was not the proximate cause of the loss.

Question 22

Registration statement

Answer 22

A document including audited financial statements that must be filed with the SEC by any company in order to sell its securities to the public through the mails or interstate commerce. The Securities Act of 1933 provides liability to security purchasers for material misrepresentations in registration statements.

Question 23

Review of financial statements

Answer 23

The performance of limited investigative procedures that are substantially less in scope than an audit made in accordance with generally accepted auditing standards. The procedures provide the CPAs with a basis to provide limited assurance that the financial statements are in accordance with generally accepted accounting principles.

Question 24

Rosenblum v. Adler

Answer 24

A common law decision by the New Jersey Supreme Court that holds CPAs liable for acts of ordinary negligence to “reasonably foreseeable third parties” not in privity of contract. Conflicts with the precedents established in both the Ultramares and the Restatement of Law of Torts approaches to liability.

Question 25

Scienter

Answer 25

Intent to deceive, manipulate, or defraud. The U.S. Supreme Court held in the Hochfelder case that scienter must be proved for the auditors to be held liable under the Securities Exchange Act of 1934.

Question 26

Second Restatement of the Law of Torts

Answer 26

A summary of tort liability, which when applied to auditor common law liability, expands auditors’ liability for ordinary negligence to include third parties of a limited class of known or intended users of the audited financial statements. Conflicts with the precedents established by the Ultramares and the Rosenblum approaches to liability.

Question 27

Securities Act of 1933

Answer 27

A federal securities statute covering registration statements for securities to be sold to the public. The act requires auditors to exercise “due diligence” and creates both civil and criminal penalties for misrepresentation.

Question 28

Securities Exchange Act of 1934

Answer 28

A federal securities statute requiring public companies to file annual audited financial statements with the SEC. The act requires auditors to “act in good faith” and creates civil and criminal penalties for misrepresentation.

Question 29

Statutory law

Answer 29

Written law created by state or federal legislative bodies. CPAs must concern themselves particularly with the federal securities acts and state blue sky laws. These laws regulate the issuance and trading of securities.

Question 30

Third-party beneficiary

Answer 30

A person, not the auditors or their client, who is named in a contract (or known to the contracting parties) with the intention that such person should have definite rights and benefits under the contract.

Question 31

Tort

Answer 31

A civil wrong. For financial statements audits, the primary tort involved is that of performing the engagement negligently.

Question 32

Ultramares v. Touche & Co.

Answer 32

A common law decision by the New York Court of Appeals (New York’s highest court) stating that auditors are liable to third parties not in privity of contract for acts of fraud or gross negligence, but not for ordinary negligence. Conflicts with precedents established by the Restatement of Torts and Rosenblum approaches to liability.