Chapter 5

Question 1

Which of the following professional bodies has the authority to revoke a CPA’s license to practice public accounting?

Answer 1

The state board of accountancy is the only body listed that can grant a CPA license and the only body that may revoke such a license, they can also suspend a CPA license

Question 2

A taxpayer filed his income tax return after the due date but neglected to file an extension form. The return indicated a tax liability of $50,000 and taxes withheld of $45,000. On what amount would the penalties for late filing and late payment be computed?

Answer 2

The penalty for failure to file a tax return by the due date is 5% per month or fraction of month (up to a maximum of 25%) on the amount of tax shown as due on the return. The penalty for failure to pay by the due date (1/2% per month) is also based on the amount due on the return.

Question 3

The negligence penalty with respect to understatement of tax:

Answer 3

The negligence penalty with respect to understatement of tax is an accuracy-based penalty for negligence or for disregard of tax rules and regulations.

Question 4

Which of the following correctly lists the order, from earliest to latest, that U.S. legislative bodies consider new tax legislation?

Answer 4

The correct order for all new tax legislation is the House of Representatives, the Senate, the Joint Conference Committee to resolve differences (if necessary), and presidential action.

Question 5

Which of the following is a list of courts that are referred to as courts of original jurisdiction, or trial courts, for tax matters?

Answer 5

The courts of original jurisdiction for tax cases, i.e., the courts in which a taxpayer would first bring a lawsuit against the IRS, are the Tax Court, the U.S. District Court, and the U.S. Court of Federal Claims.

Question 6

An accountant is prohibited from showing the workpapers to anyone without the client’s permission, except:

Answer 6

Lawful subpoena.
Surviving member of the firm.
Quality control panel.
AICPA/State Trial Board.
Court proceedings.

Question 7

The elements of constructive fraud:

Answer 7

Misrepresentation of a material fact.
Defendant acts with gross negligence or recklessly.
Intent to induce plaintiff’s reliance.
Actual and justifiable reliance by plaintiff.
Damages.
Actual fraud requires intent to deceive.

Question 8

Which of the following statements is generally correct regarding the liability of a CPA who negligently gives an opinion on an audit of a client’s financial statements?

Answer 8

The majority rule (the law followed in the majority of the states) is that accountants are liable to anyone in a class (such as potential lenders or investors) of third parties whom the CPA knows will rely on the opinion of the financial statements.

Question 9

Ultramares limits the accountant’s liability for negligence to:

Answer 9

(i) parties in privity and (ii) intended third party beneficiaries

Question 10

Which of the following is the best defense a CPA firm can assert in a suit for common law fraud based on its unqualified opinion on materially false financial statements?

Answer 10

A suit for common law fraud may succeed only if the accountant acted with scienter (knew that the statement was wrong or recklessly disregarded the truth).

Question 11

In a common law action against an accountant, lack of privity is a viable defense if the plaintiff:

Answer 11

A creditor of a client generally cannot sue the client’s accountant for negligence unless the accountant had reason to know that the creditor would be relying on the accountant’s work.

Question 12

Under common law, which of the following statements most accurately reflects the liability of a CPA who fraudulently gives an opinion on an audit of a client’s financial statements?

Answer 12

A CPA who commits fraud is liable to anyone who is injured by the fraud.

Question 13

Under Rule 10b-5, a purchaser must prove?

Answer 13

Scienter (an intent to deceive)

Question 14

Under Section 11, which of the following must be proven by a purchaser of the security?

Answer 14

a plaintiff need only prove that: (i) the plaintiff acquired (not necessarily bought) the security, (ii) there was a material misstatement in the financial statements included in the registration statement that was signed by the defendant, and (iii) the plaintiff suffered a loss

Question 15

If a CPA recklessly departs from the standards of due care when conducting an audit, the CPA will be liable to third parties who are unknown to the CPA based on:

Answer 15

Reckless departure from standards of due care constitutes gross negligence, which is also called constructive fraud. A CPA who commits constructive fraud is liable to all plaintiffs, not just those with whom the CPA dealt or of whom the CPA knew.

Note that: Negligence connotes less of a departure from due care than does recklessness connote. If a CPA is merely negligent, liability is limited to clients and persons whom the CPA knew would be relying on the CPA’s work.

Question 16

Jay and Co., CPAs, audited the financial statements of Maco Corp. Jay intentionally gave an unqualified opinion on the financial statements even though material misstatements were discovered. The financial statements and Jay’s unqualified opinion were included in a registration statement and prospectus for an original public offering of Maco stock. Which of the following statements is correct regarding Jay’s liability to a purchaser of the offering under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934?

Answer 16

A defendant is liable under rule 10b-5 if the defendant either: (i) intentionally makes a misstatement in connection with the purchase or sale of stock or (ii) recklessly disregards the truth with respect to a statement in connection with the purchase or sale or stock and the plaintiff justifiably relies on the misstatement and suffers a loss. Here, Jay, knowing that the financial statements included material misstatements, intentionally gave an unqualified opinion. Thus, if the purchaser relied on the misstatements, Jay will be liable.

Question 17

Which of the following is the best defense a CPA firm can assert in defense to a suit for common law fraud based on their unqualified opinion on materially false financial statements?

Answer 17

Common law fraud requires a showing of intent to deceive, which is scienter.

Question 18

Sun Corp. approved a merger plan with Cord Corp. One of the determining factors in approving the merger was the financial statements of Cord that were audited by Frank & Co., CPAs. Sun had engaged Frank to audit Cord’s financial statements. While performing the audit, Frank failed to discover certain irregularities that later caused Sun to suffer substantial losses. For Frank to be liable under common law negligence, Sun at a minimum must prove that Frank:

Answer 18

For a cause of action for negligence, the client must prove at least that the CPA failed to exercise due care.

Question 19

What does negligence mean?

Answer 19

Failure to exercise Due Care

Question 20

An accountant will be liable for damages under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 only if the plaintiff proves that:

Answer 20

Among other things to prove a cause of action under Rule 10b-5, a plaintiff must prove that the defendant, in connection with the purchase or sale of securities, either made a false statement of a material fact or omitted a material fact.

Question 21

Negligence has 4 elements:

Answer 21

duty of care, breach (which is lack of due care), causality and injury.

Question 22

Which of the following penalties is usually imposed against an accountant who, in the course of performing professional services, breaches contract duties owed to a client?

Answer 22

compensatory money damages

Question 23

Under the position taken by a majority of the courts, to which third parties will an accountant who negligently prepares a client’s financial report be liable?

Answer 23

Under the majority position an accountant is liable for negligence only to third parties whom the accountant knows or should foresee will be relying on the accountant’s work.

Question 24

Under the common law, which of the following defenses, if used by a CPA, would best avoid liability in an action for negligence brought by a client?

Answer 24

A plaintiff must show four elements to make a case for negligence against a CPA. The plaintiff must show the defendant owed a duty of care to the plaintiff, the defendant breached that duty by failing to act with due care, the breach caused the plaintiff’s injury, and damages. A defense that the negligence was not the proximate cause of plaintiff’s losses would be a valid defense, as the third element would not exist.

Question 25

What are the five elements of fraud?

Answer 25

These are a misrepresentation of a material fact, intent to deceive, actual and justifiable reliance on the misrepresentation, an intent to induce that reliance, and damages. A defense by Baker that there was no intent to deceive would be a valid defense against a claim of fraud.

Question 26

Tork purchased restricted securities that were issued pursuant to Regulation D of the Securities Act of 1933. Which of the following statements is correct regarding Tork’s ability to resell the securities?

Answer 26

Under Regulation D of the Securities Act of 1933, Tork may only resell if the resale transaction continues to fall under the registration exemptions found in Section 3 of the 1933 Act.

Question 27

Dean, Inc., a publicly traded corporation, paid a $10,000 bribe to a local zoning official. The bribe was recorded in Dean’s financial statements as a consulting fee. Dean’s unaudited financial statements were submitted to the SEC as part of a quarterly filing. Which of the following federal statutes did Dean violate?

Answer 27

Publicly traded corporations must register with the SEC and make certain periodic reports under the 1934 Act. These reports include business reports (10K, 10Q & 8K), insider trading tender offers & proxy solicitations. The unaudited financials, which are part of the company’s 10Q filing, fraudulently described the bribe.

Question 28

The reporting requirements of the 1934 Act apply to any company:

Answer 28

Whose shares are traded on a national exchange, or
Which has at least 500 shareholders in any one class who are not accredited and more than $10 million in assets.

Question 29

Which of the following securities would be regulated by the provisions of the Securities Act of 1933?

Answer 29

Securities issued by insurance companies

Question 30

Which of the following circumstances is a defense to an accountant’s liability under Section 11 of the Securities Act of 1933 for misstatements and omissions of material facts contained in a registration statement?

Answer 30

To establish a case under Section 11, a plaintiff need only prove that the plaintiff acquired the stock; there was a material misstatement in a registration statement signed by the defendant, and damages. However, an accountant can avoid liability by raising the defense of due diligence.

Question 31

Under Section 12 of the Securities Exchange Act of 1934, in addition to companies whose securities are traded on a national exchange, what class of companies is subject to the SEC’s continuous disclosure system?

Answer 31

Under Section 12, a company must register (is subject to continuous disclosure requirements) if it is listed on a national securities exchange or if it has at least 500 shareholders in any outstanding class and has more than $10 million in assets.

Question 32

Under the liability provisions of Section 11 of the Securities Act of 1933, a CPA who certifies financial statements included in a registration statement generally will not be liable to a purchaser of the security:

Answer 32

Under Section 11 of the Securities Act of 1933, a CPA who certifies financial statements is generally liable if the purchaser can prove the purchaser acquired the stock, the purchaser suffered a loss, and in the registration statement there was a misrepresentation of, and/or an omission of, a material fact. The purchaser does not have to prove scienter or negligence on the part of the CPA. The purchaser does not have to prove reliance. However, the CPA is not liable if the CPA can prove “due diligence.”

Question 33

What is the standard that must be established to prove a violation of the anti-fraud provisions of Rule 10b-5 of the Securities Exchange Act of 1934?

Answer 33

A violation of Rule 10b-5 will be found only if the person acted with scienter (intent to deceive or reckless disregard for the truth).

Question 34

Under the anti-fraud provisions of Section 10(b) of the Securities Exchange Act of 1934, a CPA may be liable if the CPA acted:

Answer 34

Section 10(b) prohibits fraud in connection with the sale of securities. If a CPA acts without good faith, the CPA is probably acting fraudulently.

Question 35

Sam’s Retail Outlet’s certified public accountant prepares financial statements that omit a material fact. The financial statements are part of Sam’s registration statement. An investor purchases Sam’s stock. Under Section 11 of the Securities Act of 1933, the accountant can avoid liability by showing that she:

Answer 35

A CPA’s best defense to a 1933 Section 11 action is that the CPA exercised due diligence by performing the audit in accordance with generally accepted auditing standards.

Question 36

What is for ACTUAL fraud?

Answer 36

Scientor

Question 37

What is for CONSTRUCTIONAL fraud?

Answer 37

Gross Negligence