Chapter 5

Question 1

Professionals, including CPAs, are held to what level of performance?

Answer 1

Hight Performance

Question 2

The reasons for greater litigation in today’s environment: (6)

Answer 2

1. The “expectations” gap (the difference between what an auditor’s responsibilities are and what the user expects from the auditor)
2. Increased effort by the SEC to protect investors’ interests
3. Increased complexity of auditing and accounting
4. Litigious society
5. CPA firms willing to settle legal cases out of court
6. Recession and tough economic times resulting in business failures

Question 3

What is Business failure

Answer 3

occurs when a business is unable to repay its lenders or meet the expectations of its investors

Question 4

Audit failure

Answer 4

occurs when the auditor issues an incorrect audit opinion because it failed to comply with the requirements of auditing standards

Question 5

Audit risk

Answer 5

represents the possibility that the auditor concludes after conducting an adequate audit that the financial statements were fairly stated when, in fact, they were materially misstated

Question 6

Ordinary negligence

Answer 6

Absence of reasonable care that can be expected of a person in a set of circumstances.

Question 7

Gross negligence

Answer 7

Lack of even slight care, tantamount to reckless behavior, that can be expected of a person.

Question 8

Constructive fraud

Answer 8

Existence of extreme or unusual negligence even though there was no intent to deceive or do harm.

Question 9

Fraud

Answer 9

Occurs when a mistreatment is made and there is both the knowledge of its falsity and the intent to deceive.

Question 10

Breach of contract

Answer 10

Failure of one or both parties in a contract to fulfill the requirements of the contract.

Question 11

Third-party beneficiary

Answer 11

A third party

Question 12

Sources of Legal Liability? (4)

Answer 12

1. Liability to Clients
2. Liability to Third Parties under common law
3. Civil Liability under the federal securities laws
4. Criminal Liability.

Question 13

Sources of Legal Liability? (4)

Answer 13

1. Liability to Clients
2. Liability to Third Parties under common law
3. Civil Liability under the federal securities laws
4. Criminal Liability.

Question 14

With regards to liability to Clients what is the most common source (or acts) of lawsuits?

Answer 14

Negligent acts

Question 15

Defense against client claims? (4)

Answer 15

1. Lack of duty to perform service
2. Nonnegligent performance
3. Contributory negligence
4. Absence of causal connection.

Question 16

Defense against client claims? (4)

Answer 16

1. Lack of duty to perform service
2. Nonnegligent performance
3. Contributory negligence
4. Absence of causal connection.

Question 17

Liability to third parties under common law is affected by the Ultramares Doctrine how?

Answer 17

The doctrine essentially ruled that ordinary negligence is insufficient for liability to third parties because of the lack of privity of contract between the third party and the auditor, unless the third party is a primary beneficiary.

Question 18

How was the Ultramares Doctrine changed?

Answer 18

Under the Restatement of Torts legal principles, foreseen users are a class of users that the auditor knows will rely on the financial statement.

Question 19

Liability to third parties under common law is affected by the Ultramares Doctrine how?

Answer 19

he doctrine essentially ruled that ordinary negligence is insufficient for liability to third parties because of the lack of privity of contract between the third party and the auditor, unless the third party is a primary beneficiary. (Gross negligence)

Question 20

How was the Ultramares Doctrine changed?

Answer 20

Under the Restatement of Torts legal principles, foreseen users are a class of users that the auditor knows will rely on the financial statement. (Gross negligence)

Question 21

The Securities Act of 1933

Answer 21

• Deals only with the reporting requirements for companies issuing new securities. Original purchasers of securities are the only parties who can recover from auditors
• Auditor’s defenses are that an adequate audit was conducted (due diligence) or all or a portion of the plaintiff’s loss was caused by factors other than the misleading financial statements

Question 22

The Securities Act of 1934

Answer 22

• Deals with the subsequent reporting of companies’ audited financial statements
• Auditor’s defenses include nonnegligent performance, lack of duty, and absence of causal connection

Question 23

Scienter means what?

Answer 23

Which is the knowledge and intent to deceive.

Question 24

CPAs can be found guilty under:

Answer 24

1. Federal law

2. State law

Question 25

Federal law makes what a criminal offense?

Answer 25

To defraud another person through knowingly being involved with false financial statements.

Question 26

AICPA and the Profession as a whole does what to reduce exposure to legal liability? (3)

Answer 26

1. Seek Protection from nonmeritorious litigation.
2. Improve auditing to better meet the users’ needs
3. Educate users about the limits of auditing.

Question 27

Audtiors can do the following to minimize their liability exposure (6)

Answer 27

1. Deal only with clients possessing integrity.
2. Maintain independence.
3. Understand the client’s business.
4. Perform quality audits.
5. Document the work properly.
6. Exercise professional skepticism.