REG Unit 2 Simulations Flashcards
Sleek Corp. is a public corporation whose stock is traded on a national securities exchange. Sleek hired Garson Associates, CPAs, to audit Sleek’s financial statements. Sleek needed the audit to obtain bank loans and to make a public stock offering so Sleek could undertake a business expansion program.
Before the engagement, Fred Hedge, Sleek’s president, told Garson’s managing partner that the audited financial statements would be submitted to Sleek’s banks to obtain the necessary loans.
During the course of the audit, Garson’s managing partner found that Hedge and other Sleek officers had embezzled substantial amounts of money from the corporation. These embezzlements threatened Sleek’s financial stability. When these findings were brought to Hedge’s attention, Hedge promised that the money would be repaid and begged that the audit not disclose the embezzlements.
Hedge also told Garson’s managing partner that several friends and relatives of Sleek’s officers had been advised about the projected business expansion and proposed stock offering and had purchased significant amounts of Sleek’s stock based on this information.
Garson expressed an unmodified opinion on Sleek’s financial statements, which did not include adjustments for or disclosures about the embezzlements and insider stock transactions. The financial statements and audit report were submitted to Sleek’s regular banks, including Knox Bank. Knox, relying on the financial statements and Garson’s report, gave Sleek a $2 million loan.
Sleek’s audited financial statements were also incorporated in a registration statement prepared under the provisions of the Securities Act of 1933. The registration statement was filed with the SEC in conjunction with Sleek’s public offering of 100,000 shares of its common stock at $100 per share.
An SEC investigation of Sleek Corp. disclosed the embezzlements and the insider trading. Trading in Sleek’s stock was suspended, and Sleek defaulted on the Knox loan.
For items 1 though 4, select from the option list provided the cause of action, element, or defense alleged by the plaintiffs against defendant accountants or raised by the accountants. Each defense may be used only once.
For items 5 through 7, select from the option list provided whether the statement is correct with respect to recovery from Garson under the antifraud provision of the Securities Exchange Act of 1934 (Rule 10b-5). Each choice may be used once, more than once, or not at all.
- Accountant’s failure to perform as agreed, which resulted in a loss. Breach of contract
- Gross negligence or reckless disregard for the truth substituting for intentional misstatement. Constructive fraud
- Intent or mental state element of a fraud claim. Scienter
- Breach of the duty to exercise reasonable care. Negligence
- Knox could recover, even though it lacks privity of contract with Garson. Incorrect
- Reliance generally must be proved. Correct
- Gross negligence is sufficient to show scienter. Correct
Under Section 11 of the Securities Act of 1933 and Rule 10b-5 under the Securities Exchange Act of 1934, a CPA may be sued by a purchaser of registered securities. The items below relate to what a plaintiff who purchased securities must prove in a civil suit against a CPA.
- Material misstatements were included in a filed document Both acts
- A monetary loss occurred Both acts
- Lack of due diligence by the CPA Neither act
- Privity with the CPA Neither act
- Reliance on the document Rule 10b-5 under the Securities Exchange Act of 1934
- The CPA had scienter Rule 10b-5 under the Securities Exchange Act of 1934
Select from the option list provided whether a plaintiff must prove the following in order to recover losses under Section 11 of the Securities Act of 1933. Each choice may be used once, more than once, or not at all.
- The plaintiff acquired the security from the issuer directly Not required to prove
- The plaintiff gave value for the security Not required to prove
- The plaintiff acquired the security subject to registration Must prove
- The defendant had an intent to deceive, manipulate, or defraud (scienter) Not required to prove
- The plaintiff incurred a loss (damages) Must prove
- The plaintiff relied on the misstatement Not required to prove
- The plaintiff’s loss was caused by the reliance Not required to prove
- The registration statement contained a material misstatement or omission Must prove
Select from the option list provided the phrase that correctly matches each item below. Each choice may be used once, more than once, or not at all.
- Requires periodic reporting to the SEC. Securities Exchange Act of 1934
- A substitute for proof of reliance on a misstatement. Fraud-on-the-market theory
- Must include all critical accounting policies and practices to be used. Audit reports to audit committees
- Must include the treatment of financial information preferred by the external auditors. Audit reports to audit committees
- Imposes civil liability for fraud in a new issue of securities. Securities Act of 1933
- Accountants’ nonfraud civil liability to third parties under this act requires proof of privity of contract. Securities Act of 1933
- Prohibits any scheme to defraud. Rule 10b-5 of the Securities Exchange Act of 1934
Butler Manufacturing Corp. planned to raise capital for a plant expansion by borrowing from banks and making several stock offerings. Butler engaged Weaver, CPA, to audit its December 31, Year 1, financial statements. Butler told Weaver that the financial statements would be given to certain named banks and included in the prospectuses for the stock offerings.
In performing the audit, Weaver did not confirm accounts receivable and, as a result, failed to discover a material overstatement of accounts receivable. Also, Weaver was aware of a pending class action product liability lawsuit that was not disclosed in Butler’s financial statements. Despite being advised by Butler’s legal counsel that Butler’s potential liability under the lawsuit would result in material losses, Weaver expressed an unmodified opinion on Butler’s financial statements.
In May Year 2, Union Bank, one of the named banks, relied on the financial statements and Weaver’s opinion in giving Butler a $500,000 loan.
Butler raised an additional $10,450,000 through the following stock offerings, which were sold completely:
June Year 2 - Butler made a $450,000 unregistered offering of Class B nonvoting common stock under Rule 504 of Regulation D of the Securities Act of 1933. This offering was sold over 2 years to 30 nonaccredited investors and 20 accredited investors by general solicitation. The SEC was notified 18 days after the first sale of this offering.
September Year 2 - Butler made a $10,000,000 unregistered offering of Class A voting common stock under Rule 506 of Regulation D of the Securities Act of 1933. This offering was sold over 2 years to 200 accredited investors and 30 nonaccredited investors through a private placement. The SEC was notified 14 days after the first sale of this offering.
Shortly after obtaining the Union loan, Butler began experiencing financial problems but was able to stay in business because of the money raised by the offerings. Butler was found liable in the product liability suit. This resulted in a judgment Butler could not pay. Butler also defaulted on the Union loan and was involuntarily petitioned into bankruptcy. This caused Union to sustain a loss and Butler’s stockholders to lose their investments.
Weaver’s liability extends to various infractions. Select from the option list provided the authority for each infraction listed below. Each choice may be used once, more than once, or not at all.
- The offering did not comply with the 15-day notice requirement SEC Regulations
- Failure to confirm accounts receivable AICPA Code of Professional Conduct
- Expressing an unmodified opinion on statements containing a material departure from GAAP AICPA Code of Professional Conduct
- Negligence in performing an audit Civil Law
- Gross negligence for failure to qualify an opinion Civil Law
