Deck 6: Legal, Regulatory, and Professional Obligations of Auditors

Question 1

Which of the following is NOT one of the defenses an auditor can use against third party lawsuits for fraud?

A) The third party was not in contractual privity
B) The auditor did not have a duty to the third party
C) The third party was negligent
D) The third party did not suffer a loss

Answer 1

A

Question 2

The Restatement (Second) of Torts Approach:

A) Expands an accountant's legal liability to third parties identified by the client as intended recipients of work
B) Limits an accountant's legal liability to only those parties with which it has a privity relationship
C) Limits an accountant's legal liability to only those parties that have been named by the client
D) Expands an accountant's legal liability to all possible users of the audited financial statements

Answer 2

A

Question 3

In Grant Thornton v. Prospect High Income Fund, Grant used each of the following points to defend itself against legal liability except:

A) There was no evidence of a causal connection between Grant's alleged misrepresentation and the funds' alleged injury
B) There was no evidence of actual and justifiable reliance
C) There was no evidence of the loss suffered by the plaintiffs
D) Liability for fraudulent misrepresentations runs only to those whom the auditor knows and intends to influence, all of which was not present

Answer 3

C

Question 4

The key element that protects an auditor against common law liability is:

A) Adherence to generally accepted accounting principles (GAAP)
B) Adherence to generally accepted auditing standards (GAAS)
C) Compliance with threats and safeguards approach
D) Maintain confidentiality of client information

Question 5

In Grant Thornton v. Prospect High Income Fund, the Texas Supreme Court held:

A) Auditors were not liable for accurate accounting to anyone who reads and relies upon the audit report
B) Auditors were not liable for ordinary negligence
C) Auditors are not guarantors of accurate and reliable financial statements
D) Management is responsible for the financial statements

Question 6

The Securities Act of 1933:

A) Regulates the auditing of financial statements for publicly-traded companies
B) Limits the financial liability of independent auditors except in the case of gross negligence
C) Regulates the initial offering of securities
D) Regulates which services may be performed for a publicly-traded company by an audit firm

Question 7

When courts find accountants liable for constructive fraud, the implication is that:

A) Auditors should always be liable when investors lose money due to deceit
B) Accountants may be liable for fraud even when they had no knowledge of deceit
C) Auditors should be able to detect all deceit by management
D) Accountants may be held liable even to third parties to whom they did not have a duty

Question 8

When an auditor acts so carelessly in the application of professional standards that it implies a reckless disregard for the standards of due care is referred to as:

A) Scienter
B) Fraud
C) Constructive fraud
D) Negligence

Question 9

In Tenants Corp. v. Max Rothenberg, the auditors were held legally liable for:

A) Ordinary negligence
B) Gross negligence
C) Deficient tax work
D) Write-up work

Question 10

The legal precedent that evolves from legal opinions issued by judges in deciding a case and guides judges in deciding similar cases in the future is referred to as:

A) Business law
B) Tort law
C) Common law
D) Statutory law

Question 11

Which of the following is NOT one of the four stages in an audit-related dispute?

A) Events arise that create losses for the users of the financial statements
B) Losses are linked to material misstatements of financial statements
C) Legal process resolves the dispute
D) Auditors legal liability leads to financial settlement

Question 12

A privity relationship means that:

A) A party may be a user of the financial statements
B) A party may sue if fraud has taken place
C) A party's financial liability is limited
D) A party has a contractual obligation

Question 13

In the U.S., if the auditor can demonstrate having performed services with the same degree of skill and judgment possessed by others in the profession, it can be said to have exercised:

A) Prudence
B) Scienter
C) Nonfeasance
D) Due Care

Question 14

The unique aspect of auditors' legal liability in the Rosenblum v. Adler ruling is:

A) Auditors could be held liable for ordinary negligence to all reasonably foreseeable third parties
B) Auditors could be held liable for gross negligence to all reasonably foreseeable third parties
C) Auditors could be held liable for fraud to all reasonably foreseeable third parties
D) Auditors should be able to detect all deceit by management

Question 15

Which of the following would normally be considered sufficient to demonstrate due care on the part of the auditor?

A) The auditor had its work reviewed by another audit firm
B) The auditor cites adherence to generally accepted auditing standards (GAAS)
C) No omissions or misstatements have been found in the client's financial statements
D) The auditor signs a statement expressing its unmodified opinion as to the fairness of the financial statements

Question 16

The Ultramares v. Touche case of 1933 held that a cause of action based on negligence could not be maintained by a third party who was not in contractual privity; however, it did leave open the possibility that:

A) Third parties that were "foreseeable" may sue for ordinary negligence
B) Third parties may sue if one of the parties in contractual privity allowed it to
C) Third parties may sue in the case of fraud or constructive fraud
D) Third parties who used the financial statements may sue

Question 17

The Rosenblum case ruling was of concern to the accounting profession because it implied that:

A) Full joint and several liability would be reinstated
B) All possible third party users of financial statements must be anticipated
C) The concept of contractual privity would no longer be important
D) Financial liability would occur when scienter was proven

Question 18

An audit engagement letter:

A) Offers an auditor's services to a client
B) Is required by generally accepted auditing standards (GAAS)
C) Details the SEC's expectations for the audit firm for a specific engagement
D) Formalizes the relationship between the auditor and the client for a specific engagement

Question 19

Which of the following is NOT one of the most relevant sources of civil liabilities for auditors charged with failing to adhere to the requirements of the laws in carrying out professional obligations?

A) Securities Act of 1933
B) Private Securities Litigation Reform Act of 1995
C) Securities and Exchange Act of 1934
D) Sarbanes-Oxley Act of 2002

Question 20

The Credit Alliance v. Arthur Andersen & Co. case established three tests that must be satisfied for holding auditors liable for negligence to third parties. All of the following are tests described except:

A) Knowledge by the accountant that the financial statements are to be used for a particular purpose
B) The intention of the third party to rely on those statements
C) Some action by the accountant linking him or her to the third party that provides evidence of the accountant's understanding of intended reliance
D) The identity of the third party must be directly known to the auditor

Question 21

Which of the following is NOT a requirement of Section 10A of the Securities Exchange Act of 1934 for auditors of public companies with respect to illegal acts?

A) Determine whether it is likely that an illegal act has occurred
B) Determine what the possible effect of the illegal act is on the financial statements
C) Determine whether management participated in the illegal act
D) Inform management and assure that the audit committee knows about any material illegal act that has been detected

Question 22

How long do management and the audit committee have to act if the independent auditor reports possible illegal acts to them?

A) One week
B) One month
C) Three business days
D) One business day

Question 23

The Securities and Exchange Act of 1934:

A) Limits the financial liability of independent auditors except in the case of gross negligence
B) Requires the filing of audited annual statements and reviewed quarterly statements
C) Regulates the initial offering financial statements of securities
D) Regulates which services may be performed for a publicly-traded company by an audit firm

Question 24

Which of the following elements do NOT have to be proved once a plaintiff has established the ability to sue under rule 10b-5?

A) Material, factual misrepresentation or omission
B) Error by auditor led to plaintiffs' loss
C) Reliance by the plaintiff on the financial statements
D) Damages suffered by plaintiff as a result of reliance on the financial statements

Question 25

Under the rules of the Sarbanes-Oxley Act of 2002 (SOX), who must certify the public reports filed with the SEC?

A) The independent auditor
B) The CEO and the independent auditor
C) The CEO and CFO
D) The CFO and the board of directors

Question 26

What is a worrisome consequence under the joint and several liability principle?

A) Each negligent party is liable for the portion of the damages for which it is responsible
B) All negligent parties are always liable for damages
C) Only the negligent party considered to have "deep pockets" is held liable for damages
D) Each negligent party could be held liable for the total of damages suffered

Question 27

In the case of Phar-Mor v. Coopers & Lybrand the auditors were found guilty of fraud because

A) The auditors did not follow the generally accepted auditing standards (GAAS) at the time
B) The independent audit of financial statements was not required at the time
C) The auditors were grossly negligent and had a blatant disregard for the truth
D) The auditors were not independent and conspired with management to steal funds

Question 28

The accounting issue(s) in the Crazy Eddie case were:

A) Accelerating revenues into earlier periods
B) Inflating inventory and net income
C) Capitalizing costs that should have been expensed
D) Off-balance sheet entities

Question 29

Under the Private Securities Litigation Reform Act (PSLRA), if an auditor concludes that an illegal act with a material effect on the financial statements has been reported to, but not dealt with by senior management, the auditor should next report his/her conclusions to:

A) The Securities and Exchange Commission
B) The company's board of directors
C) The office of the controller/comptroller for the appropriate state
D) The Federal Bureau of Investigation

Question 30

Under the Securities Act of 1933, accountants who assist in the preparation of the registration statement are civilly liable if the registration statement:

A) Contains untrue statements of material fact
B) Omits material facts required by statute or regulation
C) Omits information that if not given makes the facts stated misleading
D) All of the above

Question 31

The U.S. Supreme Court ruled in State Street v. Ernst that:

A) The court may "construct" fraud based on gross negligence of the auditor.
B) The auditor engaged in an act in connection with the purchase or sale of a security that caused the loss to the plaintiff
C) Breach of duty is not required to establish fraud
D) The auditor has no legal liability for fraud to third parties

Question 32

A "particularized" allegation requires establishing:

A) Strong circumstantial evidence of conscious misbehavior
B) Strong circumstantial evidence of recklessness
C) Facts showing the defendant had both motive and opportunity to commit securities fraud
D) All of the above

Question 33

Under the Securities Act of 1933 and the Securities and Exchange Act of 1934, accountants may be subject to criminal penalties for:

A) Obstruction of justice
B) Securities fraud
C) Willful violations of the securities acts
D) Violations of internal controls

Question 34

Rule 10b-5 of the Securities Exchange Act of 1934 makes it unlawful for a CPA to engage in each of the following activities except:

A) Employ any device, scheme, or artifice to defraud
B) Omit a material fact necessary for the financial statements to present fairly financial position, results of operations, and cash flows
C) Engage in any act, practice, or course of business to commit fraud or deceit in connection with the purchase or sale of a security
D) Make an untrue statement of material fact or omit a material fact necessary in order to make the statement made, in the light of the circumstances under which they were made, not misleading

Question 35

In the case of Reisman v. KPMG Peat Marwick LLP, the auditors were found guilty of fraud because

A) They fraudulently recorded inventories that did not in fact exist
B) They were aware of misrepresentations that were relied upon by others
C) They approved moving liabilities off the balance sheet by using thousands of subsidiaries
D) They were not independent and conspired with management

Question 36

Which of the following is NOT a valid defense to legal liability under the Securities Act of 1933?

A) Materiality defense
B) Non-negligence defense
C) Due diligence defense
D) Lack of causation defense

Question 37

The "particularity" provision in the PSLRA allows a plaintiff to:

A) Sue the auditor
B) Assert scienter
C) Sue management
D) Assert privity

Question 38

In establishing that the third party relied on the financial statements, one factor that works against plaintiffs' establishing such reliance is:

A) Fraud did not exist
B) Damages or loss suffered by the plaintiff would not have occurred regardless of whether the audited financial statements were misstated
C) Damages or loss suffered by the plaintiff would have occurred regardless of whether the audited financial statements were misstated
D) Negligence did not exist

Question 39

Under the Securities Act of 1933, if damages were incurred and there was a material misstatement or omission in the financial statements, the CPA will most likely lose the lawsuit unless:

A) The management intentionally deceived the auditors
B) The damages were incurred to a third party that was not a signatory to the contract
C) The CPA can shift the burden of proof to the investors
D) The CPA rebuts the allegations

Question 40

The Private Securities Litigation Reform Act of 1995 applies the practice of ________ to auditor liability determinations.

A) Risk assessment
B) Joint and several liability
C) Particularized standard
D) Proportionate liability

Question 41

In what situation can an individual be held liable for harm no what their mental state was?

A) Negligence
B) Recklessness
C) Strict Liability
D) Intent

Question 42

The problem of a compliance approach in implementing standards is that it can result in:

A) Achieving informal compliance without considering ethical consequences
B) Achieving a true and fair view with respect to the auditor's report
C) Achieving a dual system of boards of directors
D) Achieving formal compliance without considering ethical consequences

Question 43

Under section 302 of the SOX the financial statement certifying officials must include in their certification that:

A) A list of all deficiencies in the internal controls and information on any fraud that involves employees who are involved with internal activities has been created
B) The auditors are responsible for the internal controls and have evaluated and reported on them
C) All changes in internal controls or related factors that could have a negative effect on the internal controls have been made
D) The audit report was unmodified

Question 44

The name of the term used to describe issues that are important enough to merit attention from those responsible for oversight over financial reporting is commonly called:

A) Significant deficiency
B) Recklessness
C) Material weakness
D) Negligence

Question 45

Which term means a person knew or should have known that their actions were likely to cause harm?

A) Negligence
B) Recklessness
C) Strict Liability
D) Intent

Question 46

The section of SOX that requires management to prepare a report on its internal controls is:

A) Section 302
B) Section 404
C) Section 808
D) Section 10A(b)

Question 47

What argument can be made that SOX may not be effective in reducing fraud?

A) It is not as stringent as international standards
B) The SEC has many laws for many years that have not seemed to make much of a difference
C) The penalties under Sarbanes-Oxley are especially stringent, so it may not be enforced
D) Civil and criminal penalties are not effective in preventing financial fraud

Question 48

A defendant is liable for injuries when he acted with willfulness. Another term for willfulness is:

A) Negligence
B) Recklessness
C) Strict Liability
D) Intent

Question 49

Which term refers to a person acting in a way that breaches their duty to another that causes harm?

A) Negligence
B) Recklessness
C) Strict Liability
D) Intent

Question 50

A payment made to induce a foreign government official to do something they might not otherwise be required to do is a(n):

A) Bribe
B) Asset misappropriation
C) Facilitating Payment
D) Legal Payment

Question 51

The term "true and fair view" tends to be a replacement for ________ used in the U.S.

A) Full and fair
B) Present fairly
C) Representational faithfulness
D) Economic substance

Question 52

A payment made to foreign government officials to ensure that they do what is expected given their job requirements can be characterized as a(n):

A) Bribe
B) Asset misappropriation
C) Facilitating Payment
D) Legal Payment

Question 53

Which of the following are an affirmative defense for those accused of violating the FCPA?

A) The payment is lawful under the written laws of the foreign country
B) The payment can be made for reasonable and bona fide expenditures
C) A and B are both affirmative defenses
D) None of the above

Question 54

Which of the following would eliminate the ability of a plaintiff to prevail under Rule 10b-5?

A) No reliance by the plaintiff on the financial statements
B) a factual misrepresentation
C) the intent to deceive, manipulate, or defraud
D) damages suffered

Question 55

The name of the term used to describe deficiencies in internal control over financial reporting where there is a reasonable possibility that a material misstatement will not be detected on a timely basis is called:

A) Significant deficiency
B) Recklessness
C) Material weakness
D) Negligence

Question 56

Pfizer was investigated by the SEC for violating the Foreign Corrupt Practices Act (FCPA) because it allegedly:

A) Made improper payments to foreign officials to obtain regulatory and formulary approvals
B) Made improper payments to foreign officials to obtain sales
C) Made improper payments to foreign officials to obtain increased prescriptions for the company's pharmaceutical products
D) All of the above

Question 57

The FCPA requires all SEC registrants to have each of the following except:

A) Maintain internal accounting controls
B) Ensure all transactions are authorized by management and recorded properly
C) Maintain information systems that prevent fraudulent activities that violate the FCPA
D) Maintain adequate books and records to fairly reflect an issuer's transactions and disposition of assets

Question 58

One feature of a corporate governance system commonly found outside the U.S. is:

A) Unitary board of directors
B) Dual system of boards of directors
C) No board of directors
D) Acceptance of facilitating payments and bribery

Question 59

In FCPA matters, the following would be considered effective compliance program policies except:

A) Few resources dedicated to compliance of standards
B) Auditing of compliance functions
C) Availability of compliance expertise on the board
D) Clear reporting structure for compliance personnel

Question 60

In FCPA matters, the following would be considered effective compliance program policies except:

A) Dedicated resources for compliance of standards
B) Experienced personnel in compliance functions
C) Compliance personnel are independent of management
D) Unclear reporting structure for compliance personnel

Question 61

In the Advanced Battery Technologies case, the opinion of the court:

A) Held the auditors legally liable because they failed to exercise due care and to demonstrate professional skepticism
B) Held the auditors legally liable because they failed to gather sufficient, competent evidential matter to warrant the expression of an opinion
C) Held the auditors not legally liable because the plaintiff could not plead with particularity that the audit work was so deficient as to amount to no audit at all
D) Held the auditors were not legally liable because they met all professional standards

Question 62

The ethical dilemma in the TransWays' case can best be described as:

A) The external auditors are being blocked by the client in attempting to verify accounting treatment of oil drilling services
B) The Director of International Accounting questions the revenue recognition for oil drilling overseas
C) Gross negligence on behalf of the auditors to account for oil inventory
D) Whether payments made to customs officials are can be properly recorded as facilitating payments

Question 63

The following clause was included in the engagement letter between Limits and Lobits, CPAs (L&L) and Fair, Inc., an audit client of (L&L).
Fair, Inc. agrees to release, indemnify, and hold Limits & Lobits, CPAs (its partners, heirs, executors, personal representatives, successors, and assigns) harmless from any liability and costs resulting from fraud caused by or participated in by management of Fair, Inc.
Do you think such a clause is ethical? Use ethical reasoning to support your answer with reference to professional standards.

Question 64

Kay and Lee performed an audit required for Holligan Industries to extend a loan with Second National Bank & Trust. Kay and Lee may be liable for:

A) Second National Bank & Trust declining to extend the loan
B) Ordinary negligence to the bank that loaned money to Holligan because the firm did not discover improper accounting for revenue and assets
C) Gross negligence to the bank that loaned money to Holligan because the firm did not discover improper accounting for receivables and inventory
D) Holligan declaring bankruptcy without a going-concern emphasis of matter

Question 65

Do considerations of culture have a place in the FCPA? Discuss in general and with respect to Hofstede's cultural values.

Question 66

The legal liability of the auditors in the Joker & Wild case can best be described as resulting from:

A) Liability for gross negligence that constituted fraud
B) No liability because the auditor's performed their duties in accordance with GAAS
C) Liability for failing to assess current market values of inventory
D) Improper accounting for transactions involving management override

Question 67

Auditors may be held liable to both their clients and third parties under common law.
a. What must a client prove to recover its losses from an auditor under common law?
b. What must a third party prove to recover losses from an auditor under common law?
c. How does an auditor's ethical obligations and liability under common law intersect?

Question 68

Lotus Hospitality, a U.S. publicly-owned company doing business in China, deals with state-owned enterprises in a variety of countries. It is common for Chinese companies to pay custom officials in these countries amounts ranging from $100-$500 to enable their goods to be off-loaded at the receiving docks in each country. To show its appreciation for the many years of doing business in these countries, Lotus invited 50 government officials and employees of state-owned enterprises to attend the Olympic Games in China at the company's expense, and ultimately paid for such guests as well as some spouses and others who attended along with them. Sponsored guests were primarily from countries in Africa and Asia, and they enjoyed three- and four-day hospitality packages that included event tickets, luxury hotel accommodations, and sightseeing excursions valued at $12,000 to $16,000 per package. In return for the generosity of Lotus Hospitality, the state-owned enterprises promised to give preference to Chinese companies when multi-million dollar contracts are awarded.
Describe the nature of these payments under the Foreign Corrupt Practices Act (FCPA) and assess their legality. What are the potential ethical issues of allowing certain types of payments under the Act?

Question 69

The defendant-auditors in the Anjoorian case argued, in their defense, that:

A) To be found guilty to third parties, the court must find that an accountant had contemplated a specific transaction for which the financial statement will be used and that no such transaction was contemplated.
B) The plaintiff's theory of damages did not meet the foreseen legal criteria
C) They had no liability to the client because the client did not rely on the audited financial statements
D) They followed generally accepted auditing standards

Question 70

Assume a securities lawyer has just received a phone call from her client, the Chief Financial Officer (CFO) of XYZ Corporation, and informed that a securities lawsuit may be filed against her client by a group of the company's shareholders. XYZ's share price recently dropped from $40 to $4 per share after the company announced that it had to restate its quarterly results. The shareholders also learned that the CFOs compensation package ($20 million) is tied to the attainment of a $40 common stock share price. Although her client is innocent, the attorney believes the shareholders will view this as a case of securities fraud and file the suit against the CFO, alleging that due to the large compensation, the client stood to gain from reaching the share price, and with the client's ability to influence the company's revenue, the CFO possessed the motive and opportunity to defraud XYZ's investors.
Why might the facts of this case lead the attorney to conclude that a lawsuit against her client is imminent? How might the attorney assert a valid "good faith" defense?

Question 71

Cite specific cases to distinguish between an auditor's legal liability under common law and statutory law.

Question 72

In the Miller Energy Resources case, the SEC found that:

A) Held the auditors were not liable because they exercised due care and professional skepticism.
B) Held the auditors liable because they failed to gather sufficient, competent evidential matter to assess the value of assets on the financial statements.
C) Held the auditors liable because they colluded with management to misrepresent the value of assets on the financial statements.
D) The auditors were not liable because they met all professional standards.

Question 73

In the Vertical Pharmaceuticals case, Deloitte & Touche was sued because:

A) Vertical claimed the firm's false accusations of fraudulent conduct led to the withdrawal of another public company's planned acquisition of Vertical
B) Deloitte failed to issue an audit report on a timely basis thereby leading to the withdrawal by another public company's planned acquisition of Vertical
C) Vertical claimed Deloitte committed fraud in its audit of Vertical
D) Deloitte issued a modified opinion (adverse) on Vertical's financial statements thereby leading to the withdrawal by another public company's planned acquisition of Vertical

Question 74

The report provided by PwC to Billy Muldoon, CFO, identified which material weaknesses?

A) Inadequate controls over financial reporting
B) Related party transactions, impaired assets and off-balance sheet entities
C) Impaired assets, falsified bank account and facilitating payments
D) Fictitious revenue, contingent liabilities and facilitating payments

Question 75

In the Joker & Wild case, the main issue involves:

A) The accounting manager's misappropriation of assets and writing down inventory for market declines to cover theft.
B) The accounting manager's violation of the law by taking improper accounting of tax advantaged investment.
C) Accelerating revenues to commit fraud.
D) Collusion between the auditors and company management.

Question 76

The TransWays' case deals with legal liabilities due to:

A) Bribery of foreign government officials
B) Fraudulent financial statements
C) Facilitating payments to government agents
D) Bribery of U.S. government officials

Question 77

Distinguish between an auditor's legal liability under common law and statutory law.

Question 78

The QSGI case raises questions regarding the actions of the CEO and chairman of the board who:

A) Accelerated revenue into an earlier period without proper documentation
B) Delayed expenses into a later period through the use of reserves
C) Violated the Foreign Corrupt Practices Act
D) Circumvented internal controls for inventory and falsified records.

Question 79

Explain the provisions of section 302 of the Sarbanes-Oxley Act including obligations of officers; nature and scope of assertions; accounting requirements; and legal liability of officers.

Question 80

Describe the steps auditors should take to protect themselves against allegations that fraud went undetected during the audit.