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

Question 1

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

Answer 1

D

Question 2

The most relevant sources of civil liabilities for auditors failing to adhere to the requirements of the laws in carrying out professional obligations include all of the following except for:

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

Answer 2

B

Question 3

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

Answer 3

B

Question 4

All of the following proof can be used in an auditor's defense against third party lawsuits for fraud except for:

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

Question 5

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 6

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 7

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 8

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 9

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 a factor

Question 10

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 11

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

Question 12

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) All of these

Question 13

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 14

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 15

The legal term for the intent to deceive, manipulate or defraud is

A) Nonfeasance
B) Misfeasance
C) Constructive fraud
D) Scienter

Question 16

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 17

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 for

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 18

Whistleblowing as a result of a financial fraud may be appropriate under

A) State laws such as state board of accountancy rules
B) Federal laws such as Dodd-Frank
C) AICPA rules
D) All of these

Question 19

The executives of McKesson and Robbins Pharmaceuticals were able to steal about $2.9 million in 1939 because

A) Its 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) Physical inspection of inventory was not performed by the auditors
D) The auditors were not independent and conspired with management to steal the funds

Question 20

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 21

Pfizer was investigated by the SEC for violating the 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 these

Question 22

A payment made to a foreign government official to ensure that s/he does what is expected given their job requirements can be characterized as a:

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

Question 23

As a result of Scott London's actions to give inside tips about two audit clients, KPMG took each of the following actions except for

A) Admitted London violated the firm's independence rules
B) Issued a modified audit opinion on the clients financial statements because of the adverse actions of London
C) Resigned from the engagements of the two clients
D) Withdrew its audit report on the two clients

Question 24

Rajat Gupta was sentenced to two years in prison and ordered to pay a $5 million fine for

A) Trading on inside information
B) Leaking tips to Raj Rajaratnam, a hedge-fund billionaire
C) Committing fraud in the sale of securities in an IPO
D) Committing fraud in the theft of assets from the company he head

Question 25

In the SEC case of James Gansman:

A) Gansman traded on inside information for his own benefit
B) Gansman tipped off a co-worker about the stock of a client
C) Gansman tipped off his girlfriend about nonpublic information about a client
D) Gansman told a co-worker about the impending bankruptcy of a client

Question 26

The major purpose of the amended Federal Sentencing Guidelines is to:

A) Allow federal judges to mitigate any sentence imposed on a company according to a mathematical formula
B) Extend the statute of limitations for bringing a lawsuit for fraud against an auditor to seven years
C) Criminalize the bribery of foreign government/officials
D) Allow a plaintiff to bring a lawsuit under the law for managers' or board of directors' breach of fiduciary duty

Question 27

In the case of Equity Funding, the audit client

A) Fraudulently recorded inventories that did not in fact exist
B) Inflated its earnings by recording fictitious sales of insurance policies
C) Moved liabilities off the balance sheet by using thousands of subsidiaries
D) Recorded inventory below cost, therefore understating costs of goods sold and overstating net income

Question 28

Under the Private Securities Litigation Reform Act, 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 then 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 29

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

A) Risk assessment
B) Fraud triangle
C) Lowballing
D) Proportionate liability

Question 30

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

A) The independent auditor
B) The CEO
C) The CEO and CFO
D) The CFO

Question 31

The SEC attempts to control insider trading in part by:

A) Prohibiting officers and directors from buying stock of the company they work for/oversee
B) Prohibiting shareholders from buying stock of affiliated companies
C) Requiring officers, directors, and shareholders owning 10 percent of the class of equity securities registered with the SEC to file reports concerning their ownership and trading of the corporations securities
D) All of these

Question 32

Under section 302 of the Sarbanes-Oxley Act of 2002, 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) All of these

Question 33

Martha Stewart was sent to jail in the InClone Systems insider trading scandal because

A) She acted on tip information to sell InClone stock prior to the FDA's announcement that it had rejected a company product
B) She tipped off a friend about the FDA's announcement that it had rejected a company product
C) She obstructed justice
D) She wears gaudy clothing

Question 34

The best way to minimize the penalty imposed on an organization under the Federal Sentencing Guidelines is to

A) Have a chief ethics officer oversee the company's compliance with FSGFO
B) Have a code of conduct
C) Have an effective ethics and compliance program
D) Have an external audit of the organization's financial statements

Question 35

"Disgorgement" with respect to legal rulings refers to

A) A defendant being forced to at least partially repay fraudulently gained money
B) An auditor being forced to reveal private client information because fraud has occurred
C) An auditor being held financially liable for investor losses
D) Giving up one's dinner after food poisoning

Question 36

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 37

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 38

Section 10A of the Securities Exchange Act of 1934 establishes each of the following requirements for auditors of public companies with respect to illegal acts except for

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 39

What argument can be made that Sarbanes-Oxley may not be effective in reducing fraud?

A) It is not as stringent as international standards
B) The SEC has had 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 40

Clawback provisions under Dodd-Frank differ from those under SOX because:

A) Dodd-Frank requirement extends to current or former executive officers versus CEO only under SOX.
B) Dodd-Frank is a three-year period versus the one-year period under SOX.
C) Dodd-Frank applies to any restatement as a result of material noncompliance with financial reporting requirements versus restatements caused by fraud or misconduct under SOX.
D) All of these

Question 41

Differentiate between the officers and directors duty of care, duty of loyalty, and duty of good faith. How do these principle responsibilities of officers and directors relate to the business judgment rule?

Question 42

The Livingston & Haynes case involves the audit firm

A) Engaging in illegal acts in covering for a failed audit
B) Resigning from an engagement
C) Failing to follow procedures designed to provide reasonable assurance of detecting illegal acts
D) All of these

Question 43

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 Second National Bank & Trust
C) Ordinary negligence to unknown bank that provided additional funds to Holligan
D) Holligan declaring bankruptcy without a going-concern emphasis of matter

Question 44

The main focus of the Con-Way case is the company's:

A) Bribery of Philippine customs officials
B) Payments to foreign officials at state-owned airlines doing business in the Philippines
C) Failure to properly record and disclose illicit payments to Philippine customs officials and officials at state-owned airlines doing business in the Philippines
D) All of these

Question 45

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 46

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) They had no liability to third party shareholders
C) The plaintiff's theory of damages is speculative and against public policy
D) All of these

Question 47

Which Act requires firms who engaged in international operations to have internal controls and an audit committee?

A) The Foreign Corrupt Practices Act of 1977
B) The Foreign Exchange Regulation Act of 1973
C) The Foreign Exchange Management Act of 1999
D) The Foreign Management Practices Act of 1977

Question 48

Michael Trent Reznor, the lead singer in the band Nine Inch Nails, filed a lawsuit against Richard Szekelyi and the Navigent Group in the Reznor v. JAM, Inc. case alleging:

A) Negligence, breach of fiduciary duty, and aiding and abetting fraud
B) Fraudulent financial statements were prepared by the accountants
C) The auditors failed to discover material misstatements in the financial statements
D) All of these

Question 49

The SEC v. Zurich Financial Services case deals with:

A) Zurich's use of finite reinsurance transactions to inflate improperly financial performance
B) Zurich's use of false insurance invoices to inflate revenues
C) Failure of Zurich's board of directors to carry out its fiduciary duties
D) Failure of the auditors to exercise the degree of care and professional skepticism expected in an audit
Essay Questions

Question 50

In the case of SEC v. Halliburton & KBR, the SEC charged Halliburton & KBR with

A) Bribing Nigerian government officials to look the other way while the companies developed and presented fraudulent financial statements
B) Bribing Nigerian government officials in order to obtain construction contracts
C) Bribing Nigerian government officials to off-load merchandise at the country's piers
D) All of these

Question 51

A corporate director or officer may be able to avoid liability to the corporation or to its shareholders for poor business judgments by meeting the requirements of the

A) Business judgment rule
B) The ethical reasoning rule
C) Sarbanes-Oxley Act
D) Dodd-Frank Financial Reform Act

Question 52

The standard of due care requires that a director or officer

A) Act in good faith
B) Exercise the care that an ordinarily prudent person would in similar circumstances
C) Act in a way that is in the best interests of the corporation
D) All of these

Question 53

The Insider Trading and Accounting Professionals case deals with

A) Whether insider trading is legal by an employee of a CPA firm not working on the audit of a client
B) Whether tipping a fellow employee in a CPA firm to inside information about an audit client is legal
C) Whether a partner with no involvement in an audit client can own stock of that client
D) All of these

Question 54

With respect to the director duty of good faith, former Delaware Chancery Court Chief Justice Veasey defined good faith as

A) Acting in the best interests of the corporation
B) An honesty of purpose that leads to caring for the well-being of one's constituents
C) Acting in the best interests of the shareholders person
D) Exercising due care in carrying out one's responsibilities

Question 55

Negligent nonfeasance would be said to occur when

A) An auditor issues an unmodified opinion on financial statements he or she knows to be materially misstated
B) An auditor fails to use appropriate accounting procedures and thereby fails to discover a client's fraudulent practices
C) An auditor fails to report an instance of financial fraud to the SEC
D) An auditor intentionally skips parts of the audit plan to cut costs and increase profitability

Question 56

The business judgment rule applies to audit committee acts in each of the following instances except for:

A) Decisions on hiring the auditor
B) Approving audit services
C) Preparing the audit report
D) Responding to deficiencies in internal controls

Question 57

A unique aspect of the DHB (Point Blank Solutions) case is that it deals with

A) The complicity of outside directors and audit committee members in the fraud
B) A modified audit report that did not go far enough in identifying material weaknesses in the internal controls
C) Enforcement powers under Dodd-Frank
D) All of these

Question 58

The difference between an auditor's services regarding reports 10Q and 10K is

A) The auditor provides "limited assurance" regarding 10Q and "reasonable assurance" regarding 10K
B) The auditor provides "reasonable assurance" regarding 10Q and "limited assurance" regarding 10K
C) The auditor provides no assurance regarding 10Q and "limited assurance" regarding 10K
D) The auditor provides "limited assurance" regarding 10Q and "absolute assurance" regarding 10K

Question 59

The duty of loyalty requires directors to

A) Act in the best interests of the corporation
B) Act in the best interests of the shareholder
C) Act in the best interests of management
D) All of these

Question 60

The Caremark opinion dealt with which element of directors' obligations?

A) Audit obligations
B) Financial reporting obligations
C) Fiduciary obligations
D) All of these

Question 61

A student states that as long as the auditor has followed all applicable laws, then the auditor has been ethical. Do you agree? Why or why not?

Question 62

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 a client 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 63

What are the best defenses that an auditor can use to defend oneself against charges of fraud? How does ethical behavior relate to these defenses?

Question 64

What is meant by "intangible honest services?" How does it relate to the case against Jeff Skilling in the Enron fraud? How do the charges against skilling relate to director and officer fiduciary responsibilities?

Question 65

Distinguish between actually foreseen and reasonably foreseeable third-party liability.

Question 66

What is the motivation for an audit partner to trade on inside information or tip off a friend or business associate to inside information? How does this relate to the ethical standards discussed in chapter 1?

Question 67

Distinguish between an auditor's legal liability under common law and statutory law. Cite specific cases to support your answer.

Question 68

Two court decisions illustrate the application of Section 11 of the Securities Act of 1933. Identify those cases and explain the legal issues involved in each one.

Question 69

Should auditors be held legally liable for a fraud at a client even though top management intentionally withheld information from the auditors and even deceived them?

Question 70

The Private Securities Litigation Reform Act of 1995 changed the legal climate in the U.S. in a major way. Explain the nature of the changes under the PSLRA with respect to legal liability. Do you believe this act adequately protects shareholders and other third parties that might bring a lawsuit against an auditor and other defendants? Why or why not?

Question 71

Which of the provisions of the Sarbanes Oxley Act do you think has had the most important effect on the quality of audits by public companies in the U.S.? Why?

Question 72

The SEC case against Pfizer case deals with the issue of improper payments, including hospitality and travel expense, made to doctors and health-care professionals in other countries, and illustrates the importance of an effective system of internal controls, strong corporate governance, and tone at the top. Describe the facts of the case and evaluate the effect on accountants and auditors on disclosing illegal acts and evaluating internal controls.