A case by a client against its cpa firm alleging negligence would be brought under:

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Auditing and Assurance Services, 16e (Arens/Elder/Beasley) Chapter 5 Legal Liability

5 Learning Objective 5-

1. Which of the following factors does not contribute to the number of lawsuits against auditors? A) large civil court judgments against CPA firms awarded in a few cases B) growing awareness of the responsibilities of public accountants by users of financial statements C) the simplicity of auditing and accounting functions D) an increased consciousness by the SEC for its responsibility for protecting investors' interests Answer: C Terms: Major factors that have contributed to the recent increase in the number of lawsuits against auditors Diff: Easy Objective: LO 5- AACSB: Reflective thinking

2. Discuss three major factors that have contributed to the recent increase in the number of lawsuits against auditors and the size of awards to plaintiffs. Answer: Major factors include: • The growing awareness of the responsibilities of public accountants by users of financial statements • An increased consciousness on the part of the Securities and Exchange Commission regarding its responsibility for protecting investors' interests • The complexity of auditing and accounting functions caused by the increasing size of businesses, the globalization of business, and the complexities of business operations and financing transactions • The tendency of society to accept lawsuits by injured parties against anyone who might be able to provide compensation, regardless of who was at fault, coupled with joint and several liability doctrine • The global recession and tough economic times result in business failures, which prompt stakeholders to seek restitution from others, including external auditors • Large civil court judgments against CPA firms awarded in a few cases • The willingness of CPA firms to settle legal problems out of court to avoid costly legal fees and adverse publicity, rather than pursuing resolution through the judicial process • The difficulty judges and jurors have understanding and interpreting technical accounting and auditing matters

Terms: Major factors that have contributed to the recent increase in the number of lawsuits against auditors Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

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1. The auditor generally owes a duty of care to third parties who are part of a limited group of persons whose reliance is "foreseen" by the auditor. Answer: TRUE Terms: Liability to clients under common law Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

5 Learning Objective 5-

1. A(n) ________ failure occurs when an auditor issues an erroneous opinion because it failed to comply with requirements of auditing standards. A) business B) audit C) ethics D) process Answer: B Terms: Failure which occurs when an auditor issues an erroneous opinion Diff: Easy Objective: LO 5- AACSB: Reflective thinking

2. The expectation gap A) exists between the auditor and the SEC. B) exists because auditors guarantee the accuracy of the financial statements. C) often results in unwarranted lawsuits against the auditor. D) is a legal concept supported by the federal courts. Answer: C Terms: Expectation gap Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

3. Which of the following is an accurate statement regarding audit risk, audit failure, and business failure? A) Audit risk is always avoidable if the audit is conducted in accordance with generally accepted auditing standards. B) Because auditors gather evidence on a test basis, and because well-concealed frauds are difficult to detect, audit risk is unavoidable. C) Legal precedent makes it easy to determine who has the right to recover losses in the event of an audit failure. D) A business failure will always result in an audit failure. Answer: B Terms: Distinguish among business failure, audit failure, and audit risk Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

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1. If an auditor fails to fulfill a certain requirement in the contract, they may be guilty of A) contract fraud. B) breach of contract. C) constructive fraud. D) criminal neglect. Answer: B Terms: Liability when auditors fail to exercise due care Diff: Easy Objective: LO 5- AACSB: Reflective thinking

2. In the case of an audit, recklessness is present if the auditor knew an adequate audit was not done but still issued an opinion, even though there was no intent to deceive financial statement users. This description is the legal term for A) ordinary negligence. B) gross negligence. C) constructive fraud. D) fraud. Answer: C Terms: Prudent person concept; due professional care Diff: Easy Objective: LO 5- AACSB: Reflective thinking

3. The standard of due care to which the auditor is expected to adhere to in the performance of the audit is referred to as the A) prudent person concept. B) common law doctrine. C) constructive care concept. D) vigilant person concept. Answer: A Terms: Standard of due care Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

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1. Auditors may be liable to their clients if they are found guilty of A) Ordinary negligence Gross negligence Yes Yes

B) Ordinary negligence Gross negligence No No

C) Ordinary negligence Gross negligence Yes No

D) Ordinary negligence Gross negligence No Yes

Answer: A Terms: Auditor liability to clients Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

1. Under the laws of agency, partners of a CPA firm may be liable for the work of others on whom they rely. This would not include A) employees of the CPA firm. B) employees of the audit client. C) other CPA firms engaged to do part of the audit work. D) specialists employed by the CPA firm to provide technical advice on the audit. Answer: B Terms: Liability for the acts of others Diff: Easy Objective: LO 5- AACSB: Reflective thinking

2. "Absence of reasonable care that can be expected of a person in a set of circumstances" defines A) pecuniary negligence. B) gross negligence. C) extreme negligence. D) ordinary negligence. Answer: D Terms: Absence of reasonable care Diff: Easy Objective: LO 5- AACSB: Reflective thinking

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1. The assessment against a defendant of the full loss suffered by a plaintiff regardless of the extent to which other parties shared in the wrongdoing is called A) separate and proportionate liability. B) shared liability. C) unitary liability. D) joint and several liability. Answer: D Terms: Assessment against a defendant of the full loss suffered by a plaintiff Diff: Easy Objective: LO 5- AACSB: Reflective thinking

2. The assessment against a defendant of that portion of the damage caused by the defendant's negligence is called A) separate and proportionate liability. B) joint and several liability. C) shared liability. D) unitary liability. Answer: A Terms: Assessment against a defendant of that portion of the damages Diff: Easy Objective: LO 5- AACSB: Reflective thinking

3. Fraud occurs when A) a misstatement is made and there is both knowledge of its falsity and the intent to deceive. B) a misstatement is made and there is knowledge of its falsity but no intent to deceive. C) the auditor lacks even slight care in the performance in performing the audit. D) the auditor has an absence of reasonable care in the performance of the audit. Answer: A Terms: Fraud and errors Diff: Easy Objective: LO 5- AACSB: Reflective thinking

4. Which of the following most accurately describes constructive fraud? A) absence of reasonable care B) lack of slight care C) knowledge and intent to deceive D) extreme or unusual negligence without the intent to deceive Answer: D Terms: Constructive fraud Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

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1. Which of the following most accurately describes fraud? A) absence of reasonable care B) lack of slight care C) knowledge and intent to deceive D) extreme or unusual negligence without the intent to deceive Answer: C Terms: Fraud Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

2. A third-party beneficiary is one which A) has failed to establish legal standing before the court. B) does not have privity of contract and is unknown to the contracting parties. C) does not have privity of contract, but is known to the contracting parties and intended to benefit under the contract. D) may establish legal standing before the court after a contract has been consummated. Answer: C Terms: Third-party beneficiary Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

3. If the CPA negligently failed to properly prepare and file a client's tax return, the CPA may be liable for A) the penalties the client owes the IRS. B) the penalties and interest the client owes. C) the penalties and interest the client owes, plus the tax preparation fee the CPA charged. D) the penalties and interest, the tax preparation fee, and the amount of tax that was underpaid. Answer: C Terms: Liability when a CPA negligently failed to properly prepare and file tax return Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

4. Constructive fraud A) is also known as recklessness. B) requires an intent to deceive. C) involves collusion with the client. D) is also known as breach of contract. Answer: A Terms: Constructive fraud Diff: Moderate Objective: LO 5- AACSB: Analytic thinking

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1. Which of the following is a true statement regarding CPAs' liability? A) The amounts assessed under joint and several liability will not differ significantly from the amounts assessed under separate and proportionate liability. B) When lawsuits are brought under the federal securities laws, the joint and several liability approach will always apply. C) If one owner was directly involved in the actions of the owner causing the liability, the personal assets of neither owner can be subject to the damages that arise. D) Under the federal statutes, the amount of damages under separate and proportionate liability can be increased if the main defendant is insolvent. Answer: D Terms: Assessment against a defendant of that portion of the damages Diff: Challenging Objective: LO 5- AACSB: Reflective thinking

2. The legal term for when an auditor issues an audit opinion, knowing that an adequate audit was not performed, is a A) breach of contract. B) tort action for negligence. C) constructive fraud. D) fraud. Answer: C Terms: Constructive fraud Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

3. Define ordinary negligence, gross negligence, and constructive fraud. Answer: Ordinary negligence is the absence of reasonable care that can be expected of a person is a set of circumstances. For auditors, it is in terms of what other competent auditors would have done in the same situation.

Gross negligence is the lack of even slight care, tantamount to reckless behavior, that can be expected of a person in a set of circumstances. Some states do not distinguish between ordinary and gross negligence.

Constructive fraud is the existence of extreme or unusual negligence even though there was no intent to deceive or to do harm. It is also termed recklessness. In an audit, recklessness is present if the auditor knew an adequate audit was not done but still issued an opinion, even though there was no intention of deceiving statement users. Terms: Ordinary negligence, gross negligence, and constructive fraud Diff: Easy Objective: LO 5- AACSB: Reflective thinking

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1. An important concept in contract law for accountants to understand is the "third-party beneficiary doctrine." Explain and give an example. Answer: A third party who does not have privity of contract but is known to the contracting parties and is intended to have certain rights and benefits under the contract. Example: bank has a large loan outstanding at the balance sheet date and requires an audit as part of the loan agreement. Terms: Contract law; Third-party beneficiary doctrine Diff: Easy Objective: LO 5- AACSB: Reflective thinking

2. Distinguish between constructive fraud and fraud. Answer: Constructive fraud is the existence of extreme or unusual negligence even though there was no intent to deceive or do harm. In contrast, fraud occurs when a misstatement is made and there is both knowledge of its falsity and the intent to deceive. Terms: Constructive fraud Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

3. Distinguish between "joint and several liability" and "separate and proportionate liability." Answer: Under joint and several liability, the defendant can be assessed the full loss suffered by the plaintiff, regardless of the extent to which other parties shared in the wrongdoing. In contrast, under separate and proportionate liability, the defendant is assessed that portion of the damage caused by the defendant's negligence. Terms: Joint and several liability and separate and proportionate liability Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

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1. The standard of due care to which the auditor is expected to be held is referred to as the prudent person concept. Answer: TRUE Terms: Standard of due care; Prudent person concept Diff: Easy Objective: LO 5- AACSB: Reflective thinking

2. In a CPA firm operating as a limited liability partnership (LLP), the liability for one partner's actions does not extend to another partner's personal assets. Answer: TRUE Terms: CPA firm operating as a limited liability partnership Diff: Easy Objective: LO 5- AACSB: Reflective thinking

3. In a CPA firm operating as a limited liability partnership (LLP), the liability for one partner's actions extends to the firm's assets. Answer: TRUE Terms: CPA firm operating as a limited liability partnership Diff: Easy Objective: LO 5- AACSB: Reflective thinking

4. Statutory laws are laws that have been developed through court decisions rather than through the U. Congress and other governmental units. Answer: FALSE Terms: Statutory laws Diff: Easy Objective: LO 5- AACSB: Reflective thinking

5. When an auditor has failed to conduct an adequate audit, liability may depend on the level of negligence. Answer: TRUE Terms: Liability and level of negligence Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

6. Several states have statutes that permit privileged communication between the client and auditor, allowing a CPA to refuse to testify in state and federal courts. Answer: FALSE Terms: CPA and privileged communication Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

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1. Gross negligence is the existence of extreme or unusual negligence with the intent to deceive. Answer: FALSE Terms: Gross negligence Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

5 Learning Objective 5-

1. The principal issue in cases involving alleged negligence is usually A) if an engagement letter was issued. B) the level of care required. C) if fraud was committed by upper-level management. D) whether the auditor is liable under civil or criminal laws. Answer: B Terms: Level of care; Negligence Diff: Easy Objective: LO 5- AACSB: Reflective thinking

2. Which of the auditor's defenses against client suits contends no implied or expressed contract? A) lack of duty B) non-negligent performance C) contributory negligence D) absence of causal connections Answer: A Terms: Auditors' defenses against lawsuits Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

3. In connection with the audit of financial statements, an independent auditor could be responsible for failure to detect a material fraud if A) statistical sampling techniques were not used on the audit engagement. B) the auditor planned the audit in a negligent manner. C) accountants performing important parts of the work failed to discover a close relationship between the treasurer and the cashier. D) the fraud was perpetrated by one employee who circumvented the existing internal controls. Answer: B Terms: Independent auditor could be responsible for failure to detect material fraud Diff: Easy Objective: LO 5- AACSB: Reflective thinking

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1. Tort actions against CPAs are more common than breach of contract actions because A) there are more torts than contracts. B) the burden of proof is on the auditor rather than on the person suing. C) the person suing need prove only negligence. D) the amounts recoverable are normally larger. Answer: D Terms: Tort actions against CPAs Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

2. The principal issue to be resolved in cases involving alleged negligence is usually A) the amount of the damages suffered by plaintiff. B) whether to impose punitive damages on defendant. C) the level of care exercised by the CPA. D) whether defendant was involved in fraud. Answer: C Terms: Principal issue to be resolved in cases involving alleged negligence Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

3. In the auditing environment, failure to meet auditing standards is often A) an accepted practice. B) a suggestion of negligence. C) conclusive evidence of negligence. D) tantamount to criminal behavior. Answer: C Terms: Failure to meet auditing standards Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

4. A common way for a CPA firm to demonstrate a lack of duty to perform is by use of a(n) A) expert witness' testimony. B) engagement letter. C) management representation letter. D) confirmation letter. Answer: B Terms: Common way to demonstrate lack of duty to perform Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

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1. To succeed in an action against the auditor, the client must be able to show that A) the auditor was fraudulent. B) the auditor was grossly negligent. C) there was a written contract. D) there is a close causal connection between the auditor's behavior and the damages suffered by the client. Answer: D Terms: Auditors' defenses against lawsuits Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

2. Which of the following is a true statement regarding auditors' liability? A) The level of care is easy to determine in a review or compilation. B) Engagement letters will relieve the auditor of all liability. C) An auditor will always be guilty of negligence if they fail to uncover fraud. D) The most common source of lawsuits against CPAs is from clients. Answer: D Terms: Auditors' liability to clients Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

3. One of the changes in auditing procedures which was brought about as a result of the 1136 Tenants case was that auditors were encouraged to begin using A) letters of representation. B) confirmation letters. C) engagement letters. D) billet doux letters. Answer: C Terms: Audit procedure brought about by 1136 Tenants case Diff: Challenging Objective: LO 5- AACSB: Reflective thinking

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1. An example of auditor legal liability to third parties under common law would be the federal government prosecuting an auditor for knowingly issuing an incorrect audit report. Answer: FALSE Terms: Four major sources of auditors' legal liability Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

2. The 1136 Tenants case was a criminal case concerning a CPA's failure to uncover fraud during a financial statement audit. Answer: FALSE Terms: 1136 Tenants case Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

3. Many litigation experts believe that a well written engagement letter significantly reduces the likelihood of adverse legal actions. Answer: TRUE Terms: Reasons for an audit and audit evidence Diff: Easy Objective: LO 5- AACSB: Reflective thinking

5 Learning Objective 5-

1. A financial institution sues the audit firm for failure to discover that a borrower's financial statements are materially misstated. This is an example of which of the following legal liability concepts? A) liability to clients B) liability to third parties under common law C) civil liability under federal securities law D) criminal liability Answer: B Terms: Liability to third parties under common law Diff: Easy Objective: LO 5- AACSB: Reflective thinking

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1. Which of the following auditor's defenses usually means nonreliance on the financial statements by the user? A) lack of duty B) non negligent performance C) absence of causal connections D) contributory negligence Answer: C Terms: Auditor defenses against third party suits Diff: Easy Objective: LO 5- AACSB: Analytic thinking

2. A group typically included as "third parties" in common law is A) Actual and potential stockholders Employees of client Yes Yes

B) Actual and potential stockholders Employees of client No No

C) Actual and potential stockholders Employees of client Yes No

D) Actual and potential stockholders Employees of client No Yes

Answer: A Terms: Third parties in common law Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

1. The major conclusion of the 1931 Ultramares case was that A) ordinary negligence is insufficient for liability to third parties. B) third parties must file criminal charges, not civil charges, against the auditor. C) fraud or gross negligence is sufficient for liability to third parties. D) auditors have no liabilities to third parties. Answer: A Terms: Major conclusion of 1931 Ultramares case Diff: Moderate Objective: LO 5- AACSB: Reflective thinking

Under which act or acts may liability charges be filed against a CPA?

In which type of court case is providing due diligence?

Which of the following is accurate with respect to litigation involving CPAs?

Which of the following acts by a CPA would most likely be considered a violation of the aicpa?