Maintaining Professional Responsibility

8/10/2019 Maintaining Professional Responsibility

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Maintaining Professional Responsibility:

Regulation and Legal Liability

MULTIPLE CHOICE:

1. A CPA firm studies its personnel advancement experience to ascertain

whether individuals meeting stated criteria are assigned increased

degrees of responsibility. This is

evidence of the firm's adherence to prescribed standards of

a.Supervision and review.

b.Continuing professional education.

c.

Professional development.

d. Quality control.

ANSWER: D

2. Which one of the following, if present, would support a finding ofconstructive fraud on the part of a CPA?

a. Privity of contract. b. Intent to deceive.

c. Reckless disregard.

d. Ordinary negligence.

ANSWER: C

3. The CPA firm of Knox and Knox has been subpoenaed to testify and

produce its correspondence and workpapers in connection with a

lawsuit brought by a third party against one of their clients. Knox

considers the subpoenaed documents to be privileged


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communication and therefore seeks to avoid admission of such

evidence in the lawsuit. Which of the following is correct?

a.

Federal law recognizes such a privilege if the accountant is a

Certified Public Accountant.

b.

The privilege is available regarding the workpapers since the CPA

is deemed to own them.

c. The privileged communication rule as it applies to a CPA/client

relationship is the same as that of attorney-client. d. In the absence

of a specific statutory provision, the law does not recognize the

existence of the privileged communication rule between a CPA andhis client.

ANSWER: D

4. Of the following statements, which best distinguishes ordinary

negligence from gross negligence?

a. Failure to detect material errors, whether internal control is

strong or weak, suggests gross negligence.

b. Failure to exercise reasonable care denotes ordinary negligence,

whereas failure to exercise minimal care indicates gross

negligence.

c. Gross negligence is most probable when the auditor fails to

detect errors that occurred under conditions of strong internal

control.

d. The more material the undetected error the greater the likelihood

of ordinary negligence.

ANSWER: B


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5. On July 1, 2002, Kent purchased common stock of Salem Corp. in an

offering subject to the Securities Act of 1933. Mane & Co., CPAs,

rendered an unqualified opinion on the financial statements of Salem

which were included in

Salem's registration statement filed with the SEC on March 1,

2002 Kent has commenced an action against Mane based on the

Securities Act of 1933 provisions dealing with omissions of facts

required to be stated in the registration

statement. Which of the following elements of a cause of action

under the Securities Act of 1933 must be proved by Kent?

a.Kent relied upon Mane's opinion.

b.

Kent was the initial purchaser of the stock and gave value for it.

c.

Mane's omission was material.

d. Mane acted negligently or fraudulently.

ANSWER: A

6. The limitation of auditor liability under contract law is known as

a. Privity of contract.

b. Contributory liability.

c. Statutory liability.

d. Common law liability.

ANSWER: A

7. Under the Securities Act of 1933, the registration of securities which

are offered to the public in interstate commerce is


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a. Directed toward preventing the marketing of securities which pose

serious financial risks to the prospective investor. b. Not required unless

the issuer is a corporation. c. Mandatory unless the cost to the issuer

is"prohibitive" as defined in the SEC regulations. d. Required unless there

is an applicable exemption.

ANSWER: D

8. The auditor's defense of contributory negligence is most likely to

prevail when

a. Third party injury has been minimal.

b. The auditor fails to detect fraud resulting from management

override of the control structure.

c. The client is privately held as contrasted with a public company.

d. Undetected errors have resulted in materially misleading financial

statements.

ANSWER: B

9. The objective of quality control mandates that a public accounting firm

should establish policies and procedures for professional development

which provide reasonable assurance that all entry-level personnel

a.Prepare working papers which are standardized in form and

content.

b.Have the knowledge required to enable them to

fulfillresponsibilities assigned.

c. Will advance within the organization.

d. Develop specialties in specific areas of public accounting.


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ANSWER: B

10.

A plaintiff wishes to recover damages from the issuer for

losses resulting from material misstatements in a securities

registration statement. In order to be successful, one of

the elements the plaintiff must prove is that the

a.

Plaintiff was in privity of contract with the issuer or that the issuer

knew of the plaintiff.

b.Plaintiff acquired the securities.

c.

Issuer acted negligently.

d. Issuer acted fraudulently.

ANSWER: B

11. A basic objective of a CPA firm is to provide professional services that

conform with professional standards. Reasonable assurance of achievingthis basic objective is provided through

a.A system of peer review.

b.Continuing professional education.

c.

A system of quality control.

d. Compliance with generally accepted reporting standards.

ANSWER: C

12.Mix and Associates, CPAs, issued an unqualified opinion on

the financial statements of Glass Corp. for the year ended


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December 31, 2002. It was determined later that Glass' treasurer had

embezzled $300,000 from Glass during 2002. Glass sued Mix because of

Mix's failure to discover the embezzlement. Mix was unaware of the

embezzlement. Which of the following is Mix's best defense?

a. The audit was performed in accordance with GAAS. b. The treasurer

was Glass' agent and, therefore, Glass was responsible for preventing the

embezzlement. c. The financial statements were presented in

conformity with GAAP.

d. Mix had no actual knowledge of the embezzlement.

ANSWER: A

13. Which of the following is not a condition for membership in the

Division for CPA Firms?

a. Participating in peer review.

a.

Employing only CPAs.

b.Conforming to specified continuing professional

education requirements.

c.

Maintaining adequate levels of liability

insurance.

ANSWER: B

14. Gold, CPA, rendered an unqualified opinion on the 2000 financial

statements of Eastern Power Co. Egan purchased Eastern bonds in a

public offering subject to the Securities Act of 1933. The registration

statement filed with the SEC included the financial statements. Gold is

being sued by Egan under Section 11 of the Securities Act of 1933 for the


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misstatements contained in the financial statements. To prevail, Egan

must prove

Scienter Reliance

a. No No

b. No Yes

c. Yes No

d. Yes Yes

ANSWER: A

15. The Rusch Factors and Rhode Island Hospital Trust cases further

defined the doctrine of privity by stating that

a. Stockholders, as owners of the company, are also parties to the

contract between auditor and client.

b. Privity extends to primary third party beneficiaries known by the

auditor to be relying on the financial statements.

c. The doctrine of privity is broken when management intentionally

misrepresents financial position and/or results of operations.

d. Privity extends to third parties only in cases involving auditor

negligence.

ANSWER: B

16. In connection with the element of professional development, a CPA

firm's system of quality control should ordinarily provide that all

personnel


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a.

Have the knowledge required to enable them to

fulfillresponsibilities assigned.

b. Possess judgment, motivation, and adequate experience. c.Seek

assistance from persons having appropriate level

of knowledge, judgment, and authority.

d. Demonstrate compliance with peer review directives.

ANSWER: A

17. In the case of Fischer v. Kletz (Yale Express), the auditors were

charged with fraud for failing to inform users of nonexistent

accounts receivable. Although the case was settled out of court, it

did encourage the profession to issue a Statement on Auditing

Standards relating to

a. Related party transactions.

b. Auditor responsibility for detecting illegal acts.

c. Audit risk assessment.

d. Subsequent discovery of facts existing at the date of the audit

report.

ANSWER: D

18.Accounting firms should establish quality control

procedures for professional development in order to provide reasonable

assurance that

d.Persons promoted possess the appropriate


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characteristics to perform competently. b. Personnel will have the

knowledge required to fulfill responsibilities assigned.

c. The extent of supervision and review in a given

instance will be appropriate.

d. Association with a client whose management lacks integrity will be

minimized.

ANSWER: B

19. The factor that distinguishes constructive fraud from actual fraud is

a. Materiality.

b. Quality of internal control.

c. Type of error or irregularity.

d. Intent.

ANSWER: D

20. Gleam is contemplating a common law action against Moore & Co.

CPAs, based upon fraud. Gleam loaned money to Lilly & Co. relying upon

Lilly's financial statements which were audited by Moore. Gleam's action

will fail if

a.

Gleam shows only that Moore failed to meticulously follow GAAS.

b.Moore can establish that they fully complied with the statute of

frauds.

c. The alleged fraud was in part committed by

oralmisrepresentations and Moore pleads the parol


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evidence rule. d.Gleam is not a third party beneficiary in light of

the absence of privity.

ANSWER: A

21. In the Continental Vending Machine Corporation case, the court

argued that a footnote appearing in the company's

annual report was confusing and misleading. As a result, the accounting

profession

a. Encouraged practitioners to carry adequate liability insurance.

b. Issued a Statement on Auditing Standards defining related party

transactions and assigning auditor responsibility for detecting

material related party transactions and determining that the

economic substance of such transactions is properly reflected

in the financial statements.

c. Issued a Statement on Auditing Standards requiring auditor

presence at the client's physical inventory taking and auditor

confirmation of customer accounts receivable.

d. More clearly defined "privity of contract" between auditor and

client.

ANSWER: B

22. Working papers prepared by a CPA in connection with an

auditengagement are owned by the CPA, subject to

certainlimitations. The rationale for this rule is to

a. Protect the working papers from being subpoenaed. b. Provide the

basis for excluding admission of the working papers as evidence because

of the privileged communication rule. c. Provide the CPA with evidence

and documentation which may be helpful in the event of a


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ascertain whether individuals meeting stated criteria are assigned

increased degrees of responsibility. This is evidence of the CPA firm's

adherence to prescribed

a.Standards of due professional care.

b.

Quality control standards.

c.

Supervision and review standards.

d. Reporting standards.

ANSWER: B

25. West & Co., CPAs, was engaged by Sand Corp. to audit its financial

statements. West issued an unqualified opinion on Sand's financial

statements. Sand has been accused of making negligent

misrepresentations in the financial statements, which Reed relied upon

when purchasing Sand stock. West was not aware of the

misrepresentations nor was it negligent in performing the audit. If Reed

sues West for damages based upon Section 10(b) and rule 10b-5 of

theSecurities Exchange Act of 1934, West will

a. Lose, because Reed relied upon the financial statements.

b. Lose, because the statements contained

negligent misrepresentations.c. Prevail, because some element of

scienter must be proved. d.Prevail, because Reed was not in privity

of contract with West.

ANSWER: C

26. A CPA establishes quality control policies and procedures

for deciding whether to accept a new client or continue to perform

services for a current client. The primary purpose for establishing such

policies and procedures is


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a.

To enable the auditor to attest to the integrity or reliability of a

client.

b. To comply with the quality control standards

established by regulatory bodies.

c. To lessen the exposure to litigation resulting from failure to detect

irregularities in client financial statements. d. To minimize the likelihood

of association with clients whose management lacks integrity.

ANSWER: D

27. Which of the following statements is correct concerning corporations

subject to the reporting requirements of the Securities Exchange Act of

1934?

a.

The annual report (form 10-K) need not include auditedfinancial

statements.

b.

The annual report (form 10-K) must be filed with the SEC within

20 days of the end of the corporation's fiscal year.

c. A quarterly report (form 10-Q) need only be filed with the SEC by

those corporations that are also subject to the registration

requirements of the Securities Act of 1933. d. A monthly report

(form 8-K) must be filed with the SEC after the end of any month in

which a materially important event occurs.

ANSWER: D

28. In a common law action against an accountant, the lack of

privity is a viable defense if the plaintiff

a.Bases his action upon fraud.


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b.

Is the accountant's client.

c. Is a creditor of the client who sues the accountant

fornegligence. d. Can prove the presence of gross negligence

which amounts to a reckless disregard for the truth.

ANSWER: C

29. Donn & Co. is considering the sale of $11 million of its common stock

to the public in interstate commerce. In this connection, Donn has been

correctly advised that registration of the securities with the SEC is

a. Not required if the states in which the securities are to be sold have

securities acts modeled after the federal act and Donn files in those

states. b. Required in that it is necessary for the SEC to approve the

merits of the securities offered.

c.

Not required if the securities are to be sold through a

registered brokerage firm.

d. Required and must include audited financial statements as anintegral part of its registration.

ANSWER: D

30. Tulip Corp. is a registered and reporting corporation under the

Securities Exchange Act of 1934. As such it

a.Can offer and sell its securities to the public without the necessity

of registering its securities pursuant to the Securities Act of

1933.

b.Cannot make a tender offer for the equity securities ofanother

registered and reporting corporation without the consent of

the SEC.


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c. Must file annual reports (Form 10-K) with the SEC. d. Must

distribute a copy of the annual report (Form 10-K) to each of its

shareholders.

ANSWER: C

31. A CPA firm issues an unqualified opinion on financial statements not

prepared in accordance with GAAP. The CPA firm will have acted with

scienter in all the following circumstances except where the firm

a.Intentionally disregards the truth.

b.Has actual knowledge of fraud.

c.

Negligently performs auditing procedures.

d. Intends to gain monetarily by concealing the fraud.

ANSWER: C

32. Which of the following conditions suggests auditor negligence?

a. Failure to detect material errors under conditions of weak internal

control.

b. Failure to detect collusive fraud perpetrated by members of

middle management.

c. Failure to detect collusive fraud perpetrated by members of top

management.

d. Failure to detect errors occurring outside the internal control

structure.

ANSWER: A


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33. The registration of a security under the Securities Act of 1933

provides an investor with

a.

A guarantee by the SEC that the facts contained in theregistration

statement are accurate.

b. An assurance against loss resulting from purchasing

thesecurity. c. Information on the principal purposes for which

theoffering's proceeds will be used.

d. Information on the issuing corporation's trade secrets.

ANSWER: C

34. The principal purpose of the registration requirements of the

Securities Act of 1933 is to

a. Prevent public offerings of securities in which management fraud or

unethical conduct is suspected. b. Provide the SEC with the information

necessary to determine the accuracy of the facts presented in thefinancial

statements.

c. Assure that investors have adequate information upon which to base

investment decisions. d. Provide the SEC with the information necessary

to evaluate the financial merits of the securities being offered.

ANSWER: C

COMPLETION:

35.A committee formed in 1999 to focus on the problem of managed

earnings, cookie-jar reserves, purchased R&D write-offs, and abuse

of the materiality concept is known as the

____________ _______ _____________.

ANSWER: PANEL ON AUDIT EFFECTIVENESS


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36. A disparity between users' and CPAs' perceptions of auditor

responsibility is referred to as the .

ANSWER: EXPECTATION GAP

37. Ultimate authority to set accounting and auditing standards rests with

the .

ANSWER: SECURITIES AND EXCHANGE COMMISSION

38. is defined as negligence so flagrant as to border on deceit.

ANSWER: CONSTRUCTIVE FRAUD

39. The primary difference between contractual liability to clients and civil

liability to third parties is that, under civil liability, the auditor is not

liable to third parties for .

ANSWER: ORDINARY NEGLIGENCE

40. Given the Securities Exchange Act of 1934 and the concept of

"integrated disclosure", information may be ____________ ___

in Form 10-K.

ANSWER: INCORPORATED BY REFERENCE

41. The legal term for "intent to deceive" is .

ANSWER: SCIENTER

42. Auditor liability under the Securities acts is referred to as liability.

ANSWER: STATUTORY

43.

In responding to an underwriter's request for a __________


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_________, the auditor will likely apply certain limitedprocedures to

the financial data arising subsequent to the most recent audit.

ANSWER: COMFORT LETTER

44. In the Ernst and Ernst v. Hochfelder case, the U.S. Supreme Court

held that auditors are not liable for under Rule 10B-5 of the

Securities Exchange Act of 1934, but only for .

ANSWER: NEGLIGENCE, SCIENTER (FRAUD)

MATCHING:

45. Match each of the responsibilities enumerated below with

the bodies charged with that responsibility.

a. State board of accountancy

b. SEC Practice Section

c. Public Oversight Board

d. Securities and Exchange Commission

e. AICPA Quality Control Standards Board

f. Independence Standards Board

g. Emerging Issues Task Force

h.Panel on Audit Effectiveness

____ 1. Oversee peer review for public companies.

____ 2. Issue a guideline for reviewing accounting firm

personnel for promotion.


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____ 3. Issue recommendations directed toward improving the

quality of independent audits.

____ 4. Recommend that the executive committee of the SEC

Practice Section sanction a member for failing to

comply with the Sections peer review standards.

____ 5. Issue a standard prohibiting an accounting firm from

accepting an accounting service engagement from an

audit client on the basis that performing both types

of service might impair objectivity.

____ 6. Review prospectus and registration statement of

company contemplating an initial public offering.

____ 7. Revoke license of member for committing a

discreditable act.

____ 8. Monitor FASB deliberations concerning the proper

accounting treatment to be applied to derivatives.

SOLUTION:

1. b

2. e

3. h


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4. c

5. f

6. d

7. a

8. g

ESSAY

46.An auditor is sued for negligence by the stockholders of an

audit client. The auditor had issued an unqualified opinion on

the clients financial statements.It was later determined

that the statements were materially distorted due to errors

and fraud.

Required:

a. Under what conditions, in common law may an auditor be held

liable to third parties for negligence?

b. Describe two approaches for differentiating between

ordinary negligence and gross negligence. Cite examples to

support your approaches.

c. Who will prevail in the present case?

SOLUTION:

a. The doctrine of privity states that auditors are liable to

third parties for fraud but not for negligence.Subsequent

court decisions, such as Ultramares v. Touche, however, have

construed gross negligence as constructive fraud. Auditors,

therefore, may be held liable to injured third parties for


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gross negligence, but not for ordinary negligence. In

addition, privity may extend to specifically identified third

parties known by the auditor to be relying on the audited

financial statements.

b. Two approaches to distinguishing ordinary negligence from

gross negligence are materiality and internal

control.Performing an audit with due care should permit the

auditor to detect a material misstatement not cleverly

concealed.For example, an inventory extension error (price x

quantity) that overstates the ending inventory by 25 percent

and results in a material overstatement of net income should

be detected in the ordinary course of the audit.

Errors or fraud perpetrated because of weak internal controls

are more likely to be detected by the auditor than errors or

fraud perpetrated outside the existing system of internal

control. For example, material misstatements caused by

classification errors related to repairs and maintenance

expenditures versus property, plant, and equipment additions

may occur because the persons charged with determining the

appropriate accounts to be debited have not been adequately

trained. This constitutes an internal control weakness; and

the auditors should have detected the weakness and modified

their substantive audit testing accordingly.

Contrast this with a material misstatement caused by

management intentionally overriding existing internal control

for the purpose of inflating earnings. As part of the scheme,

documentation supporting fictitious sales may have been

fabricated. Under these conditions, the prudent auditor is

less likely to detect the fraud.


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c. To prevail in the present case, the plaintiffs must

demonstrate that the auditor was grossly negligent and must

also prove that the plaintiffs were injured by the auditors

negligence.

47. A. How does the level of quality maintenance within the

accounting profession impact the expectations gap? Cite

examples in your answer.

B. What is the alternative to self-regulation? Cite two

measures the profession has taken in recent years to meet the

challenges posed by the threat of a widening expectations gap?

SOLUTION:

The goal of self-regulation within the accounting profession

is to maintain the quality of accounting services at a level

that will satisfy the users of these services. The

expectations gap is the disparity between users and CPAs

perceptions of the quality of these services. Therefore, a

decline in either the quality of services rendered by CPAs orusers perceptions of quality causes a widening of the

expectations gap. Such diminishments occur, for example, when

courts find auditors negligent in the performance of audits or

when the financial press reports incidents of alleged audit

failures. Cases involving Phar Mor, Lincoln Savings and Loan,

Crazy Eddie, and Miniscribe can be cited as illustrations. CPA

consulting services for audit clients impair the appearance of

independence, and is another means for widening theexpectations gap and undermining the perceived effectiveness

of self-regulation.

The alternative to self-regulation is external regulation by

the SEC or a similar public body. One must remember that the


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SEC already has the authority granted by the securities acts

to regulate the accounting profession, but has declined to

fully exercise that authority. If the expectations gap were to

widen significantly, however, and self-regulation is perceived

to be ineffective, the SEC may well decide to actively pursue

its regulatory powers.

To meet the challenges posed the threat of a widening

expectations gap and more external regulation, the profession,

in recent years, has:

1. Assigned the auditor responsibility for planning the audit

to provide reasonable assurance of detecting material

financial statement errors and fraud;

2. Required auditors to evaluate the ability of each audit

client to continue as a going concern;

3. Encouraged clients to appoint audit committees to monitor

internal control and arbitrate disputes between management and

the external auditors;

4. Issued a new SAS that provides more explicit guidance to

auditors for detecting fraud and communicating the findings to

management and the board of directors;

5. Created an Independence Standards Board to actively pursue

issues involving auditor independence

48. For each of the following capsule cases, determine the

outcome and provide the rationale to support your conclusion.

1. A group of stockholders is suing a CPA for failing to

detect a material misappropriation of customer cash receipts

by the controller of a company in which the group has


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invested. The fraud occurred because the controller had access

to cash as well as the accounting records. The fraud was

concealed by not recording the receipts. To conceal the

overstatement of accounts receivable, the controller inflated

sales returns and allowances and wrote off some of the

accounts as uncollectible. The CPA failed to detect the fraud

in the course of the audit.

2. The management of a large manufacturer of exercise

equipment inflated net assets and net earnings by 1)recording

fictitious sales and fabricating the underlying documentation;

2)debiting operating expenses to several construction projects

in progress; and 3) inflating inventories by not recording

sales returns and including the inventory at full cost, and

inflating various inventory unit costs. These frauds were

detected by IRS auditors after the companys check for payment

of income taxes bounced.The independent auditors did not

discover the misrepresentation, and the new management is now

suing them for failure to detect the fraud.

3. A CPA failed to detect a misrepresentation fraud

perpetrated by an audit client. The fraud was material in its

impact on the financial statements and was effected by

debiting operating expenses and manufacturing overhead to work

orders for various construction projects underway. The

projects did not exist and the CPA examined a client-prepared

analysis of the work orders rather than the work orders

themselves. Moreover, the CPA did not ask to inspect any of

the projects.

An action alleging negligence was brought against the CPA by

the bank that granted a loan to the company on the basis of

the audited financial statements. The inflated earnings figure


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resulting from the misrepresentation was an integral part of

the decision to grant the loan.

The CPA had rendered an unqualified opinion on the financial

statements. This was the first year the company had been

audited. In past years, the CPA had performed only a review of

the companys financial statements; but this year the company

requested an audit as part of the banks conditions for

processing the loan application.

SOLUTION:

1. The stockholders need to prove gross negligence by the CPA,inasmuch as they are not privy to the contract between the CPA

and the client. The CPA appears to have been grossly negligent

in this case. First, the fraud was facilitated by internal

control weaknesses - the controller had access to cash as well

as to accounting records. The CPA should have noted the

weakness in assessing internal control and modified

substantive audit programs accordingly. Further investigation

of the accounts receivable write-offs, including contactingcustomers whose accounts had been written off, should have

enabled the auditor to detect the fraud. In summary, this is

a material fraud perpetratedwithin the system of internal

control, and failure to detect is evidence of gross

negligence.

2. The auditors appear not to be negligent in this case.Like

Cenco v. Seidman & Seidman, the fraud was perpetrated by topmanagement, was cleverly concealed, and was effected by

overriding internal control. As the court stated in that case,

auditors cannot be expected to detect misstatements when

management has turned the entity into an engine of fraud.


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3. The CPA will probably lose in this case. Although not

grossly negligent, privity will likely be extended to the bank

because the CPA knew the bank was the primary beneficiary of

the audited financial statements. Negligence may be inferred

by the fact that the auditor did not examine the work orders

and did not inspect any of the additions.

Maintaining Professional Responsibility

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