Auditing And Assurance Services, 15e, Global Edition

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Auditing and Assurance Services, 15e, Global Edition (Arens)

Chapter 4 Legal Liability Considerations for Auditors

Learning Objective 4-1

1) 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.

• Large civil court judgments against CPA firms.

• 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 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.

• The global recession and tough economic times result in business failures, which prompt

stakeholders to seek restitution from others, including external auditors.

Terms: Major factors that have contributed to the recent increase in the number of lawsuits

against auditors

Diff: Moderate

Objective: LO 4-1

AACSB: Reflective thinking skills

Learning Objective 4-2

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 4-2

AACSB: Reflective thinking skills

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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 4-2

AACSB: Reflective thinking skills

3) Distinguish between what is meant by business failure and audit failure.

Answer: Business failure occurs when a business is unable to repay its lenders or meet

expectations of its investors because of economic or business conditions, such as recession, poor

management decisions, or unexpected competition in the industry. Audit failure occurs when the

auditor issues an incorrect audit opinion because it failed to comply with the requirements of

auditing standards.

Terms: Business failure and audit failure

Diff: Easy

Objective: LO 4-2

AACSB: Reflective thinking skills

4) Audit risk is the risk there will be an audit failure for a given audit engagement.

A) True

B) False

Answer: B

Terms: Audit risk

Diff: Moderate

Objective: LO 4-2

AACSB: Reflective thinking skills

5) The term “audit failure” refers to the situation when the auditor has followed auditing

standards yet still fails to discover that the client’s financial statements are materially misstated.

A) True

B) False

Answer: B

Terms: Audit failure; Followed audit standards and fail to discover material misstatement

Diff: Moderate

Objective: LO 4-2

AACSB: Reflective thinking skills

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Learning Objective 4-3

1) In the performance of an audit, a CPA:

A) is legally liable for detecting an immaterial client fraud.

B) must strictly follow GAAP for privately held clients.

C) must exercise constructive professional care in the performance of their audit responsibilities.

D) must exercise due professional care in the performance of their audit responsibilities.

Answer: D

Terms: Performance of an audit

Diff: Easy

Objective: LO 4-3

AACSB: Reflective thinking skills

2) 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 4-3

AACSB: Reflective thinking skills

3) Recklessness in the case of an audit 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: Legal term for reckless in an audit with not intent to deceive

Diff: Easy

Objective: LO 4-3

AACSB: Reflective thinking skills

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4) 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 4-3

AACSB: Reflective thinking skills

5) Auditors may be liable to their clients if they are found guilty of:

A)

Ordinary negligence

Gross negligence

Yes

B)

Ordinary negligence

Gross negligence

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 4-3

AACSB: Reflective thinking skills

6) 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: Laws of agency. Partners of CPA firm liable for work of others on whom they rely

Diff: Easy

Objective: LO 4-3

AACSB: Reflective thinking skills

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7) “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 4-3

AACSB: Reflective thinking skills

8) An example of a breach of contract would likely include:

A) an auditor’s refusal to return the client’s general ledger book until the client paid last year’s

audit fees.

B) a bank’s claim that an auditor had a duty to uncover material errors in financial statements that

had been relied on in making a loan.

C) a CPA firm’s failure to complete an audit on the agreed-upon date because the firm had a

backlog of other work which was more lucrative.

D) an auditor’s claim that the client staff is unqualified.

Answer: C

Terms: Breach of contract

Diff: Easy

Objective: LO 4-3

AACSB: Reflective thinking skills

9) Privity of contract exists between:

A) auditor and the federal government.

B) auditor and third parties.

C) auditor and client.

D) auditor and client attorney.

Answer: C

Terms: Privity of contract

Diff: Easy

Objective: LO 4-3

AACSB: Reflective thinking skills

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10) An individual who is not party to the contract between a CPA and the client, but who is

known by both and is intended to receive certain benefits from the contract is known as:

A) a third party.

B) a common law inheritor.

C) a tort.

D) a third-party beneficiary.

Answer: D

Terms: Individual who is not a party to the contract between a CPA and client, but who is

known

Diff: Easy

Objective: LO 4-3

AACSB: Reflective thinking skills

11) Laws that have been passed by the U.S. Congress and other governmental units are:

A) statutory laws.

B) judicial laws.

C) federal laws.

D) common laws.

Answer: A

Terms: Laws passed through state legislatures

Diff: Easy

Objective: LO 4-3

AACSB: Reflective thinking skills

12) 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 4-3

AACSB: Reflective thinking skills

13) 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 4-3

AACSB: Reflective thinking skills

14) 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 4-3

AACSB: Reflective thinking skills

15) 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: Describes constructive fraud

Diff: Moderate

Objective: LO 4-3

AACSB: Reflective thinking skills

16) Which of the following most accurately describes fraud?