Auditing and Assurance Services, 16e (Arens/Elder/Beasley)
Chapter 5 Legal Liability
5.1 Learning Objective 5-1
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
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.
3) 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.
5.2 Learning Objective 5-2
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
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.
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.
4) Distinguish between what is meant by business failure and audit failure.
5) Audit risk is the risk there will be an audit failure for a given audit engagement.
6) 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.
5.3 Learning Objective 5-3
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.
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.
3) 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.
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.
5) 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
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.
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.
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.
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.
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.
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.
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.
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.
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.
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
16) 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
17) 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.
18) 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.
19) 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.
20) Which of the following statements is true?
A)
Gross negligence may
constitute
constructive fraud
Fraud requires the
intent to deceive
All fraud should be
detected during audit
Yes
Yes
No
B)
Gross negligence may
constitute
constructive fraud
Fraud requires the
intent to deceive
All fraud should be
detected during audit
No
Yes
No
C)
Gross negligence may
constitute
constructive fraud
Fraud requires the
intent to deceive
All fraud should be
detected during audit
Yes
No
Yes
D)
Gross negligence may
constitute
constructive fraud
Fraud requires the
intent to deceive
All fraud should be
detected during audit
No
No
No
21) The laws that have been developed through court decisions are called
A) common laws.
B) criminal laws.
C) statutory laws.
D) civil laws.
22) 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.
23) 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.
24) Define ordinary negligence, gross negligence, and constructive fraud.
25) An important concept in contract law for accountants to understand is the “third-party
beneficiary doctrine.” Explain and give an example.
26) Distinguish between constructive fraud and fraud.
27) Distinguish between “joint and several liability” and “separate and proportionate liability.”
28) Match seven of the legal terms (a-j) with the definitions provided below (1-7):
a. common law
b. constructive fraud
c. breach of contract
d. joint and several liability
e. ordinary negligence
f. third-party beneficiary
g. gross negligence
h. statutory law
i. fraud
j. separate and proportionate liability
________ 1. laws that have been passed by the U.S. Congress and other governmental units
________ 2. absence of reasonable care that can be expected of a person in a set of
circumstances
________ 3. lack of even slight care, tantamount to reckless behavior that can be expected of a
person
________ 4. the assessment against a defendant of that portion of the damage caused by the
defendant’s negligence
________ 5. failure of one or both parties in a contract to fulfill the requirements of the contract
________ 6. 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
________ 7. existence of extreme or unusual negligence even though there was no intent to
deceive or do harm; also termed recklessness
29) The standard of due care to which the auditor is expected to be held is referred to as the
prudent person concept.
30) 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.
31) In a CPA firm operating as a limited liability partnership (LLP), the liability for one partner’s
actions extends to the firm’s assets.
32) Statutory laws are laws that have been developed through court decisions rather than through
the U.S. Congress and other governmental units.
33) When an auditor has failed to conduct an adequate audit, liability may depend on the level of
negligence.
34) 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.
35) Gross negligence is the existence of extreme or unusual negligence with the intent to
deceive.
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.
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
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.
4) Which of the following is an illustration of liability to clients under common law?
A) A client sues the auditor for not discovering a theft of assets by an employee.
B) A bank sues the auditor for not discovering that the borrower’s financial statements are
misstated.
C) A combined group of stockholders sues the auditor for not discovering materially misstated
financial statements.
D) The federal government prosecutes the auditor for knowingly issuing an incorrect audit
report.
5) Which of the following is an illustration of liability under the federal securities acts?
A) A client sues the auditor for not discovering a theft of assets by an employee.
B) A bank sues the auditor for not discovering that the borrower’s financial statements are
misstated.
C) A combined group of stockholders sues the auditor for not discovering materially misstated
financial statements.
D) The auditor sues a client for not cooperating during the engagement.
6) A CPA firm normally uses one or a combination of four defenses when there are legal claims
by clients. Which one of the following is generally not a defense?
A) lack of duty
B) nonnegligent performance
C) contributory negligence
D) foreseeable users
7) 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.
8) 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.
9) 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.
10) 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.
11) 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.
12) 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.
13) 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.
14) The King Surety Company wrote a general fidelity bond covering thefts of assets by the
employees of Wilson, Inc. Thereafter, Cooney, an employee of Wilson, embezzled $17,200 of
company funds. When the activities were discovered, King paid Wilson the full amount in
accordance with the terms of the fidelity bond, and then sought recovery against Wilson’s
auditors, Lynch & Merritt, CPAs. Which of the following would be Lynch & Merritt’s best
defense?
A) King is not in privity of contract.
B) The shortages were the result of clever forgeries and collusive fraud which would not be
detected by an examination made in accordance with generally accepted auditing standards.
C) Lynch & Merritt were not guilty either of gross negligence or fraud.
D) Lynch & Merritt were not aware of the King-Wilson surety relationship.
15) There are four major sources of an auditor’s legal liability. One source is liability to the audit
client. List the other three sources.
16) Discuss each of the four defenses a CPA firm can normally use when facing legal claims by
clients.
17) 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.
18) The 1136 Tenants case was a criminal case concerning a CPA’s failure to uncover fraud
during a financial statement audit.
19) Many litigation experts believe that a well written engagement letter significantly reduces the
likelihood of adverse legal actions.
5.5 Learning Objective 5-5
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