Auditing, 12e (Arens)
Chapter 4 Legal Liability
4.1 Explain how sources of legal liability are related to a distinction between business failure
and audit failure
1) While performing services for their clients, professionals have always had a duty to provide a
level of care which is
A) reasonable.
B) greater than average.
C) superior.
D) guaranteed to be free from error.
2) In rare cases, auditors have been held liable for criminal acts. A criminal conviction against an
auditor can result only when it is demonstrated that the auditor
A) was negligent.
B) was grossly negligent.
C) intended to deceive or harm others.
D) caused a financial loss to an innocent third party.
3) What situation represents a fiduciary duty?
A) A professional accountant acts as a director of an organization.
B) A professional accountant performs an audit.
C) The owner of a private company prepares financial statements.
D) A professional accountant performs a non-assurance engagement.
4) Canadian PAs are required to have controls in place to identify and track suspicious
transactions and comply with the reporting requirements of the Proceeds of Crime and Terrorist
Financing Act. This Act requires PAs to report to FINTRAC any
A) cash payment of $10,000 or more.
B) cash payment of $100,000 or more.
C) transaction of $1,000 or more from clients suspected of being terrorists.
D) cash payment to a related party.
5) A bank sues an auditor after having lost a significant amount of money from a loan granted to
a client based on the financial statements that contained a material error. The source of the legal
liability is
A) known third party liability.
B) client liability.
C) liability under provincial securities law.
D) criminal liability.
6) Amin is distraught. There is a big box stereo store that opened just down the block from his
independent stereo and music business six months ago, and he is unable to continue operating his
business. Only eight months ago, you issued an unqualified audit opinion on his financial
statements, which showed the financial results of a well run, profitable store. Amin’s business is
experiencing
A) customer expectation gap.
B) audit failure.
C) fiduciary duty.
D) business failure.
7) When the auditor issues an erroneous opinion as the result of an underlying failure to comply
with the requirements of generally accepted auditing standards, it results in
A) business failure.
B) audit failure.
C) audit risk.
D) business risk.
8) An example of an audit failure is that the
A) auditor issues an erroneous audit opinion as the result of a failure to comply with the
requirements of GAAS.
B) audit opinion is qualified.
C) company files for bankruptcy less than 12 months after receiving an unqualified opinion.
D) auditor issues an erroneous audit opinion as the result of an undiscovered fraud that took
place in the period being audited.
9) Conflict between financial statement users and auditors often arises because of the
A) high cost of performing an audit.
B) extremely technical vocabulary which the auditor uses in the report.
C) placement of the auditor’s report in the back of the client’s annual report where it is hard to
locate.
D) expectation gap.
10) For each of the following independent situations, state whether the PA would be considered
to have a fiduciary duty. Justify your response.
A) Juan is conducting a review engagement for the fifth year for Mini Market Greenwood
Limited.
B) Lisa is working as a temporary controller at Middle Manufacturing Co. while the controller
recovers from surgery.
C) Mark is managing the assets of a ten year old buy whose parents were killed in a car accident.
Mark has signing authority on cheques and makes investment decisions.
11) There are four major sources of auditor’s legal liability. Briefly summarize the four sources.
12) PA has been recently appointed auditor of Foible Ltd., a company that sells high cost
knickknacks to third world countries. To facilitate the rapid preparation of the financial
statements, management had the physical inventory counted in October, rather than at the
December year end. During the inventory count, PA noticed that several of the boxes were
labelled with receiving documents from a competitor. PA was told that the new warehouse
supervisor worked part time at the competitor, and must have picked up the wrong boxes.
Several employees have sued Foible Ltd. for wrongful dismissal, claiming that they were
promised a job that would last at least one year, with low cost accommodations as well. They are
suing for the balance of the year’s wages and claiming that they were brought into the country
under false pretenses. These employees are all from an eastern European country. The law firm
has responded in the legal letter that this suit is without merit.
During the year Foible obtained legal services from a firm in which the Chairman of the Board
of the company is a partner. Fees and disbursements for these services for the year was
$125,000, a material amount.
During the audit, employees often spoke in a foreign language among themselves before
responding to PA, then one employee would respond after some often heated discussion.
Subsequent to the year end, the warehouse supervisor was arrested on criminal charges of theft,
and Foible charged with selling stolen goods. PA was charged as an accomplice to money
laundering, as all of the management for Foible were members of a criminal group laundering
money from eastern Europe.
Required:
Discuss the actions that PA could have taken during the engagement to prevent these charges.
4.2 Explain why the accountant does not have the right of privilege communication
1) If the public accountant negligently failed to properly prepare and file a client’s tax return, the
public accountant can be held liable for
A) the penalties which the client owes Canada Customs and Revenue Agency.
B) the penalties and interest which the client owes.
C) the penalties and interest, plus the tax preparation fee which the public accountant charged.
D) the penalties and interest, the tax preparation fee, and the amount of tax which was underpaid.
2) Most of the major lawsuits against public accounting firms have dealt with
A) audited or unaudited financial statements.
B) disputes over income tax preparation services.
C) disputes arising in the performance of management consulting services contracts.
D) unaudited financial statements.
3) There is agreement within the auditing profession and the courts that the auditor is
A) not a guarantor or insurer of financial statements.
B) a guarantor but not an insurer of the statements.
C) an insurer but not a guarantor of the statements.
D) both a guarantor and an insurer of the financial statements.
4) The standard of due care to which the auditor is expected to be held is referred to as the
A) prudent person concept.
B) common law doctrine.
C) due care concept.
D) reckless regard doctrine.
5) An individual PA sets up his or her own business as a sole practitioner. With additional
practitioners, a common structure is a partnership. Why would a large firm set up its
organizational structure as a limited liability partnership (LLP)? If the audit was conducted in
accordance with GAAS
A) partners not on the engagement would not be liable on their personal assets.
B) improved quality control practices can be initiated using technical personnel.
C) more formal reporting requirements are in place to federal tax authorities.
D) partners are liable for only a limited portion of their personal assets when sued.
6) During the audit engagement, the primary auditor may rely on other individuals, such as
specialists, other auditors and internal auditors (secondary auditors). The primary way to defend
the auditor against negligence should such other individuals conduct poor quality work is
whether the
A) other individuals were professionals with recognized credentials.
B) primary auditor conducted sufficient quality control work with respect to the secondary
auditor.
C) secondary auditor had ever been sued before.
D) the appropriate level of materiality had been used during the conduct of the engagement.
7) The PA is having a discussion with his client about the outcome of several lawsuits that are
presently in progress. The client has requested that the comments during the discussion be
removed from the audit file. The client would like the only documentation in the audit file to be
the legal letter from the client, and brief comments with respect to the auditor’s judgments with
respect to the quality of disclosure in the financial statements. The client is concerned that
A) only high quality audit working papers be included in the working paper files.
B) auditors may breach confidentiality and disclose information about the client.
C) the auditor’s working paper files may be subpoenaed by the courts.
D) the audit firm does not have adequate quality control procedures.
8) An auditor would be found negligent if he/she
A) relied on a report from management without considering management integrity.
B) relied on a report that contained errors that had been concealed by management.
C) did not consider the expenses from a division due to management intentionally withholding
that information.
D) failed to discover a payroll fraud by testing a statistical sample of transactions in the salary
expense account.
9) A bank sues the auditor after making a loan to Klaxxon, a company that went bankrupt. The
bank indicates that they relied on the year-end financial statements of Klaxxon to make the
lending decision. The bank analyst indicates that the audit opinion was unqualified so he
assumed that Klaxxon was a going concern. The auditor defends himself by referring to a note
disclosure in the financial statements about the company’s economic dependence on one buyer,
Dexters Corp. Dexters Corp had experienced some significant financial trouble for the past year
and went bankrupt 3 months after the financial statements of Klaxxon were released. The PA’s
liability is likely
A) contributory negligence.
B) fraud.
C) breach of contract.
D) gross negligence.
10) An example of a breach of contract would be
A) 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.
B) an auditor’s refusal to return a client’s records until the client paid last year’s audit fees.
C) a public accounting firm’s failure to deliver a tax return on the agreed-upon date because the
firm had a backlog of other work which was more lucrative.
D) an auditor’s failure to complete the audit by the agreed-upon date because the client’s financial
records had been destroyed.
11) Laws that have been passed through federal or provincial governments are
A) statutory law.
B) judicial law.
C) criminal law.
D) common law.
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) joint and several liability.
C) shared liability.
D) unitary 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) Small Town Lumberyard Limited (STLL) needed an additional loan from its bank to finance
its operations. To make its financial statements look better, the company overstated its inventory
and overstated its accounts payable. The auditors did not detect this deliberate misstatement
because they conducted limited tests of inventory and did not confirm accounts payable. Other
auditors agreed that the procedures conducted during this audit were inadequate. The auditors of
STLL would likely be considered to be
A) guilty of fraud.
B) negligent.
C) contributorily negligent with STLL.
D) guilty of constructive fraud.
15) The principal issue to be resolved in cases involving alleged negligence is usually
A) the amount of the damages suffered by the plaintiff.
B) whether to impose punitive damages on the defendant.
C) the level of care required to be exercised.
D) whether the defendant was involved in fraud.
16) In the auditing environment, failure to meet generally accepted auditing standards is often
A) an accepted practice.
B) a suggestion of negligence.
C) strong evidence of negligence.
D) tantamount to criminal behaviour.
17) Most accounting and auditing professionals agree that when an audit has failed to uncover
material misstatements, and the wrong type of audit opinion is issued, the audit firm
A) has failed to follow generally accepted auditing standards (GAAS).
B) deserves to lose the lawsuit.
C) should be asked to defend the quality of the audit.
D) should not be held responsible for the financial loss suffered by others.
18) A common way for a public accounting firm to demonstrate its defence of a lack of duty to
perform is by use of a(n)
A) engagement letter.
B) letter of representation.
C) confirmation letter.
D) expert witness.
19) PA was engaged by Microcomputer Distributor Limited (MDL) to conduct a review
engagement. The financial statements are used primarily by the shareholders, management, and
by the bank. Recently, an employee was fired for stealing computer parts, primarily chips and
boards that could easily be placed in a pocket. MDL is suing PA because they believed that audit
procedures, such as counting inventory, would have detected this fraud. What is PA’s best
defence?
A) absence of causal connection
B) lack of negligence
C) contributory negligence
D) lack of duty to perform
20) Joan talked to the owners of Fancy Clothing Limited before investing. She obtained a copy
of their financial statements and saw that profits were low, even considering the fact that the
owners did not take any money for themselves in the current year. However, she decided to
invest in the company because she believed her superior knowledge of the clothing industry
would turn the business around, resulting in enough profits for all owners. Unfortunately, this did
not occur and the company went bankrupt. Joan is suing the auditors because she relied upon the
financial statements during her investment decision. What is the auditor’s best defence?
A) absence of misstatement
B) contributory negligence
C) non-negligent performance
D) duty of care
21) Fabio recently sold his restaurant for $650,000, the value of the net assets as reported on the
balance sheet. After the sale, Fabio realized that he could’ve sold the restaurant for as much as
$950,000 as the fair value of the assets was $300,000 higher than what was reported on the
balance sheet. Fabio is suing the auditors for his loss. The auditor’s best defence is
A) absence of a misstatement.
B) lack of duty.
C) no damages.
D) absence of causal connection.
22) According to the CICA Handbook, the auditor’s responsibility for failure to detect fraud
arises
A) when such failure clearly results from failure to comply with generally accepted auditing
standards.
B) whenever the amounts involved are material.
C) only when the examination was specifically designed to detect fraud.
D) only when such failure clearly results from negligence so gross as to sustain an inference of
fraud on the part of the auditor.
23) Winston Chang, PA conducted the audit of Manra Manufacturing Ltd., a small company that
produces a variety of machined parts for the automotive and computer industry. The audit
showed that the company produced a small profit after paying the owners of the company a high
salary. Manra was purchased by a competitor, Cheblay. Cheblay had hoped to produce
efficiencies by combining the two companies and was unable to do so. Cheblay sued Chang
because it relied upon the financial statements when purchasing the company’s shares, claiming
that the machines, which were about fifteen years old, had been overvalued. The machines were
recorded at cost, which was below net realizable value. What is the auditor’s best defence?
A) contributory negligence
B) absence of negligence
C) duty of care
D) absence of liability
24) The King Surety Company wrote a general fidelity bond covering defalcations 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, public accountants. Which of the following would be Lynch &
Merritt’s best defence?
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 negligence or fraud.
D) Lynch & Merritt were not aware of the King-Wilson surety relationship.
25) In connection with the examination of financial statements, an 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 work in a hasty and ineffective 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 client employee, who circumvented the existing internal
controls.
26) To succeed in an action against the auditor, the client must be able to show that
A) the auditor was grossly negligent.
B) the auditor was fraudulent.
C) there is a close causal connection between the auditor’s breach of the standard of due care and
the damages suffered by the client.
D) there was a written contract.
27) The court ruled that Jones did not rely on the financial statements in his decision to purchase
shares of Manumite Limited. Instead, Jones relied upon his discussions with the owners and with
financial analysts. This result illustrates
A) absence of negligence.
B) lack of privity.
C) contributory negligence.
D) absence of causal connection.