28) A client is suing a PA firm claiming that they are responsible for the losses suffered from a
fraud in the payroll department that was not uncovered during the year end testing done by the
auditor. The auditors did indicate to management that controls over payroll calculations and
payments were weak as there was improper segregation of duties. The auditor’s best defence is
A) contributory negligence.
B) absence of negligence.
C) absence of causal connection.
D) no damages.
29) A) List the four items which a defendant must prove in an action for negligence against a
public accountant.
B) Describe each of the six defences a public accounting firm can normally use when facing
legal claims by clients.
C) Discuss what is meant by the term “expectation gap.”
30) A) What are the different business organization structures that an accountant may use? What
are the advantages of these structures?
B) What is the difference between auditors and lawyers with respect to privileged information?
31) You are the auditor of Jehello Incorporated, a public company with a December year end.
Your firm has audited Jehello for the past three years. The following issues were documented in
the working paper files for the prior year audit:
∙ The company had incurred expenditures of $400,000 related to the development of a new music
format for electronic media. The large majority of the costs were related to development of
software, hardware, and presentation of the results to customers who participated in focus
groups. Management had been optimistic that the new sound system would work well, even
though focus group results had been poor. These costs had been fully capitalized.
∙ About 40% of the company’s revenues were from one customer. That contract had been due for
renewal on May 15, ten days after the audit report had been issued. Documents on file indicated
that the customer seemed likely to renew the contract, although quality control disputes were
escalating. On May 14, Jehello was informed that the contract would not be renewed.
Jehello has defaulted on its bank loans and the bank is suing you, saying that the financial
statements presented last year were false and misleading.
Required:
A) Which defences should the auditor use?
B) Do you believe that the auditor will lose the suit? Why or why not?
32) Your firm has been the auditor of Chappello Design and Construction Limited for several
years. During the current year, a consultant on staff at your firm assisted Chappello in the
selection and implementation of a new computer system. The audit staff were not involved in
this process.
The new system was an enterprise wide system that was to be implemented without
modification using the direct cut-over approach (the old system was discontinued and the new
one continued the next day). Unfortunately, staff had extreme difficulty using the system, and
discontinued it after two months. During that time, Chappello was unable to document and bill
its work for progress billings, and borrowed heavily to continue to pay its employees while work
continued. The company reverted to its old system and claims that it has lost several hundreds of
thousands of dollars in revenues as it was unable to issue quotes and bids on new contracts.
Chappello has sued your firm for negligence with respect to the implementation of the computer
system.
Required:
Which defences should the firm use? Support your answer with reasons.
33) Musical Productions Limited has had declining sales as more and more media are being
presented online rather than on CD or DVD. It diversified its business by moving into backup
systems, but are still having trouble boosting income.
The audit team was led by Theresa Sanford, who obtained her CA last year. Theresa had two
assistants, Marv and Uhta, who did the work in the accounts receivable and inventory area.
Theresa felt that they did not require supervision, as they had been with the firm for two years,
and were expected to do well on their professional exams this year. Marv found that the accounts
receivable had many old accounts, and customers were tough to get hold of. Accordingly, he
decided to accept management’s representations with respect to the balances. Similarly, Uhta
noted that there were still many CDs in inventory that had been there for over three years.
Management insisted on recording these at cost. Uhta accepted managements’ valuation.
Two months after the audit report was issued, Musical Productions Limited went bankrupt. It
was found that many accounts receivable were for fictitious customers, and the receiver was only
able to obtain five cents on the dollar for the inventory, which was sold as scrap.
The bank is suing the auditors to recover its bank loan, which had been renegotiated based upon
the results of the financial statements.
Required:
Will the bank be successful in its suit? Why or why not?
1) An investor suing an auditor for not discovering that the financial statements of a company are
materially misstated is an example of
A) criminal liability.
B) fiduciary duty.
C) third party liability.
D) liability to client under common law.
2) The leading precedent-setting case in third-party liability was a 1931 U.S. case, Ultramares v.
Touche. What is the key aspect of this case?
A) to succeed, claimants must be foreseebale users of the audited financial statements that are
part of the claim process
B) ordinary negligence is insufficient for liability to third parties because of lack of privity of
contract
C) the auditor must have actual knowledge of the users of the financial statements to establish
privity
D) there is no general auditor liability to shareholders, since the loss of equity was suffered by
the company
3) The Ultramares doctrine is that ordinary negligence is insufficient for liability of auditors to
third parties because of the lack of privity of contract between the third party and the auditor.
What type of behaviour on the part of an auditor would result in liability to more general third
parties according to this doctrine?
A) conducting an audit engagement when a review engagement had been contracted
B) completing work in accordance with a contract that was signed with the client
C) deliberate misstatement of the financial statements by management remaining undetected
D) fraud or constructive fraud with respect to the working papers
4) Which of the following lawsuits resulted in a decision that shareholders could not sue the
auditors for the loss in the value of their shares?
A) Haig V. Bamford et al (1976)
B) Hercules Management Ltd. V. Ernst & Young (1997)
C) Ultramers Corporation V. Touche (1931)
D) United States V. Anderson (2002)
5) What rights do secondary investors (i.e. those who purchase shares after an initial offering)
have to sue an auditor?
A) since they are third-party claimants, they would be part of a limited class of known users
B) they could claim contributory negligence, since they had prior information of company results
C) they can sue under provincial legislation without the need to prove reliance
D) since there is absence of causal connection, they would not be able to sue the auditors
6) In third party suits, when there is a misstatement in the financial statements, which of the
auditor’s defences usually means non-reliance on the financial statements by the user?
A) lack of duty
B) non-negligent performance
C) contributory negligence
D) absence of causal connections
7) Pierre, a CA, was convicted of stealing money from his clients and for deliberately preparing
personal tax returns that were false. In addition, Pierre will likely
A) need to take additional training courses to upgrade his tax skills.
B) need to defend himself to prove non-negligent performance.
C) be charged with misconduct by his professional institute (or ordre).
D) have lack of privity with the federal and provincial tax authorities.
8) The Sarbanes-Oxley Act of 2002 made it a felony to
A) destroy or create documents to impede a federal investigation.
B) have internal control weaknesses.
C) have a significant internal control weakness.
D) engage in transactions with related parties.
9) In the case of Enron, Andersen was ultimately convicted on the count of
A) obstruction of justice for altering a memo.
B) obstruction of justice for shredding documents relating to the audit of Enron.
C) failing to discover the fraud.
D) refusing to testify in court against their client.
10) Enron and Equity Funding are companies that suffered from large frauds by corporate
management. One important lesson with respect to such cases is that
A) when a company does really well financially it is important to suspect that such results are
always inflated.
B) an investigation of the integrity of management is an important part of deciding upon the
extent of audit work.
C) securities and exchange commissions expect auditors to be perfect in their assessment of
management.
D) partners and staff should cooperate in preparing working papers that prove the accuracy of the
financial statements.
11) Individuals who accept fees (or property), should they know or be willfully blind to the fact
that the property was obtained illegally can be charged with money laundering, a criminal
offence. Which of the following techniques will help a PA prevent such charges?
A) ensure that the financial statements are in accordance with an acceptable reporting framework
B) require that clients carefully document the sources of their funds.
C) carefully assess management integrity.
D) obtain a detailed letter of representation from management confirming the sources of their
funds.
12) Bigland and Betton, PAs, is being sued by a bank for potential negligence during an audit
engagement which was completed over five years ago. Which one of the following actions
during that audit engagement will help ensure that the suit is fairly assessed?
A) good quality documentation
B) honest management at the client
C) low employee turnover
D) good employee memory of events
13) One of the lessons learnt from accounting scandals such as Enron is that generally accepted
accounting principles (now under an acceptable financial reporting framework) cannot be relied
upon exclusively in deciding whether financial statements are fairly presented. Why is this the
case?
4.4 List the actions that individual accountants and the profession can undertake to mitigate the
risks of legal liability
1) There are a number of things that the CICA, representing the profession as a whole, can do to
reduce the practitioner’s exposure to lawsuits. One of them is to
A) sanction members for improper conduct and performance.
B) deal only with clients possessing integrity.
C) hire qualified auditors and train and supervise them.
D) perform quality audits.
2) Danford, PA, is setting up his accounting firm as a sole practitioner. Which of the following is
an important way that Danford can reduce legal liability with respect to the work completed by
his office?
A) participate in the standard setting process for audit engagements
B) find out when his practice is due for practice inspection
C) hire only qualified personnel and train them well
D) sanction other PAs who engage in improper conduct
3) There are a number of things that the practising auditor can do to reduce the liability in
lawsuits. One of them is to
A) lobby for changes in laws.
B) carry adequate insurance.
C) establish peer review requirements.
D) revise auditing standards to meet the changing needs of society.
4) A) Describe some of the steps the CICA and the accounting profession as a whole can and are
taking to reduce the practitioner’s exposure to lawsuits.
B) Describe some of the steps individual practising auditors can take to minimize their legal
liability.
5) Sandra is a new partner at a PA firm. Sandra recently signed a new contract with Gretchen
Fabrics to become its auditor. In the process of accepting the client and planning the first year’s
audit, Sandra did the following:
– Sandra contacted the previous auditor to enquire if there were any reasons not to accept the
audit of this client. Unfortunately, the previous auditor was on vacation and did not respond to
Sandra before she accepted the client.
– Upon his return, the previous auditor did communicate with Sandra and indicated that the client
had aggressive expense deferral policies that they disagreed on. Sandra asked to review the
working papers of the previous auditor with regards to these expenses and found them to be right
below the materiality threshold.
– Gretchen Fabrics imports most of its fabrics and has two production facilities in Asia. The
company therefore has a complex tax structure and many import duties. Since this is not the area
of expertise of Sandra, she asked another auditing firm to provide the required audit procedures
for the international taxes and duties expense. When selecting the other audit firm, Sandra
researched the firm on the internet. She also ensured that they had their professional designation
and enquired with the CICA and provincial association if the firm had any complaints or
litigation outstanding for malpractice.
– Since the bidding process took time, Sandra had to start the audit almost right after learning she
had the winning bid. She did not prepare an engagement letter before starting the work. She does
not see this as being a problem since waiting until the audit has begun will provide her with a
better idea of what work has to be done and what the engagement letter should include.
Required:
Identify the good and bad steps that Sandra has undertaken in reducing her exposure to legal
liability.
4.5 Identify the actions that accountants should take to determine which legislation has an
impact on their work
1) How do quality control processes for the financial statement audit process incorporate
consideration of legislation that affects the client?
A) requiring second partner review of all working partners that relate to legislative matters
B) provide auditors with copies of legislation that affects their client
C) train all auditors in legislation details that could affect all clients
D) include in audit checklists questions that address relevant new legislation