978-0134065823 Chapter 5 Solution Manual Part 1

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Chapter 5

Legal Liability

 Concept Checks

P. 118

1. Several factors that have affected the increased number of lawsuits against

CPAs are:

responsibility for protecting investors’ interests.

 The greater complexities of auditing and accounting due to the

 Society’s increasing acceptance of lawsuits.

basis.

 The willingness of many CPA firms to settle their legal problems out

of court.

2. Business failure is the risk that a business will fail financially and, as a

result, will be unable to pay its financial obligations. Audit risk is the risk that the

recently issued audited financial statements were fairly stated. Many auditors

3. The difference between fraud and constructive fraud is that in fraud the

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P. 129

1. The four major sources of auditor legal liability are:

 Liability to clients.

2. Liability to clients under common law has remained relatively unchanged

for many years. If a CPA firm breaches an implied or expressed contract with a

except in the case of gross negligence.

the services (foreseen users). Still others have rejected the Ultramares doctrine

entirely and have held the CPA liable to anyone who relies on the CPA’s work, if

3. Under the 1934 act, the burden of proof is on third parties to show that

they relied on the statements and that the misleading statements were the

cause of the loss. The principal focus of accountants’ liability under the 1934

act is on Rule 10b–5. Under Rule 10b–5, accountants generally can only be held

 Review Questions

5–1 The most important positive effects are the increased quality control by

CPA firms that is likely to result from actual and potential lawsuits and the ability

of injured parties to receive remuneration for their damages. Negative effects

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5–2 Audit risk is the risk that the auditor concludes, after conducting an audit

in accordance with the relevant auditing standards, that the financial statements

were fairly stated when in fact they were materially misstated. Audit failure

occurs when the auditor issues an incorrect audit opinion because it failed to

comply with the relevant auditing standards. There is some level of audit risk on

every audit engagement because it would be prohibitively costly for auditors to

test every transaction and balance. Auditors gather evidence on a test basis,

and thus may fail to detect a misstatement even though they comply with

5–4 Many CPA firms willingly settle lawsuits out of court in an attempt to

minimize legal costs and avoid adverse publicity. This has a negative effect on

the profession when a CPA firm agrees to settlements even though it believes

that the firm is not liable to the plaintiffs. This encourages others to sue CPA

5–5 Contributory negligence used in legal liability of auditors is a defense used

by the auditor when he or she claims the client or user also had a responsibility

in the legal case. An example is the claim by the auditor that management knew

5–6 An auditor’s best defense for failure to detect a fraud is an audit properly

conducted in accordance with auditing standards. The Principles in auditing

standards (see Chapter 2) note that the objective of an audit is to obtain

reasonable assurance that the financial statements are free of material

5–7 An engagement letter from the auditor to the client specifies the

responsibilities of both parties and states such matters as fee arrangements and

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5–7 (continued)

easily disputed.

5–8 In more recent years, the auditor’s liability to a third party has become

affected by whether the party is known or unknown. Now a known third party,

under common law, usually has the same rights as the party that is privy to the

5–9 The differences between the auditor’s liability under the securities acts of

1933 and 1934 are because the 1933 act imposes a heavier burden on the

auditor. Third party rights as presented in the 1933 act are:

registration statement may sue the auditor.

2. Third party users do not have the burden of proof that they relied

1. The statements were not materially misstated.

2. An adequate audit was conducted.

3. The user did not incur the loss because of misleading financial

statements.

The liability of auditors under the 1934 act is not as harsh as under the

1933 act. In this instance, the burden of proof is on third parties to show that

The principal focus of accountants’ liability under the 1934 act is on Rule

10b–5. Under Rule 10b–5, accountants generally can only be held liable if they

intentionally or recklessly misrepresent information intended for third–party use.

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5–10 The auditor’s legal liability to the client can result from the auditor’s failure

to properly fulfill his or her contract for services. The lawsuit can be for breach

of contract, which is a claim that the contract was not performed in the manner

agreed upon, or it can be a tort action for negligence. An example would be the

client’s detection of a misstatement in the financial statements, which would

have been discovered if the auditor had performed all audit procedures required

in the circumstances (e.g., misstatement of inventory resulting from an inaccurate

physical inventory not properly observed by the auditor).

The auditor’s liability to third parties under common law results from any

loss incurred by the claimant due to reliance upon misleading financial statements.

omission.

Civil liability under the Securities Act of 1933 provides the right of third

parties to sue the auditor for damages if a registration statement or a prospectus

contains an untrue statement of a material fact or omits to state a material fact

that results in misleading financial statements. The third party does not have to

the auditor for negligence.

Civil liability under the Securities Act of 1934 relates to audited financial

statements issued to the public in annual reports or 10–K reports. Rule 10b–5 of

the act prohibits fraudulent activity by direct sellers of securities. Several federal

would be an auditor’s certifying financial statements that he or she knows

overstate income for the year and the financial position of the company at the

audit date.

1. Suspend the right to conduct audits of SEC clients.

2. Prohibit a firm from accepting any new clients for a period.

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5–12 The Sarbanes–Oxley Act of 2002 made it a felony to destroy or create

documents to impede or obstruct a federal investigation. As a result of the

Sarbanes–Oxley Act, a person may face fines and imprisonment for altering or

destroying documents.

5–13 Some of the ways in which the profession can positively respond and

reduce liability in auditing are:

1. Continued research in auditing.

of auditing.

3. The AICPA can establish requirements that the better practitioners

always follow in an effort to increase the overall quality of auditing.

4. Establish new peer review requirements.

settling out of court.

the attest function.

7. Improper conduct and performance by members must be sanctioned.

8. Lobby for changes in state and federal laws concerning accountants’

liability.

 Multiple Choice Questions From CPA Examinations

5–14 a. (1) b. (4) c. (3)

5–15 a. (3) b. (2) c. (4)

 Multiple Choice Questions From Becker CPA Exam Review

5–16 a. (4) b. (3) c. (2)

 Discussion Questions and Problems

5–17 1. The plaintiff will most likely not be able to seek restitution from

Brogan’s personal assets given the firm operates as a limited liability

recklessness.

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5–17 (continued)

despite the company’s subsequent bankruptcy.

4. Under common law, CPAs do not have the right to withhold

information from the courts on the grounds that the information is

privileged. Confidential discussions between the client and the

the documentation requested by the subpoena.

5. Spencer Cullen will most likely be liable for gross negligence for

failure to obtain sufficient appropriate evidence to examine the

5–18 1. c (fraud)

i (gross negligence)

2. d (ordinary negligence)

h (privity of contract)

3. a (due diligence)

supervise them, but likely did not intend to deceive the bank. At a

minimum, Marquez’s behavior constitutes constructive fraud,

which is extreme or unusual negligence without intent to deceive

(also called recklessness).