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5-8
5-19 (continued)
3. Given that the auditors were able to satisfy themselves through
nonnegligent.
4. The facts in this scenario suggest fraudulent behavior as there is
behavior if subject to the Sarbanes-Oxley Act.
5. In this scenario, Melissa Louis’ behavior would be considered
5-20 a. Yost and Co. should use the defenses of meeting auditing standards
and contributory negligence. The fraud perpetuated by Stuart Supply
In most circumstances it would not be necessary to physically
count all inventory at different locations on the same day.
b. There are two defenses Yost and Co. should use in a suit by First
City National Bank. First, there is a lack of privity of contract. Even
though the bank was a known third party, it does not
necessarily mean that there is any duty to that party in this situation.
c. She is likely to be successful in her defense against the client
because of the contributory negligence. The company has
responsibility for instituting adequate internal controls. The president’s
It is also unlikely that First City National Bank will be
successful in a suit. The court is likely to conclude that Yost
followed due care in the performance of her work. The fact that
5-9
5-20 (continued)
d. The issues and outcomes should be essentially the same under
the suit brought under the Securities Exchange Act of 1934. If the
5-21 Yes. Normally a CPA firm will not be liable to third parties with whom it
has neither dealt with nor for whose benefit its work was performed. One
notable exception to this rule is fraud. When the financial statements were
fraudulently prepared, liability runs to all third parties who relied upon the false
information contained in them. Fraud can be either actual or constructive. Here,
there was no actual fraud on the part of Small or the firm in that there was no
5-22 The answers provided in this section are based on the assumption that
the traditional legal relationship exists between the CPA firm and the third-party
a. False. There was no privity of contract between Thompson and
b. True. If gross negligence is proven, the CPA firm can and probably
c. True. See a.
d. False. Gross negligence (constructive fraud) is treated as actual
e. False. Thompson is an unknown third party and will probably be
Assuming a liberal interpretation of the legal relationship between auditors
5-10
5-23 a. Hanover will likely not be found liable to the purchasers of the
common stock if the suit is brought under Rule 10b-5 of the
b. Hanover was aware that the financial statements were to be used
to obtain financing from First National Bank. Hanover is likely to
c. The plaintiffs might state a common law action for negligence.
However, they will most likely not prevail due to the privity
requirement. There was no contractual relationship between the
5-24
acts.
2. c Both. Monetary loss must be demonstrated under both acts.
3. d Neither. Plaintiff does not have to prove lack of diligence
1934 act.
and 1934 acts.
5. b 1934 act only. Reliance is not required under the 1933 act.
5-25 The bank is likely to succeed. Robertson apparently knew that Majestic
was “technically bankrupt” at December 31, 2015. Reporting standards require
the auditor to add an explanatory paragraph to the audit report when there is
substantial doubt about an entity’s ability to continue as a going concern. She
did not include such a paragraph. To make matters worse, it appears that
5-11
5-25 (continued)
the statement about her knowledge of Majestic’s financial condition.
Robertson might also falsely testify that she did not believe that a
5-26 a. The SEC enforcement release is filed against Diamond Foods,
Inc., and its former CEO and former CFO. They are charged with
intentionally overstating earnings to meet analysts’ forecasts. The
CFO directed the effort to understate costs by deferring the costs
b. The complaint alleges violations of sections of both the Securities
Act of 1933 and the Securities Exchange Act of 1934, including
Rule 10b-5, and also for the CFO, Section 304 of the Sarbanes-
Oxley Act (requiring forfeiture of certain bonuses and profits).
may be considered negligent.
Case
5-27 PART 1
Thaxton must establish that:
1. There was an omission or misstatement of a material fact
5-12
5-27 PART 1 (continued)
shares of stock.
statements.
4. Mitchell & Moss acted with scienter (knowledge of the
misstatement).
that Mitchell & Moss did not have knowledge of the fraud and did
not recklessly disregard the truth.
shareholders must also establish either that:
1. They were third-party beneficiaries of Mitchell & Moss’
contract to audit Whitlow & Company, or
Although many cases have expanded a CPA’s legal responsibilities
to a third party for negligence, the facts of this case may fall within
the traditional rationale limiting a CPA’s liability for negligence; that
is, the unfairness of imputing an indeterminate amount of liability
5-27 PART 2
a. The basis of Jackson’s claim will be that she sustained a loss based
5-13
5-27 PART 2 (continued)
time of such acquisition he knew of such untruth or
omission) may, either at law or in equity, in any court of
in order to recover the damages. The burden is placed on the
defendant to provide defenses that will enable it to avoid liability.
b. The first defense that could be asserted is that Jackson knew of
contained in a registration statement, plus any other information
requested by the group, she may have had sufficient knowledge of
the facts claimed to be untrue or omitted. If this were the case,
then she would not be relying on the certified financial statements
but upon her own knowledge.
have deterred or tended to deter the average prudent investor
from purchasing the security in question.
Allen, Dunn, and Rose would also assert that the loss in
question was not due to the false statement or omission; that is,
5-14
5-27 PART 2 (continued)
was not factually connected with the false statement or omission,
