ANSWERS TO PROBLEMS
1. Baldwin Corporation made a public offering of $25 million of convertible debentures
and registered the offering with the SEC. The registration statement contained financial
statements certified by Adams and Allen, Certified Public Accountants. The financial
statements overstated Baldwin’s net income and assets by 20 percent and understated the
company’s liability by 15 percent. Because Adams and Allen did not carefully follow
Generally Accepted Accounting Standards, it failed to detect these inaccuracies, the
discovery of which has caused the bond prices to drop from their original selling price of
$1,000 per bond to $720. Can Conrad, who purchased $10,000 of the debentures, collect
from Adams and Allen for his damages? Explain.
2. Ingram is a Certified Public Accountant (CPA) employed by Jordan, Keller and Lane,
CPAs, to audit Martin Enterprises, Inc., a fast-growing service firm that went public two
years ago. The financial statements Ingram audited were included in a proxy statement
$10.5 million. Third, Martin’s net profits for the current year were reported as $700,000,
when the firm actually had no earnings at all.
(a) What civil liability, if any, does Ingram have?
(b) What criminal liability, if any, does Ingram have?
Answer: Liability: Securities Exchange Act of 1934.
(a) Ingram is civilly liable under Section 18 of the 1934 Act unless he can show that he
3. Girard & Company, Certified Public Accountants, audited the financial statements
included in the annual report submitted by PMG Enterprises, Inc., to the Securities and
Exchange Commission (SEC). The audit failed to detect numerous false and misleading
statements contained in the financial statements.
(a) Investors who subsequently purchased PMG stock have brought suit against Girard
under Section 18 of the 1934 Act. What defenses, if any, are available to Girard?
(b) The SEC has initiated criminal proceedings under the 1934 Act against Girard. What
must be proven for Girard to be held criminally liable?
Answer: Liability: Securities Exchange Act of 1934.
(a) Under Section 18 of the 1934 Act, Girard’s defense would be that it acted in good faith
and that it had no knowledge that the financial statement was false or misleading. Section
18 imposes express civil liability upon an accountant if she makes or causes to be made
negligence on his part and that he had no knowledge of the fraudulent conduct. Is
Dryden liable under the Securities Exchange Act of 1934? Why?
5. Johnson Enterprises, Inc., contracted with the accounting firm of P, A & E to perform an
audit of Johnson. The accounting firm performed its duty in a nonnegligent, competent
manner but failed to discover a novel embezzlement scheme perpetrated by Johnson’s
treasurer. Shortly thereafter, Johnson’s treasurer disappeared with $75,000 of the
company’s money. Johnson now refuses to pay P, A & E its $20,000 audit fee and is
seeking to recover $75,000 from P, A & E.
(a) What are the rights and liabilities of P, A & E and Johnson? Explain.
(b) Would your answer to (a) differ if the scheme were a common embezzlement scheme
that Generally Accepted Accounting Standards should have disclosed? Explain.
Answer: Negligence Liability.
(a) P, A & E will collect its $20,000 audit fee from Johnson and will not be liable to
Johnson for the $75,000 embezzled by Johnson’s treasurer. An auditor’s duty to its client
6. The accounting firm of T, W & S was engaged to perform an audit of Progate
Manufacturing Company. During the course of its investigation, T, W & S discovered that
the company had overvalued its inventory by carrying the inventory on the books at the
previous year’s prices, which were significantly higher than current prices. When T, W &
statement. What are the rights and liabilities of First National Bank, Thomas, and T, W &
S?
7. J, B & J, Certified Public Accountants, has audited the Highcredit Corporation for the
past five years. Recently, the Securities and Exchange Commission (SEC) has
commenced an investigation of Highcredit for possible violations of Federal securities
law. The SEC has subpoenaed all of J, B & J’s working papers pertinent to the audit of
Highcredit. Highcredit insists that J, B & J not turn over the documents to the SEC. What
action should J, B & J take? Why?
8. On February 1, the Gazette Corporation hired Susan Sharp to conduct an audit of its
books and to prepare financial statements for the corporation’s annual meeting on July 1.
Sharp made every reasonable attempt to comply with the deadline but could not finish the
report on time due to delays in receiving needed information from Gazette. Gazette now
refuses to pay Sharp for her audit and is threatening to bring a cause of action against
Sharp. What course of action should Sharp pursue? Why?
9. John P. Butler Accountancy Corporation agreed to audit the financial statements of
Westside Mortgage, Inc., a mortgage company that arranged financing for real property,
for the year ending December 31, 2012. On March 22, 2013, after completing the audit,
Butler issued unqualified audited financial statements listing Westside’s corporate net
worth as $175,036. The primary asset on the balance sheet was a $100,000 note
receivable that had, in reality, been rendered worthless in August 2011 when the trust
deed on real property securing the note was wiped out by a prior foreclosure of a
superior deed of trust. The note constituted 57 percent of Westside’s net worth and was
thus material to an accurate representation of Westside’s financial position. In October
2013, International Mortgage Company (IMC) approached Westside for the purpose of
buying and selling loans on the secondary market. IMC signed an agreement with
Westside in December after reviewing Westside’s audited financial statements. In June
2014, Westside issued a $475,293 promissory note to IMC, on which it ultimately
defaulted. IMC brought an action against Westside, its owners, principals, and Butler.
IMC alleged negligence and negligent misrepresentation against Butler in auditing and
issuing without qualification the defective financial statements on which IMC relied in
deciding to do business with Westside. Butler claimed that it owed no duty of care to
IMC, a third party who was not specifically known to Butler as an intended recipient of
the audited financial statements. Is Butler correct? Explain.
Answer: Negligence. Judgment for IMC. The landmark opinion in applying the “duty”
doctrine to the accounting profession is that of Justice Cardozo in Ultramares Corp. v.
Touche, where the liability of a CPA in preparing and issuing unqualified audited
financial statements was limited to those “in privity” with the accountant. The
10. Equisure, Inc., was required to file audited financial statements when it applied to have
its stock listed on the American Stock Exchange (AmEx). It retained an accounting firm,
defendant Stirtz Bernards Boyden Surdel & Larter, P.A. (Stirtz). Stirtz issued a favorable
interim audit report that Equisure used to gain listing on the stock exchange.
Subsequently, Equisure retained Stirtz to audit the financial statements required for
Equisure’s Form 10 filing with the U.S. Securities and Exchange Commission (SEC).
Stirtz’s auditor knew that the audit was for the SEC reports. Stirtz issued a “clean” audit
opinion, which, with the audited financial statements, was included in Equisure’s SEC
filing and made available to the public. NorAm Investment Services, Inc., also known as
Equity Securities Trading Company, Inc. (NorAm), a securities broker, began lending
margin credit to purchasers of Equisure stock. These purchasers advanced only a portion
of the purchase price; NorAm extended credit (a margin loan) for the balance and held
the stock as collateral for the loan, charging interest on the balance. When NorAm had
loaned approximately $900,000 in margin credit, its president, Nathan Newman,
reviewed Stirtz’s audit report and the audited financial statements. Based on his review,
NorAm extended more than $1.6 million of additional margin credit for the purchase of
Equisure shares. When AmEx stopped trading Equisure stock due to allegations of
insider trading and possible stock manipulation, the stock became worthless. NorAm was
left without collateral for more than $2.5 million in margin loans. Stirtz resigned as
auditor of Equisure and warned that its audit report might be misleading and should no
longer be relied upon. NorAm sued Stirtz for negligent misrepresentation and negligence.
Explain whether or not NorAm will prevail.
Answer: Liability: NorAm should not prevail. The Restatement (Second) of Torts § 552 sets
out the criteria for accountants’ liability to third parties who rely on the accountants’
negligent audits: An auditor may be held liable for negligent misrepresentations in an
audit report to those persons who act in reliance upon those misrepresentations in a
ANSWERS TO “TAKING SIDES” PROBLEMS
Arthur Young & Co., a firm of certified public accountants, was the independent auditor for
Amerada Hess Corporation. During its review of Amerada’s financial statements as
required by federal securities laws, Young confirmed Amerada’s statement of its contingent
tax liabilities and prepared tax accrual work papers. These work papers, which pertained to
Young’s evaluation of Amerada’s reserves for contingent tax liabilities, included discussions
of questionable positions Amerada might have taken on its tax returns. The Internal Revenue
Service (IRS) initiated a criminal investigation of Amerada’s tax returns when, during a
routine audit, it discovered questionable payments made by Amerada from a “special
disbursement account.” The IRS summoned Young to make available all its information
relating to Amerada, including the tax accrual work papers. Amerada instructed Young not
to obey the summons. The IRS then brought an action against Young to enforce the
administrative summons.
(a) What are the arguments that Young must turn over the work papers?
(b) What are the arguments that the work papers are protected from government
summons?
(c) Who should prevail? Explain.
ANSWER:
(a) The work papers of an accountant, like attorney work papers, should be protected
from government subpoena. If not, clients will not be fully honest with their
accountant in fear of information being divulged to government officials.