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Auditing: A Risk Based Approach to Conducting a Quality Audit, 10e
Solutions for Chapter 4
True/False Questions
4-1 F
4-2 T
4-4 F
4-6 F
4-8 T
4-10 F
4-12 F
Multiple-Choice Questions
4-13 C
4-14 C
4-16 E
4-18 B
4-20 E
4-22 E
4-24 C
Review and Short Case Questions
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The reasons for continued high rates of litigation against auditors include:
• Liability doctrines that include joint and several liability statutes permitting a
plaintiff to recover the full amount of a settlement from an external auditing firm,
even though that firm is found to be only partially responsible for the loss (often
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• Breach of contract occurs when a person fails to perform a contractual duty. As an
example, an auditor was hired to find a material fraud. If reasonable procedures
would have detected the fraud and the auditor failed to uncover the fraud, the auditor
would have breached the contract. As another example, if the auditor agreed to
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• Common law is developed through court decisions, such as the Ultramares case.
• Statutory law is created by legislation, such as the Securities Act of 1933, the 1934
Securities and Exchange Act, and the Sarbanes-Oxley Act of 2002.
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The potential causes for action against the auditor for breach of contract include
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Remedies include:
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a. The auditor can use the following as defenses against a breach of contract suit:
• The auditor used due professional care.
b. Defenses under statutory law are:
• The auditor used due professional care.
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a. Moss Adams is being sued by the trustee because the auditor failed to detect the
4-4
4-32
The three primary tests that have been utilized by the courts include:
• Identified user test
• Foreseen user test
• Foreseeable user test
The class of potential users, and thus the number of users, increases as one moves from
the identified user test to the foreseeable user test as described below.
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Auditors found to be unqualified, unethical, or in willful violation of any provision of the
federal securities laws can be disciplined by the SEC. Possible sanctions available to the
SEC include:
• Temporarily or permanently revoking the firm’s registration with the Public
Company Accounting Oversight Board (PCAOB), meaning that the SEC will not
4-5
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a. The primary purpose of the Securities Act of 1933, which deals with bringing new
debt or equity issues to market, is to ensure that prospective investors are
provided full and accurate information for making investment decisions. It shifts
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Under the 1933 Act, the auditor is liable to third parties for fraud, gross negligence, and
negligence. The auditor has the burden of proving his or her innocence. Under this Act,
anyone may sue on the grounds that the financial statements were misleading and they
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Yes, there is a conceptual difference between an error and ordinary negligence. Errors in
judgment can, and do, occur on almost every audit such as when the auditor may have
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4-37
The Hochfelder case is a U.S. Supreme Court case that established the negligence
standard for cases brought under Rule 10-b5 of the 1934 Securities and Exchange Act.
The standard set by the court was scienter. The Court attempted to interpret the intent of
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a. The plaintiff would win because the plaintiff is a primary beneficiary and meets
the identified user test.
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a. Under the Ultramares precedent, the auditor is liable for negligence only to third
parties who are the primary beneficiaries of the audit as specified in the engagement
letter.
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b. Opinions will vary widely on this question. Points to discuss include:
• Should all likely users financially injured because of the auditor’s carelessness
be able to recover their losses from the auditor? Does this approach encourage
frivolous lawsuits that waste a lot of time and money?
• Does society benefit from the rash of litigation against auditors and other
professionals who are negligent? Or does this approach tie up time the
professionals could better spend performing their normal duties?
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4-41
The auditor could try to prove that the audit did not cause the investor’s loss. The investor
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The auditor could also try the defense that the investor was not an identified or foreseen
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a. The bank is an identified user if it can be shown that the auditor knew that the audit
was done for the primary purpose of obtaining a loan from First Bank.
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a. True. It deals with the public registration of securities.
b. True. The 1933 Act liability provisions are broad and include anyone who would
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a. Crea is not liable to the purchasers of the common stock. To establish a cause of
action under Section 10(b) and Rule 10b-5 of the 1934 Act, the purchasers
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because such conduct amounts merely to negligence. Therefore, Crea will not be
liable for damages under the 1934 Act. If the purchasers of the stock could prove
gross negligence, they might win. The Hochfelder case did not clarify the issue of
gross negligence liability.
b. Crea is likely to be held liable to Safe and the purchasers of the stock under the
1933 Act because of the auditor’s negligence. Safe and the purchasers need only
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Part A
a. Peters will not prevail. The facts do not involve liability in the sale of registered
securities or liability for reports filed with the SEC. Because the stock
transactions involved interstate commerce, Peter’s claim may be based on Rule
10b-5 under the Securities Exchange Act of 1934. He will have to show scienter
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Part B
a. Ira will likely prevail and recover damages from Baker.
b. Ira will base his action on Section 11 of the Securities Act of 1933, which imposes
liability on experts, including accountants, whose opinions appear in a registration
statement. The experts are liable to all those who in relying on their opinions, purchase
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The steps are: (1) structure the problem, (2) assess consequences of decision, (3) assess
risks and uncertainties of the problem, (4) evaluate information/evidence gathering
alternatives, (5) conduct sensitivity analysis, (6) gather additional evidence, and (7) make
the decision.
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Professional judgment involves applying relevant professional knowledge and experience
to unique and potentially uncertain facts and circumstances in order to reach a conclusion
or make a decision. Professional judgment is the key to conducting a quality audit.
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Professional skepticism is important because without it auditors are susceptible to
accepting weak or inaccurate audit evidence. By exercising adequate professional
skepticism, auditors are less likely to overlook unusual circumstances, to over generalize
from limited audit evidence, or to use inappropriate assumptions in determining the
nature, timing, and extent of audit procedures. An auditor who is professionally skeptical
will do the following:
• Critically question contradictory audit evidence
• Carefully evaluate the reliability of audit evidence, especially in situations in
which fraud risk is high and/or only a single piece of evidence exists to support a
material financial accounting transaction or amount
• Reasonably question the authenticity of documentation, while accepting that
understanding.
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a. Scharfman appears to have conducted sham audits in each of these cases. He
accepted engagements and then completed them in a number of days, rather than
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4-50
Utilitarian theory holds that what is ethical is the action that achieves the greatest good
for the greatest number of people. Actions that result in outcomes that fall short of the
greatest good for the greatest number and those that represent inefficient means to
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Rights theory focuses on evaluating actions based on the fundamental rights of the parties
involved. The highest order rights include the right to life, to autonomy, and to human
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The steps are: (1) identify the ethical issue, (2) determine affected parties and identify
4-53
a. The ethical dilemma faced by Birkert’s colleague and friend was whether or not
to report her inappropriate actions to superiors at KPMG. Such an allegation
would clearly lead to dire consequences for Birkert, and the individual likely
considered the obvious loss of the friendship should Birkert determine who made
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Step 1. The ethical issue involves the disclosure of the transaction and how either
disclosure or nondisclosure may affect the rights of various parties and which approach
Step 2. To keep the discussion manageable, we limit discussion of parties to current and
existing shareholders, lenders, and company management. Shareholders have a right to
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Step 3. It is the author’s assessment that a stewardship function does exist and that the
owners of the organization (shareholders) have a right to know how well that stewardship
Step 4.
a. Do not describe the transaction as requested by management.
Step 5.
a. There will likely be a consequence only if the client subsequently fails and a
Step 6. The two potential consequences from requiring disclosure or specific accounting
are that (a) owners receive a more informative report on the operations of the company
and the stewardship of management and (b) management becomes disillusioned and
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Step 7. The intent is to generate discussion of the topic by the students. The case was
taken from the files of a Big 5 firm that chose not to disclose the transaction. The authors
of the text believe that the stewardship function is an important concept in financial
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a. While individual answers will of course vary, we present a potential approach to
moving through the seven steps in resolving the difficult, but realistic, ethical issue
encountered by the staff member.
Step 1. The ethical difficulty is that the audit staff is being pushed to do a high quality job
Step 2. Affected parties include shareholders (right to receive a quality audit at a fair
price), the audit committee and board of directors (right to receive a quality audit at a fair
price), client management (right to receive a quality audit at a fair price), the Firm (the
Step 4. The staff auditors could do all the work necessary and under-report the hours
actually worked; the auditor could do a minimal job working only the hours already
Step 5.
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problem will continue. Further, if the audit staff members stays under budget it is
likely that the staff member will be positively evaluated.
Step 6. When assessing the consequences, the greatest good for the greatest number
Step 7. The third option, or some variant whereby the audit fee is adjusted upward with
the client’s consent, seems preferable.
b. The most important thing to achieve in this scenario is good communication between
engagement team members and the client. In pilot-testing of this case in an ethics
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• Integrity—A professional accountant should be straightforward and honest in
performing professional services.