5 Chapter Practice
Multiple Choice Identify the letter of the choice that best completes the statement or answers the question. 1. Common law liability a. Is to the PCAOB. b. Is liability to the various states. c. Extends to both clients and third parties. d. Is to the SEC. ANSWER: C NOTES: REF: 2. Common law liability to clients is based on a. The auditor being an employee of the client. b. A contractual relationship between the auditor and the client. c. Third party expectations of the auditor. d. The Securities Act of 1934. ANSWER: B NOTES: REF: 3. The party furthest removed from the contractual arrangement between the client and the auditor is a. Primary beneficiaries. b. Foreseeable third parties. c. The client. d. Foreseen third parties. ANSWER: B NOTES: REF: 4. Which of the following is not an item which must be proved or disproved in an audit liability case? a. Deficient conduct by the auditor. b. Damage or loss by the plaintiff. c. Reliance on the financial statements. d. Lack of industry knowledge by the auditor. ANSWER: D NOTES:
REF: 5. The Restatement of Tort doctrine a. Serves to limit the auditor's liability to only those in a contractual relationship. b. Is an interpretation made by the SEC of the Securities Act of 1934. c. Extends the auditor's liability to parties the auditor could have reasonably foreseen. d. Applies to cases brought under statutory law. ANSWER: C NOTES: REF: 6. Joint-and-several liability is a. The ability of the defendant to recover all damages from the auditor alone, even though the opinion only contributed partially to the loss. b. Liability under both common and statutory law. c. Liability under both the Securities Acts of 1933 and 1934. d. The ability of the defendant to recover the auditor's proportionate share of the loss. ANSWER: A NOTES: REF: 7. The 1136 Tenants case was important because of its emphasis on the legal liability of the CPA when a. Performing a review of financial statements. b. An engagement letter is not obtained. c. An audit results in a disclaimer of opinion. d. Preparing letters for underwriters. ANSWER: B NOTES: REF: 8. The CPAs rendered an unqualified opinion on the financial statements of a company that sold common stock in a public offering subject to the Securities Act of 1933. Based on a false statement in the financial statements, the CPAs are being sued by an investor who purchased shares of this public offering. Which of the following represents a viable defense? a. The investor has not met the burden of proving fraud or negligence by the CPAs. b. The investor did not actually rely on the false statement. c. Detection of the false statement by the CPAs occurred after the audit
date. d. The false statement is immaterial in the overall context of the financial statements. ANSWER: B NOTES: REF: 9. The Investor is suing the CPAs to recover losses incurred in connection with the Investor's transactions in the Client's securities. The Client's Annual Form 10-K Report contained material false and misleading statements in the audited financial statements. To recover under the Securities and Exchange Act of 1934, the Investor must, among other things, establish that a. All of the Investor's past transactions in the Client's securities, both before and after the auditors' report date, resulted in net losses. b. The transaction in the Client's securities that resulted in a loss occurred within 90 days of the auditors' report date. c. There was reliance on the financial statements in the decision to purchase or sell the Client securities. d. The market price of the stock dropped significantly after the Client issued corrected financial statements. ANSWER: C NOTES: REF: 10. An auditor who believes that a material misstatement may exist should initially a. Discuss the matter with those believed to be involved in the perpetration of the material irregularity. b. Discuss the matter with management above those thought to be involved. c. Withdraw from the engagement. d. Consult the legal counsel of the client. ANSWER: B NOTES: REF: 11. The auditor is most likely to presume that a high risk of fraud exists if a. The client is a multinational company that does business in numerous foreign countries. b. The client does business with several related parties. c. Inadequate segregation of duties places an employee in a position to perpetrate and conceal thefts. d. Inadequate employee training results in lengthy exception reports each month.
ANSWER: C NOTES: REF: 12. When seeking to recover losses from a public accounting firm on the basis of an unqualified opinion that accompanied a registration statement, an investor must establish that a. The audited financial statements were materially misstated. b. The audit firm did not document in its planning of the engagement the procedures to search for misstatements. c. The CPA firm did not act in good faith. d. If the CPA firm had exercised due care, the material misstatement would have been discovered. ANSWER: A NOTES: REF: 13. An auditor is subject to criminal liability for a. Refusing to return a client's working papers. b. Performing an audit negligently. c. Willfully omitting a material fact required to be stated in a registration statement. d. Willfully breaching a contract with a client. ANSWER: C NOTES: REF: 14. An engagement letter was not prepared when the CPAs agreed to audit the Client's financial statements. Which of the following best describes the obligation assumed by the CPAs? a. None; the agreement is not in writing. b. An implied promise to exercise due care. c. An implied obligation to detect all fraud. d. An implied obligation to detect all illegal acts. ANSWER: B NOTES: REF: 15. If there is evidence that material errors or fraud may exist, the auditor should a. Consider the implications and discuss the matter with appropriate levels of management. b. Make the investigation necessary to determine whether the errors or
fraud have, in fact, occurred. c. Request that management investigate whether the errors or fraud have, in fact, occurred. d. Consider whether the errors or fraud were the result of a failure by employees to comply with existing internal controls. ANSWER: A NOTES: REF: 16. One of the most significant aspects of the Continental Vending case was that it a. Created a more general awareness of the auditor's exposure to criminal prosecution. b. Extended the auditor's responsibility for financial statements of subsidiaries. c. Extended the auditor's responsibility for events after the end of the audit period. d. Defined the auditor's common-law responsibilities to third parties. ANSWER: A NOTES: REF: 17. With respect to errors and fraud, which of the following should be part of an auditor's planning of the audit engagement? a. Plan to search for errors or fraud that would have a material or immaterial effect on the financial statements. b. Plan to discover errors or fraud that are either material or immaterial. c. Plan to discover fraud that is material and errors which are immaterial. d. Plan to consider factors affecting the risk of material misstatement both at the financial statement and the account balance level. ANSWER: D NOTES: REF: 18. If an auditor believes a client may have committed illegal acts, which of the following actions should be taken? a. Consult with the client's counsel and the auditor's counsel to determine how the suspected illegal acts will be communicated to stockholders. b. Notify the Securities and Exchange Commission of the possible illegal acts. c. Make inquiries of the client's management and obtain an understanding of the circumstances underlying the acts and of other
evidence to determine the effects of the acts on the financial statements. d. Notify each member of the audit committee of the board of directors about nature of the acts and request that they advise an approach to be taken by the auditor. ANSWER: C NOTES: REF: 19. An audit client's board of directors and audit committee refused to take action about an immaterial illegal act that was brought to their attention by the auditor. Because of their failure to act, the auditor withdrew from the engagement. The auditor's decision to withdraw was primarily due to doubts concerning a. Inadequate financial statement disclosures. b. Compliance with the Foreign Corrupt Practices Act. c. Scope limitations resulting from the inaction. d. Reliance on management's representations. ANSWER: D NOTES: REF: 20. Plaintiffs may bring action against auditors a. If they are primary beneficiaries only. b. Only under the law in the state in which the client is primarily located. c. Under statutory only. law d. Under common law or statutory law. ANSWER: D NOTES: REF: 21. A comfort letter a. Is written for underwriters. b. Provide comfort to the SEC regarding an entity's first stock offering. c. Is signed by management of the client. d. Serves to limit the auditor's liability. ANSWER: A NOTES: REF: 22. Which of the following is not one of the items typically included in the information on the registration statement?
a. b. c. d.
Description of the securities offered. List of potential investors. Estimated net proceeds from the offering. The history of the entity.
ANSWER: B NOTES: REF: 23. Which of the following constitutes fraud? a. Mistakes in the application of accounting principles. b. Clerical mistakes in the accounting data underlying the financial statements. c. Misappropriation of assets. d. Misinterpretations of facts that existed when the financial statements were prepared. ANSWER: C NOTES: REF: 24. When unable to determine the amounts associated with possible illegal acts committed by a client, the auditor would most likely issue a. A review opinion with a separate explanatory paragraph. b. Only an adverse opinion. c. Either a qualified opinion or an adverse opinion. d. Either a qualified opinion or a disclaimer of opinion. ANSWER: D NOTES: REF: 25. The Client was insured by a general fidelity bond covering defalcations by the employees of the Client. An employee of the Client then embezzled company funds. The Insurance Company paid the Client the full amount under the terms of the fidelity bond and then sought recovery against the Client's auditors. Which of the following is the CPA's best defense? a. The CPAs were not aware of the Insurance Company-Client relationship. b. The Insurance Company is not in privity of contract. c. The shortages were the result of clever forgeries and collusive fraud that could not be detected by an audit. d. The audit opinion was intended for investors not the Insurance Company. ANSWER: C
NOTES: REF: 26. The audited financial statements were included in the Client's annual report and Form 10K filed with the SEC. As a result of negligence, the CPA did not detect material misstatements in the financial statements. Based on the financial statements, an Investor purchased stock in the Client. The Client then became insolvent and the price of the stock declined drastically. The Investor has commenced legal action against the CPA for damages. The CPA's best defense is a. There has been no subsequent sale for which a loss can be computed. b. The Investor lacks privity to sue. c. The engagement letter specifically disclaimed all liability to third parties. d. There was no scienter. ANSWER: D NOTES: REF: 27. The Investor purchased bonds of the Client in a public offering subject to the Securities Act of 1933 based on an unqualified opinion on the Client's financial statements which was included in the registration statement. The CPA is being sued by the Investor because of misstatements in the financial statements. To be successful, the Client must prove a. Neither damages nor misstatements. b. Damages, but not misstatements. c. Not damages, but misstatements. d. Damages and misstatements. ANSWER: D NOTES: REF: 28. An auditor who finds that the client possibly has committed an illegal act would be most likely to withdraw from the engagement when the a. Illegal act affects the auditor's ability to rely on management representations. b. Illegal act has material financial statement implications. c. Illegal act has received widespread publicity. d. Auditor cannot reasonably estimate the dollar impact of the illegal act. ANSWER: A NOTES: REF:
29. The Foreign Corrupt Practices Act requires that a. Auditors engaged to examine the financial statements of publicly held companies report illegal payments to the SEC. b. Privately held companies devise and maintain an adequate system of internal control. c. Publicly held companies devise and maintain an adequate system of internal control. d. U.S. firms doing business abroad report sizable payments made to non-U.S. citizens to the Justice Department. ANSWER: C NOTES: REF: 30. The CPAs audited the financial statements included in the annual report submitted by the Client to the SEC. The audit was deficient and the Client is now insolvent. The shareholders have taken legal action against the CPAs under the Securities Exchange Act of 1934. Which of the following is the best defense? a. The Act of 1934 does not apply. b. There was no intent to deceive, manipulate, or defraud shareholders. c. The engagement letter specifically disclaimed liability to any third party. d. The CPA was not in privity to the shareholders. ANSWER: B NOTES: REF: 31. Which of the following best describes a trend in litigation involving CPAs? a. A CPA cannot render an opinion on a company unless the CPA has audited all affiliates of that company. b. A CPA may successfully assert as a defense that the CPA had no motive to be part of a fraud. c. A CPA may be exposed to criminal as well as civil liability. d. A CPA is primarily responsible for a client's footnotes in an annual report filed with the SEC. ANSWER: C NOTES: REF: 32. Which of the following is a criminal case? a. Credit Alliance b. Rusch Factors c. Continental Vending d. Ultramares
ANSWER: C NOTES: REF:
True/False Indicate whether the sentence or statement is true or false. 33. Fraud is defined as a reckless departure from generally accepted auditing standards. ANSWER: F Fraud is an intentional misstatement or omission of a material fact that results in another party being deceived and injured. The definition in the question is for gross negligence. NOTES: REF: 34. Gross negligence can be so great as to constitute constructive fraud. ANSWER: T In Ultramares, gross negligence was ruled to be so great as to constitute constructive fraud. NOTES: REF: 35. The auditor's responsibility is higher to third parties than to clients. ANSWER: F The auditor is responsible for a higher level of conduct to clients than to third parties. NOTES: REF: 36. Parties may acquire a client's right to sue an auditor by subrogation. ANSWER: T A bonding company for example may acquire the client's right to sue the auditor by subrogation (substitution). NOTES: REF: 37. An important case extending auditor liability to foreseeable third parties is Rosenblum v. Adler. ANSWER: T
Rosenblum v. Adler is a significant case illustrating liability to foreseeable third parties. NOTES: REF: 38. The Securities Exchange Act of 1934 is sometimes referred to as the "truth in securities" law. ANSWER: F The Act of 1933 is referred to as the "truth in securities" law. NOTES: REF: 39. An auditor may not be held criminally liable. ANSWER: F An auditor may be criminally liable under several federal statutes, as well as under state statutes. NOTES: REF: 40. The RICO Act includes civil penalties. ANSWER: T The RICO Act includes both criminal and civil provisions. NOTES: REF: 41. Violations of Environmental Protection Agency regulations are unlikely to be uncovered in an audit of a university. ANSWER: T Such regulations are far removed from the accounting transactions and events of a university. NOTES: REF: 42. If the auditor is precluded from obtaining evidence about a possible illegal act involving a very large amount, a disclaimer is appropriate. ANSWER: T Because of the material scope limitation, a disclaimer would be issued. NOTES: REF:
Matching Match the following: a. Primary beneficiaries b. Common law c. Securities Act of 1934 d. FCPA e. The auditor's conduct was deficient
f. g. h. i. j.
Fraud Foreseeable third parties RICO Act SEC Ordinary negligence
43. Parties who have a reasonable need to rely on an entity's financial statements ANSWER: G NOTES: REF: 44. A point which must be proved or disproved in a lawsuit against an auditor. ANSWER: E NOTES: REF: 45. Administers the Securities Acts of 1933 and 1934 ANSWER: I NOTES: REF: 46. Includes requirements for the trading of securities offered and sold ANSWER: C NOTES: REF: 47. Requires management to implement internal controls to provide reasonable assurance that transactions are executed in accordance with management's authorization ANSWER: D NOTES: REF: 48. Specifically identified to auditors as the beneficiaries of audit services ANSWER: A NOTES: REF:
49. Written opinions of prior courts ANSWER: B NOTES: REF: 50. Lack of reasonable care ANSWER: J NOTES: REF: 51. Intended to curtail the movement of organized crime into legitimate business ANSWER: H NOTES: REF: 52. Intentional misstatement or omission of a material fact ANSWER: F NOTES: REF: