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Chapter 3 Legal Liability3 Understand the auditors' legal environment Many PAs prepare tax returns for individuals and for corporations. Under what circumstances is liability insurance required to cover the preparation of tax returns? A) When the PA is a member of a professional accounting associati...

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Test Item File for Arens, Auditing, 13CE

Chapter 3 Legal Liability 3.1 Understand the auditors' legal environment 1) Many PAs prepare tax returns for individuals and for corporations. Under what circumstances is liability insurance required to cover the preparation of tax returns? A) When the PA is a member of a professional accounting association. B) When any number of tax returns are prepared, including no-charge tax returns. C) When fees are being charged and more than a handful of returns are being prepared. D) When the bulk of the PA's income comes from preparing tax returns. Answer: C Diff: 2 Type: MC Page Ref: 49-51 Learning Obj.: 3-1 Understand the auditors' legal environment 2) One reason for lawsuits against public accountants is A) lack of awareness of the responsibilities of public accountants by users of financial statements. B) the increasing complexity of auditing and accounting functions. C) reduced consciousness on the part of provincial securities commissions of their responsibility for protecting investors' interests. D) many public accounting firms are not willing to settle legal problems. Answer: Diff: 1 Type: MC Page Ref: 51 Learning Obj.: 3-1 Understand the auditors' legal environment 3) Pierre, a CPA, was convicted of stealing money from his clients and deliberately preparing personal tax returns that were false. In addition, Pierre will likely A) need to take additional training courses to upgrade his tax skills. B) need to defend himself to prove non-negligent performance. C) be charged with misconduct by his professional institution (or order). D) have lack of privity with the federal and provincial tax authorities. Answer: C Diff: 2 Type: MC Page Ref: 51 Learning Obj.: 3-1 Understand the auditors' legal environment 4) There are a number of things that a practising auditor can do to reduce liability in lawsuits. One of them is to A) lobby for changes in laws. B) carry adequate insurance. C) establish peer-review requirements. D) revise auditing standards to meet the changing needs of society. Answer: B Diff: 1 Type: MC Page Ref: 52 Learning Obj.: 3-1 Understand the auditors' legal environment

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Test Item File for Arens, Auditing, 13CE

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5) What are the 6 major factors contributing to the high number of lawsuits against pubic accountants and the high amounts in settlements being awarded to plaintiffs? Answer: The six reasons are: • growing awareness of the responsibilities of public accountants by users of financial statements • increased consciousness on the part of provincial securities commissions for their responsibility for protecting investors' interests • increasing complexity of auditing and accounting functions • tough economic times resulting in business failures, which prompt stakeholders to seek restitution from others, including external auditors • the common belief that public accounting firms have deep pockets • many public accounting firms being willing to settle legal problems out of court in order to avoid costly legal fees and adverse publicity Diff: 2 Type: ES Page Ref: 51 Learning Obj.: 3-1 Understand the auditors' legal environment 3.2 Explain the relationship between the expectations gap and lawsuits 1) When an auditor issues an erroneous opinion as the result of an underlying failure to comply with the requirements of generally accepted auditing standards, it results in A) business failure. B) audit failure. C) audit risk. D) business risk. Answer: B Diff: 1 Type: MC Page Ref: 51 Learning Obj.: 3-2 Explain the relationship between the expectations gap and lawsuits 2) An example of an audit failure is when the A) auditor issues an erroneous audit opinion as the result of a failure to comply with the requirements of GAAS. B) audit opinion is qualified. C) company files for bankruptcy less than 12 months after receiving an unqualified opinion. D) auditor issues an erroneous audit opinion as the result of an undiscovered fraud that took place in the period being audited. Answer: A Diff: 1 Type: MC Page Ref: 51 Learning Obj.: 3-2 Explain the relationship between the expectations gap and lawsuits

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Test Item File for Arens, Auditing, 13CE

3) Amin is distraught. Six months ago, a big-box stereo store opened just down the street from his independent stereo and music business and now he is unable to continue operating his business. Only eight months ago, you issued an unqualified audit opinion on his financial statements that showed the financial results of a well-run, profitable store. Amin's business is experiencing A) customer expectation gap. B) audit failure. C) fiduciary duty. D) business failure. Answer: D Diff: 2 Type: MC Page Ref: 51-52 Learning Obj.: 3-2 Explain the relationship between the expectations gap and lawsuits 4) While performing services for their clients, professionals have always had a duty to provide a level of care that is A) reasonable. B) greater than average. C) superior. D) guaranteed to be free from error. Answer: A Diff: 1 Type: MC Page Ref: 52 Learning Obj.: 3-2 Explain the relationship between the expectations gap and lawsuits 5) Danford, a PA, is setting up his accounting firm as a sole practitioner. Which of the following is not an important way that Danford can reduce legal liability with respect to the work completed by his office? A) participate in the standard-setting process for audit engagements B) find out when his practice is due for practice inspection C) hire only qualified personnel and train them well D) sanction other PAs who engage in improper conduct Answer: B Diff: 2 Type: MC Page Ref: 52 Learning Obj.: 3-2 Explain the relationship between the expectations gap and lawsuits 6) Conflict between financial statement users and auditors often arises because of the A) high cost of performing an audit. B) extremely technical vocabulary auditors use in their reports. C) placement of the auditor's report in the back of the client's annual report, where it is hard to locate. D) expectation gap. Answer: D Diff: 1 Type: MC Page Ref: 52 Learning Obj.: 3-2 Explain the relationship between the expectations gap and lawsuits

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Test Item File for Arens, Auditing, 13CE

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7) A) Describe some of the steps the CPA and the accounting profession as a whole can and are taking to reduce practitioners' exposure to lawsuits. B) Describe some of the steps individual practising auditors can take to minimize their legal liability. Answer: A) Steps the profession is taking to reduce practitioners' exposure to lawsuits include: • research in auditing • standard and rule setting and revisions to meet the changing needs of the profession • setting requirements to protect auditors • establishing practice inspection requirements • defending unjustified lawsuits • educating investors and other users of financial statements as to the meaning of the auditor's report and the nature of the auditor's work • sanctioning members for improper conduct • lobbying for changes in laws B) There are many steps individual practitioners can take to minimize legal liability, including: • dealing only with clients possessing integrity • hiring qualified personnel and train and supervise them properly • following the standards of the profession • maintaining independence • understanding the client's business • performing quality audits • documenting work properly • obtaining an engagement letter and a representation letter • maintaining confidential relations • carrying adequate insurance • seeking legal counsel Diff: 2 Type: ES Page Ref: 51-52 Learning Obj.: 3-2 Explain the relationship between the expectations gap and lawsuits

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Test Item File for Arens, Auditing, 13CE

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8) PA has been recently appointed auditor of Foible Ltd., a company that exports high-cost knickknacks. To facilitate the rapid preparation of the financial statements, management had the physical inventory counted in October, rather than at the December year-end. During the inventory count, PA noticed that several of the boxes were labelled with receiving documents from a competitor. PA was told that the new warehouse supervisor worked part-time at the competitor and must have picked up the wrong boxes. Several employees have sued Foible Ltd. for wrongful dismissal, claiming that they were promised a job that would last at least one year and would be provided with low cost accommodations. They are suing for the balance of the year's wages and are claiming that they were brought into the country under false pretenses. These employees are all from an EasternEuropean country. The law firm has responded in a legal letter that this suit is without merit. During the year, Foible obtained legal services from a firm in which Foible's Chairman of the Board of is a partner. Fees and disbursements for these services for the year were $125 000, a material amount. During the audit, employees often spoke in a foreign language among themselves before responding to PA. Then one employee would respond after some (often heated) discussion. Subsequent to the year end, the warehouse supervisor was arrested on criminal charges of theft, and Foible was charged with selling stolen goods. PA was charged as an accomplice to money laundering, as all of the management for Foible were members of a criminal group found to be laundering money from Eastern Europe. Required: Discuss the actions that PA could have taken during the engagement to prevent these charges. Answer: Prior to accepting an engagement, an auditor should assess the integrity of management. This would involve credit checks and background checks using a credit bureau. PA could also have consulted with the previous auditor (if taking over the audit from another PA) and/or reviewed previous permanent files for hints of wrong-doing. During the audit, PA had many warning signs, such as the possibility of stolen goods being included in inventory. Management conflict of interest and possible illegal actions with respect to employees were also present. When these signs occurred, PA should have consulted legal advice and also required second partner review or peer assistance from his provincial professional association. PA should have ensured that the lawsuits were disclosed in the financial statements and that the related party transactions (the legal fees) also were disclosed in the financial statements. PA could have consulted independent legal advice with respect to the employee lawsuits. Diff: 3 Type: ES Page Ref: 52 Learning Obj.: 3-2 Explain the relationship between the expectations gap and lawsuits

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Test Item File for Arens, Auditing, 13CE

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3.3 Understand and analyze auditors' liability and related defences 1) An example of a breach of contract would be A) a bank's claim that an auditor had a duty to uncover material errors in financial statements that had been relied on in making a loan. B) an auditor's refusal to return a client's records until the client paid last year's audit fees. C) a public accounting firm's failure to deliver a tax return on the agreed-upon date because the firm had a backlog of other work that was more lucrative. D) an auditor's failure to complete the audit by the agreed-upon date because the client's financial records had been destroyed. Answer: C Diff: 1 Type: MC Page Ref: 52 Learning Obj.: 3-3 Understand and analyze auditors' liability and related defences 2) In rare cases, auditors have been held liable for criminal acts. A criminal conviction against an auditor can result only when it is demonstrated that the auditor A) was negligent. B) was grossly negligent. C) knowingly issued an incorrect auditor's report. D) caused a financial loss to an innocent third party. Answer: C Diff: 2 Type: MC Page Ref: 52-53 Learning Obj.: 3-3 Understand and analyze auditors' liability and related defences 3) The assessment against a defendant of the full loss suffered by a plaintiff regardless of the extent to which other parties shared in the wrongdoing is called A) separate and proportionate liability. B) joint and several liability. C) shared liability. D) unitary liability. Answer: B Diff: 1 Type: MC Page Ref: 52-53 Learning Obj.: 3-3 Understand and analyze auditors' liability and related defences 4) If the public accountant negligently failed to properly prepare and file a client's tax return, the public accountant can be held liable for A) the penalties the client owes Canada Customs and Revenue Agency. B) the penalties and interest the client owes. C) the penalties and interest, plus the tax preparation fee that the public accountant charged. D) the penalties and interest, the tax preparation fee, and the amount of tax that was underpaid. Answer: C Diff: 2 Type: MC Page Ref: 53 Learning Obj.: 3-3 Understand and analyze auditors' liability and related defences

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Test Item File for Arens, Auditing, 13CE

5) Most of the major lawsuits against public accounting firms have dealt with A) audited or unaudited financial statements. B) disputes over income-tax preparation services. C) disputes arising in the performance of management consulting services contracts. D) unaudited financial statements. Answer: A Diff: 2 Type: MC Page Ref: 53 Learning Obj.: 3-3 Understand and analyze auditors' liability and related defences 6) An auditor would be found negligent if he/she A) relied on a report from management without considering management integrity. B) relied on a report that contained errors that had been concealed by management. C) did not consider the expenses from a division due to management intentionally withholding that information. D) failed to discover a payroll fraud by testing a statistical sample of transactions in the salary expense account. Answer: A Diff: 3 Type: MC Page Ref: 53 Learning Obj.: 3-3 Understand and analyze auditors' liability and related defences 7) Laws that have been passed through federal or provincial governments are A) statutory law. B) judicial law. C) criminal law. D) common law. Answer: A Diff: 1 Type: MC Page Ref: 53 Learning Obj.: 3-3 Understand and analyze auditors' liability and related defences 8) Small Town Lumberyard Limited (STLL) needed an additional bank loan to finance its operations. To make its financial statements look better, the company overstated its inventory and overstated its accounts payable. The auditors did not detect this deliberate misstatement because they conducted limited tests of inventory and did not confirm accounts payable. Other auditors agreed that the procedures conducted during this audit were inadequate. The auditors of STLL would likely be considered to be A) guilty of fraud. B) negligent. C) contributorily negligent with STLL. D) guilty of constructive fraud. Answer: B Diff: 2 Type: MC Page Ref: 53 Learning Obj.: 3-3 Understand and analyze auditors' liability and related defences

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Test Item File for Arens, Auditing, 13CE

9) The principal issue to be resolved in cases involving alleged negligence is usually A) the amount of the damages suffered by the plaintiff. B) whether to impose punitive damages on the defendant. C) the level of care required. D) whether the defendant was involved in fraud. Answer: C Diff: 2 Type: MC Page Ref: 53 Learning Obj.: 3-3 Understand and analyze auditors' liability and related defences 10) In the auditing environment, failure to meet generally accepted auditing standards is often A) an accepted practice. B) a suggestion of negligence. C) strong evidence of negligence. D) tantamount to criminal behaviour. Answer: C Diff: 2 Type: MC Page Ref: 53 Learning Obj.: 3-3 Understand and analyze auditors' liability and related defences 11) To succeed in an action against the auditor, the client must be able to show that A) the auditor was grossly negligent. B) the auditor was fraudulent. C) there is a close causal connection between the auditor's breach of the standard of due care and the damages suffered by the client. D) there was a written contract. Answer: C Diff: 2 Type: MC Page Ref: 53 Learning Obj.: 3-3 Understand and analyze auditors' liability and related defences 12) What rights do secondary investors (i.e. those who purchase shares after an initial offering) have to sue an auditor? A) Since they are third-party claimants, they would be part of a limited class of known users. B) They could claim contributory negligence since they had prior information of company results. C) They can sue under provincial legislation without the need to prove reliance. D) Since there is absence of causal connection, they would not be able to sue the auditors. Answer: C Diff: 2 Type: MC Page Ref: 53 Learning Obj.: 3-3 Understand and analyze auditors' liability and related defences

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Test Item File for Arens, Auditing, 13CE

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13) PA was engaged by Microcomputer Distributor Limited (MDL) to conduct a review engagement. The financial statements are used primarily by the shareholders, management, and by the bank. Recently, an employee was fired for stealing computer parts, primarily chips and boards that could easily be placed in a pocket. MDL is suing PA because they believed that audit procedures, such as counting inventory, would have detected this fraud. What is PA's best defence? A) absence of causal connection B) lack of negligence C) contributory negligence D) duty of care not required Answer: D Diff: 3 Type: MC Page Ref: 53 Learning Obj.: 3-3 Understand and analyze auditors' liability and related defences 14) The leading precedent-setting case in third-party liability was a 1931 U.S. case, Ultramares v. Touche. What is the key aspect of this case? A) To succeed, claimants must be foreseeable users of the audited financial statements that are part of the claim process. B) Ordinary negligence is insufficient for liability to third parties because of lack of privity of contract. C) The auditor must have actual knowledge of the users of the financial statements to establish privity. D) There is no general auditor liability to shareholders, since the loss of equity was suffered by the company. Answer: B Diff: 2 Type: MC Page Ref: 54 Learning Obj.: 3-3 Understand and analyze auditors' liability and related defences 15) The Ultramares doctrine is that ordinary negligence is insufficient for liability of auditors to third parties because of the lack of privity of contract between the third party and the auditor. What type of behaviour on the part of an auditor would result in liability to more general third parties according to this doctrine? A) conducting an audit engagement when a review engagement had been contracted B) completing work in accordance with a contract that was signed with the client C) deliberate misstatement of the financial statements by management remaining undetected D) fraud or constructive fraud with respect to the working papers Answer: D Diff: 2 Type: MC Page Ref: 54 Learning Obj.: 3-3 Understand and analyze auditors' liability and related defences

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Test Item File for Arens, Auditing, 13CE

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16) Which of the following lawsuits resulted in a decision that shareholders could not sue the auditors for the loss in the value of their shares? A) Haig v. Bamford et al.(1976) B) Hercules Management Ltd. v. Ernst & Young (1997) C) Ultramers Corporation v. Touche (1931) D) United States v. Anderson (2002) Answer: B Diff: 2 Type: MC Page Ref: 54 Learning Obj.: 3-3 Understand and analyze auditors' liability and related defences 17) A) List the four items a defendant must prove in an action for negligence against a public accountant. B) Discuss what is meant by the term "expectation gap." Answer: A) The four items a defendant must prove are as follows: • the auditor owed a duty...