Auditing Chapter 5

1. Which of the following statements is true?

Gross negligence may constitute constructive fraud

Fraud requires the intent to deceive

All fraud should be detected during audit

Yes Yes No

No Yes Yes

Yes No Yes

No No No

2. Privity of contract exists between:

Auditor and the federal government.

Auditor and third parties.

Auditor and client.

Auditor and client attorney.

3. While the Foreign Corrupt Practices Act of 1977 remains in effect, it has been largely superseded by which of the following?

The Sarbanes-Oxley Act of 2002.

The Racketeer Influenced and Corrupt Organization Act.

The Federal False Statements Statute.

The Federal Mail Fraud Statute.

4. An example of a breach of contract would likely include:

An auditor’s refusal to return the client’s general ledger book until the client paid last year’s audit fees.

An auditor’s claim that the client staff is unqualified.

5. Auditors may be liable to their clients for:

Punitive damages

Compensatory damages

Yes Yes

No No

Yes No

No Yes

6. While performing services for their clients, professionals have a duty to provide a level of care which is

Free from judgment errors.

Superior.

Greater than average.

Reasonable.

7. "Absence of reasonable care that can be expected of a person in a set of circumstances" defines:

Pecuniary negligence.

Gross negligence.

Extreme negligence.

Ordinary negligence.

8. Tort actions can be based on which of the following?

Ordinary negligence

Gross negligence

Yes Yes

No No

Yes No

No Yes

9. Section 10 and Rule 10b-5 of the Securities Exchange Act of 1934 are often referred to as:

The antifraud provisions.

The new issues provisions.

The full-employment act for accountants.

The RICO provisions.

10. Auditors who fail to exercise due care in their performance of professional services may be liable for:

Punitive liability.

Breach of contract.

Excess liability.

Criminal charges.

11. The principal issue to be resolved in cases involving alleged negligence is usually:

The amount of the damages suffered by plaintiff.

Whether to impose punitive damages on defendant.

The level of care exercised by the CPA.

Whether defendant was involved in fraud.

12. Which of the following is an illustration of liability under the federal securities acts?

Client sues auditor for not discovering a theft of assets by an employee.

Bank sues auditor for not discovering that borrower’s financial statements are misstated.

Combined group of stockholders sue auditor for not discovering materially misstated financial statements.

Auditor sues client for not cooperating during engagement.

13. In the auditing environment, failure to meet auditing standards is often:

An accepted practice.

A suggestion of negligence.

Conclusive evidence of negligence.

Tantamount to criminal behavior.

14. Under the Securities Exchange Act of 1934, most of the litigation against the auditor has been generated because of the auditor's involvement with the:

8-K form.

10-K form.

10-Q form.

S-1 form.

15. A major purpose of federal securities regulations is to:

Provide sufficient reliable information to the investing public who purchases securities in the marketplace.

Establish the qualifications for accountants who are members of the profession.

Eliminate incompetent attorneys and accountants who participate in the registration of securities to be offered to the public.

16. In a leading securities law and CPA liabilities case, the U.S. Supreme Court ruled in 1976 in Hochfelder v. Ernst & Ernst that before CPAs could be held liable for Rule 10b-5 of the Securities Exchange Act of 1934, what would be required to be shown to the court was the auditor's:

Ordinary negligence.

Gross negligence.

Knowledge and intent to deceive.

Financial gain at the expense of the plaintiff.

17. If the CPA negligently failed to properly prepare and file a client's tax return, the CPA may be liable for:

The penalties the client owes the IRS.

The penalties and interest the client owes.

The penalties and interest the client owes, plus the tax preparation fee the CPA charged.

The penalties and interest, the tax preparation fee, and the amount of tax that was underpaid.

18. The increased litigation under the federal securities laws has resulted from:

The availability of class-action litigation

The strict liability standards imposed on CPAs by the securities laws

An excess of attorneys

Yes Yes Yes

Yes No No

Yes Yes No

No No No

19. The Private Securities Litigation Reform Act of 1995 reduced potential damages in securities-related litigation, but because the act applied only to federal courts, attorneys began taking cases to state courts. Which of the following eliminated this loophole?

Private Securities Litigation Reform Amendment.

Securities Litigation Uniform Standards Act of 1998.

Racketeer Influenced and Corrupt Organization Act.

U.S. Securities Claims Reform Act.

20. To succeed in an action against the auditor, the client must be able to show that:

The auditor was fraudulent.

The auditor was grossly negligent.

There was a written contract.

There is a close causal connection between the auditor’s behavior and the damages suffered by the client.

21. The Securities and Exchange Commission can impose all but which of the following sanctions?

Suspend a CPA from auditing SEC clients.

Prohibit a CPA from accepting new SEC clients for a period of time.

Require a CPA to participate in continuing-education programs and make changes in their practice.

Revoke a CPA license.

22. Which of the following is an illustration of liability to clients under common law?

Client sues auditor for not discovering a theft of assets by an employee.

Bank sues auditor for not discovering that borrower’s financial statements are misstated.

Combined group of stockholders sue auditor for not discovering materially misstated financial statements.

Federal government prosecutes auditor for knowingly issuing an incorrect audit report.

23. The King Surety Company wrote a general fidelity bond covering thefts of assets by the employees of Wilson, Inc. Thereafter, Cooney, an employee of Wilson, embezzled $17,200 of company funds. When the activities were discovered, King paid Wilson the full amount in accordance with the terms of the fidelity bond, and then sought recovery against Wilson's auditors, Lynch & Merritt, CPAs. Which of the following would be Lynch & Merritt's best defense?

King is not in privity of contract.

Lynch & Merritt were not guilty either of gross negligence or fraud.

Lynch & Merritt were not aware of the King-Wilson surety relationship.

24. "Privileged communication" between client and auditor is:

Available in all federal courts.

Not available in any court.

Available in several states.

Available for matters involving income taxes only.

25. The most significant audit issue that came as a result of the court decision in the Escott et al. v. Bar Chris Construction Corporation case in 1968 was:

The court’s reaffirmation that the burden of proof was on the plaintiff to prove the auditor was negligent.

The increased auditor responsibility when associated with unaudited financial statements.

The court’s refusal to allow the percentage-of-completion method of accounting for revenues.

26. Which of the following resulted in a federal law passed in 1995 that significantly reduced potential damages in securities-related litigation?

Private Securities Litigation Reform Act.

Public Securities Damages and Settlements Act.

Racketeer Influenced and Corrupt Organization Act.

U.S. Securities Claims Reform Act.

27. Under the federal securities acts, one significant result occurring directly due to the Escott et al. v. Bar Chris Construction Corporation case was that SAS was changed to require:

Greater emphasis on subsequent events procedures.

New standards for unaudited statements.

A broader definition of third-party beneficiaries.

More companies to file annual reports with the SEC.

28. Failure of a party to meet its obligations, thereby causing injury to another party to whom a duty was owed, is:

Breach of contract.

Tort action for negligence.

Constructive fraud.

Fraud.

29. The Foreign Corrupt Practices Act (FCPA) of 1977:

Requires auditors to review and evaluate systems of internal control as a part of an audit.

Requires SEC registrants to maintain a reasonably complete and accurate set of records and an adequate system of internal control.

Requires auditors to file a report with the SEC if client’s internal control system is inadequate.

30. Under the Securities Act of 1933, the auditor's responsibility for making sure the financial statements were fairly stated extends to:

The date of the financial statements.

The date the registration statement becomes effective.

The date of the audit report.

One year beyond the date of the financial statements.

31. Under the Securities Exchange Act of 1934, which type of organizations is required to submit audited financial statements to the SEC?

Every company with securities traded on national and over-the-counter exchanges.

Every company issuing new securities.

Every corporation which is chartered by a state government.

32. As a consequence of his failure to adhere to generally accepted auditing standards in the course of his examination of the Lamp Corp., Harrison, CPA, did not detect the embezzlement of a material amount of funds by the company's controller. As a matter of common law, to what extent would Harrison be liable to the Lamp Corp. for losses attributable to the theft?

He would have no liability, since the ordinary examination cannot be relied upon to detect thefts of assets by employees.

He would have no liability because privity of contract is lacking.

He would be liable for losses attributable to his negligence.

He would be liable only if it could be proven that he was grossly negligent.

33. Which of the following statements about the Securities Act of 1933 is not true?

The amount of the potential recovery is the original purchase price plus punitive damages.

It deals with the information in registration statements and prospectuses.

It concerns only the reporting requirements for companies issuing new securities.

The only parties that can recover from auditors are original purchasers of securities.

34. The Securities and Exchange Commission has authority to:

Prescribe specific auditing procedures to detect fraud concerning inventories and accounts receivable of companies engaged in interstate commerce.

Deny lack of privity as a defense in third-party actions for gross negligence against the auditors of public companies.

Determine accounting principles for the purpose of financial reporting by companies offering securities to the public.

35. Gregory & Hedrick, a medium-sized CPA firm, employed Elise as a staff accountant. Elise was negligent while auditing several of the firm's clients. Under these circumstances, which of the following statements is true?

Elise would have no personal liability for negligence.

Gregory & Hedrick is not liable for Elise’s negligence because CPAs are generally considered to be independent contractors.

36. The prudent person concept establishes that:

The CPA firm is not expected to make only perfect judgments.

The courts do not require that the auditor become the insurer or guarantor of the accuracy of the statements.

All CPAs are considered prudent.

37. In connection with a public offering of first mortgage bonds by Henson Corp., the bond underwriter has asked Henson's CPA to furnish him with a comfort letter giving as much assurance as possible relative to Henson's unaudited financial statements for the three months ended March 31, 2007. The CPA had expressed an unqualified opinion on Henson's financial statements for the year ended December 31, 2006 and he has performed a limited review of Henson's financial statements for the three months ended March 31, 2007. Nothing has come to his attention that would indicate that the March 31, 2007 statements are not properly presented. Under these circumstances, the CPA's response to the underwriter's request should be to:

Furnish to the underwriters an opinion that the March 31, 2007 statements are fairly presented subject to year-end audit adjustments.

Give negative assurance as to the March 31, 2007 financial statements but disclaim an opinion on these statements.

Furnish to the underwriters an adverse opinion covering financial statements for the three months ended March 31, 2007.