Chapter 5 Homework and Lecture

court

Common law is law derived from ___ decisions. It is constantly changing.

2, 3

Subsequent discovered facts are facts that become known after the date of the audit report, that have they been known, would had caused a different audit report. Facts discovered in period __ and __.

1

Subsequent events are events that occur in period __

Credit Alliance

The New York State Court of Appeals upheld the basic concept of privity established by Ultramares and stated that to be liable, (1) an auditor must know and intend that the work product would be used by the third party for a specific purpose, and (2) the knowledge and intent must be evidenced by the auditor's conduct.

limited

The Restatement Rule is that foreseen users must be members of a reasonably ___ and identifiable group of users who have relied on the CPA's work, such as creditors, even though those persons were not specifically known to the CPA at the time the work was done.

sue

The Securities act of 1933 - How do we as auditors get involved with a lawsuit under this law? It deals with the Financial Statements that we are associated with including the registration statement. The initial purchasers can ___ us under this act.. The burden of proof is on the auditor because all you have to do is point out material misstatement. We are guilty until proven innocent.

Civil liability

___ ___ under federal securities laws- Combined group of stockholders sues auditor for not discovering materially misstated financial statements.

Ordinary Negligence

Absence of reasonable care that can be expected of a person in a set of circumstances. For auditors, it is in terms of what other competent auditors would have done in the same situation

engagement, review

1136 Tenants - established liability where agreement is unclear Led to ___ letters Led to development of ___ standards

1

14 a. In a common law action against an accountant, lack of privity is a viable defense if the plaintiff (1) is the client's creditor who sues the accountant for negligence. (2) can prove the presence of gross negligence that amounts to a reckless disregard for the truth. (3) is the accountant's client. (4) bases the action upon fraud.

4

14 b. The 1136 Tenants case was important chiefly because of its emphasis on the legal liability of the CPA when associated with (1) an SEC engagement. (2) an audit resulting in a disclaimer of opinion. (3) letters for underwriters. (4) unaudited financial statements.

3

14 c. DMO Enterprises, Inc., engaged the accounting firm of Martin, Seals, & Anderson to perform its annual audit. The firm performed the audit in a competent, nonnegligent manner and billed DMO for $48,000, the agreed fee. Shortly after delivery of the audited financial statements, Hightower, the assistant controller, disappeared, taking with him $82,000 of DMO's funds. It was then discovered that Hightower had been engaged in a highly sophisticated, novel defalcation scheme during the past year. He had previously embezzled $105,000 of DMO funds. DMO has refused to pay the accounting firm's fee and is seeking to recover the $187,000 that was stolen by Hightower. Which of the following is most likely true? (1) The accountants cannot recover their fee and are liable for $187,000. (2) DMO is entitled to rescind the audit contract and thus is not liable for the $48,000 fee, but it cannot recover damages. (3) The accountants are entitled to collect their fee and are not liable for $187,000. (4) DMO is entitled to recover the $82,000 defalcation and is not liable for the $48,000 fee.

3

15 a. Major, Major & Sharpe, CPAs, are the auditors of MacLain Technologies. In connection with the public offering of $10 million of MacLain securities, Major expressed an unmodified opinion as to the financial statements. Subsequent to the offering, certain misstatements were revealed. Major has been sued by the purchasers of the stock offered pursuant to the registration statement that included the financial statements audited by Major. In the ensuing lawsuit by the MacLain investors, Major will be able to avoid liability if (1) the misstatements were caused primarily by MacLain. (2) it can be shown that at least some of the investors did not actually read the audited financial statements. (3) it can prove due diligence in the audit of the financial statements of MacLain. (4) MacLain had expressly assumed any liability in connection with the public offering.

2

15 b. Donalds & Company, CPAs, audited the financial statements included in the annual report submitted by Markum Securities, Inc., to the SEC. The audit was improper in several respects. Markum is now insolvent and unable to satisfy the claims of its customers. The customers have instituted legal action against Donalds based on Section 10b and Rule 10b-5 of the Securities Exchange Act of 1934. Which of the following is likely to be Donalds' best defense? (1) Section 10b does not apply to them. (2) They did not intentionally certify false financial statements. (3) They were not in privity of contract with the creditors. (4) Their engagement letter specifically disclaimed any liability to any party that resulted from Markum's fraudulent conduct.

4

15 c. Which is the true statement concerning an auditor's statutory legal liability? (1) The Securities Act of 1933 broadened the auditor's liability relative to common law and the Securities Exchange Act of 1934 narrowed it. (2) Criminal liability only arises under state law. (3) The auditor may limit exposure to liability by destroying documents that might suggest an improper act. (4) The auditor has a greater burden of defense under the Securities Act of 1933 than the Securities Exchange Act of 1934.

4

16 a. Which of the following elements is required to be proven by the plaintiff to hold an accountant liable for gross negligence but not for actual fraud? (1) Misrepresentation of a material fact (2) Intention to deceive (3) Intention to induce client's reliance on the misrepresentation (4) Reckless action

3

16 b. One of the elements that a plaintiff must prove to hold a CPA who signs off on financial statements in a registration statement liable for misstatements in the financial statements under Section 11 of the 1933 Act is that the (1) plaintiff relied on the misrepresentation. (2) CPA intended to deceive. (3) plaintiff suffered a loss. (4) CPA was negligent.

2

16 c. Under the Ultramares rule, an accountant that negligently prepares a client's financial report will be liable to (1) clients and any person or limited foreseeable class of persons who the CPA knows will be relying on the CPA's work. (2) persons in privity of contract with the CPA and intended third parties. (3) clients and any third party that foreseeably relied on the accountant's report. (4) the client only.

lawsuits

3 of 4 defenses that we have used have been successfuly used to fight off these Third-party ____: lack of duty to perform the service, nonnegligent performance, and absence of causal connection

Third-party beneficiary

A third party who does not have privity of contract but is known to the contracting parties and is intended to have certain rights and benefits under the contract. A common example is a bank that has a large loan outstanding at the balance sheet date and requires an audit as a part of its loan agreement. While the contract for the audit engagement is between the client and the audit firm, both parties are aware the bank will be relying on the audited financial statements

560

Code Section ___ Subsequent event and subsequent discovered facts

925

Code section 925 Filings With the U.S. Securities and Exchange Commission Under the Securities Act of 1933

lack of duty, nonnegligent performance, absense of causal connection

Defenses against 3rd parties?

Constructive Fraud

Existence of extreme or unusual negligence even though there was no intent to deceive or do harm. Constructive fraud is also termed recklessness. Recklessness in the case of an audit is present if the auditor knew an adequate audit was not done but still issued an opinion, even though there was no intention of deceiving statement users

Breach of contract

Failure of one or both parties in a contract to fulfill the requirements of the contract. An example is the failure of a CPA firm to deliver a tax return on the agreed-upon date. Parties who have a relationship that is established by a contract are said to have privity of contract

Criminal liability

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

lack of duty, nonnegligent performance, contributory negligence, absense of causal connection

Four defenses for auditors in client cases: 1.) ___ ___ ___ 2.) ___ ___ 3.) ___ ___ 4.) ___ ___ ___ ___

easier

It is ___ to prove negligence than gross negligence or fraud.

primary beneficiary

It's a party that is relying on the financial statements.

Gross negligence

Lack of even slight care, tantamount to reckless behavior, that can be expected of a person. Some states do not distinguish between ordinary and gross negligence.

Common Law

Laws that have been developed through court decisions rather than through government statutes.

Statutory Law

Laws that have been passed by the U.S. Congress and other governmental units. The Securities Acts of 1933 and 1934 and Sarbanes-Oxley Act of 2002 are important statutory laws affecting auditors

torts

Most states fall into Restatement of ___. Identifiable group that relied on the auditor's work.

Fraud

Occurs when a misstatement is made and there is both the knowledge of its falsity and the intent to deceive.

Joint and several liability

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. For example, if management intentionally misstates financial statements, an auditor can be assessed the entire loss to shareholders if the company is bankrupt and management is unable to pay

foreseeable

The broadest interpretation of the rights of third party beneficiaries is to use the concept of ___ users. Anybody that auditor should have foreseen as a user of the financial statements, i.e. stockholders. ( Mississippi and Wisconsin)

ordinary negligence

The primary beneificiary can sue you for as little as ___ ___ under common law.

securities laws

The second source of lawsuits is suing under the federal ___ ___.

breach

Tort is any civil wrong other than ___.

subsequent

Two types of subsequent events: 1.) ___ event - on the date of the balance sheet date: 12/31/16, plane crashes on 12/29/17. 2.) things that were subsequently discovered after the balance sheet date, requires footnote disclosure. Need to follow GAAP.

not required

We are ___ ___ to perform any procedures in period 2, but if we become aware of relevant events, we need to act. May need to revise the financial statements. We can extend the subsequent events to a later date or add a second date.

Ordinary negligence, Gross Negligence, Constructive fraud, fraud

What are the four types of negligence?

engagement

You establish a primary beneficiary relationship through an ___ letter.

Liability to clients

___ ___ ___ - Client sues auditor for not discovering a material fraud during the audit.

Liability to third parties

___ ___ ___ ___ under common law - Bank sues auditor for not discovering that a borrower 's financial statements are materially misstated.

Separate, proportionate

___ and ___ liability - The assessment against a defendant of that portion of the damage caused by the defendant's negligence. For example, if the courts determine that an auditor's negligence in conducting an audit was the cause of 30% of a loss to a defendant, only 30% of the aggregate damage will be assessed to the CPA firm.

Three

___ distinct periods. 1.) Period between balance sheet date and the date on the audit report. 2.) Date of audit report and date issued to the public 3.) FS and audit report are being used.

Requirements

___ in period 1 we are responsible to find all subsequent events requiring adjustment or disclosure in the financial statements.

Subsequent

___ procedures all the way to the date of the registration statement.

Torts

___ result in larger settlements

Clients

___ suing us is the number one source of law suits. They sue us under common law and it's usually a contract dispute.

Scienter

____ - commission of an act with knowledge or intent to deceive. knowingly intends to defraud. The smoking gun standard.. One shade less than full proof.

1934

under ___ 10k has to be filed annually. Deals with period filings.