CHAPTER 4

Third-party beneficiary

A person, not the auditor or their client, who is named in a contract (or known to the contracting parties) with the intention that such person should have definite rights and benefits under the contract

Rosenblum v. Adler

A common law decision by the New Jersey Supreme Court that holds CPAs liable for acts of ordinary negligence to "reasonably foreseeable third parties" not in privity of contract

Ultramares v. Touche & Co.

A common law decision by the New York Court of Appeals stating that auditors are liable to third parties not in privity of contract for acts of fraud or gross negligence, but not for ordinary negligence

Credit Alliance Corp. v Arthur Andersen & Co.

A common law decision by the New York Court of Appeals stating that the auditors must demonstrate knowledge of reliance on the financial statements by a third party for a particular purpose to be held liable for ordinary negligence to that party. Basically, this case held the Ultramares v. Touche & Co. rule

Comparative negligence

A concept used by certain courts to allocate damages between negligent parties based on the degree to which each party is at fault

Registration statement

A document including audited financial statement that must be filed with the SEC by any company in order to sell its securities to the public through the mails or interstate commerce

Securities Act of 1933

A federal securities statute covering registration statements for securities to be sold to the public. The act requires auditors to exercise "due diligence" and creates both civil and criminal penalties for misrepresentation

Securities Exchange Act of 1934

A federal securities statute requiring public companies to file annual audited financial statements with the SEC. The act requires auditors to "act in good faith" and creates civil and criminal penalties for misrepresentation

Due diligence

A public accounting firm's contention that its audit work was adequate to support its opinion on financial statements included in a registration statement filed with the SEC under the Securities Act of 1933

Engagement letter

A written contract summarizing the contractual relationship between the CPAs and the client. It typically specifies the scope of professional services to be rendered, expected completion dates, and the basis for determination of the CPAs' fee

If the CPAs provided negligent tax advice to a public company, the client would bring suit under:

Common law

Under common law, the CPAs who were negligent may mitigate some damages to a client by proving:

Contributory negligence

The most significant result of the Continental Vending case was that it:

Created more awareness of the possibility of auditor criminal prosecution.

Which of the following cases reaffirmed the principles in the Ultramares case?

Credit Alliance Corp. v. Arthur Andersen & Co.

If a CPA performs an audit recklessly, the CPA will be liable to third parties who were unknown and not foreseeable to the CPA for:

Gross negligence

Scienter

Intent to deceive, manipulate, or defraud. It must be proved for the auditors to be held liable under the Securities Exchange Act of 1934

Gross negligence

Lack of even slight care, indicative of a reckless disregard for one's professional responsibilities

Loss sustained by client, suit brought under common law

Liable

Constructive fraud

Performing duties with such recklessness that persons believing the duties to have been completed carefuly are being misled. It does not involve knowledge of misrepresentations within the financial statements

Under the Securities and Exchange Act of 1934, auditors and other defendants are faced with:

Proportionate liability

In cases of breach of contract, plaintiffs generally have to prove all of the following, except:

The CPA made a false statement

Which of the following approaches to auditors' liability is least desirable from the CPA's perspective?

The Rosenblum approach

A CPA issued an unqualified opinion on the financial statement of a company that sold common stock in a public offering subject to the Securities Act of 1933. Based on a misstatement in the financial statement, the CPA is being sued by an investor who purchased shares of this public offering. Which of the following represents a viable defense?

The false statement is immaterial in the overall context of the financial statements.

Defendant

The party against which damages and suit are brought by the plaintiff

Plaintiff

The party claiming damages and bringing suit against the defendant

Compilation of financial statement

The preparation of financial statements by CPAs based on representations of management, with the expression of no assurance concerning the statements' compliance with generally accepted accounting principles

Which statement best expresses the factors that purchasers of securities registered under the Securities Act of 1933 need to prove to recover losses from auditors?

The purchasers of securities must prove that the financial statements were misleading: then, the burden of proof is shifted to the auditors to show that the audit was performed with "due diligence"

The 1136 Tenants' case was important because of its emphasis upon the legal liability of the CPA when associated with:

Unaudited financial statement

Common law

Unwritten law that has developed through court decisions; it represents judicial interpretation of a society's concept of fairness

Negligence

Violation of a legal duty to exercise degree of care that an ordinarily purdent person would exercise under similar circumstances

Statutory law

Written law created by state or federal legislative bodies. CPAs must concern themselves particularly with the federal securities acts and state blue sky laws. These laws regulate the issuance and trading of securities

Item (a) relates to what a plaintiff who purchased securities must prove in a civil liability suit against a CPA. a. The plaintiff security purchaser must prove material misstatements were included in a filed document.

applies to both acts

Item (b) relates to what a plaintiff who purchased securities must prove in a civil liability suit against a CPA. b. The plaintiff security purchaser must prove a monetary loss occurred.

applies to both acts

Item (c) relates to what a plaintiff who purchased securities must prove in a civil liability suit against a CPA. c. The plaintiff security purchaser must prove lack of due diligence by the CPA.

applies to neither of the acts

Item (d) relates to what a plaintiff who purchased securities must prove in a civil liability suit against a CPA. d. The plaintiff security purchaser must prove privity with the CPA.

applies to neither of the acts

failure of one or both parties to a contract to perform in accordance with the contract's provisions

breach of contract

Unwritten law that has developed through court decisions; it represents judicial interpretation of a society's concept of fairness.

common law

Performing duties with such recklessness that persons believing the duties to have been completed carefully are being misled. The person performing the duties does not have knowledge of misrepresentations within the financial statements.

constructive fraud

misrepresentation by a person of a material fact, known by that person to be untrue or made with reckless indifference as whether the fact is true, with intent to deceive and with the result that another party is injured

fraud

Ernst & Ernst v. Hochfelder

A landmark case in which the US Supreme Court decided that the auditors could not be held liable under the SEC Act of 1934 for ordinary negligence

Joint and several liability

A legal concept that holds a class of defendants jointly responsible for losses attributed to the class as well as liable for any share of losses that cannot be collected from those unable to pay their share

Precedent

A legal principle that evolves from a common law court decision and then serves as a standard for future decisions in similar cases

Proportionate liability

A method of allocating damages to each group that is liable according to that group's pro rata share of any damages recovered by the plaintiff

Proximate cause

Damage to another that is directly attributable to a wrongdoer's act. This issue may be raised as a defense in litigation

Which of the following elements is most frequently necessary to hold CPA liable to a client?

Failed to exercise due care

Breach of contract

Failure of one or both parties to a contract to perform in accordance with the contract's provisions

Contributory negligence

Negligence on the part of the plaintiff that has contributed to his or her having incurred a loss. It may be used as a defense, because the court may limit or bar recovery by a plaintiff whose own negligence contributed to the loss

loss sustained by a bank known to the auditors to be relying on the financial statements for a loan; suit brought in a state court that adheres to the credit alliance v. arthur andersen precedent

liable

loss sustained by a bank named as a third party beneficiary in the engagement letter; suit brought under common law

liable

loss sustained by a lender not in privity of contract, suit brought in a state court that adheres to the rosenblum v. adler predent

liable

losses to stockholders purchasing shares at a public offering; suit brought under the securities act of 1933

liable

Violation of a legal duty to exercise a degree of care that an ordinarily prudent person would exercise under similar circumstances.

negligence

Loss sustained by trade creditor, not in privity of contract, suit brought in a state court that adheres to the Ultramares v. Touche Co. precedent

not liable

losses sustained by stockholders, suit brought under sections 18a and 10b of the securities exchange act of 1934

not liable

Item (e) relates to what a plaintiff who purchased securities must prove in a civil liability suit against a CPA. e. The plaintiff security purchaser must prove reliance on the document.

only applies to section 10b of the securities exchange act

Item (f) relates to what a plaintiff who purchased securities must prove in a civil liability suit against a CPA. f. The plaintiff security purchaser must prove the CPA had scienter.

only applies to section 10b of the securities exchange act

A method of allocating damages to each group that is liable according to that group's pro-rata share of any damages recovered by the plaintiff. For example, if the plaintiff was awarded a total of $500,000 and the CPAs were found to bear 30 percent of the responsibility for the damages, the CPAs would be assessed $150,000.

proportionate liability

Damage to another is directly attributable to a wrongdoer's act. This issue may be raised as a defense in litigation—that is, the defense may argue that some other factor caused the loss.

proximate cause

intent to deceive, manipulate, or defraud. this concept is used in the 1934 securities exchange act to establish auditor liability

scienter

a federal securities statute covering registration statements for securities to be sold to the public

securities act of 1933

Written law created by state or federal legislative bodies.

statutory law