Chapter 4 - Legal Liability of CPAs

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

3. Proportionate liability

e. The accountants could avoid liability if they could show they were not negligent:

true An accountant successfully asserting the "due diligence" defense can avoid liability

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

5. Fraud

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

1. Breach of contract

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

1. Contributory negligence

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

1. Created more awareness of the possibility of auditor criminal prosecution.

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

1. Credit Alliance Corp. v. Arthur Andersen & Co.

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

12. Securities act of 1933

j. Written law created by state or federal legislative bodies.

14. Statutory law

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

2. Common law

a. 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:

2. Gross negligence

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

2. The CPA made a false statement

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

2. The Rosenblum approach

g. 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.

3. Constructive fraud

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

3. Failed to exercise due care

j. 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?

3. 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"

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

4. Common law

h. 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?

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

b. Will Maxwell recover?

The prospects for Maxwell's recovery of its $30,000 loss are substantially less than those of Busch. Maxwell was not a third-party beneficiary to the contract. Thus, in many jurisdictions following Ultramares, Maxwell cannot recover losses attributable to the CPAs' ordinary negligence. Similarly, it is doubtful that Maxwell would qualify as a foreseen third party as necessary under the Restatement approach. Even in a jurisdiction accepting the Rosenblum precedent, which allows third parties to recover losses caused by the auditors' ordinary negligence, Maxwell would have to prove that it was a "foreseeable third party relying upon the financial statements for routine business purposes." It is questionable whether the loan by Maxwell was either "reasonably foreseeable" or "routine," as Maxwell was a customer of Meglow, not a lender.

a. Discuss each of the theories of liability that Risk Capital will probably assert as its basis for recovery.

The first basis for liability would be to assert ordinary negligence by Wilson and Wyatt. The failure to meet the standards of the profession would be indicative of ordinary negligence. Since the purpose of the audit was the purchase of the treasury stock, Risk Capital is a third-party beneficiary under the contract between Wilson and Wyatt and Florida Sunshine. Therefore, Wilson and Wyatt would be held liable for ordinary negligence to Risk Capital. The second basis for liability is constructive fraud. Here Risk Capital must show that the accountants either knew the financial statements were incorrect or examined them without regard for due professional care; that is, that their negligence was so great (i.e., grossly negligence) as to constitute constructive fraud. If fraud is proven, privity is not necessary for recovery by a third party.

a. The Securities Act of 1933 applies to the above-described public offering of securities.

True The Securities Act of 1933 regulates interstate offerings of securities to the public

b. The accounting firm has potential liability to any person who acquired the stock:

True The effect of the Securities Act of 1933 is to give to third parties who purchase registered securities the same rights against the auditor as are possessed by the client under common law.

b. Assuming that only ordinary negligence by Wilson and Wyatt is proved, will Risk Capital prevail? State yes or no and explain.

Yes. In this case Risk Capital is clearly a third-party beneficiary. Therefore, Risk Capital could recover losses, if it can be established that the firm of Wilson and Wyatt is guilty of ordinary negligence.

c. An insider who had knowledge of all the facts regarding the loans to the two paper corporations could nevertheless recover from the accounting firm:

false Section 11(a) of the Securities Act of 1933 specifically bars recovery by anyone knowing of an untruth or omission in a registration statement.

d. In court, investors who bought shares in Dandy Container need only show that they sustained a loss and that failure to explain the nature of the loans in question constituted a false statement or misleading omission in the financial statements:

true The Securities Act of 1933 shifts the burden of proving that the audit was conducted properly to the defendant auditors.

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

7. Negligence

b. 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.

9. proportionate liability

a. Will Busch recover?

Yes, but only to the extent of $70,000. Busch is a third-party beneficiary of the contract between Meglow and its auditors, and may therefore recover from the auditors' losses caused by the CPAs' ordinary negligence. However, the original $50,000 loan was made prior to Busch's reliance upon the negligently audited financial statements. Thus, the auditors' negligence was not the proximate cause of this portion of Busch's loss. The auditors' negligence may, however, be considered the proximate cause of the $70,000 loss incurred as a result of reliance upon the misleading statements

c. 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.

10. Proximate cause

e. Intent to deceive, manipulate, or defraud. This concept is used in the 1934 Securities Exchange Act to establish auditor liability.

11. Scienter

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

2. Unaudited financial statement

g. The Securities and Exchange Commission would defend any action brought against the accountants in that the SEC examined and approved the registration statement:

false The SEC does not pass on the merit of securities, nor does it defend accountants.

f. The accountants could avoid or reduce the damages asserted against them if they could establish that the drop in the stock's market price was due in whole or in part to other causes:

true The accountants' defense will usually include efforts to establish that there were other causes for the plaintiffs' losses.