Name: Auditing And Assurance Services 13th Edition by Arens - Test Bank
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Sample Questions Posted Below

Chapter 5

Multiple-Choice Questions

1.	While performing services for their clients, professionals have a duty to provide a level of care
easy	which is:
d	a.	free from judgment errors.
	b.	superior.
	c.	greater than average.
	d.	reasonable.
2.	Auditors who fail to exercise due care in their performance of professional services may be
easy	liable for:
b	a.	punitive liability.
	b.	breach of contract.
	c.	excess liability.
	d.	criminal charges.
3.	Which of the following may give rise to a business failure?
easy	a.	An erroneous audit opinion is issued.
b	b.	Management may make ill-advised business decisions.
	c.	Auditors may fail to uncover employee fraud.
	d.	Poorly trained auditors may perform a company’s audit.
4.	A(n) _____ failure occurs when an auditor issues an erroneous opinion as the result of an
easy	underlying failure to comply with auditing standards.
b	a.	business
	b.	audit
	c.	ethics
	d.	process
5.	The standard of due care to which the auditor is expected to adhere is referred to as the:
easy	a.	prudent person concept.
a	b.	common law doctrine.
	b.	common law doctrine.
	c.	due care concept.
	d.	vigilant person concept.
6.	Auditors may be liable to their clients for:
easy			Punitive damages		Compensatory damages
a	a.		Yes	Yes
	b.		No	No
	c.		Yes	No
	d.		No	Yes
7.	Under the laws of agency, partners of a CPA firm may be liable for the work of others on whom
easy	they rely. This would not include:
b	a.	employees of the CPA firm.
	b.	employees of the audit client.
	c.	other CPA firms engaged to do part of the audit work.
	d.	specialists employed by the CPA firm to provide technical advice on the audit.

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8.	“Absence of reasonable care that can be expected of a person in a set of circumstances” defines:
easy	a.	pecuniary negligence.
d	b.	gross negligence.
	c.	extreme negligence.
	d.	ordinary negligence.
9.	An example of a breach of contract would likely include:
easy	a.	an auditor’s refusal to return the client’s general ledger book until the client paid last
c		year’s audit fees.
	b.	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.
	c.	a CPA firm’s failure to complete an audit on the agreed-upon date because the firm had a
		backlog of other work which was more lucrative.
	d.	an auditor’s claim that the client staff is unqualified.
10.	Privity of contract exists between:
easy	a.	auditor and the federal government.
c	b.	auditor and third parties.
	c.	auditor and client.
	d.	auditor and client attorney.
11.	Audit contracts (engagement letters):
easy	a.	may be either oral or written.
b	b.	must be written.
	c.	must be written and notarized.
	d.	must be written if the client is regulated by the Securities and Exchange Commission.
12.	An individual who is not party to the contract between a CPA and the client, but who is known
easy	by both and is intended to receive certain benefits from the contract is known as:
d	a.	a third party.
	b.	a common law inheritor.
	c.	a tort.
	d.	a third-party beneficiary.
13.	Laws that have been developed through court decisions rather than by passage through
easy	legislative bodies are:
d	a.	statutory laws.
	b.	judicial laws.
	c.	federal laws.
	d.	common laws.
14.	Laws that have been passed through state legislatures are:
easy	a.	statutory laws.
a	b.	judicial laws.
	c.	federal laws.
	d.	common laws.
15.	The assessment against a defendant of the full loss suffered by a plaintiff regardless of other
easy	parties’ liability in the wrongdoing is called:
d	a.	separate and proportionate liability.
	b.	shared liability.
	c.	unitary liability.
	d.	joint and several liability.

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16.	_____ risk represents the possibility that the auditor concludes after conducting an adequate
easy	audit that the financial statements were fairly stated when they were actually misstated.
c	a.	Business
	b.	Process
	c.	Audit
	d.	Failure
17.	The assessment against a defendant of that portion of the damage caused by the defendant’s
easy	negligence is called:
a	a.	separate and proportionate liability.
	b.	joint and several liability.
	c.	shared liability.
	d.	unitary liability.
18.	In third-party suits, which of the auditor’s defenses contends lack of privity of contract?
easy	a.	Lack of duty.
a	b.	Non-negligent performance.
	c.	Contributory negligence.
	d.	Absence of causal connections.
19.	Which of the following auditor’s defenses usually means non-reliance on the financial
easy	statements by the user?
c	a.	Lack of duty.
	b.	Non-negligent performance.
	c.	Lack of causal connections.
	d.	Contributory negligence.
20.	There are a number of things that the AICPA, representing the profession as a whole, can do to
easy	reduce the CPA’s exposure to lawsuits. One of them is to:
a	a.	sanction members for improper conduct and performance.
	b.	deal only with clients possessing integrity.
	c.	hire qualified auditors and train and supervise them.
	d.	perform quality audits.
21.	In	connection with the audit of financial statements, an independent auditor could be
easy	responsible for failure to detect a material fraud if:
b	a.	statistical sampling techniques were not used on the audit engagement.
	b.	the auditor planned the audit in a negligent manner.
	c.	accountants performing important parts of the work failed to discover a close relationship
		between the treasurer and the cashier.
	d.	the fraud was perpetrated by one employee who circumvented the existing internal
		controls.
22.	Which of the following most accurately describes constructive fraud?
medium	a.	Absence of reasonable care.
b	b.	Lack of slight care.
	c.	Knowledge and intent to deceive.
	d.	Extreme or unusual negligence without the intent to deceive.
23.	Which of the following most accurately describes fraud?
medium	a.	Absence of reasonable care.
c	b.	Lack of slight care.
	c.	Knowledge and intent to deceive.
	d.	Extreme or unusual negligence without the intent to deceive.

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24.	Which of the following is an illustration of liability to clients under common law?
medium	a.	Client sues auditor for not discovering a theft of assets by an employee.
a	b.	Bank sues auditor for not discovering that borrower’s financial statements are misstated.
	c.	Combined group of stockholders sue auditor for not discovering materially misstated
		financial statements.
	d.	Federal government prosecutes auditor for knowingly issuing an incorrect audit report.
25.	Which of the following is an illustration of liability under the federal securities acts?
medium	a.	Client sues auditor for not discovering a theft of assets by an employee.
c	b.	Bank sues auditor for not discovering that borrower’s financial statements are misstated.
	c.	Combined group of stockholders sue auditor for not discovering materially misstated
		financial statements.
	d.	auditor sues client for not cooperating during engagement.
26.	A third-party beneficiary is one which:
medium	a.	has failed to establish legal standing before the court.
c	b.	does not have privity of contract and is unknown to the contracting parties.
	c.	does not have privity of contract, but is known to the contracting parties and intended to
		benefit under the contract.
	d.	may establish legal standing before the court after a contract has been consummated.
27.	If the CPA negligently failed to properly prepare and file a client’s tax return, the CPA may be
medium	liable for:
c	a.	the penalties the client owes the IRS.
	b.	the penalties and interest the client owes.
	c.	the penalties and interest the client owes, plus the tax preparation fee the CPA charged.
	d.	the penalties and interest, the tax preparation fee, and the amount of tax that was
		underpaid.
28.	Historically, most major lawsuits against CPA firms have dealt with:
medium	a.	disputes over income tax preparation services.
d	b.	disputes arising in the performance of MAS contracts.
	c.	disputes over the accuracy of bookkeeping services.
	d.	audited and unaudited financial statements.
29.	“Privileged communication” between client and auditor is:
medium	a.	available in all federal courts.
c	b.	not available in any court.
	c.	available in several states.
	d.	available for matters involving income taxes only.
30.	Which of the following statements is true?
medium
a			Gross negligence
			may constitute	Fraud requires the	All fraud should be detected
			constructive fraud		intent to deceive	during audit
	a.		Yes	Yes	No
	b.		No	Yes	Yes
	c.		Yes	No	Yes
	d.		No	No	No

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31.	Failure of a party to meet its obligations, thereby causing injury to another party to whom a duty
medium	was owed, is:
b	a.	breach of contract.
	b.	tort action for negligence.
	c.	constructive fraud.
	d.	fraud.
32.	Tort actions against CPAs are more common than breach of contract actions because:
medium	a.	there are more torts than contracts.
d	b.	the burden of proof is on the auditor rather than on the person suing.
	c.	the person suing need prove only negligence.
	d.	the amounts recoverable are normally larger.
33.	The principal issue to be resolved in cases involving alleged negligence is usually:
medium	a.	the amount of the damages suffered by plaintiff.
c	b.	whether to impose punitive damages on defendant.
	c.	the level of care exercised by the CPA.
	d.	whether defendant was involved in fraud.
34.	In the auditing environment, failure to meet auditing standards is often:
medium	a.	an accepted practice.
c	b.	a suggestion of negligence.
	c.	conclusive evidence of negligence.
	d.	tantamount to criminal behavior.
35.	A common way for a CPA firm to demonstrate its lack of duty to perform is by use of a(n):
medium	a.	expert witness’ testimony.
b	b.	audit contract, or engagement letter.
	c.	management representation letter.
	d.	confirmation letter.
36.	The prudent person concept establishes that:
medium	a.		the CPA firm is not expected to make only perfect judgments.
a	b.		an audit in accordance with GAAS is subject to limitations and cannot be relied upon for
			complete assurance that all errors and irregularities will be found.
	c.		the courts do not require that the auditor become the insurer or guarantor of the accuracy
			of the statements.
	d.		all CPAs are considered prudent.
37.	To succeed in an action against the auditor, the client must be able to show that:
medium	a.		the auditor was fraudulent.
d	b.		the auditor was grossly negligent.
	c.		there was a written contract.
	d.		there is a close causal connection between the auditor’s behavior and the damages
			suffered by the client.
38.	A group typically included as “third parties” in common law is:
medium
a			Actual and potential stockholders		Employees of client
	a.		Yes	Yes
	b.		No	No
	c.		Yes	No
	d.		No	Yes

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39.

The major conclusion of the 1931 Ultramares case was that:

mediuma

	a.	ordinary negligence is insufficient for liability to third parties.
	b.	ordinary negligence is sufficient for liability to third-party beneficiaries.
	c.	fraud or gross negligence is sufficient for liability to third parties.
	d.	auditors have no liabilities to third parties.
40.	Under common law, a foreseen user would be treated the same as:

mediuma

A primary beneficiary

A known third party

a.YesYesb.NoNoc.YesNod.NoYes41.

	A broad interpretation of the rights of third-party beneficiaries holds that users that the auditor
medium	should have been able to foresee as being likely users of financial statements have the same
b	rights as those with privity of contract. This is known as the concept of:

a.foreseen users.b.foreseeable users.c.expected users.d.four-party contracts.42.

	Which of the auditor’s defenses is ordinarily not available when lawsuits are filed by a third
medium	party?

ba.Absence of causal connections.b.Contributory negligence.c.Non-negligent performance.d.Lack of duty.43.

	According to the principle established by the Restatement of Torts case, foreseen users must be
medium	members of:

ca.any potential user group.b.a legally protected class.

	c.	a reasonably limited and identifiable user group.
	d.	a reasonably limited and established user group.
44.	The increased litigation under the federal securities laws has resulted from:

mediumcThe strict liabilitystandards imposed onThe availability ofCPAs by the securitiesclass-action litigationlawsAn excess of attorneys

	a.		Yes	Yes	Yes
	b.		Yes	No	No
	c.		Yes	Yes	No
	d.		No	No	No
45.	Which of the following statements about the Securities Act of 1933 is not true?
medium	a.	The amount of the potential recovery is the original purchase price plus punitive damages.
a	b.	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.

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46.	Under the Securities Act of 1933, the auditor’s responsibility for making sure the financial
medium	statements were fairly stated extends to:
b	a.	the date of the financial statements.
	b.	the date the registration statement becomes effective.
	c.	the date of the audit report.
	d.	one year beyond the date of the financial statements.
47.	Under the Securities Exchange Act of 1934, which type of organizations is required to submit
medium	audited financial statements to the SEC?
a	a.	Every company with securities traded on national and over-the-counter exchanges.
	b.	Every corporation.
	c.	Every company issuing new securities.
	d.	Every corporation which is chartered by a state government.
48.	The Securities and Exchange Commission can impose all but which of the following sanctions?
medium	a.	Suspend a CPA from auditing SEC clients.
d	b.	Prohibit a CPA from accepting new SEC clients for a period of time.
	c.	Require a CPA to participate in continuing-education programs and make changes in
		their practice.
	d.	Revoke a CPA license.
49.	The Foreign Corrupt Practices Act (FCPA) of 1977:
medium	a.	requires auditors to review and evaluate systems of internal control as a part of an audit.
b	b.	requires SEC registrants to maintain a reasonably complete and accurate set of records
		and an adequate system of internal control.
	c.	requires auditors to review client’s internal control system in a manner which is thorough
		enough to judge whether client meets the requirements of the FCPA.
	d.	requires auditors to file a report with the SEC if client’s internal control system is
		inadequate.
50. (SOX)	While the Foreign Corrupt Practices Act of 1977 remains in effect, it has been largely
medium	superseded by which of the following?
a	a.	The Sarbanes-Oxley Act of 2002.
	b.	The Racketeer Influenced and Corrupt Organization Act.
	c.	The Federal False Statements Statute.
	d.	The Federal Mail Fraud Statute.
51.	Which of the following is not likely a factor in the increase in the number of lawsuits and sizes
medium	of awards to plaintiffs related to auditor behavior?
c	a.	Increased awareness of auditor responsibilities by users of financial statements.
	b.	CPA firms are more willing to settle lawsuits.
	c.	Difficulty judges and jurors have in understanding legal matters.
	d.	Increased consciousness on the part of the SEC for its responsibility to protect investors.
52.	Historically, one of the leading case of criminal action against CPAs is the:
medium	a.	1136 Tenants case.
b	b.	United States v. Simon case.
	c.	Escott et al. v. Bar Chris case, aka Bar Chris.
	d.	Ultramares Corporation v. Touche case.
53.	A major purpose of federal securities regulations is to:
medium	a.	provide sufficient reliable information to the investing public who purchases securities in
a		the marketplace.
	b.	establish the qualifications for accountants who are members of the profession.
	c.	eliminate incompetent attorneys and accountants who participate in the registration of

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securities to be offered to the public.

provide a set of uniform standards and tests for accountants, attorneys, and others who practice before the Securities and Exchange Commission.

54.	A CPA is subject to criminal liability if the CPA:
medium	a.	refuses to turn over requested audit documentation to a client.
c	b.	performs an audit in a negligent manner.
	c.	willfully omits a material fact from a set of financial statements.
	d.	willfully breaches a contract with a client.
55.	Which of the following best describes a trend in litigation involving CPAs?
medium	a.	A CPA cannot render an opinion unless the CPA has audited all affiliates of a company.
c	b.	A CPA may not successfully assert that the CPA had no motive to be part of a fraud.
	c.	A CPA may be exposed to criminal as well as civil liability.
	d.	A CPA is primarily responsible for a client’s footnotes filed with the SEC.
56.	Tort actions can be based on which of the following?
medium
a			Ordinary negligence		Gross negligence
	a.		Yes	Yes
	b.		No	No
	c.		Yes	No
	d.		No	Yes
57.	The preferred defense in third-party suits is:
medium	a.	lack of duty to perform.
b	b.	non-negligent performance.
	c.	absence of causal connection.
	d.	client fraud.
58.	Which of the following resulted in a federal law passed in 1995 that significantly reduced
challenging	potential damages in securities-related litigation?
a	a.	Private Securities Litigation Reform Act.
	b.	Public Securities Damages and Settlements Act.
	c.	Racketeer Influenced and Corrupt Organization Act.
	d.	U.S. Securities Claims Reform Act.
59.	The Private Securities Litigation Reform Act of 1995 reduced potential damages in securities-
challenging	related litigation, but because the act applied only to federal courts, attorneys began taking cases
b	to state courts. Which of the following eliminated this loophole?
	a.	Private Securities Litigation Reform Amendment.
	b.	Securities Litigation Uniform Standards Act of 1998.
	c.	Racketeer Influenced and Corrupt Organization Act.
	d.	U.S. Securities Claims Reform Act.
60.	One of the changes in auditing procedure which was brought about as a result of the 1136
challenging	Tenants case was that auditors were encouraged to begin using:
c	a.	letters of representation.
	b.	confirmation letters.
	c.	engagement letters.
	d.	billet doux letters.
61.	The leading precedent-setting auditing case in third-party liability is:
challenging	a.	Escott et al. v. Bar Chris Construction Corp.
c	b.	Hochfelder v. Ernst & Ernst.
	c.	Ultramares Corporation v. Touche.

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	d.	United States v. Simon.
62.	Under common law, an individual or company that (1) does not have a contract with an auditor,
challenging	(2) is known by the auditor in advance of the audit, and (3) will use the auditor’s report to make
d	decisions about the client company has:
	a.	no rights unless an auditor is grossly negligent.
	b.	no rights unless an auditor is fraudulent.
	c.	no rights against an auditor.
	d.	the same rights against an auditor as a client.
63.	The basic legal concept which was affirmed in the 1985 New York case, Credit Alliance, was
challenging	that:
a	a.	the auditor’s defense of privity of contract is still valid against third parties.
	b.	the auditor is liable for ordinary negligence to specifically foreseen third parties.
	c.	the auditor is liable for ordinary negligence to reasonably foreseeable third parties.
	d.	the auditor’s defense of contributory negligence is no longer valid.
64.	Which of the following statements about the Securities Act of 1933 is not true?
challenging	a.	A third party that purchased securities described in the registration statement may sue the
c		auditor for material misrepresentations or omissions in the audited financial statements.
	b.	A third-party user does not have the burden of proof that he/she relied on the financial
		statements.
	c.	A third-party user has the burden of proof that the auditor was either negligent or
		fraudulent in doing the audit.
	d.	A third-party user does not have the burden of proof that the loss was caused by the
		misleading statements.
65.	The most significant audit issue that came as a result of the court decision in the Escott et al. v.
challenging	Bar Chris Construction Corporation case in 1968 was:
b	a.	the court’s reaffirmation that the burden of proof was on the plaintiff to prove the auditor
		was negligent.
	b.	the affirmation of the increased auditor’s responsibility when performing an S-1 review, a
		review of events subsequent to the balance sheet, for registration statements.
	c.	the increased auditor responsibility when associated with unaudited financial statements.
	d.	the court’s refusal to allow the percentage-of-completion method of accounting for
		revenues.
66.	Under the federal securities acts, one significant result occurring directly due to the Escott et al.
challenging	v. Bar Chris Construction Corporation case was that SAS was changed to require:
a	a.	greater emphasis on subsequent events procedures.
	b.	new standards for unaudited statements.
	c.	a broader definition of third-party beneficiaries.
	d.	more companies to file annual reports with the SEC.
67.	Under the Securities Exchange Act of 1934, most of the litigation against the auditor has been
challenging	generated because of the auditor’s involvement with the:
b	a.	8-K form.
	b.	10-K form.
	c.	10-Q form.
	d.	S-1 form.
68.	Section 10 and Rule 10b-5 of the Securities Exchange Act of 1934 are often referred to as:
challenging	a.	the antifraud provisions.
a	b.	the new issues provisions.
	c.	the full-employment act for accountants.
	d.	the RICO provisions.

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69.	In a leading securities law and CPA liabilities case, the U.S. Supreme Court ruled in 1976 in
challenging	Hochfelder v. Ernst & Ernst that before CPAs could be held liable for Rule 10b-5 of the
c	Securities Exchange Act of 1934, what would be required to be shown to the court was the
	auditor’s:
	a.	ordinary negligence.
	b.	gross negligence.
	c.	knowledge and intent to deceive.
	d.	financial gain at the expense of the plaintiff.
70.	The similarity that exists in both the United States v. Natelli case (i.e., the National Student
challenging	Marketing case of 1975), and the ESM Government Securities v. Alexander Grant & Co. case of
d	1986 is that in each case:
	a.	a partner in a national CPA firm served prison time.
	b.	the partners were punished for the shoddy work of their subordinates.
	c.	a presidential pardon kept them from serving time in prison and allowed them to retain
		their CPA licenses.
	d.	the auditors were not convicted for failing to discover the problem in year 1, but for failing
		to disclose the problem when it was discovered in year 2.
71.	The Securities and Exchange Commission has authority to:
challenging	a.	prescribe specific auditing procedures to detect fraud concerning inventories and
c		accounts receivable of companies engaged in interstate commerce.
	b.	deny lack of privity as a defense in third-party actions for gross negligence against the
		auditors of public companies.
	c.	determine accounting principles for the purpose of financial reporting by companies
		offering securities to the public.
	d.	require a change of auditors of governmental entities after a given period of years as a
		means of ensuring auditor independence.
72.	The partnership of Booth & Haynes, CPAs, has been engaged to examine the financial
challenging	statements	of	Paul, Inc.,	in connection with	the registration of Paul’s securities	with the
a	Securities	and	Exchange	Commission. Under	these circumstances, which of the	following
	statements is true?
	a.	Booth & Haynes is assuming much greater third-party liability than it assumes on
		engagements under common law.
	b.	If its examination is not fraudulent, Booth & Haynes may issue an appropriate disclaimer
		to the financial statements and thereby avoid liability.
	c.	Booth & Haynes must incorporate if they wish to practice before the SEC.
	d.	Booth & Haynes must be a large interstate firm if they wish to practice before the SEC.
73.	Gregory & Hedrick, a medium-sized CPA firm, employed Elise as a staff accountant. Elise was
challenging	negligent while auditing several of the firm’s clients. Under these circumstances, which of the
d	following statements is true?
	a.	Elise would have no personal liability for negligence.
	b.	Gregory & Hedrick is not liable for Elise’s negligence because CPAs are generally
		considered to be independent contractors.
	c.	Gregory & Hedrick would not be liable for Elise’s negligence if Winters disobeyed
		specific instructions in the performance of the audits.
	d.	Gregory & Hedrick can recover against its insurer on its malpractice policy even if one of
		the partners was also negligent in reviewing Elise’s work.
74.	The King Surety Company wrote a general fidelity bond covering thefts of assets by the
challenging	employees of Wilson, Inc. Thereafter, Cooney, an employee of Wilson, embezzled $17,200 of
b	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

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auditors, Lynch & Merritt, CPAs. Which of the following would be Lynch & Merritt’s best defense?

King is not in privity of contract.

The shortages were the result of clever forgeries and collusive fraud which would not be detected by an examination made in accordance with generally accepted auditing standards.

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

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

75.	As a consequence of his failure to adhere to generally accepted auditing standards in the course
challenging	of his examination of the Lamp Corp., Harrison, CPA, did not detect the embezzlement of a
c	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?
	a.	He would have no liability, since the ordinary examination cannot be relied upon to detect
		thefts of assets by employees.
	b.	He would have no liability because privity of contract is lacking.
	c.	He would be liable for losses attributable to his negligence.
	d.	He would be liable only if it could be proven that he was grossly negligent.
76.	In connection with a public offering of first mortgage bonds by Henson Corp., the bond
challenging	underwriter has asked Henson’s CPA to furnish him with a comfort letter giving as much
b	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:
	a.	furnish to the underwriters an opinion that the March 31, 2007 statements are fairly
		presented subject to year-end audit adjustments.
	b.	give negative assurance as to the March 31, 2007 financial statements but disclaim an
		opinion on these statements.
	c.	inform the underwriters that no comfort letter is possible without an audit of the financial
		statements for the three months ended March 31, 2007.
	d.	Furnish to the underwriters an adverse opinion covering financial statements for the three
		months ended March 31, 2007.

Essay Questions

77.

easy

Distinguish between what is meant by business failure and audit failure.

Answer:

Business failure occurs when a business is unable to repay its debts, the extreme case of

which is filing for bankruptcy. Audit failure occurs when the auditor issues an incorrect

audit report as the result of failing to follow generally accepted auditing standards.

78.

easy

Distinguish between ordinary negligence and gross negligence.

Answer:

Ordinary negligence is the absence of reasonable care, whereas gross negligence is the

absence of even slight care that can be expected of a person in a set of circumstances.

Arens/Elder/Beasley

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79.

easy

Distinguish between audit risk and audit failure.

Answer:

Audit risk is the risk that the auditor will conclude that the financial statements are fairly

stated and issue an unqualified report when, in fact, the financial statements are materially

misstated. An audit failure occurs when the auditor, as a result of his or her failure to

follow GAAS, issues an erroneous audit report.

80.

easy

Discuss some of the steps individual practicing auditors can take to minimize their legal liability.

Answer:

There are many steps individual practitioners can take to minimize

including:

legal

liability

Deal only with clients possessing integrity.

Hire qualified personnel and train and supervise them properly.

Follow the standards of the profession.

Maintain independence.

Understand the client’s business.

Perform quality audits.

Document the work properly.

Obtain an engagement letter and a representation letter.

Maintain confidential relations.

Carry adequate insurance.

Seek legal counsel.

Choose a form of organization with limited liability.

81.

medium

Distinguish between constructive fraud and fraud.

Answer:

Constructive fraud is the existence of extreme or unusual negligence with no intent to

deceive or do harm. In contrast, fraud involves both knowledge and intent to deceive.

82.

medium

There are four major sources of an auditor’s legal liability. One source is liability to the audit client under common law. Briefly summarize the other three sources.

Answer:

The other three sources of auditor’s legal liability are:

Liability to third parties under common law.

Liability to shareholders under federal securities acts.

Criminal liability.

Arens/Elder/Beasley

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83.

medium

Discuss three major factors that have contributed to the recent increase in the number of lawsuits against auditors and the size of awards to plaintiffs.

Answer:

Major factors include:

The growing awareness of the responsibilities of public accountants by users of

financial statements.

An increased consciousness on the part of the Securities and Exchange Commission

regarding its responsibility for protecting investors’ interests.

Increasing complexity of auditing and accounting.

Large civil court judgments against CPA firms.

Joint and several liability doctrine which encourages plaintiffs to sue auditors

regardless of fault.

The willingness of CPA firms to settle out of court to avoid costly legal fees and

adverse publicity.

The difficulty courts have in interpreting technical accounting and auditing matters.

84.

medium

Distinguish between “joint and several liability” and “separate and proportionate liability.”

Answer:

Under joint and several liability, the defendant can be assessed the full loss suffered by the

plaintiff, regardless of the extent to which other parties shared in the wrongdoing. In

contrast, under separate and proportionate liability, the defendant is assessed that portion

of the plaintiff’s loss caused by the defendant’s wrongdoing.

85.

medium

Discuss each of the four defenses a CPA firm can normally use when facing legal claims by clients. Which of these defenses is ordinarily not available against third-party suits?

Answer:

Lack of duty. The CPA firm could claim that there was no implied or expressed contract

to perform between the CPA firm and the client.

Nonnegligent performance. The CPA firm could claim that the audit was performed in accordance with GAAS.

Contributory negligence. The CPA firm could claim that the client’s actions either caused the loss, or interfered with the auditor’s ability to discover the cause of the loss. This defense is not available in third-party suits.

Absence of causal connection. The CPA firm could claim that the auditor’s substandard performance did not cause the damages suffered by the client.

Arens/Elder/Beasley

HYPERLINK “http://downloadslide.blogspot.com”

86.

medium

Discuss some of the steps the AICPA and the accounting profession as a whole can and are taking to reduce the practitioner’s exposure to lawsuits.

Answer:

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 peer review requirements.

Opposing 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.

87.

medium

Discuss the sanctions the Securities and Exchange Commission can impose on auditors.

Answer:

The SEC has the power to suspend, temporarily or permanently, practitioners from doing

audits for SEC-regulated companies. The SEC can also require individual CPAs or CPA

firms to have an extensive review of their practices by another CPA firm, to participate in

continuing professional education programs, and to make changes in their practice.

88.

medium

Discuss some of the actions that can be taken by individual CPAs to protect themselves from legal liability.

Answer:

Deal only with clients possessing integrity.

Hire qualified personnel and train and supervise them properly.

Follow professional standards.

Maintain independence.

Understand the client’s business.

Perform quality audits.

Document the work properly.

Obtain an engagement letter and a representation letter.

Carry adequate insurance.

Seek legal counsel.

Choose a form of organization with limited liability.

Exercise professional skepticism.

Arens/Elder/Beasley

HYPERLINK “http://downloadslide.blogspot.com”

89.	Explain what each of the following terms means:
medium	(1)	Business failure.
	(2)	Audit failure.
	(3)	Audit risk.

Answer:

Business failure occurs when a business is unable to repay its lenders or meet the expectations of its investors because of economic or business conditions. The extreme case of business failure is filing for bankruptcy.

Audit failure occurs when the auditor issues an erroneous audit opinion as the result of a failure to comply with the requirements of generally accepted auditing standards.

Audit risk is the risk that the auditor will conclude that the financial statements are fairly stated and an unqualified opinion can be issued when, in fact, they are materially misstated.

90. Three approaches to the application of the foreseen users’ concept are (1) the Credit Alliance

challenging approach, (2) the restatement of torts approach, and (3) the foreseeable user approach.

Summarize each of these three approaches.

Answer:

The Credit Alliance approach upholds the concept of privity of contract established by the Ultramares Corporation v. Touche case. Under this approach, for an auditor to be liable to third parties, the auditor (1) must know and intend that his or her 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.

Under the restatement of torts approach, foreseen third-party users of the auditor’s work product must be members of a reasonably limited and identifiable group of users, even though those persons were not specifically known to the CPA at the time the work was done.

Under the foreseeable user approach, any users that the auditor should have reasonably been able to foresee as being likely users of financial statements have the same rights as those with privity of contract.

Arens/Elder/Beasley

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g		1.	A situation in which the auditor issues an erroneous audit opinion as the result
				of an underlying failure to comply with the requirements of generally
				accepted auditing standards.
b		2.	A federal statute dealing with companies that trade securities on national and
				over-the-counter exchanges. Auditors are involved because the annual
				reporting requirements include audited financial statements.
k		3.	An auditor’s legal defense under which the auditor claims that the client failed
				to perform certain obligations and that it is the client’s failure to perform those
				obligations that brought about the claimed damages.
a		4.	A federal statute that makes it illegal to offer a bribe to an official of a foreign
				country.
e		5.	A common-law approach to third-party liability in which ordinary negligence
				is insufficient for liability to third parties, because of the lack of privity of
				contract between the third party and the auditor unless the third party is a
				primary beneficiary.
c		6.	A federal statute designed to cause class-action securities lawsuits to be
				addressed in federal district courts.
n		7.	An auditor’s legal defense under which the auditor claims that the audit was
				performed in accordance with generally accepted auditing standards.
j		8.	An auditor’s legal defense under which the auditor contends that the damages
				claimed by the client were not brought about by any act of the auditor.
93.	The standard of due care to which the auditor is expected to be held is referred to as the prudent
easy	person concept.
a	a.	True
	b.	False

Auditing And Assurance Services 13th Edition by Arens – Test Bank

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