Exercise about Legal Liability

MULTIPLE CHOICE QUESTIONS
1. The traditional common-law rules regarding accountants' liability to third parties for negligence
a. Remain substantially unchanged since their inception.
b. Were more stringent than the rules currently applicable.
c. Are of relatively minor importance to the accountant.
d. Have been substantially changed at both the federal and state levels.

2. Gaspard & Devlin, a medium-sized CPA firm, employed Marshall as a staff accountant. Marshall was
negligent in auditing several of the firm's clients. Under these circumstances which of the following
statements is true?
a. Gaspard & Devlin is not liable for Marshall's negligence.
b. Gaspard & Devlin can recover against its insurer on its malpractice policy even if one of the
partners was also negligent in reviewing Marshall's work.
c. Marshall would have no personal liability for negligence.
d. None of these.

3. For what minimum period should audit WP's be retained by the CPA?
a. For the period during which the entity remains a client of the independent CPA.
b. For the period during which an auditor-client relationship exists but not more than six years.
c. For the statutory period within which legal action may be brought against the independent CPA.
d. For as long as the CPA is in public practice.

4. The 1136 Tenants case was chiefly important because of its emphasis upon the legal liability of the CPA
when associated with
a. A review of interim statements.
b. Unaudited financial statements.
c. An audit resulting in a disclaimer of opinion.
d. Letters for underwriters.

5. You are a CPA retained by the manager of a cooperative retirement village to do "write-up work." You
are expected to prepare unaudited financial statements with each page marked "unaudited" and
accompanied by a disclaimer of opinion stating no audit was made. In performing the work you discover
that there are no invoices to support $25,000 of the manager's claimed disbursements. The
managerinforms you that all the disbursements are proper. What should you do?
a. Submit the expected statements but omit the $25,000 of unsupported disbursements.
b. Include the unsupported disbursements in the statements since you are not expected to make an
audit.
c. Obtain from the manager a written statement that you informed him of the missing invoices and
his assurance that the disbursements are proper.
d. Notify the owner that some of the claimed disbursements are unsupported & withdraw if the
situation is not satisfactorily resolved.
6. Winslow Manufacturing Inc., sought a $200,000 loan from National Lending Corporation. National
Lending insisted that audited financial statements be submitted before it would extend credit. Winslow
agreed to this and also agreed to pay the audit fee. An audit was performed by an independent CPA who
submitted his report to Winslow to be used solely for the purpose of negotiating a loan from National.
National, upon reviewing the audited financial statements decided in good faith not to extend the credit
desired. Certain ratios which as a matter of policy were used by National in reaching its decision, were
deemed too low. Winslow used copies of the audited financial statements to obtain credit elsewhere. It
was subsequently learned that the CPA, despite the exercise of reasonable care, had failed to discover a
sophisticated embezzlement scheme by Winslow's chief accountant. Under these circumstances, what
liability does the CPA have?
a. The CPA is liable to third parties who extended credit to Winslow based upon the audited
financial statements.
b. The CPA is liable to Winslow to repay the audit fee because credit was not extended by
National.
c. The CPA is liable to Winslow for any losses Winslow suffered as a result of failure to discover
the embezzlement.
d. The CPA is not liable to any of the parties.

7. Martinson is a duly licensed CPA. One of his clients is suing him for negligence alleging that he failed to
meet generally accepted auditing standards in the current year's audit thereby failing to discover large
thefts of inventory. Under the circumstances
a. Martinson is not bound by generally accepted auditing standards unless he is a member of the
AICPA.
b. Martinson's failure to meet generally accepted auditing standards would result in liability.
c. Generally accepted auditing standards do not currently cover the procedures which must be used
in verifying inventory for balance sheet purposes.
d. If Martinson failed to meet generally accepted auditing standards, he would undoubtedly be
found to have committed the tort of fraud.

8. An investor seeking to recover stock market losses from a CPA firm, based upon an unqualified opinion
on financial statements which accompanied a registration statement, must establish that
a. There was a false statement or omission of material fact contained in the audited financial
statements.
b. He relied upon the financial statements.
c. The CPA firm did not act in good faith.
d. The CPA firm would have discovered the false statement or omission if it had exercised due
care in its examination.

9. Josephs & Paul is a growing medium-sized partnership of CPAs. One of the firm's major clients is
considering offering its stock to the public. This will be the firm's first client to go public. Which of the following is true with respect to this engagement?
a. If the client is a service corporation, the Securities Act of 1933 will not apply.
b. If the client is not going to be listed on an organized exchange the Securities Exchange Act of
1934 will not apply.
c. The Securities Act of 1933 imposes important additional potential liability on Josephs & Paul.
d. As long as Josephs & Paul engages exclusively in interstate business, the federal securities laws
will not apply.

10. The most significant aspect of the Continental Vending case was that it
a. Created a more general awareness of the auditor's exposure to criminal prosecution.
b. Extended the auditor's responsibility for financial statements of subsidiaries.
c. Extended the auditor's responsibility for events after the end of the audit period.
d. Defined the auditor's common-law responsibilities to third parties.

11. A third-party purchaser of securities has brought suit based upon the Securities Act of 1933 against a
CPA firm. The CPA firm will prevailing the suit brought by the third party even though the CPA firm
issued an unqualified opinion on materially incorrect financial statements if
a. The CPA firm was unaware of the defects.
b. The third-party plaintiff had no direct dealings with the CPA firm.
c. The CPA firm can show that the third-party plaintiff did not rely upon the audited financial
statements.
d. The CPA firm can establish that it was not guilty of actual fraud.

12. Doe and Co., CPAs, issued an unqualified opinion on the 1983 financial statements of Marx Corp.
These financial statements were included in Marx's annual report and Form 10-K filed with the SEC.
Doe did not detect material misstatements in the financial statements as a result of negligence in the
performance of the audit. Based upon the financial statements, Fitch purchased stock in Marx. Shortly
thereafter, Marx became insolvent, causing the price of the stock to decline drastically. Fitch has
commenced legal action against Doe for damages based upon Section 10(b) and Rule 10b-5 of the
Securities Exchange Act of 1934. Doe's best defense to such an action would be that
a. Fitch lacks privity to sue.
b. The engagement letter specifically disclaimed all liability to third parties.
c. There is no proof of scienter.
d. There has been no subsequent sale for which a loss can be computed.

13. If a stockholder sues a CPA for common law fraud based upon false statements contained in the
financial statements audited by the CPA, which of the following is the CPA's best defense?
a. The stockholder lacks privity to sue.
b. The CPA disclaimed liability to all third parties in the engagement letter.
c. The contributory negligence of the client.
d. The false statements were immaterial.


Questions 14 and 15 are based on the following information:
Jane Cox, a shareholder of Mix Corp., has properly commenced a derivative action against Mix's Board
of Directors. Cox alleges that the Board breached its fiduciary duty and was negligent by failing to
independently verify the financial statements prepared by management upon which Smart & Co., CPAs,
issued an unqualified opinion. The financial statements contained inaccurate information which the
Board relied upon in committing large sums of money to capital expansion. This resulted in Mix
having to borrow money at extremely high interest rates to meet current cash needs. Within a short
period of time, the price of Mix Corp. stock declined drastically.

14. Which of the following statements is correct?
a. The Board is strictly liable, regardless of fault, since it owes a fiduciary duty to both the
corporation and the shareholders.
b. The Board is liable since any negligence of Smart is automatically imputed to the Board.
c. The Board may avoid liability if it acted in good faith and in a reasonable manner.
d. The Board may avoid liability in all cases where it can show that it lacked scienter.

15. If the court determines that the Board was negligent and the Board seeks indemnification for its legal fees
from Mix, which of the following are correct?
a. The Board may not be indemnified since a presumption that the Board failed to act in good faith
arises from the judgment.
b. The Board may not be indemnified unless Mix's shareholders approve such indemnification.
c. The Board may be indemnified by Mix only if Mix provides liability insurance for its officers
and directors.
d. The Board may be indemnified by Mix only if the court deems it proper.

16. Locke, CPA, was engaged by Hall, Inc., to audit Willow Company. Hall purchased Willow after
receiving Willow's audited financial statements, which included Locke's unqualified auditor's opinion.
Locke was negligent in the performance of the Willow audit engagement. As a result of Locke's
negligence, Hall suffered damages of $75,000. Hall appears to have grounds to sue Locke for
Breach of
Contract Negligence
a. yes yes
b. yes no
c. no yes
d. no no

17. Gleam is contemplating a common law action against Moore & Co., CPAs, based upon fraud. Gleam
loaned money to Lilly & Company relying upon Lilly's financial statements which were audited by
Moore. Gleam's action will fail if
a. Gleam shows only that Moore failed to meticulously follow GAAS.
b. Moore can establish that they fully complied with the statute of frauds.
c. The alleged fraud was in part committed by oral misrepresentations and Moore pleads the parole
evidence rule.
d. Gleam is not a third party beneficiary in light of the absence of privity.


18. George, a CPA, has prepared a tax return for his client, Arbor. The return was prepared in a fraudulent
manner. Regarding George's potential liability to various parties, which of the following would be
dismissed?
a. A federal criminal action.
b. A federal action for civil penalties.
c. A federal action to revoke George's CPA certificate.
d. A malpractice action by the client.

19. If a CPA firm is being sued for common law fraud by a third party based upon materially false financial
statements, which of the following is the best defense which the accountants could assert?
a. Lack of privity.
b. Lack of reliance.
c. A disclaimer contained in the engagement letter.
d. Contributory negligence on the part of the client.

20. Which of the following statements concerning the scope of Section 10(b) of the Securities Exchange Act
of 1934 is correct?
a. It applies to purchases as well as sales of securities in interstate commerce.
b. There is an exemption from its application for securities registered under the Securities Act of
1934.
c. It applies exclusively to securities of corporations registered under the Securities Exchange Act
of 1934.
d. In order to come within its scope, a transaction must have taken place on a national stock
exchange.

21. A requirement of a private action to recover damages for violation of the registration requirements of the Securities Act of '33 is that
a. The plaintiff has acquired the securities in question.
b. The issuer or other defendents commit either negligence or fraud in the sale of the securities.
c. A registration statement has been filed.
d. The securities be purchased from an underwriter.

22. Lewis & Clark, CPAs, rendered an unqualified opinion on the financial statements of a company that
sold common stock in a public offering subject to the Securities Act of 1933. Based on a false statement
in the financial statements, Lewis & Clark are being sued by an investor who purchased shares of this
public offering. Which of the following represents a viable defense?
a. The investor has not met the burden of proving fraud or negligence by Lewis & Clark.
b. The investor did not actually rely upon the false statement.
c. Detection of the false statement by Lewis & Clark occurred after their examination date.
d. The false statement is immaterial in the overall context of the financial statements.

23. Gibson is suing Simpson & Sloan, CPAs, to recover losses incurred in connection with Gibson's
transactions in Zebra Corporation securities. Zebra's Annual Form 10-K Report contained material
false and misleading statements in the financial statements audited by Simpson & Sloan. To recover
under the Securities and Exchange Act of 1934, Gibson must, among other things, establish that
a. All of his past transactions in Zebra securities, both before and after the auditor's report date,
resulted in net loss.
b. The transaction in Zebra securities that resulted in a loss occurred within 90 days of the
auditors' report date.
c. He relied upon the financial statements in his decision to purchase or sell Zebra securities.
d. The market price of the stock dropped significantly after corrected financial statements were
issued by Zebra.

24. Donalds & Company, CPAs, audited the financial statements included in the annual report submitted by
Markum Securities, Inc., to the Securities and Exchange Commission. 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 upon Section 10b and Rule 10b-5 of the
Securities Exchange Act of 1934. Which of the following is likely to be Donalds' best defense?
a. They did not intentionally certify false financial statements.
b. Section 10b does not apply to them.
c. They were not in privity of contact with the creditors.
d. Their engagement letter specifically disclaimed any liability to any party which resulted from
Markum's fraudulent conduct.