Ethical Obligations And Decision Making in Accounting Text and Cases 4th Edition by Steven M Mintz Chair – Test Bank A+

$35.00
Ethical Obligations And Decision Making in Accounting Text and Cases 4th Edition by Steven M Mintz Chair – Test Bank A+

Ethical Obligations And Decision Making in Accounting Text and Cases 4th Edition by Steven M Mintz Chair – Test Bank A+

$35.00
Ethical Obligations And Decision Making in Accounting Text and Cases 4th Edition by Steven M Mintz Chair – Test Bank A+

The key element that protects an auditor against common law liability is:

A.Adherence to generally accepted accounting principles (GAAP)

B.Adherence to generally accepted auditing standards (GAAS)

C.Compliance with threats and safeguards approach

D.Maintain confidentiality of client information

2.Which of the following is NOT one of the four stages in an audit-related dispute?

A.Events arise that create losses for the users of the financial statements

B.Losses are linked to material misstatements of financial statements

C.Legal process resolves the dispute

D.Auditors legal liability leads to financial settlement

3.Which of the following would normally be considered sufficient to demonstrate due care on the part of the auditor?

A.The auditor had its work reviewed by another audit firm

B.The auditor cites adherence to generally accepted auditing standards (GAAS)

C.No omissions or misstatements have been found in the client’s financial statements

D.The auditor signs a statement expressing its unmodified opinion as to the fairness of the financial statements

4.In the U.S., if the auditor can demonstrate having performed services with the same degree of skill and judgment possessed by others in the profession, it can be said to have exercised:

A.Prudence

B.Scienter

C.Nonfeasance

D.Due Care

5.The legal precedent that evolves from legal opinions issued by judges in deciding a case and guides judges in deciding similar cases in the future is referred to as:

A.Business law

B.Tort law

C.Common law

D.Statutory law

6.A privity relationship means that:

A.A party may be a user of the financial statements

B.A party may sue if fraud has taken place

C.A party’s financial liability is limited

D.A party has a contractual obligation

7.The Ultramares v. Touche case of 1933 held that a cause of action based on negligence could not be maintained by a third party who was not in contractual privity; however, it did leave open the possibility that:

A.Third parties that were “foreseeable” may sue for ordinary negligence

B.Third parties may sue if one of the parties in contractual privity allowed it to

C.Third parties may sue in the case of fraud or constructive fraud

D.Third parties who used the financial statements may sue

8.The Restatement (Second) of Torts Approach:

A.Expands an accountant’s legal liability to third parties identified by the client as intended recipients of work

B.Limits an accountant’s legal liability to only those parties with which it has a privity relationship

C.Limits an accountant’s legal liability to only those parties that have been named by the client

D.Expands an accountant’s legal liability to all possible users of the audited financial statements

9.The Rosenblum case ruling was of concern to the accounting profession because it implied that:

A.Full joint and several liability would be reinstated

B.All possible third party users of financial statements must be anticipated

C.The concept of contractual privity would no longer be important

D.Financial liability would occur when scienter was proven

10.The Credit Alliance v. Arthur Andersen & Co. case established three tests that must be satisfied for holding auditors liable for negligence to third parties. All of the following are tests described except:

A.Knowledge by the accountant that the financial statements are to be used for a particular purpose

B.The intention of the third party to rely on those statements

C.Some action by the accountant linking him or her to the third party that provides evidence of the accountant’s understanding of intended reliance

D.The identity of the third party must be directly known to the auditor

11.The unique aspect of auditors’ legal liability in the Rosenblum v. Adler ruling is:

A.Auditors could be held liable for ordinary negligence to all reasonably foreseeable third parties

B.Auditors could be held liable for gross negligence to all reasonably foreseeable third parties

C.Auditors could be held liable for fraud to all reasonably foreseeable third parties

D.Auditors should be able to detect all deceit by management

12.In Tenants Corp. v. Max Rothenberg, the auditors were held legally liable for:

A.Ordinary negligence

B.Gross negligence

C.Deficient tax work

D.Write-up work

13.When an auditor acts so carelessly in the application of professional standards that it implies a reckless disregard for the standards of due care is referred to as:

A.Scienter

B.Fraud

C.Constructive fraud

D.Negligence

14.When courts find accountants liable for constructive fraud, the implication is that:

A.Auditors should always be liable when investors lose money due to deceit

B.Accountants may be liable for fraud even when they had no knowledge of deceit

C.Auditors should be able to detect all deceit by management

D.Accountants may be held liable even to third parties to whom they did not have a duty

15.Which of the following is NOT one of the defenses an auditor can use against third party lawsuits for fraud?

A.The third party was not in contractual privity

B.The auditor did not have a duty to the third party

C.The third party was negligent

D.The third party did not suffer a loss

16.An audit engagement letter:

A.Offers an auditor’s services to a client

B.Is required by generally accepted auditing standards (GAAS)

C.Details the SEC’s expectations for the audit firm for a specific engagement

D.Formalizes the relationship between the auditor and the client for a specific engagement

17.Which of the following is NOT one of the most relevant sources of civil liabilities for auditors charged with failing to adhere to the requirements of the laws in carrying out professional obligations?

A.Securities Act of 1933

B.Private Securities Litigation Reform Act of 1995

C.Securities and Exchange Act of 1934

D.Sarbanes-Oxley Act of 2002

18.The Securities Act of 1933:

A.Regulates the auditing of financial statements for publicly-traded companies

B.Limits the financial liability of independent auditors except in the case of gross negligence

C.Regulates the initial offering of securities

D.Regulates which services may be performed for a publicly-traded company by an audit firm

19.In Grant Thornton v. Prospect High Income Fund, the Texas Supreme Court held:

A.Auditors were not liable for accurate accounting to anyone who reads and relies upon the audit report

B.Auditors were not liable for ordinary negligence

C.Auditors are not guarantors of accurate and reliable financial statements

D.Management is responsible for the financial statements

20.In Grant Thornton v. Prospect High Income Fund, Grant used each of the following points to defend itself against legal liability except:

A.There was no evidence of a causal connection between Grant’s alleged misrepresentation and the funds’ alleged injury

B.There was no evidence of actual and justifiable reliance

C.There was no evidence of the loss suffered by the plaintiffs

D.Liability for fraudulent misrepresentations runs only to those whom the auditor knows and intends to influence, all of which was not present

21.Under the Securities Act of 1933, accountants who assist in the preparation of the registration statement are civilly liable if the registration statement:

A.Contains untrue statements of material fact

B.Omits material facts required by statute or regulation

C.Omits information that if not given makes the facts stated misleading

D.All of the above

22.Under the Securities Act of 1933, if damages were incurred and there was a material misstatement or omission in the financial statements, the CPA will most likely lose the lawsuit unless:

A.The management intentionally deceived the auditors

B.The damages were incurred to a third party that was not a signatory to the contract

C.The CPA can shift the burden of proof to the investors

D.The CPA rebuts the allegations

23.Which of the following is NOT a valid defense to legal liability under the Securities Act of 1933?

A.Materiality defense

B.Non-negligence defense

C.Due diligence defense

D.Lack of causation defense

24.The accounting issue(s) in the Crazy Eddie case were:

A.Accelerating revenues into earlier periods

B.Inflating inventory and net income

C.Capitalizing costs that should have been expensed

D.Off-balance sheet entities

25.In establishing that the third party relied on the financial statements, one factor that works against plaintiffs’ establishing such reliance is:

A.Fraud did not exist

B.Damages or loss suffered by the plaintiff would not have occurred regardless of whether the audited financial statements were misstated

C.Damages or loss suffered by the plaintiff would have occurred regardless of whether the audited financial statements were misstated

D.Negligence did not exist

26.Under the Securities Act of 1933 and the Securities and Exchange Act of 1934, accountants may be subject to criminal penalties for:

A.Obstruction of justice

B.Securities fraud

C.Willful violations of the securities acts

D.Violations of internal controls

27.The Securities and Exchange Act of 1934:

A.Limits the financial liability of independent auditors except in the case of gross negligence

B.Requires the filing of audited annual statements and reviewed quarterly statements

C.Regulates the initial offering financial statements of securities

D.Regulates which services may be performed for a publicly-traded company by an audit firm

28.Rule 10b-5 of the Securities Exchange Act of 1934 makes it unlawful for a CPA to engage in each of the following activities except:

A.Employ any device, scheme, or artifice to defraud

B.Omit a material fact necessary for the financial statements to present fairly financial position, results of operations, and cash flows

C.Engage in any act, practice, or course of business to commit fraud or deceit in connection with the purchase or sale of a security

D.Make an untrue statements of material fact or omit a material fact necessary in order to make the statement made, in the light of the circumstances under which they were made, not misleading

29.Which of the following elements do NOT have to be proved once a plaintiff has established the ability to sue under rule 10b-5?

A.Material, factual misrepresentation or omission

B.Error by auditor led to plaintiffs’ loss

C.Reliance by the plaintiff on the financial statements

D.Damages suffered by plaintiff as a result of reliance on the financial statements

30.The U.S. Supreme Court ruled in Ernst & Ernst v. Hochfelder that:

A.A private cause of action for damages does not come under rule 10b-5 in the absence of any allegation of scienter

B.The auditor engaged in an act in connection with the purchase or sale of a security that caused the loss to the plaintiff

C.Breach of duty is not required to establish fraud

D.The auditor has no legal liability for fraud to third parties

31.The executives of McKesson and Robbins Pharmaceuticals were able to steal about $2.9 million in 1939 because:

A.Its auditors did not follow the generally accepted auditing standards (GAAS) at the time

B.The independent audit of financial statements was not required at the time

C.Physical inspection of inventory was not performed by the auditors

D.The auditors were not independent and conspired with management to steal the funds

32.In the case of Equity Funding, the audit client:

A.Fraudulently recorded inventories that did not in fact exist

B.Inflated its earnings by recording fictitious sales of insurance policies

C.Moved liabilities off the balance sheet by using thousands of subsidiaries

D.Recorded inventory below cost, therefore understating costs of goods sold and overstating net income

33.Under the Private Securities Litigation Reform Act (PSLRA), if an auditor concludes that an illegal act with a material effect on the financial statements has been reported to, but not dealt with by senior management, the auditor should next report his/her conclusions to:

A.The Securities and Exchange Commission

B.The company’s board of directors

C.The office of the controller/comptroller for the appropriate state

D.The Federal Bureau of Investigation

34.How long do management and the audit committee have to act if the independent auditor reports possible illegal acts to them?

A.One week

B.One month

C.Three business days

D.One business day

35.The “particularity” provision in the PSLRA allows a plaintiff to:

A.Sue the auditor

B.Assert scienter

C.Sue management

D.Assert privity

36.A “particularized” allegation requires establishing:

A.Strong circumstantial evidence of conscious misbehavior

B.Strong circumstantial evidence of recklessness

C.Facts showing the defendant had both motive and opportunity to commit securities fraud

D.All of the above

37.The Private Securities Litigation Reform Act of 1995 applies the practice of ______ to auditor liability determinations.

A.Risk assessment

B.Joint and several liability

C.Particularized standard

D.Proportionate liability

38.What is a worrisome consequence under the joint and several liability principle?

A.Each negligent party is liable for the portion of the damages for which it is responsible

B.All negligent parties are always liable for damages

C.Only the negligent party considered to have “deep pockets” is held liable for damages

D.Each negligent party could be held liable for the total of damages suffered

39.Which of the following is NOT a requirement of Section 10A of the Securities Exchange Act of 1934 for auditors of public companies with respect to illegal acts?

A.Determine whether it is likely that an illegal act has occurred

B.Determine what the possible effect of the illegal act is on the financial statements

C.Determine whether management participated in the illegal act

D.Inform management and assure that the audit committee knows about any material illegal act that has been detected

40.Under the rules of the Sarbanes-Oxley Act of 2002 (SOX), who must certify the public reports filed with the SEC?

A.The independent auditor

B.The CEO and the independent auditor

C.The CEO and CFO

D.The CFO and the board of directors

41.Under section 302 of the SOX the financial statement certifying officials must include in their certification that:

A.A list of all deficiencies in the internal controls and information on any fraud that involves employees who are involved with internal activities has been created

B.The auditors are responsible for the internal controls and have evaluated and reported on them

C.All changes in internal controls or related factors that could have a negative effect on the internal controls have been made

D.The audit report was unmodified

42.What argument can be made that SOX may not be effective in reducing fraud?

A.It is not as stringent as international standards

B.The SEC has many laws for many years that have not seemed to make much of a difference

C.The penalties under Sarbanes-Oxley are especially stringent, so it may not be enforced

D.Civil and criminal penalties are not effective in preventing financial fraud

43.The section of SOX that requires management to prepare a report on its internal controls is:

A.Section 302

B.Section 404

C.Section 808

D.Section 10A(b)

44.A payment made to foreign government officials to ensure that they do what is expected given their job requirements can be characterized as a:

A.Bribe

B.Asset misappropriation

C.Facilitating Payment

D.Legal Payment

45.A payment made to induce a foreign government official to do something they might not otherwise be required to do is a:

A.Bribe

B.Asset misappropriation

C.Facilitating Payment

D.Legal Payment

46.Which of the following is NOT an affirmative defense for those violating the FCPA?

A.The payment is lawful under the written laws of the foreign country

B.The payment can be made for reasonable and bona fide expenditures

C.A and B are both affirmative defenses

D.None of the above

47.Pfizer was investigated by the SEC for violating the Foreign Corrupt Practices Act (FCPA) because it allegedly:

A.Made improper payments to foreign officials to obtain regulatory and formulary approvals

B.Made improper payments to foreign officials to obtain sales

C.Made improper payments to foreign officials to obtain increased prescriptions for the company’s pharmaceutical products

D.All of the above

48.The FCPA requires all SEC registrants to have each of the following except:

A.Maintain internal accounting controls

B.Ensure all transactions are authorized by management and recorded properly

C.Maintain information systems that prevent fraudulent activities that violate the FCPA

D.Maintain adequate books and records to fairly reflect an issuer’s transactions and disposition of assets

49.The International Federation of Accountants (IFAC) Policy Position Paper #4 A Public Interest Framework for the Accountancy Position addresses:

A.Bribery on an international level

B.High standards of ethical behavior and professional judgment required in the accountancy profession

C.Internal control to prevent fraud

D.Corporate governance systems

50.Gray uses Hofstede’s cultural values that were discussed in Chapter 1 to:

A.Set forth accounting values that can be used to define a country’s cultural foundation with respect to financial reporting

B.Set forth corporate governance provisions that define an ethical organization culture

C.Define what is meant by the public interest in accounting

D.Define what is meant by internal controls over financial reporting in a cultural context

51.Which of the following is NOT a cultural factor identified in Gray’s Model?

A.Professionalism

B.Flexibility

C.Conservatism

D.Secrecy

52.With respect to U.S. GAAP, the SEC’s approach to determining whether International Financial Reporting Standards (IFRS) should be allowed for and/or replace GAAP can be described as:

A.Transparency

B.Comparability

C.Convergence

D.Condorsement

53.The name of the international securities body that facilitates a country’s choice to regulate the use and application of IFRS is:

A.International Accounting Standards Board

B.International Federation of Accountants

C.International Organization of Securities Commissions

D.International Securities and Exchange Commission

54.Principles-based standards differ from a rules-based approach because:

A.Principles-based standards rely on bright-line concepts to apply accounting standards

B.Rules-based standards rely on bright-line rules to apply accounting standards

C.Principles-based standards set uniform goals for the application of accounting standards

D.Rules-based standards form the basis of IFRS

55.One feature of a corporate governance system commonly found outside the U.S. is:

A.Unitary board of directors

B.Dual system of boards of directors

C.No board of directors

D.Acceptance of facilitating payments and bribery

56.The term “true and fair view” tends to be a replacement for _________ used in the U.S.

A.Full and fair

B.Present fairly

C.Representational faithfulness

D.Economic substance

57.The problem of a compliance approach in implementing global standards is that it can result in:

A.Achieving informal compliance without considering ethical consequences

B.Achieving a true and fair view with respect to the auditor’s report

C.Achieving a dual system of boards of directors

D.Achieving formal compliance without considering ethical consequences

58.The international body responsible for developing and issuing high-quality ethical standards and other pronouncements for professional accountants for use around the world is:

A.International Organization of Securities Commissions

B.International Accounting Standards Board

C.International Ethics Board

D.International Ethics Standards Board for Accountants

59.The IFAC Global Code of Ethics is similar to the AICPA Code in each of the following areas except it doesn’t:

A.Require acting in accordance with the public interest

B.Address threats to independence

C.Identify safeguards to mitigate threats to independence

D.Establish state boards of accountancy to regulate standards

60.The difference between the United Kingdom Bribery Act and the FCPA in the U.S. is:

A.The UK Bribery Act permits bribery as well as facilitating payments

B.The UK Bribery Act prohibits both bribery and facilitating payments

C.The FCPA permits both bribery and facilitating payments

D.There are no differences between the two laws

61.PCAOB inspections of U.S. audit firms operating in China creates challenges because:

A.China requires the PCAOB to come to China to do their inspections

B.The SEC has to work through the China Securities Regulatory Commission to facilitate inspections of U.S. audit firms operating in China

C.China refuses to cooperate on any level with the SEC

D.The SEC requires that U.S. audit firms operating in China transmit all work papers to the U.S. audit firm’s headquarters before an inspection can take place

62.In the Advanced Battery Technologies case, the opinion of the court:

A.Held the auditors legally liable because they failed to exercise due care and to demonstrate professional skepticism

B.Held the auditors legally liable because they failed to gather sufficient, competent evidential matter to warrant the expression of an opinion

C.Held the auditors not legally liable because the plaintiff could not plead with particularity that the audit work was so deficient as to amount to no audit at all

D.Held the auditors were not legally liable because they met all professional standards

63.In Heinrich Müller: Big-Four Whistleblower, Müller had an ethical dilemma because:

A.Confidential tax documents demonstrate the firm was engaged in illegal firm-arranged tax avoidance deals

B.Confidential tax documents indicate the client violated the law by taking advantage of tax advantaged investment

C.His supervisor ordered him to commit tax fraud

D.His supervisor was engaged in tax fraud

64.The Richards & Co. case raises questions for the quality review partner because the client had:

A.Accelerated revenue into an earlier period without proper documentation

B.Delayed expenses into a later period through the use of reserves

C.Violated the Foreign Corrupt Practices Act

D.Recorded supplier-provide credits as revenue with the promise of purchasing merchandise from that supplier

65.The defendant-auditors in the Anjoorian case argued, in their defense, that:

A.To be found guilty to third parties, the court must find that an accountant had contemplated a specific transaction for which the financial statement will be used and that no such transaction was contemplated.

B.The plaintiff’s theory of damages did not meet the foreseen legal criteria

C.They had no liability to the client because the client did not rely on the audited financial statements

D.They followed generally accepted auditing standards

66.In the Vertical Pharmaceuticals case, Deloitte & Touche was sued because:

A.Vertical claimed the firm’s false accusations of fraudulent conduct led to the withdrawal of another public company’s planned acquisition of Vertical

B.Deloitte failed to issue an audit report on a timely basis thereby leading to the withdrawal by another public company’s planned acquisition of Vertical

C.Vertical claimed Deloitte committed fraud in its audit of Vertical

D.Deloitte issued a modified opinion (adverse) on Vertical’s financial statements thereby leading to the withdrawal by another public company’s planned acquisition of Vertical

67.Kay and Lee performed an audit required for Holligan Industries to extend a loan with Second National Bank & Trust. Kay and Lee may be liable for:

A.Second National Bank & Trust declining to extend the loan

B.Ordinary negligence to the bank that loaned money to Holligan because the firm did not discover improper accounting for revenue and assets

C.Gross negligence to the bank that loaned money to Holligan because the firm did not discover improper accounting for receivables and inventory

D.Holligan declaring bankruptcy without a going-concern emphasis of matter

68.The ethical dilemma in the Getaway Cruise Lines case can best be described as:

A.The external auditors are being blocked by the client in attempting to verify accounting treatment of surplus electricity and water provided by the client to the local government

B.The Director of International Accounting questions the requirement to provide surplus electricity and water to the local government

C.The external auditors question the requirement to make facilitating payments to the local authorities

D.The Director of International Accounting questions the requirement to provide surplus electricity and water and make facilitating payments to the local authorities

69.The Con-Way case deals with legal liabilities due to:

A.Bribery of foreign government officials

B.Fraudulent financial statements

C.Facilitating payments to government agents

D.Bribery of U.S. government officials

70.The fraud at Satyam involved:

A.Related party transactions, fictitious revenue and falsified bank account balances

B.Related party transactions, impaired assets and off-balance sheet entities

C.Impaired assets, falsified bank account and facilitating payments

D.Fictitious revenue, contingent liabilities and facilitating payments

71.The legal liability of the auditors in the Autonomy case can best be described as resulting from:

A.Liability for gross negligence that constituted fraud

B.No liability because the firms were not sued by Autonomy

C.Liability for failing to inform creditors of a nonexistent bank account carried on Autonomy’s books

D.Improper accounting for a merger transaction between Hewlett-Packard and Autonomy

Essay Questions

72.Distinguish between an auditor’s legal liability under common law and statutory law.

73.Cite specific cases to support your answer to question 1 about the differences between common law and statutory law legal liability of auditors.

74.Describe the steps auditors should take to protect themselves against allegations that fraud went undetected during the audit.

75.The following clause was included in the engagement letter between Limits and Lobits, CPAs (L&L) and Fair, Inc., an audit client of (L&L).

Fair, Inc. agrees to release, indemnify, and hold Limits & Lobits, CPAs (its partners, heirs, executors, personal representatives, successors, and assigns) harmless from any liability and costs resulting from fraud caused by or participated in by management of Fair, Inc.

Do you think such a clause is ethical? Use ethical reasoning to support your answer with reference to professional standards.

76.Assume a securities lawyer has just received a phone call from her client, the Chief Financial Officer (CFO) of XYZ Corporation, and informed that a securities lawsuit may be filed against her client by a group of the company’s shareholders. XYZ’s share price recently dropped from $40 to $4 per share after the company announced that it had to restate its quarterly results. The shareholders also learned that the CFOs compensation package ($20 million) is tied to the attainment of a $40 common stock share price. Although her client is innocent, the attorney believes the shareholders will view this as a case of securities fraud and file the suit against the CFO, alleging that due to the large compensation, the client stood to gain from reaching the share price, and with the client’s ability to influence the company’s revenue, the CFO possessed the motive and opportunity to defraud XYZ’s investors.

Why might the facts of this case lead the attorney to conclude that a lawsuit against her client is imminent? How might the attorney assert a valid “good faith” defense?

77.Auditors may be held liable to both their clients and third parties under common law.

a. What must a client prove to recover its losses from an auditor under common law?
b. What must a third party prove to recover losses from an auditor under common law?
c. How does an auditor’s ethical obligations and liability under common law intersect?

78.Lotus Hospitality, a U.S. publicly-owned company doing business in China, deals with state-owned enterprises in a variety of countries. It is common for Chinese companies to pay custom officials in these countries amounts ranging from $100-$500 to enable their goods to be off-loaded at the receiving docks in each country. To show its appreciation for the many years of doing business in these countries, Lotus invited 50 government officials and employees of state-owned enterprises to attend the Olympic Games in China at the company’s expense, and ultimately paid for such guests as well as some spouses and others who attended along with them. Sponsored guests were primarily from countries in Africa and Asia, and they enjoyed three- and four-day hospitality packages that included event tickets, luxury hotel accommodations, and sightseeing excursions valued at $12,000 to $16,000 per package. In return for the generosity of Lotus Hospitality, the state-owned enterprises promised to give preference to Chinese companies when multi-million dollar contracts are awarded.

Describe the nature of these payments under the Foreign Corrupt Practices Act (FCPA) and assess their legality. What are the potential ethical issues of allowing certain types of payments under the Act?

79.Do considerations of culture have a place in the FCPA? Discuss in general and with respect to Hofstede’s cultural values.

80.Explain the provisions of section 302 of the Sarbanes-Oxley Act including obligations of officers; nature and scope of assertions; accounting requirements; and legal liability of officers.

81.In chapter 4 we discussed the rules for independence. Auditor violations of independence can cause legal liability issues for the individual auditor and, perhaps, the audit firm. Describe situations where auditor legal liability has occurred as a result of independence violations and identify other situations addressed in the AICPA Code that could lead to legal liability.

Chapter 06 Legal, Regulatory, and Professional Obligations of Auditors Answer Key

Multiple Choice Questions

1.The key element that protects an auditor against common law liability is:

A.Adherence to generally accepted accounting principles (GAAP)

B.Adherence to generally accepted auditing standards (GAAS)

C.Compliance with threats and safeguards approach

D.Maintain confidentiality of client information

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

2.Which of the following is NOT one of the four stages in an audit-related dispute?

A.Events arise that create losses for the users of the financial statements

B.Losses are linked to material misstatements of financial statements

C.Legal process resolves the dispute

D.Auditors legal liability leads to financial settlement

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

3.Which of the following would normally be considered sufficient to demonstrate due care on the part of the auditor?

A.The auditor had its work reviewed by another audit firm

B.The auditor cites adherence to generally accepted auditing standards (GAAS)

C.No omissions or misstatements have been found in the client’s financial statements

D.The auditor signs a statement expressing its unmodified opinion as to the fairness of the financial statements

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Evaluate
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

4.In the U.S., if the auditor can demonstrate having performed services with the same degree of skill and judgment possessed by others in the profession, it can be said to have exercised:

A.Prudence

B.Scienter

C.Nonfeasance

D.Due Care

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

5.The legal precedent that evolves from legal opinions issued by judges in deciding a case and guides judges in deciding similar cases in the future is referred to as:

A.Business law

B.Tort law

C.Common law

D.Statutory law

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

6.A privity relationship means that:

A.A party may be a user of the financial statements

B.A party may sue if fraud has taken place

C.A party’s financial liability is limited

D.A party has a contractual obligation

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

7.The Ultramares v. Touche case of 1933 held that a cause of action based on negligence could not be maintained by a third party who was not in contractual privity; however, it did leave open the possibility that:

A.Third parties that were “foreseeable” may sue for ordinary negligence

B.Third parties may sue if one of the parties in contractual privity allowed it to

C.Third parties may sue in the case of fraud or constructive fraud

D.Third parties who used the financial statements may sue

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 3 Hard
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

8.The Restatement (Second) of Torts Approach:

A.Expands an accountant’s legal liability to third parties identified by the client as intended recipients of work

B.Limits an accountant’s legal liability to only those parties with which it has a privity relationship

C.Limits an accountant’s legal liability to only those parties that have been named by the client

D.Expands an accountant’s legal liability to all possible users of the audited financial statements

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

9.The Rosenblum case ruling was of concern to the accounting profession because it implied that:

A.Full joint and several liability would be reinstated

B.All possible third party users of financial statements must be anticipated

C.The concept of contractual privity would no longer be important

D.Financial liability would occur when scienter was proven

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Evaluate
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

10.The Credit Alliance v. Arthur Andersen & Co. case established three tests that must be satisfied for holding auditors liable for negligence to third parties. All of the following are tests described except:

A.Knowledge by the accountant that the financial statements are to be used for a particular purpose

B.The intention of the third party to rely on those statements

C.Some action by the accountant linking him or her to the third party that provides evidence of the accountant’s understanding of intended reliance

D.The identity of the third party must be directly known to the auditor

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Evaluate
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

11.The unique aspect of auditors’ legal liability in the Rosenblum v. Adler ruling is:

A.Auditors could be held liable for ordinary negligence to all reasonably foreseeable third parties

B.Auditors could be held liable for gross negligence to all reasonably foreseeable third parties

C.Auditors could be held liable for fraud to all reasonably foreseeable third parties

D.Auditors should be able to detect all deceit by management

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Evaluate
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

12.In Tenants Corp. v. Max Rothenberg, the auditors were held legally liable for:

A.Ordinary negligence

B.Gross negligence

C.Deficient tax work

D.Write-up work

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

13.When an auditor acts so carelessly in the application of professional standards that it implies a reckless disregard for the standards of due care is referred to as:

A.Scienter

B.Fraud

C.Constructive fraud

D.Negligence

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

14.When courts find accountants liable for constructive fraud, the implication is that:

A.Auditors should always be liable when investors lose money due to deceit

B.Accountants may be liable for fraud even when they had no knowledge of deceit

C.Auditors should be able to detect all deceit by management

D.Accountants may be held liable even to third parties to whom they did not have a duty

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

15.Which of the following is NOT one of the defenses an auditor can use against third party lawsuits for fraud?

A.The third party was not in contractual privity

B.The auditor did not have a duty to the third party

C.The third party was negligent

D.The third party did not suffer a loss

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

16.An audit engagement letter:

A.Offers an auditor’s services to a client

B.Is required by generally accepted auditing standards (GAAS)

C.Details the SEC’s expectations for the audit firm for a specific engagement

D.Formalizes the relationship between the auditor and the client for a specific engagement

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

17.Which of the following is NOT one of the most relevant sources of civil liabilities for auditors charged with failing to adhere to the requirements of the laws in carrying out professional obligations?

A.Securities Act of 1933

B.Private Securities Litigation Reform Act of 1995

C.Securities and Exchange Act of 1934

D.Sarbanes-Oxley Act of 2002

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Evaluate
Difficulty: 3 Hard
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

18.The Securities Act of 1933:

A.Regulates the auditing of financial statements for publicly-traded companies

B.Limits the financial liability of independent auditors except in the case of gross negligence

C.Regulates the initial offering of securities

D.Regulates which services may be performed for a publicly-traded company by an audit firm

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

19.In Grant Thornton v. Prospect High Income Fund, the Texas Supreme Court held:

A.Auditors were not liable for accurate accounting to anyone who reads and relies upon the audit report

B.Auditors were not liable for ordinary negligence

C.Auditors are not guarantors of accurate and reliable financial statements

D.Management is responsible for the financial statements

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

20.In Grant Thornton v. Prospect High Income Fund, Grant used each of the following points to defend itself against legal liability except:

A.There was no evidence of a causal connection between Grant’s alleged misrepresentation and the funds’ alleged injury

B.There was no evidence of actual and justifiable reliance

C.There was no evidence of the loss suffered by the plaintiffs

D.Liability for fraudulent misrepresentations runs only to those whom the auditor knows and intends to influence, all of which was not present

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

21.Under the Securities Act of 1933, accountants who assist in the preparation of the registration statement are civilly liable if the registration statement:

A.Contains untrue statements of material fact

B.Omits material facts required by statute or regulation

C.Omits information that if not given makes the facts stated misleading

D.All of the above

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

22.Under the Securities Act of 1933, if damages were incurred and there was a material misstatement or omission in the financial statements, the CPA will most likely lose the lawsuit unless:

A.The management intentionally deceived the auditors

B.The damages were incurred to a third party that was not a signatory to the contract

C.The CPA can shift the burden of proof to the investors

D.The CPA rebuts the allegations

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

23.Which of the following is NOT a valid defense to legal liability under the Securities Act of 1933?

A.Materiality defense

B.Non-negligence defense

C.Due diligence defense

D.Lack of causation defense

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

24.The accounting issue(s) in the Crazy Eddie case were:

A.Accelerating revenues into earlier periods

B.Inflating inventory and net income

C.Capitalizing costs that should have been expensed

D.Off-balance sheet entities

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

25.In establishing that the third party relied on the financial statements, one factor that works against plaintiffs’ establishing such reliance is:

A.Fraud did not exist

B.Damages or loss suffered by the plaintiff would not have occurred regardless of whether the audited financial statements were misstated

C.Damages or loss suffered by the plaintiff would have occurred regardless of whether the audited financial statements were misstated

D.Negligence did not exist

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

26.Under the Securities Act of 1933 and the Securities and Exchange Act of 1934, accountants may be subject to criminal penalties for:

A.Obstruction of justice

B.Securities fraud

C.Willful violations of the securities acts

D.Violations of internal controls

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

27.The Securities and Exchange Act of 1934:

A.Limits the financial liability of independent auditors except in the case of gross negligence

B.Requires the filing of audited annual statements and reviewed quarterly statements

C.Regulates the initial offering financial statements of securities

D.Regulates which services may be performed for a publicly-traded company by an audit firm

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

28.Rule 10b-5 of the Securities Exchange Act of 1934 makes it unlawful for a CPA to engage in each of the following activities except:

A.Employ any device, scheme, or artifice to defraud

B.Omit a material fact necessary for the financial statements to present fairly financial position, results of operations, and cash flows

C.Engage in any act, practice, or course of business to commit fraud or deceit in connection with the purchase or sale of a security

D.Make an untrue statements of material fact or omit a material fact necessary in order to make the statement made, in the light of the circumstances under which they were made, not misleading

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Evaluate
Difficulty: 3 Hard
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

29.Which of the following elements do NOT have to be proved once a plaintiff has established the ability to sue under rule 10b-5?

A.Material, factual misrepresentation or omission

B.Error by auditor led to plaintiffs’ loss

C.Reliance by the plaintiff on the financial statements

D.Damages suffered by plaintiff as a result of reliance on the financial statements

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

30.The U.S. Supreme Court ruled in Ernst & Ernst v. Hochfelder that:

A.A private cause of action for damages does not come under rule 10b-5 in the absence of any allegation of scienter

B.The auditor engaged in an act in connection with the purchase or sale of a security that caused the loss to the plaintiff

C.Breach of duty is not required to establish fraud

D.The auditor has no legal liability for fraud to third parties

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Evaluate
Difficulty: 3 Hard
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

31.The executives of McKesson and Robbins Pharmaceuticals were able to steal about $2.9 million in 1939 because:

A.Its auditors did not follow the generally accepted auditing standards (GAAS) at the time

B.The independent audit of financial statements was not required at the time

C.Physical inspection of inventory was not performed by the auditors

D.The auditors were not independent and conspired with management to steal the funds

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 3 Hard
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

32.In the case of Equity Funding, the audit client:

A.Fraudulently recorded inventories that did not in fact exist

B.Inflated its earnings by recording fictitious sales of insurance policies

C.Moved liabilities off the balance sheet by using thousands of subsidiaries

D.Recorded inventory below cost, therefore understating costs of goods sold and overstating net income

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

33.Under the Private Securities Litigation Reform Act (PSLRA), if an auditor concludes that an illegal act with a material effect on the financial statements has been reported to, but not dealt with by senior management, the auditor should next report his/her conclusions to:

A.The Securities and Exchange Commission

B.The company’s board of directors

C.The office of the controller/comptroller for the appropriate state

D.The Federal Bureau of Investigation

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

34.How long do management and the audit committee have to act if the independent auditor reports possible illegal acts to them?

A.One week

B.One month

C.Three business days

D.One business day

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

35.The “particularity” provision in the PSLRA allows a plaintiff to:

A.Sue the auditor

B.Assert scienter

C.Sue management

D.Assert privity

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

36.A “particularized” allegation requires establishing:

A.Strong circumstantial evidence of conscious misbehavior

B.Strong circumstantial evidence of recklessness

C.Facts showing the defendant had both motive and opportunity to commit securities fraud

D.All of the above

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 3 Hard
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

37.The Private Securities Litigation Reform Act of 1995 applies the practice of ______ to auditor liability determinations.

A.Risk assessment

B.Joint and several liability

C.Particularized standard

D.Proportionate liability

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 3 Hard
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

38.What is a worrisome consequence under the joint and several liability principle?

A.Each negligent party is liable for the portion of the damages for which it is responsible

B.All negligent parties are always liable for damages

C.Only the negligent party considered to have “deep pockets” is held liable for damages

D.Each negligent party could be held liable for the total of damages suffered

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 3 Hard
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

39.Which of the following is NOT a requirement of Section 10A of the Securities Exchange Act of 1934 for auditors of public companies with respect to illegal acts?

A.Determine whether it is likely that an illegal act has occurred

B.Determine what the possible effect of the illegal act is on the financial statements

C.Determine whether management participated in the illegal act

D.Inform management and assure that the audit committee knows about any material illegal act that has been detected

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 3 Hard
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Statutory Liability

40.Under the rules of the Sarbanes-Oxley Act of 2002 (SOX), who must certify the public reports filed with the SEC?

A.The independent auditor

B.The CEO and the independent auditor

C.The CEO and CFO

D.The CFO and the board of directors

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-03 Discuss auditors’ legal liabilities under SOX.
Topic: SOX and Auditor Legal Liabilities

41.Under section 302 of the SOX the financial statement certifying officials must include in their certification that:

A.A list of all deficiencies in the internal controls and information on any fraud that involves employees who are involved with internal activities has been created

B.The auditors are responsible for the internal controls and have evaluated and reported on them

C.All changes in internal controls or related factors that could have a negative effect on the internal controls have been made

D.The audit report was unmodified

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Evaluate
Difficulty: 3 Hard
Learning Objective: 06-03 Discuss auditors’ legal liabilities under SOX.
Topic: SOX and Auditor Legal Liabilities

42.What argument can be made that SOX may not be effective in reducing fraud?

A.It is not as stringent as international standards

B.The SEC has many laws for many years that have not seemed to make much of a difference

C.The penalties under Sarbanes-Oxley are especially stringent, so it may not be enforced

D.Civil and criminal penalties are not effective in preventing financial fraud

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-03 Discuss auditors’ legal liabilities under SOX.
Topic: SOX and Auditor Legal Liabilities

43.The section of SOX that requires management to prepare a report on its internal controls is:

A.Section 302

B.Section 404

C.Section 808

D.Section 10A(b)

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 06-03 Discuss auditors’ legal liabilities under SOX.
Topic: SOX and Auditor Legal Liabilities

44.A payment made to foreign government officials to ensure that they do what is expected given their job requirements can be characterized as a:

A.Bribe

B.Asset misappropriation

C.Facilitating Payment

D.Legal Payment

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-04 Explain the provisions of the FCPA.
Topic: Foreign Corrupt Practices Act (FCPA)

45.A payment made to induce a foreign government official to do something they might not otherwise be required to do is a:

A.Bribe

B.Asset misappropriation

C.Facilitating Payment

D.Legal Payment

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-04 Explain the provisions of the FCPA.
Topic: Foreign Corrupt Practices Act (FCPA)

46.Which of the following is NOT an affirmative defense for those violating the FCPA?

A.The payment is lawful under the written laws of the foreign country

B.The payment can be made for reasonable and bona fide expenditures

C.A and B are both affirmative defenses

D.None of the above

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 06-04 Explain the provisions of the FCPA.
Topic: Foreign Corrupt Practices Act (FCPA)

47.Pfizer was investigated by the SEC for violating the Foreign Corrupt Practices Act (FCPA) because it allegedly:

A.Made improper payments to foreign officials to obtain regulatory and formulary approvals

B.Made improper payments to foreign officials to obtain sales

C.Made improper payments to foreign officials to obtain increased prescriptions for the company’s pharmaceutical products

D.All of the above

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 06-04 Explain the provisions of the FCPA.
Topic: Foreign Corrupt Practices Act (FCPA)

48.The FCPA requires all SEC registrants to have each of the following except:

A.Maintain internal accounting controls

B.Ensure all transactions are authorized by management and recorded properly

C.Maintain information systems that prevent fraudulent activities that violate the FCPA

D.Maintain adequate books and records to fairly reflect an issuer’s transactions and disposition of assets

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-04 Explain the provisions of the FCPA.
Topic: Foreign Corrupt Practices Act (FCPA)

49.The International Federation of Accountants (IFAC) Policy Position Paper #4 A Public Interest Framework for the Accountancy Position addresses:

A.Bribery on an international level

B.High standards of ethical behavior and professional judgment required in the accountancy profession

C.Internal control to prevent fraud

D.Corporate governance systems

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Evaluate
Difficulty: 3 Hard
Learning Objective: 06-05 Describe the cultural and professional constraints on adopting IFRS.
Topic: Regulatory and Professional Issues: An International Perspective

50.Gray uses Hofstede’s cultural values that were discussed in Chapter 1 to:

A.Set forth accounting values that can be used to define a country’s cultural foundation with respect to financial reporting

B.Set forth corporate governance provisions that define an ethical organization culture

C.Define what is meant by the public interest in accounting

D.Define what is meant by internal controls over financial reporting in a cultural context

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-05 Describe the cultural and professional constraints on adopting IFRS.
Topic: Regulatory and Professional Issues: An International Perspective

51.Which of the following is NOT a cultural factor identified in Gray’s Model?

A.Professionalism

B.Flexibility

C.Conservatism

D.Secrecy

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 3 Hard
Learning Objective: 06-05 Describe the cultural and professional constraints on adopting IFRS.
Topic: Regulatory and Professional Issues: An International Perspective

52.With respect to U.S. GAAP, the SEC’s approach to determining whether International Financial Reporting Standards (IFRS) should be allowed for and/or replace GAAP can be described as:

A.Transparency

B.Comparability

C.Convergence

D.Condorsement

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 06-05 Describe the cultural and professional constraints on adopting IFRS.
Topic: Regulatory and Professional Issues: An International Perspective

53.The name of the international securities body that facilitates a country’s choice to regulate the use and application of IFRS is:

A.International Accounting Standards Board

B.International Federation of Accountants

C.International Organization of Securities Commissions

D.International Securities and Exchange Commission

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 06-05 Describe the cultural and professional constraints on adopting IFRS.
Topic: Regulatory and Professional Issues: An International Perspective

54.Principles-based standards differ from a rules-based approach because:

A.Principles-based standards rely on bright-line concepts to apply accounting standards

B.Rules-based standards rely on bright-line rules to apply accounting standards

C.Principles-based standards set uniform goals for the application of accounting standards

D.Rules-based standards form the basis of IFRS

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-05 Describe the cultural and professional constraints on adopting IFRS.
Topic: Regulatory and Professional Issues: An International Perspective

55.One feature of a corporate governance system commonly found outside the U.S. is:

A.Unitary board of directors

B.Dual system of boards of directors

C.No board of directors

D.Acceptance of facilitating payments and bribery

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-05 Describe the cultural and professional constraints on adopting IFRS.
Topic: Regulatory and Professional Issues: An International Perspective

56.The term “true and fair view” tends to be a replacement for _________ used in the U.S.

A.Full and fair

B.Present fairly

C.Representational faithfulness

D.Economic substance

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-06 Distinguish between legal compliance and management by values.
Topic: Compliance and Ethical Issues

57.The problem of a compliance approach in implementing global standards is that it can result in:

A.Achieving informal compliance without considering ethical consequences

B.Achieving a true and fair view with respect to the auditor’s report

C.Achieving a dual system of boards of directors

D.Achieving formal compliance without considering ethical consequences

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-06 Distinguish between legal compliance and management by values.
Topic: Compliance and Ethical Issues

58.The international body responsible for developing and issuing high-quality ethical standards and other pronouncements for professional accountants for use around the world is:

A.International Organization of Securities Commissions

B.International Accounting Standards Board

C.International Ethics Board

D.International Ethics Standards Board for Accountants

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 06-07 Discuss the factors that promote global ethics, and prevent global fraud and bribery.
Topic: Global Ethics, Fraud, and Bribery

59.The IFAC Global Code of Ethics is similar to the AICPA Code in each of the following areas except it doesn’t:

A.Require acting in accordance with the public interest

B.Address threats to independence

C.Identify safeguards to mitigate threats to independence

D.Establish state boards of accountancy to regulate standards

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-07 Discuss the factors that promote global ethics, and prevent global fraud and bribery.
Topic: Global Ethics, Fraud, and Bribery

60.The difference between the United Kingdom Bribery Act and the FCPA in the U.S. is:

A.The UK Bribery Act permits bribery as well as facilitating payments

B.The UK Bribery Act prohibits both bribery and facilitating payments

C.The FCPA permits both bribery and facilitating payments

D.There are no differences between the two laws

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 06-07 Discuss the factors that promote global ethics, and prevent global fraud and bribery.
Topic: Global Ethics, Fraud, and Bribery

61.PCAOB inspections of U.S. audit firms operating in China creates challenges because:

A.China requires the PCAOB to come to China to do their inspections

B.The SEC has to work through the China Securities Regulatory Commission to facilitate inspections of U.S. audit firms operating in China

C.China refuses to cooperate on any level with the SEC

D.The SEC requires that U.S. audit firms operating in China transmit all work papers to the U.S. audit firm’s headquarters before an inspection can take place

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-07 Discuss the factors that promote global ethics, and prevent global fraud and bribery.
Topic: Global Ethics, Fraud, and Bribery

62.In the Advanced Battery Technologies case, the opinion of the court:

A.Held the auditors legally liable because they failed to exercise due care and to demonstrate professional skepticism

B.Held the auditors legally liable because they failed to gather sufficient, competent evidential matter to warrant the expression of an opinion

C.Held the auditors not legally liable because the plaintiff could not plead with particularity that the audit work was so deficient as to amount to no audit at all

D.Held the auditors were not legally liable because they met all professional standards

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

63.In Heinrich Müller: Big-Four Whistleblower, Müller had an ethical dilemma because:

A.Confidential tax documents demonstrate the firm was engaged in illegal firm-arranged tax avoidance deals

B.Confidential tax documents indicate the client violated the law by taking advantage of tax advantaged investment

C.His supervisor ordered him to commit tax fraud

D.His supervisor was engaged in tax fraud

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

64.The Richards & Co. case raises questions for the quality review partner because the client had:

A.Accelerated revenue into an earlier period without proper documentation

B.Delayed expenses into a later period through the use of reserves

C.Violated the Foreign Corrupt Practices Act

D.Recorded supplier-provide credits as revenue with the promise of purchasing merchandise from that supplier

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

65.The defendant-auditors in the Anjoorian case argued, in their defense, that:

A.To be found guilty to third parties, the court must find that an accountant had contemplated a specific transaction for which the financial statement will be used and that no such transaction was contemplated.

B.The plaintiff’s theory of damages did not meet the foreseen legal criteria

C.They had no liability to the client because the client did not rely on the audited financial statements

D.They followed generally accepted auditing standards

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

66.In the Vertical Pharmaceuticals case, Deloitte & Touche was sued because:

A.Vertical claimed the firm’s false accusations of fraudulent conduct led to the withdrawal of another public company’s planned acquisition of Vertical

B.Deloitte failed to issue an audit report on a timely basis thereby leading to the withdrawal by another public company’s planned acquisition of Vertical

C.Vertical claimed Deloitte committed fraud in its audit of Vertical

D.Deloitte issued a modified opinion (adverse) on Vertical’s financial statements thereby leading to the withdrawal by another public company’s planned acquisition of Vertical

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

67.Kay and Lee performed an audit required for Holligan Industries to extend a loan with Second National Bank & Trust. Kay and Lee may be liable for:

A.Second National Bank & Trust declining to extend the loan

B.Ordinary negligence to the bank that loaned money to Holligan because the firm did not discover improper accounting for revenue and assets

C.Gross negligence to the bank that loaned money to Holligan because the firm did not discover improper accounting for receivables and inventory

D.Holligan declaring bankruptcy without a going-concern emphasis of matter

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

68.The ethical dilemma in the Getaway Cruise Lines case can best be described as:

A.The external auditors are being blocked by the client in attempting to verify accounting treatment of surplus electricity and water provided by the client to the local government

B.The Director of International Accounting questions the requirement to provide surplus electricity and water to the local government

C.The external auditors question the requirement to make facilitating payments to the local authorities

D.The Director of International Accounting questions the requirement to provide surplus electricity and water and make facilitating payments to the local authorities

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-07 Discuss the factors that promote global ethics, and prevent global fraud and bribery.
Topic: Global Ethics, Fraud, and Bribery

69.The Con-Way case deals with legal liabilities due to:

A.Bribery of foreign government officials

B.Fraudulent financial statements

C.Facilitating payments to government agents

D.Bribery of U.S. government officials

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-04 Explain the provisions of the FCPA.
Topic: Foreign Corrupt Practices Act (FCPA)

70.The fraud at Satyam involved:

A.Related party transactions, fictitious revenue and falsified bank account balances

B.Related party transactions, impaired assets and off-balance sheet entities

C.Impaired assets, falsified bank account and facilitating payments

D.Fictitious revenue, contingent liabilities and facilitating payments

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-06 Distinguish between legal compliance and management by values.
Topic: Compliance and Ethical Issues

71.The legal liability of the auditors in the Autonomy case can best be described as resulting from:

A.Liability for gross negligence that constituted fraud

B.No liability because the firms were not sued by Autonomy

C.Liability for failing to inform creditors of a nonexistent bank account carried on Autonomy’s books

D.Improper accounting for a merger transaction between Hewlett-Packard and Autonomy

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

Essay Questions

72.Distinguish between an auditor’s legal liability under common law and statutory law.

Common law

Common-law liability evolves from legal opinions issued by judges in deciding a case. These opinions become legal principles that set a precedent and guide judges in deciding similar cases in the future. Statutory law reflects legislation passed at the state or federal level that establishes certain courses of conduct that must be adhered to by covered parties.

Common-law liability requires the auditor to perform professional services with due care. Evidence of having exercised due care exists if the auditor can demonstrate having performed services with the same degree of skill and judgment possessed by others in the profession. Typically, an auditor would cite adherence to generally accepted auditing standards as evidence of having exercised due care in conducting the audit. Due care includes exercising the degree of professional skepticism expected in the audit of financial statements.

An accountant has a contractual obligation to the client that creates a privity relationship. A client can bring a lawsuit against an accountant for failing to live up to the terms of the contract, asserting breach of contract, and other tort actions. When privity exists, plaintiffs must demonstrate all of the following:

1. They suffered an economic loss.
2. Auditors did not perform in accordance with the terms of the contract, thereby breaching that contract.
3. Auditors failed to exercise the appropriate level of professional care related to tort actions.
4. The breach of contract or failure to exercise the appropriate level of care caused the loss.

In addition to breach of contract, auditors may be liable to clients for tort liability that ranges from simple ordinary negligence to the more serious case of fraud. In the case of ordinary negligence, the auditor failed to exercise due care or the standard of care that other accountants would have done in similar situations.

Statutory Law

Auditors may have (statutory) legal liability under the Securities Act of 1933 and the Securities Exchange Act of 1934. These statutory liabilities may lead to convictions for crimes, provided their conduct was “willful.”

The Securities Act of 1933 regulates the disclosure of information in a registration statement for a new public offering of securities (i.e., IPO). Companies must file registration statements (S-1, S-2, and S-3 forms) and prospectuses that contain financial statements that have been audited by an independent CPA. Accountants who assist in the preparation of the registration statement are civilly liable if the registration statement (1) contains untrue statements of material facts, (2) omits material facts required by statute or regulation, or (3) omits information that if not given makes the facts stated misleading.

Section 11 of the Securities Act of 1933 imposes a liability on issuer companies and others, including auditors, for losses suffered by third parties when false or misleading information is included in a registration statement. Any purchaser of securities may sue: The purchaser generally must prove that (1) the specific security was offered through the registration statements, (2) damages were incurred, and (3) there was a material misstatement or omission in the financial statements included in the registration statement. The plaintiff need not prove reliance on the financial statements unless the purchase took place after one year of the offering.

If items (2) and (3) are proven, it is a prima facie case (sufficient to win against the CPA unless rebutted) and shifts the burden of proof to the accountant, who may escape liability by proving the following: (1) after reasonable investigation, the CPA concludes that there is a reasonable basis to believe that the financial statements were true and there was no material misstatement (the materiality defense); (2) a “reasonable investigation” was conducted (the due diligence defense); (3) the plaintiff knew that the financial statements were incorrect when the investment was made (the knowledge of falsehood defense); or (4) the loss was due to factors other than the material misstatement or omission (the lack of causation defense).

An accountant might argue that the false or misleading information is not material and thus should not have an impact on the purchaser’s decision-making process. The SEC and the courts have attempted to define materiality. The term material describes the kind of information that an average prudent investor would want to have so that he can make an intelligent, informed decision whether or not to buy the security. Thus, it is linked to objectivity. A material fact is one that, if correctly stated or disclosed, would have deterred or tended to deter the average prudent investor from purchasing the securities in question. The term does not cover minor inaccuracies or errors in matters of no interest to investors. Facts that tend to deter a person from purchasing a security are those that have an important bearing upon the nature or condition of the issuing corporation or its business.

To establish a due diligence defense, the defendant must prove that a reasonable investigation of the financial statements of the issuer and controlling persons was conducted. As a result, there was no reason to believe any of the information in the registration statement or prospectus was false or misleading. To determine whether a reasonable investigation has been made, the law provides that the standard of reasonableness is that required of a prudent person in the management of his own property. The burden of proof is on the defendant, and the test is as of the time the registration became effective. The due diligence defense, in effect, requires proof that a party was not guilty of fraud or negligence.

The due diligence defense available to the auditor under Section 11 requires that the auditor has made a reasonable investigation of the facts supporting or contradicting the information included in the registration statement. The test is whether a “prudent person” would have made a similar investigation under similar circumstances.

The Securities Exchange Act of 1934 regulates the ongoing reporting by companies whose securities are listed and traded on stock exchanges. The Act requires ongoing filing of quarterly (10-Q) and annual (10-K) reports and the periodic filing of an 8-K form whenever a significant event takes place affecting the entity, such as a change in auditors. Entities having total assets of $10 million or more and 500 or more stockholders are required to register under the Securities Exchange Act. The form and content of 10-K and 10-Q filings are governed by the SEC through Regulation S-X (which covers annual and interim financial statements) and Regulation S-K (which covers other supplementary disclosures).

Section 18 of the Act imposes liability on any person who makes a material false or misleading statement in documents filed with the SEC. The auditor’s liability can be limited if the auditor can show that she “acted in good faith and had no knowledge that such statement was false or misleading.” However, a number of cases have limited the auditor’s good-faith defense when the auditor’s action has been judged to be grossly negligent.

The liability of auditors under the act often centers on Section 10 and Rule 10b-5. These provisions make it unlawful for a CPA to (1) employ any device, scheme, or artifice to defraud; (2) make an untrue statement of material fact or omit a material fact necessary in order to make the statement made, in the light of the circumstances under which they were made, not misleading; or (3) engage in any act, practice, or course of business to commit fraud or deceit in connection with the purchase or sale of the security.

Once a plaintiff has established the ability to sue under Rule 10b-5, the following elements must be proved: (1) a material, factual misrepresentation or omission, (2) reliance by the plaintiff on the financial statements, (3) damages suffered as a result of reliance on the financial statements, and (4) the intent to deceive, manipulate, or defraud (scienter).

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Legal Liability of Auditors: An Overview
Topic: Statutory Liability

73.Cite specific cases to support your answer to question 1 about the differences between common law and statutory law legal liability of auditors.

Common law cases

In the 1933 landmark case, Ultramares v. Touche, the New York State Court of Appeals held that a cause of action based on negligence could not be maintained by a third party who was not in contractual privity. The court did leave open the possibility that a third party could successfully sue for gross negligence that constitutes fraud and actual fraud.

The importance of the Ultramares decision is that third parties (i.e., Ultramares) without privity could sue if negligence was so great as to constitute gross negligence. The opinion of the New York Court of Appeals was written by Judge Benjamin Cardozo.

If a liability for negligence exists, a thoughtless slip or blunder, the failure to detect a theft or forgery beneath the cover of deceptive entries, may expose accountants to a liability in an indeterminate amount for an indeterminate time to an indeterminate class [third parties]. The hazards of a business on these terms are so extreme as to [raise] doubt whether a flaw may not exist in the implication of a duty that exposes to these circumstances.

The Ultramares decision was the first of three different judicial approaches to deciding the extent of an accountant’s liability to third parties. The other two are the Restatement (Second) of the Law of Torts approach and the foreseeable third-party approach.

With respect to liability to third parties, while the Ultramares decision established a strict privity standard, a number of subsequent court decisions in other states moved away from this standard over time. The New York Court of Appeals expanded the privity standard in the case of Credit Alliance v. Arthur Andersen & Co. to include a near-privity relationship between third parties and the accountant. In the case, Credit Alliance was the principal lender to the client and demonstrated that Andersen had known Credit Alliance was relying on the client’s financial statements prior to extending credit. The court also ruled that there had been direct communication between the lender and the auditor regarding the client.

The Credit Alliance case establishes the following tests that must be satisfied for holding auditors liable for negligence to third parties: (1) knowledge by the accountant that the financial statements are to be used for a particular purpose; (2) the intention of the third party to rely on those statements; and (3) some action by the accountant linking him or her to the third party that provides evidence of the accountant’s understanding of intended reliance.

The “middle ground” approach followed by the vast majority of states (and federal courts located within those states) expands the class of third parties that can sue successfully an auditor for negligence beyond near-privity to a person or limited group of persons whose reliance is (actually) foreseen, even if the specific person or group is unknown to the auditor.

The courts have deviated from the Ultramares principle through a variety of decisions. For example, a federal district court in Rhode Island decided a case in 1968, Rusch Factors, Inc. v. Levin, that held an accountant liable for negligence to a third party that was not in privity of contract. In that case, Rusch Factors had requested financial statements prior to granting a loan. Levin audited the statements, which showed the company to be solvent when it was actually insolvent. After the company went into receivership, Rusch Factors sued, and the court ruled that the Ultramares doctrine was inappropriate. In its decision, the court relied heavily on the Restatement (Second) of the Law of Torts.

The Restatement (Second) of the Law of Torts approach, sometimes known as Restatement 552, expands accountants’ legal liability exposure for negligence beyond those with near privity (actually foreseen) to a small group of persons and classes who are or should be foreseen by the auditor as relying on the financial information. This is known as the foreseen third-party concept because even though there is no privity relationship, the accountant knew that that party or those parties would rely on the financial statements for a specified transaction.

A majority of states now use the modified privity requirement imposed by Section 552 of the Restatement (Second) of the Law of Torts. The Restatement modifies the traditional rule of privity by allowing non-clients to sue accountants for negligent misrepresentation, provided that they belong to a “limited group” and provided that the accountant had actual knowledge that his or her professional opinion would be supplied to that group. In some state court decisions, a less restrictive interpretation of Section 552 has been made. For example, a 1986 decision by the Texas Court of Appeals in Blue Bell, Inc. v. Peat, Marwick, Mitchell & Co. (now KPMG) held that if an accountant preparing audited statements knows or should know that such statements will be relied upon, the accountant may be held liable for negligent misrepresentation.

A third judicial approach to third-party liability expands the legal liability of accountants well beyond Ultramares. The reasonably foreseeable third-party approach results from a 1983 decision by the New Jersey Supreme Court in Rosenblum, Inc. v. Adler. In that case, the Rosenblum family agreed to sell its retail catalog showroom business to Giant Stores, a corporation operating discount department stores, in exchange for Giant common stock. The Rosenblum’s relied on Giant’s 1971 and 1972 financial statements, which had been audited by Touche (now Deloitte & Touche). When the statements were found to be fraudulent and the stock was deemed worthless, the investors sued Touche. The lower courts did not allow the Rosenblum’s claims against Touche on the grounds that the plaintiffs did not meet either the Ultramares privity test or the Restatement standard. The case was taken to the New Jersey Supreme Court, and it overturned the lower courts’ decision, ruling that auditors can be held liable for ordinary negligence to all reasonably foreseeable third parties who are recipients of the financial statements for routine business purposes.

The legal liability of accountants is not limited to audited statements. In the 1967 case 1136 Tenants Corp. v. Max Rothenberg & Co. an accounting firm was sued for negligent failure to discover embezzlement by the managing agent who had hired the firm to “write up” the books, which did not include any audit procedures. The firm was held liable for failure to inquire or communicate about missing invoices, despite a disclaimer on the financial statements informing users that “No independent verification were undertaken thereon.” The firm moved to dismiss the case, but the court denied the motion and held that even if a CPA “acted as a robot, merely doing copy work,” there was an issue as to whether there were suspicious circumstances relating to missing invoices that imposed a duty on the firm to warn the client.

(REMIND STUDENTS TO LOOK AT EXHIBIT 6.2)

Exhibit 6.2
Auditor Legal Liability to Third Parties
Legal ApproachCaseLegal PrincipleLegal Liability to Third Parties
UltramaresUltramares v. TouchePrivity (only clients can sue)Possibly gross negligence that constitutes (constructive) fraud
Near-privity relationshipCredit AllianceThree-pronged approach: knowledge of accountant that the statements will be used for a particular purpose; intention of third party to rely on those statements; some action by third party that provides evidence of the accountant’s understanding of intended relianceOrdinary negligence
Restatement (Second) of the Law of TortsRusch FactorsActually foreseen third-party usersOrdinary negligence beyond near-privity
Foreseeable third partyRosenblumReasonably foreseeable third-party usersOrdinary negligence with reliance on the statements


Two court decisions illustrate the application of Section 11 of the Securities Exchange Act of 1933 to securities registration matters: Escott v. BarChris Construction Corp. and Bernstein v. Crazy Eddie, Inc. (These cases are summarized in Exhibits 6.4 and 6.5, respectively.)

In Escott v. BarChris Construction Corp., the company issued a registration statement in 1961 in connection with its public offering of convertible bonds. The statements included audited financial statements by Peat, Marwick, Mitchell & Co. The financial statements included material overstatements of revenues, current assets, gross profit, and backlog of sales orders and material understatements of contingent liabilities, loans to company officers, and potential liability for customer delinquencies. BarChris’s worsening financial position resulted in a default on interest payments and the company eventually declared bankruptcy. Barry Escott and other investors sued BarChris’s executive officers, directors, and the auditors under Section 11 of the Securities Act, citing a lack of appropriate professional care during the conduct of the audit. The judge ruled that the auditor’s actions in reviewing events subsequent to the balance sheet date were not conducted with due diligence because the senior auditor in charge of reviewing these events had not spent sufficient time and accepted unconvincing answers to key questions. The court determined that there had been sufficient warning signs that further investigation was necessary. The auditors’ failure to perform a reasonable investigation of subsequent events did not satisfy Section 11(b) and resulted in their liability to investors in BarChris’s bonds.

Crazy Eddie made several public offerings of securities from 1984 through 1987, during which time the prospectuses wrongly gave the impression that the company was a growing concern. The financial statements had been misstated by a number of schemes, including inflated inventory and net income. The plaintiffs in the case were purchasers of the company’s stock prior to the disclosure of the fraudulent financial statements. They sued Peat Marwick, the board of directors, and others, alleging that the accounting firm had violated GAAS and GAAP by failing to uncover the company’s fraudulent and fictitious activities. The plaintiffs were able to show that they suffered a loss and that the certified financial statements in the registration statements and prospectuses had been false and misleading, in violation of Sections 11 and 12 of the Securities Acts of 1933. The court decided the plaintiffs did not have to prove fraud or gross negligence, only that any material misstatements in the registration statements were misleading and that they had suffered a loss. In this case, the auditor was unable to prove that they had exercised appropriate due professional care to rebut the claim.

An important case that strengthens the scienter requirement is the 1976 U.S. Supreme Court reversal in Ernst & Ernst v. Hochfelder. The U.S. Court of Appeals had ruled in favor of Hochfelder and reversed the lower court opinion. The court decision includes this statement: “One who breaches a duty of inquiry and disclosure owed another is liable in damages for aiding and abetting a third party’s violation of Rule 10b-5of the Securities Exchange Act of 1934 if the fraud would have been discovered or prevented but for the breach, and that there were genuine issues of fact as to whether [Ernst] committed such a breach, and whether inquiry and disclosure would have led to discovery or prevention of the… fraud.”

The U.S. Supreme Court reversed the lower court’s decision that a private cause of action can come under Rule 10b-5. The Supreme Court ruled that a private cause of action for damages does not come under Rule 10b-5 in the absence of any allegation of scienter. The Court cited the language in Section 10 that it is unlawful for any person to use or employ any manipulative or deceptive device or contrivance in contravention of SEC rules. The Court ruled that the use of those words clearly shows that it was intended to prohibit a type of conduct quite different from negligence. The term manipulative connotes intentional or willful conduct designed to deceive or defraud investors, a type of conduct that did not exist in the case.

In a footnote to the decision, the Court recognized that in certain areas of the law, recklessness is considered to be a form of intentional conduct for the purpose of imposing liability for some act, thereby providing potential exposure to auditors for gross negligence under the Securities Exchange Act.

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Learning Objective: 06-02 Explain the basis for auditors’ statutory legal liability.
Topic: Legal Liability of Auditors: An Overview
Topic: Statutory Liability

74.Describe the steps auditors should take to protect themselves against allegations that fraud went undetected during the audit.

The role of the external auditor is to perform an audit in accordance with generally accepted auditing standards (GAAS) upon which the auditor renders an independent opinion whether those statements have been prepared in accordance with generally accepted accounting principles (GAAP) that have been consistently applied and contains full and fair disclosures of information the public needs to know. The auditor’s examination of client-prepared financial statements is designed to evaluate whether any material misstatements in the financial statements exist as a result of fraud or illegal acts.

The audit must be carried out with objectivity, due care, and professional skepticism. Auditors are not guarantors that fraud will be detected. Instead, the opinion provides reasonable assurance that the financial statements are free of material misstatements due to fraud. As long as the auditor meets these standards, a due diligence defense can be asserted.

Here are four key questions to answer that may help successfully defend a lawsuit alleging auditor malpractice.

Was the audit done in accordance with professional standards?

GAAS apply to the audits of all entities while the auditing standards of the Public Company Accounting Oversight Board (PCAOB) applies to registrants with the SEC. A key standard is Consideration of Fraud in a Financial Statement Audit (AU-C section 240). This standard outlines the process auditors must go through as they consider the possibility that fraud could occur within the company. Was the issue of fraud appropriately considered, and were audit procedures designed accordingly? Did the audit team thoughtfully consider the issue of fraud and thoroughly examine any possible issues before deciding on a scope of work as it relates to fraud.

Auditors should follow the guidelines of the fraud triangle to assess the risk of fraud: pressures/incentives to commit fraud; opportunity to do so; and the rationalizations that are typically given to rationalize the fraud. It is critically important to carefully assess management’s representations with respect to assertions in the financial statements and to gather sufficient, competent evidential matter to support those assertions. During the course of the audit, auditors must document due care and professional skepticism as these are areas often probed during litigation.

Do the working papers show that the auditors completed all the procedures suggested by the audit program?

Auditors do have some latitude in designing audit procedures, based on their evaluation of materiality and of the risks facing the company and the results of testing. This is an area in which the auditors are likely to get tripped up in a lawsuit, however, if their documentation procedures are not thorough.

It is important for auditors to determine whether any problems discovered during audit testing were dealt with appropriately. For example, if the auditors’ testing revealed that documentation did not support numbers in a certain area of the financial statements (or documentation was not available), then the auditors must follow this with additional analysis and/or procedures.

Did staff, managers, and partners sign off on the work programs appropriately?

In addition to performing all the appropriate audit procedures, the auditors must document this work (and relevant issues to consider) in the work programs. Do the work programs reflect the work actually done? Was a box checked or a space signed only if the work was actually done? This can be a tedious thing to analyze, as the expert must go through all of the work programs in conjunction with the workpapers, and make sure that the representations in the work programs match the documented work.

Were firm quality controls adequately applied including second partner/technical review partner reviewing the working papers?

The engagement partner has ultimate responsibility for the audit. Audit firms demonstrate due care when they have a second partner review those work papers including any that indicate differences of opinion with management and how they were resolves as well as communications with the audit committee. An important consideration is whether the firm reviewed management’s report on internal controls over financial reporting and whether the firm issued its own report based on that assessment. This is required under section 404 of SOX. PCAOB inspections oftentimes identify internal control assessments as deficiencies based on inspections of audit working papers.

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 06-03 Discuss auditors’ legal liabilities under SOX.
Topic: SOX and Auditor Legal Liabilities

75.The following clause was included in the engagement letter between Limits and Lobits, CPAs (L&L) and Fair, Inc., an audit client of (L&L).

Fair, Inc. agrees to release, indemnify, and hold Limits & Lobits, CPAs (its partners, heirs, executors, personal representatives, successors, and assigns) harmless from any liability and costs resulting from fraud caused by or participated in by management of Fair, Inc.

Do you think such a clause is ethical? Use ethical reasoning to support your answer with reference to professional standards.

With the continuing focus on management fraud and an auditors’ responsibility to detect fraud, some CPAs have expressed an interest in including an indemnification clause covering management fraud in engagement letters. Where management fraud is not detected by the auditor and litigation ensues, the success of this clause in protecting the CPA would be dependent upon the views of the governing jurisdiction.

An indemnification or hold harmless clause in an engagement letter typically provides that the client will indemnify or hold the CPA harmless in the event the CPA sustains a loss resulting from claims arising from the CPA’s work on the subject engagement. Indemnification clauses are not intended to preclude the CPA from incurring liability for professional malpractice. Instead, such a clause is intended to preclude liability where the client knowingly makes misrepresentations to the CPA, causes or participates in a fraud, conceals information from the CPA, or otherwise leads the CPA astray.

Where permitted, indemnification clauses may provide valuable benefits to the CPA. For example, the inclusion of an indemnification clause could prove to be a deterrent to a client considering a potential claim against a CPA firm. Recognizing the existence of the indemnification clause, the client may view an action against the CPA as being without potential benefit. Further, for the CPA and client desiring to keep the engagement risk and reward equation in balance, the use of an indemnification clause could provide support for the CPA’s adjusting the fee for the subject services. Also, the upfront discussion and use of such a clause affords the parties the opportunity to address their specific risk management and risk allocation needs before the engagement commences and thereby provide both parties with knowledge of their individual limits and exposures.

The ethical issue turns on whether these clauses could jeopardize an auditor’s performance and independence. Given that independence is both a factual determination as well as the appearance of independence, it would seem that a reasonable observer might conclude that an auditor(s) is less diligent in doing all that is necessary to find fraud if, for example, the audit is late and above budget because of the limitation of liability. On the other hand, the auditor(s) liability to investors and other third party users cannot be similarly limited.

For some time the position of the SEC and PCAOB with regard to the use of an indemnification provision by a CPA/CPA firm auditing a public company has been that an agreement that provides complete indemnification to an auditor impairs independence in attest engagements. Prior to the revision to the AICPA Code, such indemnification clauses were permitted so that they were acceptable by the profession for non-public companies.

The Revised AICPA Code contains a provision under section 1.228.020, Indemnification of Attest Client, that indemnification clauses in audit engagement letters create a threat to independence that cannot be reduced to an acceptable level by the application of safeguards if the covered member (CPA on the attest engagement team) enters into an agreement providing, among other things, that the covered member indemnifies the attest client for damages, losses, or costs arising from lawsuits, claims, or settlements that related, directly or indirectly to the attest client’s acts. The covered member’s independence would be impaired under these circumstances.

The ethics of using an indemnification clause in an audit engagement is best viewed through the prism of fairness. Is it fair for a CPA firm to be held legally liable when client management knowingly deceives the auditor about a financial matter and then takes steps to cover its tracks? On the other hand, is it fair to the client to have such limitations on CPAs’ liabilities if, for example, a rogue employee caused the fraud and, as alleged by the client, the CPAs should have discovered it through their audit procedures?

There is no simple answer to the fairness issue because it depends on the underlying circumstances. CPAs who seek to limit their liability to clients when management fraud leads to materially misstated financial statements seek to hold management legally liable for its own fraud. Responsibility and accountability are integral elements in ethical behavior.

From a utilitarian perspective, the CPA could easily justify using indemnification clauses because the costs to them are negligible while the benefits of not being financially responsible for management fraud are substantial. From a practical perspective, it may not be so easy to determine where management fraud begins and audit insufficiencies start.

Another aspect of this issue is that audit engagement agreements between a company and its auditor aren’t public documents. As a result, some investors are pushing companies to spell out these provisions and make their implications crystal clear.

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 06-03 Discuss auditors’ legal liabilities under SOX.
Topic: SOX and Auditor Legal Liabilities

76.Assume a securities lawyer has just received a phone call from her client, the Chief Financial Officer (CFO) of XYZ Corporation, and informed that a securities lawsuit may be filed against her client by a group of the company’s shareholders. XYZ’s share price recently dropped from $40 to $4 per share after the company announced that it had to restate its quarterly results. The shareholders also learned that the CFOs compensation package ($20 million) is tied to the attainment of a $40 common stock share price. Although her client is innocent, the attorney believes the shareholders will view this as a case of securities fraud and file the suit against the CFO, alleging that due to the large compensation, the client stood to gain from reaching the share price, and with the client’s ability to influence the company’s revenue, the CFO possessed the motive and opportunity to defraud XYZ’s investors.

Why might the facts of this case lead the attorney to conclude that a lawsuit against her client is imminent? How might the attorney assert a valid “good faith” defense?

The attorney probably believes the allegations may create a strong inference that the CFO acted with the required state of mind, or scienter, which is a mental state that reflects a defendant’s intent to deceive, manipulate, or defraud. Scienter is a required element of a private securities fraud claim.

The Private Securities Litigation Reform Act strengthened the pleading standards for fraud cases by requiring the plaintiff to state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind. The courts look at whether the defendant’s motive and opportunity to commit fraud reflect evidence of conscious misbehavior or recklessness.

A legal principle that makes officers, directors, managers, and other agents of a corporation immune from liability is when their decisions are made in good faith. Under the business judgment rule, the officers and directors of a corporation are immune from liability to the corporation for losses incurred in corporate transactions within their authority, so long as the transactions are made in good faith and with reasonable skill and prudence.

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

77.Auditors may be held liable to both their clients and third parties under common law.

a. What must a client prove to recover its losses from an auditor under common law?
b. What must a third party prove to recover losses from an auditor under common law?
c. How does an auditor’s ethical obligations and liability under common law intersect?

a. A client has a privity relationship with the auditor, which makes the auditor liable for fraud, gross negligence, and ordinary negligence. To recover losses under common law, a client must prove losses, reliance on the auditors’ representations, that the reliance was proximate cause of the losses, and negligence on the part of the auditors.

b. A third party is not in a contractual relationship with the auditor. The auditor has a liability for fraud and gross negligence but it is not completely clear that the auditor would be liable to the client for ordinary negligence. Common law decisions establish legal standards for liability in that regard.

Generally, to recover losses under common law, ordinary third parties must prove losses, reliance on the auditors’ report, that the reliance was proximate cause of the losses, and gross negligence on the part of the auditors. Courts may also require demonstrating a direct link between the auditor and third party and that the third party was not negligent in using the audited information for decision making.

c. The student may use rights, deontology, utilitarianism, or virtue theories to argue that if the auditor does his job, meeting all duties and obligations, then the law and ethical obligations are in alignment. For example, the diligent auditor demonstrates objectivity, due care and professional skepticism, and virtues that are critical to conducting an audit in accordance with GAAS. An auditor that places his obligation to third parties, such as creditors, ahead of that to the client, is meeting his public interest responsibility. Investors and creditors have a right to receive accurate and reliable financial report information. Auditors should act in a way they would want other auditors to act in similar situations for similar reasons so that their actions have universal appeal and would be acceptable to a broad group of accounting professionals. Utilitarianism comes into play when applying rule utilitarianism which holds that regardless of utilitarian benefits (act utilitarianism), certain rules should never be violated including knowingly providing false information to a third party.

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

78.Lotus Hospitality, a U.S. publicly-owned company doing business in China, deals with state-owned enterprises in a variety of countries. It is common for Chinese companies to pay custom officials in these countries amounts ranging from $100-$500 to enable their goods to be off-loaded at the receiving docks in each country. To show its appreciation for the many years of doing business in these countries, Lotus invited 50 government officials and employees of state-owned enterprises to attend the Olympic Games in China at the company’s expense, and ultimately paid for such guests as well as some spouses and others who attended along with them. Sponsored guests were primarily from countries in Africa and Asia, and they enjoyed three- and four-day hospitality packages that included event tickets, luxury hotel accommodations, and sightseeing excursions valued at $12,000 to $16,000 per package. In return for the generosity of Lotus Hospitality, the state-owned enterprises promised to give preference to Chinese companies when multi-million dollar contracts are awarded.

Describe the nature of these payments under the Foreign Corrupt Practices Act (FCPA) and assess their legality. What are the potential ethical issues of allowing certain types of payments under the Act?

The payments of $100-$500 to expedite off-loading of the goods are facilitating payments because they are made to expedite a process, but one that should occur as a normal course of business except for the payment. It is common in many countries to have to “grease the wheels” to get things done that should be done anyway because it is part of the acting officials routine duties.

The sponsoring of guests from state-owned enterprises to attend the Olympics in China are bribe payments to win lucrative contracts to be awarded to Chinese businesses as a return favor. It is a “quid pro quo,” or something that is given to someone or done for someone in return for something given to or done for someone else. The covering of expenses for the guests is a payment to be awarded the future contracts so they are made to induce a behavior that otherwise should not necessarily be done until and unless a competitive bidding process is allowed to play out.

Facilitating payments involve a set of questionable behaviors because:

• The custom official has an incentive not to carry out her duties of resolving the issues entrusted to her as swiftly or as efficiently as is to be expected of a conscientious public servant.
• The Chinese companies are entitled to the service, and have it delivered on a timely basis.
• The official may ask for larger and larger payments over time especially if foreign suppliers agree to make these payments readily.
• Facilitating payments may represent a step towards a culture of corruption in society above all if instances of easy wealth, legal impunity and willingness to break the law proliferate.
• The Chinese companies may take the initiative to offer other officials facilitating payments believing it is part of the cost of doing business in these countries even if such payments are not requested.
• Facilitating payments lead to inefficiencies in the providing of services to Chinese and other companies that play the game.
• Shareholders are not aware of the payments generally speaking and probably would not approve of the use of the company’s resources in that way.
• If the use of facilitating payments becomes common practice, they have a corrosive effect on people’s trust in legal, administrative and judicial procedures.

Ethical legalism is at play in this case. Facilitating payments are legal but not very ethical. Just imagine if every company had to make such payments to get things done (They do in some countries). The level playing field for multinationals is lost unless every company makes the payments and then the requested payments would likely increase in amount. It becomes a snowball effect and once a company agrees to such payments, it has begun the slide down the ethical slippery slope.

Facilitating payments have a pernicious effect on the working of the requesting government administration because all too often they are the slippery slope to more serious forms of corruption. They impose additional costs on companies and citizens and in the long run threaten the ethical foundations of organizations.

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 06-04 Explain the provisions of the FCPA.
Topic: Foreign Corrupt Practices Act (FCPA)

79.Do considerations of culture have a place in the FCPA? Discuss in general and with respect to Hofstede’s cultural values.

In FCPA enforcement, cultural norms are irrelevant. It does not matter to law enforcement whether corrupt acts – like paying “commissions” to sales agents in Brazil making small payments to regulatory officials in Turkey – are standard practice in a certain country.

It is true that the FCPA provides an affirmative defense for activity that is lawful under written local laws or regulations. But we know of no written local laws that legalize bribery, even petty corruption. However, arguments are sometimes made in favor of making exceptions to anti-bribery rules based on local culture. Consider the following rationalizations for facilitating payments and/or bribes.

1. “In cultures where bribery is accepted, it is justified.” This argument implies that some cultures are inherently more corrupt than others. Not surprisingly, this view is frequently offensive to people from the “more corrupt” cultures, and the argument is further weakened by the difficulty of measuring and defining corruption.

The view also suggests that tolerating bribery equates to implicit approval or acceptance by a country’s people. If you were to ask people on the streets of Rio de Janeiro, Brazil or Lagos, Nigeria if they approve of officials who accept bribes, you would get few, if any, “yeses”. People in countries with high corruption understand the personal impact of procurement officials who select low quality goods like poorly constructed roads and bridges in exchange for kickbacks.

2. “In some countries, bribery is built into the economy.” In other words, the system itself expects bribery. The tax collector must demand bribes because she is not paid enough to live on. But, even considering these human dimensions, corruption is still criminal. The plight of low-level officials highlight not the need for more bribes but the need for improved state systems. If a company wants to change such systems to improve the business environment, there are ways to do this short of bribery.

3. “Bribes make an economy more efficient.” Some argue that bribes make economies work better by, for example, streamlining bureaucracies. But, in practice, the opposite is generally true. When corruption is tolerated, bureaucrats have an incentive to create more choke points from which they can extract even more benefits.

4. “These are not bribes, they are something else.” One of the trickiest areas for FCPA compliance is determining when a gift, entertainment, or something else of value that is acceptable in one culture is actually a bribe under the FCPA. What if business people would regularly take high-ranking public officials to expensive dinners and say that is the way things are done. But is it legal?

Complicated matters like these must be decided on a case-to-case basis with the participation and judgment of a compliance officer, attorney, and other qualified management. They should be decided with careful consideration of the company’s own compliance program, acceptable standards in the industry, and law enforcement’s guidance in previous actions, opinion releases, public statements, and other sources of authority.

Geert Hofstede’s studies of cultural values were discussed in Chapter 1. Originally, Hofstede was able to draw out four dimensions of culture, which included: power distance, uncertainty avoidance, individualism, and masculinity. He later added a fifth – long-term orientation.

Power distance was thought to capture the extent to which there was equality in power between members in society. For example, in a society where there is great power distance, many individuals accept the authority and have no say in decisions that are made. With respect to facilitating payments, a society with a high score on power distance might tolerate such payments because of the strong authority position of the central government. A low score on individualism implies a society run for the collective good with loyalty to the group, citizenry and government. Here, facilitating payments are more likely to be accepted by society in order to “go along to get along.” The same result would occur with a high score on uncertainty avoidance as people in that kind of society do not want to rock the boat. If a person has weak uncertainty avoidance then they will be content with letting things happen as they may.

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-07 Discuss the factors that promote global ethics, and prevent global fraud and bribery.
Topic: Global Ethics, Fraud, and Bribery

80.Explain the provisions of section 302 of the Sarbanes-Oxley Act including obligations of officers; nature and scope of assertions; accounting requirements; and legal liability of officers.

A company’s CEO and CFO must each provide two certifications as part of the company’s quarterly Form 10-Q and annual Form 10-K. The certifications are required under Sections 302 and 906 of the SOX. The certifications are executed individually and filed as exhibits to the applicable quarterly and annual filings. Although certifications are not included in reports other than Forms 10-Q and 10-K, the disclosure controls and procedures to which the CEO and CFO certify must ensure full and timely disclosure in all current reports, as well as definitive proxy materials and definitive information statements.

Under Section 302, the CEO and CFO make statements related to the accuracy of the reports filed with the SEC and the controls and procedures established by the company to ensure the accuracy of such reports. The certification must be in the exact form set forth in the rule, and the wording may not be changed in any respect whatsoever. The CEO and CFO must each certify that:

• She has reviewed the report;
• Based on her knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances, not misleading;
• Based on her knowledge, the financial statements and financial information fairly present, in all material respects, the company’s financial condition, results of operations and cash flows of the company;
• The certifying officer(s) is/are responsible for:

• establishing and maintaining disclosure controls and procedures;
• having designed such disclosure controls and procedures to ensure that they are informed of all material information;
• having each evaluated the effectiveness of the disclosure and financial controls and procedures as of the end of each period in which they are making the certification; and
• having disclosed their conclusions regarding the effectiveness of the controls and procedures in the subject Form 10-Q or 10-K;

• She has disclosed to the company auditors and to the audit committee any significant deficiencies or material weaknesses in the design or operation of internal controls over financial reporting which could adversely affect the company’s ability to record, process, summarize and report financial data;
• She has disclosed to the company auditors and to the audit committee any fraud, material or not, that involves employees who have a significant role in internal controls over financial reporting; and
• She has disclosed any changes in the internal controls or financial reporting in the subject Form 10-Q or 10-K, including changes designed to correct deficiencies or material weaknesses.

If a material weakness is uncovered, it must be disclosed in a Form 10-K and, as a result, management cannot conclude that its controls and procedures are effective. The SEC defines a material weakness to be a deficiency, or a combination of deficiencies, in internal control over financial reporting that creates a reasonable possibility that a material misstatement of a company’s annual or interim financial statements will not be prevented or detected on a timely basis. The disclosure of a material weakness should include the nature of the weakness, its impact on financial reports and plans or steps and changes made to correct the disclosed material weakness.

Section 302 does not specify methods or procedures that should be used for effective internal controls and procedures. Rather, the SEC encourages CEO’s and CFO’s to develop systems that best fit the facts and circumstances of their particular enterprises. However, the SEC has given some guidance, encouraging that management (i) develop and continually test its procedures and their effectiveness; (ii) that evaluation be documented in writing, including methods used to test and evaluate procedures and the conclusions and results; (iii) keep good records and documentation; and (iv) rely on outside auditors and advisors to provide input.

In order to ensure that the CEO and CFO certifications are accurate and can properly be executed, a company must establish the underlying procedures to which the CEO and CFO evaluate and attest. The controls and procedures must be designed to address both quality and timeliness of disclosure. Unlike pre-existing concepts of internal controls over financial reporting, the SOX certifications include required material non-financial information, as well as financial information.

The SEC has identified the Treadway Commission Committee of Sponsoring Organizations report and framework on internal controls as an acceptable system and accordingly, it is almost uniformly used and relied upon. The Treadway Commission has published a separate report directed towards internal control systems for smaller public companies. The report noted that smaller companies’ management tends to have a hands-on approach, wider spans of control and the ability to provide ongoing monitoring through direct relationships with key personnel, customers, vendors and capital providers that, along with in-depth knowledge of operations, processes, contractual commitments and business risks, can create opportunities for controls to be effective while being less formal. Managers in smaller public companies are more directly involved with the company’s controls on a daily basis.

In general, as signors of such reports, the CEO/CFO can be liable for material misstatements or omissions under general antifraud standards and under the SEC authority to pursue actions against those who cause or aid or abet securities law violations. An officer providing a false certification potentially could be subject to SEC action for violating Section 13(a) or 15(d) of the Exchange Act and to both the SEC and private actions for violating Section 10(b) of the Exchange Act and Exchange Act Rule 10b-5.

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 06-03 Discuss auditors’ legal liabilities under SOX.
Topic: SOX and Auditor Legal Liabilities

81.In chapter 4 we discussed the rules for independence. Auditor violations of independence can cause legal liability issues for the individual auditor and, perhaps, the audit firm. Describe situations where auditor legal liability has occurred as a result of independence violations and identify other situations addressed in the AICPA Code that could lead to legal liability.

Two examples of insider trading were discussed in Chapter 4 – Scott London at KPMG and Thomas Flanagan at Deloitte. Scott London, an audit partner at KPMG who traded on inside information and violated audit independence by leaking confidential information to his friend, Brian Shaw, about Deckers, Pacific Capital Bancorp, Skechers, and Herbalife – all audit clients of KPMG. The leak of information about quarterly earnings information led to Shaw’s unjust enrichment of $1.27 million. Shaw, a jewelry store owner and country club friend of London, repaid London with $50,000 in cash and a Rolex watch, according to legal filings.

London settled administrative proceedings with the Securities and Exchange Commission that includes SEC sanctions and forfeiture of the right to appear or practice before the SEC as an accountant. On the criminal side, London was convicted of insider trading in June 2014, and is serving a 14-month sentence for his crime.

In 2010, Deloitte and Touche was investigated by the SEC for repeated insider trading by Thomas P. Flanagan, a former management advisory partner and a Vice Chairman at Deloitte. Flanagan traded in the securities of multiple Deloitte clients on the basis of inside information that he learned through his duties at the firm. The inside information concerned market moving events such as earnings results, revisions to earnings guidance, sales figures and cost cutting, and an acquisition. Flanagan’s illegal trading resulted in profits of more than $430,000. In the SEC action, Flanagan was sentenced to 21 months in prison after he pleaded guilty to securities fraud. Flanagan also tipped his son, Patrick, to certain of this material non-public information. Patrick then traded based on that information. His illegal trading resulted in profits of more than $57,000.

A number of additional situations can cause an actual breach of independence, or—just as serious—the appearance of such a breach. These include the following:

1. Employment relationships. AICPA and SEC independence rules both provide that an audit firm’s independence will be impaired if former firm professionals are subsequently employed by or associated with an attest client in a key position, unless certain conditions are met. In addition, the SEC rules, being the more restrictive, include shareholders as covered members and require a one year cooling-off period before a company can hire an individual formerly employed by its auditor for a position involving oversight of the financial reporting process at the registrant entity.

2. Direct or material indirect financial interests. The AICPA and SEC independence rules both explicitly state that a member or a member’s firm may not have or be committed to acquire any direct or material indirect financial interests in a client. Further, both the AICPA and SEC independence rules provide similar, but not identical, language regarding guidance on situations in which serving as a trustee or executor of an estate that has a direct or material indirect financial interest in the client will impair independence.

3. Loans to and from clients. AICPA guidance provides that all loans to or from clients, without regard to materiality, impair independence (unless the loan is from a financial institution and certain criteria are met).

4. Business relationships. AICPA and SEC independence rules provide that business relationships with clients – such as joint ventures, limited partnership agreements, investments in supplier or customer companies and sales by the member of items other than professional services – will impair independence. AICPA rules regarding business relationships with clients provide that if a member or a member’s firm has a material joint, closely held business investment with a client, independence is impaired. A joint closely held business investment refers to an investment that is subject to the control of the member or the member’s firm, the client, the client’s officers, directors or principal stockholders or any combination thereof. The AICPA rules address such situations as creating a threat to independence that must be mitigated by specific safeguards to avoid violating the independence rules.

The foregoing are certainly not the only instances in which auditor independence could be lost or threatened. Importantly, since the appearance of independence must be maintained, various permutations of these fact patterns, even if not expressly addressed by SEC or AICPA rules, could give rise to allegations of breaches making auditors vulnerable to assertions of malpractice.

As further scrutiny is placed on auditor independence, in both fact and appearance, it is probable that auditor liability due to violations of auditor independence will remain an area ripe for litigation.

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 06-01 Distinguish between common-law rulings and auditors’ legal liability.
Topic: Legal Liability of Auditors: An Overview

Chapter 07

Earnings Management

Multiple Choice Questions

1.Who linked earnings management to an excessive zeal to project smoother earnings from year to year that casts a pall over the quality of the underlying numbers?

A.Warren Buffet

B.Arthur Levitt

C.Thomas E. McKee

D.Lynn Turner

2.Which of the following is NOT a motivation to manage earnings?

A.Companies try to meet or beat Wall Street earnings projections in order to grow market capitalization and increase the value of stock options

B.Avoid the consequences of violating debt covenants

C.To smooth net income over time

D.To maximize employee bonuses

3.An unusual aspect of the Green Mountain case is it included:

A.Conference calls that provided earnings guidance to shareholders and analysts were used to mask a financial fraud

B.Desire to meet or beat analysts’ earnings expectations led to manipulation of receivables balances

C.Company violated the Sarbanes-Oxley Act

D.PricewaterhouseCoopers knew about inflated inventory values

4.What is the SEC’s position on companies that communicate with investors on social media?

A.It is illegal to do so

B.It is legal so long as companies inform investors which outlets they intend to use

C.It is legal so long as the postings are restricted to Facebook

D.There are no limitations on companies communicating through social media

5.Which of the following has NOT been found to be a measure of a non-GAAP financial metric?

A.Earnings before depreciation and amortization

B.Operating income before certain non-recurring expense or revenue items

C.EBITDA

D.GAAP earnings

6.Motivations to smooth net income over time include each of the following except:

A.Maximize bonuses and stock option values

B.Steady increase in earnings each year

C.Minimize overall taxes

D.Make it appear managers are doing better than they really are

7.A common method used to smooth net income over time is:

A.Accelerate revenue into earlier periods

B.Delay expenses into later periods

C.Using accrual of operating expenses and future adjustments

D.Using nonrecurring items to increase earnings in one year and reduce it later on

8.If a company is managing its earnings, which of the ethical theories are they most likely following?

A.Rights

B.Fairness

C.Egoism

D.Virtue

9.Which of the following is NOT considered “earnings management?”

A.“Earnings management” is done to project smoother earnings from year to year

B.Management emphasizes achieving long-term results to meet financial goals

C.Management uses “cookie-jar reserves each year”

D.Executives manipulate the earnings in order to match their predetermined target

10.Which technique was used by both WorldCom and Waste Management to manage earnings?

A.Manipulating asset net valuation amounts to minimize operating expenses for a period

B.Accelerating the recording of revenue into an earlier period

C.Delaying needed repairs to a later period

D.All of the above were used

11.Which of the following author(s) emphasize(s) a “purposeful act by management in pursuit of its own self-interests as might be the case when earnings are manipulated to get the stock price up in advance of the exercise of stock options?”

A.Dechow and Skinner

B.Healy and Wahlen

C.Schipper

D.Thomas E. McKee

12.Which of the following authors(s) focus(es) on “management’s intent to deceive the stakeholders by using accounting devices to positively influence reported earnings?”

A.Dechow and Skinner

B.Healy and Wahlen

C.Schipper

D.Thomas E. McKee

13.Which of the following authors(s) link earnings management to choices made in determining earnings that may comprise aggressive, but acceptable, accounting estimates and judgments, as compared to fraudulent practices that are clearly intended to deceive others?

A.Dechow and Skinner

B.Healy and Wahlen

C.Schipper

D.Thomas E. McKee

14.Which of the following author(s) define(s) earnings management as “reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results?”

A.Dechow and Skinner

B.Healy and Wahlen

C.Schipper

D.Thomas E. McKee

15.Who distinguished between earnings manipulation and earnings management?

A.Hopwood et al.

B.Thomas E. McKee

C.Arthur Levitt

D.Belverd Needles

16.One result of earnings management is:

A.It brings into question the quality of earnings

B.It uses a non-GAAP financial measure to manipulate earnings

C.EBITDA does not reflect GAAP earnings

D.It improves shareholder returns over time

17.In surveys of managers, which technique to manage earnings was considered most acceptable?

A.Changing inventory valuation in order to influence earnings

B.Accounting manipulation

C.Manipulating operating decisions

D.Establishing cookie jar reserves

18.Needles suggests that making judgments about what earnings management is becomes difficult because:

A.It depends on management’s intentions

B.There is no clear limit beyond which a choice is clearly unethical

C.A perfectly routine accounting estimate may be illegal and unethical

D.All of the above

19.Each of the following is a finding of a survey of CFOs about their perceptions of earnings quality except:

A.CFOs believe that earnings are high quality when they are sustainable and backed by actual cash flows

B.CFOs believe that reporting discretion has declined over time, and that current standards somewhat restrain reporting high quality earnings

C.CFOs estimate that roughly 20 percent of firms manage earnings and the typical misrepresentation for such firms is about 10 percent of reported EPS

D.CFOs estimate that income increasing and income decreasing devices to manage earnings show a 50:50 split

20.Accruals that are based on estimated changes in fundamental economic performance of the firm are:

A.Discretionary accruals

B.Nondiscretionary accrual

C.Operating accruals

D.Cookie jar accruals

21.Accruals are potentially troublesome because:

A.They can lead to giving an unmodified audit opinion when it should have been modified

B.They provide an opportunity to manage earnings through aggressive or more conservative estimations

C.They always lead to fraud in financial statements

D.They provide an opportunity to shift debt off the books by setting up an SPE

22.The main difference between a discretionary and nondiscretionary accrual is:

A.Discretionary accruals are items that management has full control over

B.Discretionary accruals are based on changes in the fundamental performance of the firm

C.Discretionary accruals arise from transactions considered normal for the firm

D.Discretionary accruals always lead to an increase in earnings

23.The concept that earnings management might align with conservative versus aggressive reporting is known as the:

A.Earnings judgment

B.Earnings accruals

C.Earnings continuum

D.Earnings manipulations

24.Which of the following is NOT a qualitative factor when assessing materiality?

A.A misstatement that changes a loss into income or vice versa

B.The existence of statutory or regulator reporting requirements that affect materiality thresholds

C.The potential effect of the misstatement on trends, especially trends in profitability

D.The use of simplistic numerical thresholds and rules of thumb

25.Vorhies identities four perspectives to help CPAs identify key internal control exceptions under the Sarbanes Oxley Act (SOX) including:

A.An internal control deficiency caused by accounting manipulations

B.A large variance in an accounting estimate compared with the actual determined amount

C.A misstatement that changes a loss into income or vice versa

D.All were identified

26.Which of the following is NOT required of management under Section 302 of the SOX?

A.Review their disclosure controls and procedures quarterly

B.Identify key control exceptions and determine which are internal control deficiencies

C.Assess each internal control deficiency’s impact on the audit report

D.Identify and report significant control deficiencies on material weaknesses to the audit committee and independent auditor

27.In the Matrixx Initiatives v. Siracusano case, the Supreme Court adopted the position about materiality that:

A.It should always be determined only through qualitative evaluations

B.It should always be determined through quantitative evaluations

C.It should always be determined by considering whether the amount affects past financial statements

D.It should be determined by considering whether the total mix of information would be viewed by a reasonable investor as possibly accepting judgment

28.Inherent risk refers to:

A.The possibility that a material misstatement will occur within the reporting company’s accounting information system

B.The possibility that a material misstatement that has occurred will not be detected on a timely basis by the company’s control system

C.The possibility that a material misstatement that has occurred will not be caught be the independent auditor’s testing

D.The possibility that a material misstatement will occur in the financial statements

29.Which of the following is NOT one of the techniques used by Gemstar TV Guide International in its accounting fraud?

A.Created cookie jar reserves of advertising revenue to smooth net income

B.Engaged in round trip transactions

C.Used channel stuffing to accelerate the recording of revenue into earlier periods

D.Inflated advertising revenue from nonmonetary and barter transactions

30.“Cookie jar reserves” can best be described as:

A.Buying a lot of chocolate chip cookies, storing them for when you have a hunger attack, and then releasing them into your stomach

B.Overstating or understating allowances and reversing amounts in the future to smooth out net income over time

C.Accelerating the recording of revenues into an earlier year than is warranted

D.Delaying the recording of expenses to a later year to boost income in the current year

31.All of the following are examples of “Recording revenue too soon or of questionable quality” except:

A.Recording sales that lack economic substance

B.Recording revenue when future services remain to be provided

C.Recording revenue before shipment or before the customer’s unconditional acceptance

D.Recording revenue even though the customer is not obligated to pay

32.All of the following are examples of “Boosting Income with One-Time Gains” except:

A.Recording sales that lack economic substance

B.Boosting profits by selling undervalued assets

C.Including investment income or gains as part of revenue

D.Including investment income or gains as a reduction in operating expenses

33.Auditors need to be attuned to the red flags that fraud may exist because:

A.Materiality judgments are based on red flags identifying possible material misstatements

B.Audit opinions must be withdrawn when red flags indicate fraud may exist

C.Overly-aggressive accounting and outright manipulation of earnings may exist

D.All of the above

34.Which of the following was not pointed to by the SEC as a motivation for fraud in the Xerox case?

A.Xerox misled investors by polishing its reputation on Wall Street and to boost the company’s stock price

B.Xerox top management overrode the internal control to manipulate earnings

C.Xerox failed to disclose GAAP violations that led to acceleration in the recognition of approximately $3 billion in equipment revenues

D.Xerox recognized a greater amount of revenue on leases in early years than warranted and didn’t break out revenues that should have been deferred and recognized in future years

35.Which of the following earnings management techniques were not used in the Lucent Technologies, Inc.’s case?

A.Shifting current revenue to a later period

B.Boosting income with one-time gains

C.Recording revenue too soon or of questionable quality

D.Shifting current expenses to a later or earlier period

36.Which of the following was not true according to the Enron case?

A.Fastow developed the concept of buying up oil and gas companies to establish SPEs

B.Fastow worked to structure ventures that met the conditions under GAAP to keep the partnership activities off Enron’s books and on the separate books of the partnership

C.Fastow created SPEs that borrowed money from banks and transferred it to Enron in a sale of an operating asset no longer need by Enron

D.The SPE created by Fastow enabled Enron to keep debt off its books while benefiting from transfer and use of the cash borrowed by the SPE

37.Which of the following was not a technique used by Enron to manage earnings?

A.Used reserves to increase earnings when reported amounts were too low

B.Deliberately overstated the allowance for uncollectibles and adjusted it downward in future years

C.Used mark-to-market estimates to inflate earnings in violation of GAAP

D.Selected which operating assets to “sell” to the SPEs, affecting the gain on transfer and earnings effect

38.Which of the following partnerships that Enron created eventually lead to its demise?

A.JEDI

B.Cactus

C.Chewco

D.Ironman

39.What was the original motivation by FASB on SPEs?

A.To establish a mechanism to encourage companies to invest in needed assets while keeping related debt of its books

B.To keep the large amount of debt off the books

C.To sell non-producing assets to the SPE

D.To select which assets to sell to the SPEs affecting the gain

40.There are several aspects of the Enron fraud that are dealt with directly in SOX further connecting Enron to reform in the accounting profession. Which of the following is true?

A.SOX permitted the provision of internal audit service for audit clients

B.Off-balance-sheet financing activities were prohibited for all companies

C.Related-party transactions require disclosure in the notes

D.Cookie jar reserves must be disclosed in the notes

41.The best way to characterize the role of Sherron Watkins in the downfall of Enron is:

A.She directed the internal auditors to examine numerous transactions that led to the discovery of the fraud

B.She gave in to the pressure of Andy Fastow to go along with materially misstated financial statements

C.She was sent to jail even though she cooperated with the government in its case against Enron

D.She tried to alert Ken Lay about the accounting scandal at Enron

42.Which of the following is NOT an earnings management technique?

A.Failing to write down or write off impaired assets

B.Releasing questionable reserves into income

C.Failing to record expenses and related liabilities when future obligations remain

D.Creating an allowance for uncollectible accounts and adjusting it at year end

43.In the CVS acquisition of Longs Drug, the SEC concluded that the purchase price accounting (PPA) was not in compliance with GAAP because:

A.The amount did not reflect current use of Longs personal property at the acquisition date

B.CVS used an overly-aggressive technique to value Longs

C.CVS did not account for its use of Long’s assets to generate revenue after the acquisition date

D.All of the above

44.Each of the following is a common revenue recognition device to manage earnings except:

A.Multiple deliverables

B.Channel stuffing

C.Buy and hold

D.Round tripping

45.The best definition of a financial restatement is:

A.A company, either voluntarily or under prompting by its auditors or regulators, revises its public financial information that was previously reported

B.A company, either voluntarily or under prompting by its auditors or regulators, revises its public financial information for the current period

C.An adjustment of financial information due to an error correction

D.All are part of the definition

46.The SEC requires stealth restatements to be:

A.Disclosed only in periodic reports

B.Disclosed only in an 8-K report or amended 10-K/A or 10-Q/A

C.Increased to more 50% of restatements

D.Disclosed in ten business days after determination of need for restatement

47.In the Hertz fraud, the company tried to explain its use of non-GAAP financial measures by:

A.Comparing them to aggressive but ethical measurements

B.Comparing the validity of the amounts to pre-tax GAAP income

C.Having a conference call with financial analysts to explain their position

D.Correcting problems in internal controls

48.Your professor asks you to consider whether earnings management can be justified by arguing that the net benefits of managing earnings exceeds any harms that may occur. The professor is asking you to apply what reasoning methods to make the analysis?

A.Egoism

B.Act utilitarianism

C.Rule utilitarianism

D.Virtue

49.You work for a company that always pushes the envelope with respect to reporting revenues and expenses. You often disagree with the company because its approach to reporting these amounts cannot be justified from a GAAP perspective. You are upset and are considering whether this is a company that has a culture you want to be part of. Which of the following best characterizes the ethical issues of concern?

A.Rights Theory

B.Moral blindness

C.Ethical Dissonance

D.Materiality

50.Debbie and Steve are discussing a lecture given by their ethics professor after class one day. The professor said that misstatements of earnings are always unethical. Debbie agrees with this situation but Steve does not. What statement might Steve make to best support his point of view?

A.It depends on whether the misstatements were made deliberately

B.It depends on whether a user relied on the financial statements

C.It depends on whether the statements lead to a modified or unmodified opinion

D.All are valid statements for Steve to support his point of view

51.Kelly and Jordan are writing a term paper together on the concept of “faithful representation” in the financial statements. Kelly is assigned the task of defining it in the context of an amount being an estimate. Which of the following statements should NOT be used by Kelly in her description?

A.Good faith attempt to gather evidence to support the amount

B.Clear disclosure of an amount as an estimate

C.The nature and limitations of the estimating process

D.Error free procedures in selecting and applying an appropriate process for developing the estimate

52.The main accounting issues in the Nortel Networks case were:

A.Premature revenue recognition and hidden cash reserves

B.Capitalization of operating expenses and hidden cash reserves

C.Premature revenue recognition and off-balance-sheet entities

D.Capitalization of operating expenses and off-balance-sheet entities

53.Sarah’s concern in the Solutions Network case is:

A.Expenses were delayed at year-end to manage earnings

B.Revenue was recorded at year-end before the agreement with the customer was finalized

C.Revenue was accelerated into an earlier period through channel stuffing

D.Off-balance sheet entities were not disclosed

54.The SEC’s complaint in its case against GE included a charge that the company:

A.Used off-balance sheet entities to manipulate earnings

B.Falsified inventory values to inflate earnings

C.Used non-GAAP measures to meet EPS estimates

D.Used EBITDA to obscure reported earnings

55.The Harrison Industries case deals with:

A.Using non-GAAP measures of earnings

B.Acceptability of recording unpaid severance accruals

C.Using EBITDA to obscure earnings

D.All of the above.

56.The accounting shenanigan used in the Dell Computer case can best be described as:

A.Recording revenue from exclusivity payments too soon or of questionable quality

B.Shifting current revenue from exclusivity payments to a later period

C.Shifting future expenses to the current period as a special charge

D.Shifting current expenses to a later period

57.The auditors in the Tier One Bank case were investigated by the SEC because it:

A.Failed to obtain sufficient competent evidential matter to support audit conclusions

B.Failed to exercise the appropriate level of care in its audit

C.Failed to exercise the proper degree of professional skepticism

D.All of the above

58.Which of the following was not an accounting issue in the Sunbeam case?

A.Cookie jar reserves

B.Channel stuffing

C.Bill and hold sales

D.Swap transactions

59.The Sino-Forest case centered around the:

A.Acceleration of revenue due to channel stuffing arrangements

B.Use of cookie jar reserves to manage earnings

C.Existence of assets

D.Contingent liabilities due to forestry fires

60.The North Face case deals with materiality and how auditors employ that metric in an audit. The following are all true except:

A.North Face accounted for barter transactions with full normal margin recognized

B.Crawford devised the 1997 barter transaction so that it was just beneath the materiality threshold

C.Crawford followed the GAAP methods that Deloitte suggested

D.Deloitte proposed an adjusting entry for the 1997 barter transaction, but “passed” on it as immaterial

61.Which of the following was NOT one of the schemes used by Beazer Homes to manipulate its earnings?

A.Improper recording of revenue on sale-leaseback transactions

B.Fraudulently increased land inventory expense accounts to reduce earnings

C.Over-reserving of house cost-to-complete expenses to increase reported earnings in earlier periods

D.Recording revenue from roundtrip transactions prematurely

Essay Questions

62.Explain why a company’s reported earnings may not necessarily be an objective measure of economic reality. Give examples of when this might occur.

63.Analyze and discuss when earnings management may be an ethical practice and when it is an unethical practice.

64.Discuss all the factors an auditor should consider in making a materiality judgment.

65.What is a financial shenanigan and what is it designed to do? Explain each of the financial shenanigans described by Schilit and provide examples of each.

66.Explain what is meant by “quality of earnings” including links to earnings management and audit committee responsibilities in evaluating the quality of earnings?

67.Categorize the financial shenanigans in the fraud cases at Gemstar-TV Guide and Lucent.

68.The Xerox case deals with accounting for multiple deliverables. Explain what this means in the context of the Xerox fraud.

69.Assume you are a CPA and the accounting manager of a small privately-owned business that has three co-equal shareowners. Your company receives $1,000 from a cash sale of merchandise taken by the customer. Your boss tells you to recognize only $700 and put the other $300 in reserves. What would you do and say and why? Use ethical reasoning to support your position.

70.In Chapter 7 we discuss the work of Sam Antar, a convicted felon and former CFO of Crazy Eddie, in helping to analyze and ferret out the fraud at Green Mountain Roasters in September 2012. Today Antar works very closely with the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify and catch white-collar criminals.

In October 2015, Andy Fastow, also a CFO (at Enron) and convicted felon, spoke at the University of Missouri on “Pride and Repentance: The Enron Story,” focusing on his personal shortcomings and similar number-fudging he says is still occurring in companies across the world. Despite the damage he caused, Fastow said he didn’t break any rules while at Enron but instead found ways around the rules for his own and the company’s benefit.

Do you believe that convicted felons should be allowed to benefit from their work and speeches in a financial or reputational way? Use ethical reasoning to support your answer.

71.March 26, 2015, A San Francisco federal judge allowed Zynga Inc. shareholders to proceed with their class-action lawsuit alleging the online gaming company failed to disclose slumping revenue growth before its market value declined by several billion dollars in 2012. According to the plaintiffs, Zynga concealed declining user activity, masked how changes in a Facebook platform for its games would affect demand, and inflated its 2012 revenue forecast. The shares fell from a peak of $15.91 on March 2, 2012 to below $3 on July 26, 2012, when Zynga posted disappointing earnings and cut its outlook.

Zynga says it recognizes revenue after it determines that a service has been provided to a player and the collection of fees is “reasonably assured.” But determining that a service has been provided seems a little more complicated than it would appear, because Zynga needs to differentiate between the types of goods it sells its players.

Zynga, which makes games like FarmVille and Mafia Wars for social networking platforms like Facebook, classifies the game items it sells to players as either “consumable” or “durable” goods. The former category is for goods that players can immediately use, like energy in the game CityVille; the latter is for goods that players buy and keep for the duration of the game, such as tractors in FarmVille.

The company recognizes revenue for the consumable goods as soon as they are consumed. The durable goods present a problem, however, because things like virtual tractors don’t depreciate, but potentially live forever, and the company is obligated to ensure that the virtual game pieces continue to exist in the game world. That’s forced Zynga to come up with a system of determining how long that may be.

Discuss the challenges of recognizing revenue for the online products/services Zynga provides to its customers. Draw an analogy between how Zynga should go about recognizing revenue and when gift cards are sold to be used at a later date.

Chapter 07 Earnings Management Answer Key

Multiple Choice Questions

1.Who linked earnings management to an excessive zeal to project smoother earnings from year to year that casts a pall over the quality of the underlying numbers?

A.Warren Buffet

B.Arthur Levitt

C.Thomas E. McKee

D.Lynn Turner

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 07-01 Describe the motivation for earnings management.
Topic: Motivation for Earnings Management

2.Which of the following is NOT a motivation to manage earnings?

A.Companies try to meet or beat Wall Street earnings projections in order to grow market capitalization and increase the value of stock options

B.Avoid the consequences of violating debt covenants

C.To smooth net income over time

D.To maximize employee bonuses

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 07-01 Describe the motivation for earnings management.
Topic: Motivation for Earnings Management

3.An unusual aspect of the Green Mountain case is it included:

A.Conference calls that provided earnings guidance to shareholders and analysts were used to mask a financial fraud

B.Desire to meet or beat analysts’ earnings expectations led to manipulation of receivables balances

C.Company violated the Sarbanes-Oxley Act

D.PricewaterhouseCoopers knew about inflated inventory values

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-01 Describe the motivation for earnings management.
Topic: Motivation for Earnings Management

4.What is the SEC’s position on companies that communicate with investors on social media?

A.It is illegal to do so

B.It is legal so long as companies inform investors which outlets they intend to use

C.It is legal so long as the postings are restricted to Facebook

D.There are no limitations on companies communicating through social media

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 07-01 Describe the motivation for earnings management.
Topic: Motivation for Earnings Management

5.Which of the following has NOT been found to be a measure of a non-GAAP financial metric?

A.Earnings before depreciation and amortization

B.Operating income before certain non-recurring expense or revenue items

C.EBITDA

D.GAAP earnings

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 07-01 Describe the motivation for earnings management.
Topic: Motivation for Earnings Management

6.Motivations to smooth net income over time include each of the following except:

A.Maximize bonuses and stock option values

B.Steady increase in earnings each year

C.Minimize overall taxes

D.Make it appear managers are doing better than they really are

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 07-01 Describe the motivation for earnings management.
Topic: Motivation for Earnings Management

7.A common method used to smooth net income over time is:

A.Accelerate revenue into earlier periods

B.Delay expenses into later periods

C.Using accrual of operating expenses and future adjustments

D.Using nonrecurring items to increase earnings in one year and reduce it later on

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 07-01 Describe the motivation for earnings management.
Topic: Motivation for Earnings Management

8.If a company is managing its earnings, which of the ethical theories are they most likely following?

A.Rights

B.Fairness

C.Egoism

D.Virtue

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: 2 Medium
Learning Objective: 07-01 Describe the motivation for earnings management.
Topic: Motivation for Earnings Management

9.Which of the following is NOT considered “earnings management?”

A.“Earnings management” is done to project smoother earnings from year to year

B.Management emphasizes achieving long-term results to meet financial goals

C.Management uses “cookie-jar reserves each year”

D.Executives manipulate the earnings in order to match their predetermined target

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 07-01 Describe the motivation for earnings management.
Topic: Motivation for Earnings Management

10.Which technique was used by both WorldCom and Waste Management to manage earnings?

A.Manipulating asset net valuation amounts to minimize operating expenses for a period

B.Accelerating the recording of revenue into an earlier period

C.Delaying needed repairs to a later period

D.All of the above were used

AACSB: Ethics
AICPA: BB Legal
AICPA: FN Reporting
Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: 3 Hard
Learning Objective: 07-02 Explain what earnings management seeks to accomplish.
Topic: Characteristics of Earnings Management

11.Which of the following author(s) emphasize(s) a “purposeful act by management in pursuit of its own self-interests as might be the case when earnings are manipulated to get the stock price up in advance of the exercise of stock options?”

A.Dechow and Skinner


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