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CHAPTER 24-ACCOUNTANTS' LIABILITY
TRUE/FALSE
1. One of the accountant's most important roles is to serve as an independent evaluator of the
financial statements issued by management to investors and creditors.
Answer: True
2. To verify transactions, accountants use two mirror-image processes: vouching and tracing.
Tracing is a process where the accountant begins with an item of original data and checks out
all the activity that has occurred from beginning to end to make sure it has been properly
recorded throughout the bookkeeping process.
Answer: True
3. Generally accepted accounting principles are the rules for preparing financial statements.
Answer: True
4. Manuel, in conducting an audit, must rely most heavily on rules found in generally
accepted accounting principles (GAAP).
Answer: False
5. The accounting firm of Griggs, Macon, and Fiurre audits the financial records of Chasse
Co. The Sarbanes-Oxley Act prohibits the accounting firm from providing consulting services
to Chasse on human resource matters.
Answer: True
6. Under the UCC, contracts between accountants and their clients must be in writing.
Answer: False
7. Teresa is suing her accountant for fraud. To win, Teresa must show that she justifiably
relied on the accountant’s fraudulent statement.
Answer: True
8. Under the amended Securities Exchange Act of 1934, accountants are liable jointly and
severally whether or not they knew they were violating the law.
Answer: True

9. BGH Accounting firm audited the financial statements that were included in E-prise's
registration statement. The financial statements overstated sales by 2000%. In conducting the
audit, BGH did not comply with generally accepted auditing standards (GAAS). Under
Section 11 of the 1933 Act, BGH is liable for any material misstatement in the financial
statements.
Answer: True
10. An auditor for Ralco Accounting firm was auditing the financial statements of E-prise.
The auditor suspected that E-prise was engaged in conduct that violated FCPA, a federal law.
Under Section 10A of the 1934 Act, the auditor is required to notify E-prise's board of
directors of the suspicions.
Answer: True
11. Ralco was preparing Heidi's tax return. In confidence, Heidi revealed some information to
Ralco. Under the federal accountant-client privilege, the information Heidi disclosed is
protected from disclosure in a criminal action by the U.S. government.
Answer: False
12. After completing an audit, the most unfavorable opinion an auditor can issue is a
disclaimer of opinion.
Answer: False
13. Auditors cannot protect themselves from liability to third parties by issuing a qualified or
an adverse opinion.
Answer: False
14. Halbeck, LLC was negligent in its audit of E-treme, Inc. Unbeknownst to Halbeck, Etreme used the financial statements to secure a loan from Great State Bank. Under the
Ultramares doctrine, Halbeck will be liable to Great State Bank for its losses on the loan.
Answer: False
15. Halbeck, LLC was negligent in its audit of E-treme, Inc. Unbeknownst to Halbeck, Etreme used the financial statements to secure a loan from Great State Bank. Under the
foreseeable doctrine, Halbeck will be liable to Great State Bank for its losses on the loan.
Answer: True

MULTIPLE CHOICE
1. Which of the following opinions indicates that the company's financial statements fairly
present its financial condition according to GAAP?
a. Qualified opinion.
b. Adverse opinion.
c. Disclaimer of opinion.
d. Unqualified opinion.
Answer: D
2. An accountant is liable for fraud to:
a. only her client.
b. only her client and any known user of her information.
c. any foreseeable user of her work product who justifiably relied on it.
d. any third party who used the information contained in her work product.
Answer: C
3. Clint is auditing MegaCorp. In reviewing the sales ledger, Clint saw that MegaCorp had
sold 3,000 disk drives to CompSales, Inc. Clint reviewed the original invoice of this sale to
ensure that the date, price, quantity, and customer's name all match. He then verified each
step along the paper trail until the disk drives left the warehouse. This illustrates:
a. tracing.
b. vouching.
c. following.
d. monitoring.
Answer: A
4. John is auditing MegaCorp. He finds an accounts payable for 1,000 reams of photocopy
paper. He checks to make sure the paper actually arrived and that the receiving department

had signed and dated the invoice. He also checks the original purchase order to make sure the
purchase was properly authorized. This illustrates:
a. tracing.
b. vouching.
c. following.
d. monitoring.
Answer: B
5. In January, E-treme Inc. entered into an oral contract with Ralco, LLC, an accounting firm,
for the preparation of its tax return. The contract is:
a. unenforceable under the statute of frauds since it is not in writing.
b. unenforceable under the UCC since it is not in writing.
c. enforceable, but only up to a value of $10,000.
d. enforceable even though it is oral.
Answer: D
6. An engagement letter is a written contract:
a. between an accountant and client.
b. in anticipation of marriage.
c. between a corporation and the AICPA.
d. intended to create a fiduciary duty of an accountant to his client.
Answer: A
7. Sally prepared financial statements for MegaCorp knowing that the company would be
using her statements when applying for a loan at Big Bank. It is discovered she was negligent
in preparing the statements and Big Bank sued her. Sally is liable under the:
a. Ultramares doctrine.
b. foreseeable doctrine.

c. Restatement doctrine.
d. All the above.
Answer: D
8. Rick prepared financial statements for MegaCorp knowing that it was going to use his
statements to apply for a loan with Big Bank. When Big Bank turned MegaCorp down, it
applied to Fourth Bank for a loan. MegaCorp presented the statements prepared by Rick to
Fourth Bank which gave the company a loan. It was discovered that Rick was negligent in
preparing the statements, and Fourth Bank sued Rick. Under which of the following tests is
Rick liable?
a. Ultramares doctrine.
b. Foreseeable doctrine.
c. Restatement doctrine.
d. Rick would be liable under both the foreseeable doctrine and the Restatement doctrine.
Answer: D
9. To prevail under Section 11 of the 1933 Securities Act, the plaintiff must prove:
a. the registration statement contained a material misstatement or omission; and the plaintiff
lost money.
b. the registration statement contained a material misstatement or omission; the auditor acted
knowingly or recklessly; and the plaintiff lost money.
c. the registration statement contained a material misstatement or omission; the auditor
intended to deceive; and the plaintiff lost money.
d. the registration statement contained a material misstatement or omission; the auditor acted
with scienter; and the plaintiff lost money.
Answer: A
10. If a plaintiff is successful in proving that an auditor has violated Section 10(b) of the 1934
Act, the auditor has:
a. primary liability.

b. secondary liability.
c. contingent liability.
d. rebuttable liability.
Answer: A
11. A study by the Government Accountability Office found:
a. substantial market power in the four largest accounting firms. The Big Four audit 97
percent of all public companies in the United States that have sales over $250 million.
b. evidence of collusion among the top accounting firms in the United States.
c. conclusive evidence that consolidation in the accounting industry led to an increase in audit
fees and a decline in independence.
d. All of the above.
Answer: A
12. Adam claimed that N & A, its accounting firm, negligently prepared an audit. To hold the
accounting firm liable, which of the following elements must be established?
a. Scienter or guilty knowledge.
b. A fiduciary relationship.
c. Failure to exercise due care.
d. An executed engagement letter.
Answer: C
13. An auditor who determines a company is materially misstating certain items on its
financial statements should issue:
a. an unqualified opinion.
b. a qualified opinion.
c. an adverse opinion.
d. a disclaimer of opinion.

Answer: C
14. Great State Bank claimed that Wiles Accounting committed fraud in the preparation of an
audit. To hold the accounting firm liable, which of the following elements must be
established?
a. Knowledge or reckless disregard of the truth.
b. A fiduciary relationship.
c. Failure to exercise due care.
d. An executed engagement letter.
Answer: A
15. Who owns and controls an accountant's working papers?
a. The client, in theory.
b. The IRS.
c. The accountant, in theory and practice.
d. The AICPA.
Answer: A
16. GBH, an accounting firm, was hired to prepare financial statements for E-treme. GBH:
a. cannot show the working papers to E-treme unless there is a valid court order.
b. cannot show the working papers to E-treme unless it obtains permission from the AICPA.
c. can show the working papers to anyone that asks, since the accountant owns them.
d. must allow E-treme access to the working papers.
Answer: D
17. GBH, an accounting firm, was hired to prepare financial statements for E-treme. Great
State Bank has asked to see GBH's working papers. Great State Bank is thinking about
extending a $4 million line of credit to E-treme. GBH:
a. can show the bank the working papers because Great State Bank has a proper purpose.

b. can show the bank the working papers because Great State Bank is a known third party.
c. cannot show the bank the working papers under any circumstances as they are not
finalized.
d. cannot show the bank the working papers unless E-treme gives permission.
Answer: D
18. Criminal liability for accountants:
a. is not an option under securities law; there is only civil liability.
b. is possible under the Securities Act of 1933, the 1934 Act, state securities laws, and the
Internal Revenue Code.
c. may result in fines but not imprisonment from violation of the federal securities laws.
d. will result from violation of the accountant-client privilege under federal law.
Answer: B
19. The IRS files criminal charges against Rich for evasion of federal taxes. Rich's
accountant, Sonya, is summoned to appear in court to testify against Rich. The state where
the incident occurred recognizes an accountant-client privilege. Does Sonya have to testify in
federal court against her client?
a. Yes.
b. Yes, but only if she is granted immunity by her state.
c. No, the federal court must recognize her state's accountant-client privilege.
d. No, the federal accountant-client privilege will protect her from testifying.
Answer: A
20. In which of the following cases will the federal accountant-client privilege protect the
information from being disclosed?
a. A criminal case.
b. A case involving the SEC.
c. A case concerning the preparation of tax returns.

d. A civil fraud case involving the IRS.
Answer: D
21. The Big Four accounting firms spend about what percentage of their revenue on
litigation, including settlements and insurance?
a. Less than five percent.
b. Between 10 and 20 percent.
c. About 25 percent.
d. Over 30 percent.
Answer: B
22. The accounting firm of Gray & Co. did accounting work for both Regional Bank and
Carter Electronics. Without Carter’s knowledge or approval, Gray & Co. discussed Carter’s
financial problems with Regional Bank. Gray & Co.:
a. breached a legal obligation to keep all client information confidential.
b. breached a moral, but not a legal, obligation of confidentiality.
c. did not breach any obligations to its clients.
d. acted properly because it was protecting its client, Regional Bank, from possibly making
an unwise loan to Carter Electronics.
Answer: A
23. Larry is a certified public accountant in a firm which audits public companies. Larry is
accused of unethical conduct. Is Larry required to abide by the ethical standards of the Public
Company Accounting Oversight Board?
a. Yes.
b. He can be held liable only if he had actual knowledge of the particular guideline he is
accused of violating.
c. No, the PCAOB establishes audit rules, not ethical guidelines.
d. No, the PCAOB has no authority over Larry.

Answer: A
24. A CPA's duty of care to a client most likely will be breached when the CPA:
a. gives a client an oral report instead of a written report.
b. gives a client incorrect advice based on an honest error in judgment.
c. fails to give tax advice that would save the client money.
d. fails to follow generally accepted auditing standards (GAAS).
Answer: D
25. Which of the following is not a provision of the Sarbanes-Oxley Act of 2002?
a. Congress established the Public Company Accounting Oversight Board, which has the
authority to regulate public accounting firms, establishing audit rules and ethics guidelines.
b. After five years with a client, the lead audit partner must rotate off the account for at least
five years.
c. Congress established the American Institute of Certified Public Accountants to develop
ethical guidelines in a Code of Professional Conduct.
d. Auditors must communicate regularly and completely with audit committees of their
clients and must describe options the firm considers in preparing financial statements.
Answer: C
ESSAY
1. Discuss how SEC rules affect the legal and the ethical relationship between accountants
and the companies they audit.
Answer: The SEC rules require accountants to maintain independence from their clients. The
accountant must be able to exercise objective and impartial judgment on all issues. One way
to ensure this is by forbidding an auditor or the auditor’s family from maintaining a financial
or business relationship with the client. Specifically, the SEC rules prohibit accountants or
their families from owning stock in a company that their firm audits. SEC rules of practice
say that an accountant who engages in unethical or improper professional conduct may be
banned from practice before the SEC. Banned or suspended auditors cannot perform the
audits required by the 1933 and 1934 Securities Acts.

2. Discuss the advantages and disadvantages of using IFRS.
Answer: As businesses become more international, using IFRS, or international financial
reporting standards, would make cross-country comparisons easier. Worldwide consistency
would be possible. Foreign companies might be more willing to invest in the United States if
they could use international accounting rules. A disadvantage is that some IFRS standards are
weaker than the GAAP standards. Also, some experts fear allowing use of IFRS would
amount to outsourcing financial safety standards.
3. Fast Auditors prepared audited financial statements for Mega Company's registration
statement in compliance with the 1933 Securities Act. John bought stock in Mega Company.
It was discovered that the financial statements prepared for the registration statement
contained some important omissions. John sued Fast Auditors to recover his investment when
Mega Company turned out to be a bad investment. What must John prove to recover from
Fast Auditors?
Answer: To prevail under Section 11 of the 1933 Act, John must prove only that the
registration statement contained a material misstatement or omission, and he lost money.
4. An auditor suspects its client is committing illegal acts that will have a material impact on
its financial statements. What is the auditor legally required to do and under what
circumstances would the auditor directly notify the SEC?
Answer: Under Section 10A of the 1934 Act, the auditor must first contact the company's
board of directors. If the board refuses to take corrective action, the auditor is required to
issue a formal report to the board. If the board receives such an official report from the
auditor, it is required to notify the SEC within one business day. If the auditor does not
receive a copy of this SEC notice, it must notify the SEC directly.
5. Ron is an accountant who was contacted by Zebra Toy Company to prepare financial
statements. Zebra Toy Company told Ron that it wished to present these documents to Lion
Wholesalers, Inc., a large supplier of toys. If Lion is convinced that Zebra Toy Company is
financially solid, it will issue Zebra a large line of credit.
After Ron prepares the financial documents, Zebra presents the information to Lion
Wholesalers and also to Tiger Toy Company, another wholesaler of toys. Zebra wishes to
obtain a line of credit from Tiger as well as from Lion. If Ron committed a serious error by

overstating Zebra Toy Company's financial soundness and the two creditors, Lion and Tiger,
are damaged as a result, can these third parties recover damages from Ron? Explain.
Answer: The answer depends on what rule the state follows in determining an accountant's
liability for negligence to third parties.
Under the Restatement Doctrine both creditors can recover. Under this doctrine a third party
can recover if it can prove the accountant failed to use due care and if the creditor was either
(1) a party the accountant knew would rely on this information or (2) a party in the same class
who relied on the information. Lion was a known third party and Tiger was in the same class,
a potential creditor of Zebra Toy.
Under the Ultramares Doctrine, Ron is liable to Lion, a known third party. Tiger could not
collect under this doctrine since its identity was not known to Ron.
Under the Foreseeable Doctrine, Ron is also liable to both Lion and Tiger since both Lion and
Tiger were foreseeable parties who would use Ron's information.
6. Nancy is an auditor. She works in a state that uses the Ultramares Doctrine. She
fraudulently prepared financial documents for her client, Star, Inc. Her client presented the
information to Moonglow, Inc. Moonglow was a potential creditor of Star, Inc., and was
seriously damaged by the fraudulent financial information. Moonglow sued Nancy. She
claims she is not liable to Moonglow, a third party, since she was not provided with its name
at the time the audit was prepared. Is she liable to Moonglow? Explain.
Answer: Yes. Any time an accountant or auditor commits a fraudulent act that injures a third
party, the accountant or auditor is liable to any third party who could have foreseeably used
the information and who justifiably relied on it. This applies even in states that use the
Ultramares doctrine. The Ultramares doctrine deals with negligent conduct on the part of the
accountant. Since fraud, an intentional tort, is a very serious act, courts hold accountants or
auditors liable to any foreseeable parties who justifiably relied on the work product and were
harmed by the fraudulent conduct of the professional.

Test Bank For Introduction to Business Law
Jeffrey F. Beatty, Susan S. Samuelson
9781133188155

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