Chapter 5 Auditing Homework

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Monroe Community College *

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204

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Accounting

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Apr 3, 2024

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Francesco Panaccione Professor Lori Hofer ACC 360 Chapter 5 Homework Question 1 The most important positive effects are the increased quality control by CPA firms that is likely to result from actual and potential lawsuits and the ability of injured parties to receive remuneration for their damages. Negative effects are the energy required to defend meritless cases and the harmful impact on the public's image of the profession. Legal liability may also increase the cost of audits to society, by causing CPA firms to increase the evidence accumulated. Question 2 business will fail financially, unqualified opinion, where are misstatement. When there has been a business failure, but not an audit failure, it is common for statement users to claim there was an audit failure, even if the most recently issued audited financial statements were fairly stated. Many auditors evaluate the potential for business failure in an engagement in determining the appropriate audit risk. Question 3 The prudent person concept states that a person is responsible for conducting a job in good faith and with integrity but is not infallible. Therefore, the auditor is expected to conduct an audit using due care but does not claim to be a guarantor or insurer of financial statements. Question 4 Many CPA firms willingly settle lawsuits out of court to minimize legal costs and avoid adverse publicity. This has a negative effect on the profession when a CPA firm agrees to settlements even though it believes that the firm is not liable to the plaintiffs. This encourages others to sue CPA firms when they probably would not to such an extent if the firms had the reputation of contesting the litigation. Therefore, out-of-court settlements encourage more lawsuits and, in essence, increase the auditor's liability because many firms will pay even though they do not believe they are liable. Question 5 Contributory negligence used in legal liability of auditors is a defense used by the auditor when he or she claims the client or user also had a responsibility in the legal case. An example is the claim by the auditor that management knew of the potential for fraud because of deficiencies in internal control but refused to correct them. The auditor thereby claims that the client contributed to the fraud by not correcting material weaknesses in internal control. Question 6 An audit properly conducted in accordance with auditing standards. Reasonable assurance is not a guarantor.

Question 7 Engagement letters offer legal protection to both parties in the case of disagreements or misunderstandings. Preventing any form of misunderstanding with clients will not only protect your firm's legal and financial interests but will also defend its reputation. Question 8 In more recent years, the auditor's liability to a third party has become affected by whether the party is known or unknown. Now a known third party, under common law, usually has the same rights as the party that is privy to the contract. An unknown third party usually has fewer rights. The approach followed in most states is the Restatement of Torts approach to the foreseen user’s concept. Under the Restatement of Torts approach, foreseen users must be members of a reasonably limited and identifiable group of users that have relied on the CPA's work, even though those persons were not specifically known to the CPA at the time the work was done. Question 9 The liability of auditors under the 1933 Act there are more heavy burden on the auditor. The client must prove: any third party who buys the securities as mentioned in the registration statement may sue the auditor, and there is no burden on the third parties that they depended on the financial statements, but merely prove they were misleading. Auditor must prove: no significant misstatements, a proper audit was conducted, and there was no loss to users because of the F.S that were misleading. The auditors do not have such harsh liability under 1934. Client must prove reliance on the financial statements and the reason of the low was misleading financial statements. Auditor: as per Rule 10b-5 they can only be held responsible if they intentionally misrepresented the financial information. Question 10 The auditor's legal liability to the client can result from the auditor's failure to properly fulfill his or her contract for services. The lawsuit can be for breach of contract, which is a claim that the contract was not performed in the manner agreed upon, or it can be a tort action for negligence. An example would be the client's detection of a misstatement in the financial statements, which would have been discovered if the auditor had performed all audit procedures required in the circumstances. The auditor's liability to third parties under common law results from any loss incurred by the claimant due to reliance upon misleading financial statements. An example would be a bank that has loans outstanding to an audited company. If the audit report did not disclose that the company had contingent liabilities that subsequently became real liabilities and forced the company into bankruptcy, the bank could proceed with legal action against the auditors for the material omission. Under the Securities Act of 1933, third parties can sue auditors if financial statements contain false information or omit material facts, leading to misleading statements. Proof of reliance or loss isn't required. For example, if an investor suffers losses due to undisclosed information in audited financial statements, they can sue for negligence. Civil liability under the Securities Act of 1934 applies to audited financial statements in public reports, with Rule 10b-5

prohibiting fraudulent activities. Courts have extended this rule to include auditors. Auditors may face criminal charges if they knowingly participate in fraudulent financial statements, such as overstating income. Question 11 The SEC ensures auditors practice due care through regulatory oversight, mandating compliance with auditing standards like GAAS and PCAOB requirements. Regular inspections assess audit quality and identify deficiencies. Enforcement actions, such as penalties and sanctions, deter non- compliance, while public reporting of audit practices promotes transparency and accountability, collectively fostering responsible auditing of listed companies. Question 12 Increased legal responsibilities of the CPA and their auditor to implement the professional skepticism in a stronger way to reduce the scope of frauds in the audit report. - The act requires the CEO and CFO to certify the annual and quarterly financial statements filed with the SEC. - Management must submit the report of the efficiency of the internal control of financial reporting - The auditor also must submit his opinion on the efficiency of the internal control system over financial reporting - The auditor will be exposed to legal liability on account of his opinion on the internal control system Question 13 Some of the ways in which the profession can positively respond and reduce liability in auditing are: 1. Continued research in auditing. 2. Standards and rules must be revised to meet the changing needs of auditing. 3. The AICPA can establish requirements that the better practitioners always follow in an effort to increase the overall quality of auditing. 4. Establish new peer review requirements. 5. CPA firms should oppose all unfounded lawsuits rather than settling out of court. 6. Users of financial statements need to be better educated regarding the attest function. 7. Improper conduct and performance by members must be sanctioned. 8. Lobby for changes in state and federal laws concerning accountants' liability. Problem 18 Scenarios 1 and 2 : Ordinary negligence. Scenario 3: Depending on the circumstances, could range from ordinary negligence to gross negligence or constructive fraud. Scenario 4: Fraudulent behavior and potentially criminal. Scenario 5: Constructive fraud or fraud.

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