Maintaining Professional Responsibility:

Regulation and Legal Liability

MULTIPLE CHOICE:
1.

A CPA firm studies its personnel advancement experience to

ascertain whether individuals meeting stated criteria are
assigned increased degrees of responsibility. This is
evidence of the firm's adherence to prescribed standards of
a.
Supervision and review.
b.
Continuing professional education.
c.
Professional development.
d.
Quality control.
ANSWER:

2.

Which one of the following, if present, would support a

finding of constructive fraud on the part of a CPA?
a.
Privity of contract.
b.
Intent to deceive.
c.
Reckless disregard.
d.
Ordinary negligence.

ANSWER:
3.

The CPA firm of Knox and Knox has been subpoenaed to testify
and produce its correspondence and workpapers in connection
with a lawsuit brought by a third party against one of their
clients. Knox considers the subpoenaed documents to be
privileged communication and therefore seeks to avoid
admission of such evidence in the lawsuit. Which of the
following is correct?
a.
Federal law recognizes such a privilege if the
accountant is a Certified Public Accountant.
b.
The privilege is available regarding the workpapers
since the CPA is deemed to own them.
c.
The privileged communication rule as it applies to a
CPA/client relationship is the same as that of
attorney-client.
d.
In the absence of a specific statutory provision, the
law does not recognize the existence of the privileged
communication rule between a CPA and his client.
ANSWER:

4.

Of the following statements, which best distinguishes

ordinary negligence from gross negligence?
a.
Failure to detect material errors, whether internal
control is strong or weak, suggests gross negligence.

20

Chapter 3 Maintaining Professional Responsibility

b.
c.
d.

Failure to exercise reasonable care denotes ordinary

negligence, whereas failure to exercise minimal care
indicates gross negligence.
Gross negligence is most probable when the auditor
fails to detect errors that occurred under conditions
of strong internal control.
The more material the undetected error the greater the
likelihood of ordinary negligence.

ANSWER:
5.

The limitation of auditor liability under contract law is

known as
a.
b.
c.
d.

Privity of contract.
Contributory liability.
Statutory liability.
Common law liability.

ANSWER:
7.

On July 1, 2002, Kent purchased common stock of Salem Corp.

in an offering subject to the Securities Act of 1933. Mane
& Co., CPAs, rendered an unqualified opinion on the
financial statements of Salem which were included in
Salem's
registration statement filed with the SEC on March
1, 2002
Kent has commenced an action against Mane based on
the Securities Act of 1933 provisions dealing with omissions
of facts required to be stated in the registration
statement. Which of the following elements of a cause of
action under the Securities Act of 1933 must be proved by
Kent?
a.
Kent relied upon Mane's opinion.
b.
Kent was the initial purchaser of the stock and gave
value for it.
c.
Mane's omission was material.
d.
Mane acted negligently or fraudulently.
ANSWER:

6.

21

Under the Securities Act of 1933, the registration of

securities which are offered to the public in interstate
commerce is
a.
Directed toward preventing the marketing of securities
which pose serious financial risks to the prospective
investor.
b.
Not required unless the issuer is a corporation.
c.
Mandatory unless the cost to the issuer is
"prohibitive" as defined in the SEC regulations.
d.
Required unless there is an applicable exemption.

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Chapter 3 Maintaining Professional Responsibility

ANSWER:
8.

The auditor's defense of contributory negligence is most

likely to prevail when
a.
b.

Third party injury has been minimal.

The auditor fails to detect fraud resulting from
management override of the control structure.
The client is privately held as contrasted with a
public company.
Undetected errors have resulted in materially
misleading financial statements.

c.
d.

ANSWER:
9.

A plaintiff wishes to recover damages from the issuer for

losses resulting from material misstatements in a securities
registration statement. In order to be successful, one of
the elements the plaintiff must prove is that the
a.
Plaintiff was in privity of contract with the issuer or
that the issuer knew of the plaintiff.
b.
Plaintiff acquired the securities.
c.
Issuer acted negligently.
d.
Issuer acted fraudulently.

ANSWER:
11.

The objective of quality control mandates that a public

accounting firm should establish policies and procedures for
professional development which provide reasonable assurance
that all entry-level personnel
a.
Prepare working papers which are standardized in form
and content.
b.
Have the knowledge required to enable them to fulfill
responsibilities assigned.
c.
Will advance within the organization.
d.
Develop specialties in specific areas of public
accounting.
ANSWER:

10.

A basic objective of a CPA firm is to provide professional

services that conform with professional standards.
Reasonable assurance of achieving this basic objective is
provided through
a.
A system of peer review.
b.
Continuing professional education.
c.
A system of quality control.
d.
Compliance with generally accepted reporting standards.

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Chapter 3 Maintaining Professional Responsibility

ANSWER:
12.

Mix and Associates, CPAs, issued an unqualified opinion on

the financial statements of Glass Corp. for the year ended
December 31, 2002. It was determined later that Glass'
treasurer had embezzled $300,000 from Glass during 2002.
Glass sued Mix because of Mix's failure to discover the
embezzlement. Mix was unaware of the embezzlement. Which
of the following is Mix's best defense?
a.
The audit was performed in accordance with GAAS.
b.
The treasurer was Glass' agent and, therefore, Glass
was responsible for preventing the embezzlement.
c.
The financial statements were presented in conformity
with GAAP.
d.
Mix had no actual knowledge of the embezzlement.
ANSWER:

13.

Which of the following is not a condition for membership in

the Division for CPA Firms?
a.
Participating in peer review.
a.
Employing only CPAs.
b.
Conforming to specified continuing professional
education requirements.
c.
Maintaining adequate levels of liability
insurance.

ANSWER:
14.

Gold, CPA, rendered an unqualified opinion on the 2000

financial statements of Eastern Power Co. Egan purchased
Eastern bonds in a public offering subject to the Securities
Act of 1933. The registration statement filed with the SEC
included the financial statements. Gold is being sued by
Egan under Section 11 of the Securities Act of 1933 for the
misstatements contained in the financial statements. To
prevail, Egan must prove
Scienter
No
No
Yes
Yes

a.
b.
c.
d.
ANSWER:
15.

Reliance
No
Yes
No
Yes

The Rusch Factors and Rhode Island Hospital Trust cases

further defined the doctrine of privity by stating that

24

Chapter 3 Maintaining Professional Responsibility

a.
b.
c.
d.

Stockholders, as owners of the company, are also

parties to the contract between auditor and client.
Privity extends to primary third party beneficiaries
known by the auditor to be relying on the financial
statements.
The doctrine of privity is broken when management
intentionally misrepresents financial position and/or
results of operations.
Privity extends to third parties only in cases
involving auditor negligence.

ANSWER:
16.

In connection with the element of professional development,

a CPA firm's system of quality control should ordinarily
provide that all personnel
a.
b.
c.
d.

Have the knowledge required to enable them to fulfill

responsibilities assigned.
Possess judgment, motivation, and adequate experience.
Seek assistance from persons having appropriate level
of knowledge, judgment, and authority.
Demonstrate compliance with peer review directives.

ANSWER:
17.

In the case of Fischer v. Kletz (Yale Express), the auditors

were charged with fraud for failing to inform users of
nonexistent accounts receivable. Although the case was
settled out of court, it did encourage the profession to
issue a Statement on Auditing Standards relating to
a.
b.
c.
d.

Related party transactions.

Auditor responsibility for detecting illegal acts.
Audit risk assessment.
Subsequent discovery of facts existing at the date of
the audit report.

ANSWER:
18.

Accounting firms should establish quality control

procedures for professional development in order to provide
reasonable assurance that
d.
Persons promoted possess the appropriate
characteristics to perform competently.
b.
Personnel will have the knowledge required to fulfill
responsibilities assigned.
c.
The extent of supervision and review in a given
instance will be appropriate.

Chapter 3 Maintaining Professional Responsibility

d.

Association with a client whose management lacks

integrity will be minimized.

ANSWER:
19.

Gleam is contemplating a common law action against Moore &

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

21.

The factor that distinguishes constructive fraud from actual

fraud is
a.
Materiality.
b.
Quality of internal control.
c.
Type of error or irregularity.
d.
Intent.
ANSWER:

20.

25

In the Continental Vending Machine Corporation case, the

court argued that a footnote appearing in the company's
annual report was confusing and misleading. As a result,
the accounting profession
a.
Encouraged practitioners to carry adequate liability
insurance.
b.
Issued a Statement on Auditing Standards defining
related party transactions and assigning auditor
responsibility for detecting material related party
transactions and determining that the economic
substance of such transactions is properly reflected in
the financial statements.
c.
Issued a Statement on Auditing Standards requiring
auditor presence at the client's physical inventory
taking and auditor confirmation of customer accounts
receivable.
d.
More clearly defined "privity of contract" between
auditor and client.
ANSWER:

26

22.

Chapter 3 Maintaining Professional Responsibility

Working papers prepared by a CPA in connection with an audit
engagement are owned by the CPA, subject to certain
limitations. The rationale for this rule is to
a.
Protect the working papers from being subpoenaed.
b.
Provide the basis for excluding admission of the
working papers as evidence because of the privileged
communication rule.
c.
Provide the CPA with evidence and documentation which
may be helpful in the event of a lawsuit.
d.
Establish a continuity of relationship with the client
whereby indiscriminate replacement of CPAs is
discouraged.
ANSWER:

23.

Mead Corp. orally engaged Dex & Co., CPAs, to audit its
financial statements. The management of Mead informed Dex
that it suspected that the accounts receivable were
materially overstated. Although the financial statements
audited by Dex did, in fact, include a materially
overstated accounts receivable balance, Dex issued an
unqualified opinion. Mead relied on the financial
statements in deciding to obtain a loan from City Bank to
expand its operations. City relied on the financial
statements in making the loan to Mead. As a result of the
overstated accounts receivable balance, Mead has defaulted
on the loan and has incurred a substantial loss. If Mead
sues Dex for negligence in failing to discover the
overstatement, Dex's best defense would be that
a.
No engagement letter had been signed by Dex.
b.
The audit was performed by Dex in accordance with
generally accepted auditing standards.
c.
Dex was not in privity of contract with Mead.
d.
Dex did not perform the audit recklessly or with an
intent to deceive.
ANSWER:

24.

Dickens, a CPA firm's personnel partner, periodically

studies the CPA firm's personnel advancement experience to
ascertain whether individuals meeting stated criteria are
assigned increased degrees of responsibility. This is
evidence of the CPA firm's adherence to prescribed
a.
Standards of due professional care.
b.
Quality control standards.
c.
Supervision and review standards.
d.
Reporting standards.
ANSWER:

Chapter 3 Maintaining Professional Responsibility

25.

West & Co., CPAs, was engaged by Sand Corp. to audit its
financial statements. West issued an unqualified opinion on
Sand's financial statements. Sand has been accused of
making negligent misrepresentations in the financial
statements, which Reed relied upon when purchasing Sand
stock. West was not aware of the misrepresentations nor was
it negligent in performing the audit. If Reed sues West for
damages based upon Section 10(b) and rule 10b-5 of the
Securities Exchange Act of 1934, West will
a.
Lose, because Reed relied upon the financial
statements.
b.
Lose, because the statements contained negligent
misrepresentations.
c.
Prevail, because some element of scienter must be
proved.
d.
Prevail, because Reed was not in privity of contract
with West.
ANSWER:

26.

A CPA establishes quality control policies and procedures

for deciding whether to accept a new client or continue to
perform services for a current client. The primary purpose
for establishing such policies and procedures is
a.
To enable the auditor to attest to the integrity or
reliability of a client.
b.
To comply with the quality control standards
established by regulatory bodies.
c.
To lessen the exposure to litigation resulting from
failure to detect irregularities in client financial
statements.
d.
To minimize the likelihood of association with clients
whose management lacks integrity.
ANSWER:

27.

27

Which of the following statements is correct concerning

corporations subject to the reporting requirements of the
Securities Exchange Act of 1934?
a.
The annual report (form 10-K) need not include audited
financial statements.
b.
The annual report (form 10-K) must be filed with the
SEC within 20 days of the end of the corporation's
fiscal year.
c.
A quarterly report (form 10-Q) need only be filed with
the SEC by those corporations that are also subject to
the registration requirements of the Securities Act of
1933.
d.
A monthly report (form 8-K) must be filed with the SEC

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Chapter 3 Maintaining Professional Responsibility

after the end of any month in which a materially
important event occurs.
ANSWER:

28.

In a common law action against an accountant, the lack of

privity is a viable defense if the plaintiff
a.
Bases his action upon fraud.
b.
Is the accountant's client.
c.
Is a creditor of the client who sues the accountant for
negligence.
d.
Can prove the presence of gross negligence which
amounts to a reckless disregard for the truth.
ANSWER:

29.

Tulip Corp. is a registered and reporting corporation under

the Securities Exchange Act of 1934. As such it
a.
Can offer and sell its securities to the public without
the necessity of registering its securities pursuant to
the Securities Act of 1933.
b.
Cannot make a tender offer for the equity securities of
another registered and reporting corporation without
the consent of the SEC.
c.
Must file annual reports (Form 10-K) with the SEC.
d.
Must distribute a copy of the annual report (Form 10-K)
to each of its shareholders.
ANSWER:

31.

Donn & Co. is considering the sale of $11 million of its

common stock to the public in interstate commerce. In this
connection, Donn has been correctly advised that
registration of the securities with the SEC is
a.
Not required if the states in which the securities are
to be sold have securities acts modeled after the
federal act and Donn files in those states.
b.
Required in that it is necessary for the SEC to approve
the merits of the securities offered.
c.
Not required if the securities are to be sold through a
registered brokerage firm.
d.
Required and must include audited financial statements
as an integral part of its registration.
ANSWER:

30.

A CPA firm issues an unqualified opinion on financial

statements not prepared in accordance with GAAP. The CPA
firm will have acted with scienter in all the following
circumstances except where the firm

Chapter 3 Maintaining Professional Responsibility

a.
b.
c.
d.

Intentionally disregards the truth.

Has actual knowledge of fraud.
Negligently performs auditing procedures.
Intends to gain monetarily by concealing the fraud.

ANSWER:
32.

b.
c.
d.

Failure to detect material errors under conditions of

weak internal control.
Failure to detect collusive fraud perpetrated by
members of middle management.
Failure to detect collusive fraud perpetrated by
members of top management.
Failure to detect errors occurring outside the internal
control structure.

ANSWER:

The registration of a security under the Securities Act of

1933 provides an investor with
a.
A guarantee by the SEC that the facts contained in the
registration statement are accurate.
b.
An assurance against loss resulting from purchasing the
security.
c.
Information on the principal purposes for which the
offering's proceeds will be used.
d.
Information on the issuing corporation's trade secrets.
ANSWER:

34.

Which of the following conditions suggests auditor

negligence?
a.

33.

29

The principal purpose of the registration requirements of

the Securities Act of 1933 is to
a.
Prevent public offerings of securities in which
management fraud or unethical conduct is suspected.
b.
Provide the SEC with the information necessary to
determine the accuracy of the facts presented in the
financial statements.
c.
Assure that investors have adequate information upon
which to base investment decisions.
d.
Provide the SEC with the information necessary to
evaluate the financial merits of the securities being
offered.
ANSWER:

30

Chapter 3 Maintaining Professional Responsibility

COMPLETION:
35.

A committee formed in 1999 to focus on the problem of

managed earnings, cookie-jar reserves, purchased R&D writeoffs, and abuse of the materiality concept is known as the
__________ __ _______ _____________.
ANSWER:

36.

A disparity between users' and CPAs' perceptions of auditor

responsibility is referred to as the
.
ANSWER:

37.

SCIENTER

Auditor liability under the Securities acts is referred to

as
liability.
ANSWER:

43.

INCORPORATED BY REFERENCE

The legal term for "intent to deceive" is

ANSWER:

42.

ORDINARY NEGLIGENCE

Given the Securities Exchange Act of 1934 and the concept of

"integrated disclosure", information may be ____________ ___
in Form 10-K.
ANSWER:

41.

CONSTRUCTIVE FRAUD

The primary difference between contractual liability to

clients and civil liability to third parties is that, under
civil liability, the auditor is not liable to third parties
for
.
ANSWER:

40.

SECURITIES AND EXCHANGE COMMISSION

is defined as negligence so
flagrant as to border on deceit.
ANSWER:

39.

EXPECTATION GAP

Ultimate authority to set accounting and auditing standards

rests with the
.
ANSWER:

38.

PANEL ON AUDIT EFFECTIVENESS

STATUTORY

In responding to an underwriter's request for a __________

_________, the auditor will likely apply certain limited
procedures to the financial data arising subsequent to the
most recent audit.

Chapter 3 Maintaining Professional Responsibility

ANSWER:
44.

31

COMFORT LETTER

In the Ernst and Ernst v. Hochfelder case, the U.S. Supreme

Court held that auditors are not liable for
under
Rule 10B-5 of the Securities Exchange Act of 1934, but only
for
.
ANSWER:

NEGLIGENCE, SCIENTER (FRAUD)

MATCHING:
45.

Match each of the responsibilities enumerated below with the

bodies charged with that responsibility.
a.
b.
c.
d.
e.
f.
g.
h.

State board of accountancy

SEC Practice Section
Public Oversight Board
Securities and Exchange Commission
AICPA Quality Control Standards Board
Independence Standards Board
Emerging Issues Task Force
Panel on Audit Effectiveness

____ 1. Oversee peer review for public companies.

____ 2. Issue a guideline for reviewing accounting firm
personnel for promotion.
____ 3. Issue recommendations directed toward improving the
quality of independent audits.
____ 4. Recommend that the executive committee of the SEC
Practice Section sanction a member for failing to
comply with the Sections peer review standards.
____ 5. Issue a standard prohibiting an accounting firm from
accepting an accounting
service engagement from an
audit client on the basis that performing both types
of service might impair objectivity.
____ 6. Review prospectus and registration statement of
company contemplating an initial public offering.
____ 7. Revoke license of member for committing a
discreditable act.
____ 8. Monitor FASB deliberations concerning the proper

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Chapter 3 Maintaining Professional Responsibility

accounting treatment to be applied to derivatives.

SOLUTION:
1.
2.
3.
4.
5.
6.
7.
8.

b
e
h
c
f
d
a
g

ESSAY
46.An auditor is sued for negligence by the stockholders of an
audit client. The auditor had issued an unqualified opinion on
the clients financial statements. It was later determined that
the statements were materially distorted due to errors and fraud.
Required:
a.
Under what conditions, in common law may an auditor be
held liable to third parties for negligence?
b.
Describe two approaches for differentiating between
ordinary negligence and gross negligence. Cite examples to
support your approaches.
c.

Who will prevail in the present case?

SOLUTION:
a.
The doctrine of privity states that auditors are liable
to third parties for fraud but not for negligence. Subsequent
court decisions, such as Ultramares v. Touche, however, have
construed gross negligence as constructive fraud. Auditors,
therefore, may be held liable to injured third parties for gross
negligence, but not for ordinary negligence. In addition,
privity may extend to specifically identified third parties known
by the auditor to be relying on the audited financial statements.
b.
Two approaches to distinguishing ordinary negligence
from gross negligence are materiality and internal control.
Performing an audit with due care should permit the auditor to
detect a material misstatement not cleverly concealed. For
example, an inventory extension error (price x quantity) that
overstates the ending inventory by 25 percent and results in a
material overstatement of net income should be detected in the
ordinary course of the audit.
Errors or fraud perpetrated because of weak internal
controls are more likely to be detected by the auditor than

Chapter 3 Maintaining Professional Responsibility

33

errors or fraud perpetrated outside the existing system of

internal control. For example, material misstatements caused by
classification errors related to repairs and maintenance
expenditures versus property, plant, and equipment additions may
occur because the persons charged with determining the
appropriate accounts to be debited have not been adequately
trained. This constitutes an internal control weakness; and the
auditors should have detected the weakness and modified their
substantive audit testing accordingly.
Contrast this with a material misstatement caused by
management intentionally overriding existing internal control for
the purpose of inflating earnings. As part of the scheme,
documentation supporting fictitious sales may have been
fabricated. Under these conditions, the prudent auditor is less
likely to detect the fraud.
c.
To prevail in the present case, the plaintiffs must
demonstrate that the auditor was grossly negligent and must also
prove that the plaintiffs were injured by the auditors
negligence.
47. A. How does the level of quality maintenance within the
accounting profession impact the expectations gap? Cite examples
in your answer.
B. What is the alternative to self-regulation? Cite two
measures the profession has taken in recent years to meet the
challenges posed by the threat of a widening expectations gap?
SOLUTION:
The goal of self-regulation within the accounting profession
is to maintain the quality of accounting services at a level that
will satisfy the users of these services. The expectations gap
is the disparity between users and CPAs perceptions of the
quality of these services. Therefore, a decline in either the
quality of services rendered by CPAs or users perceptions of
quality causes a widening of the expectations gap. Such
diminishments occur, for example, when courts find auditors
negligent in the performance of audits or when the financial
press reports incidents of alleged audit failures. Cases
involving Phar Mor, Lincoln Savings and Loan, Crazy Eddie, and
Miniscribe can be cited as illustrations.
CPA consulting
services for audit clients impair the appearance of independence,
and is another means for widening the expectations gap and
undermining the perceived effectiveness of self-regulation.
The alternative to self-regulation is external regulation by
the SEC or a similar public body. One must remember that the SEC
already has the authority granted by the securities acts to
regulate the accounting profession, but has declined to fully
exercise that authority. If the expectations gap were to widen

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Chapter 3 Maintaining Professional Responsibility

significantly, however, and self-regulation is perceived to be

ineffective, the SEC may well decide to actively pursue its
regulatory powers.
To meet the challenges posed the threat of a widening
expectations gap and more external regulation, the profession, in
recent years, has:
1.
Assigned the auditor responsibility for planning the
audit to provide reasonable assurance of detecting material
financial statement errors and fraud;
2.
Required auditors to evaluate the ability of each audit
client to continue as a going concern;
3.
Encouraged clients to appoint audit committees to
monitor internal control and arbitrate disputes between
management and the external auditors;
4.
Issued a new SAS that provides more explicit guidance
to auditors for detecting fraud and communicating the findings to
management and the board of directors;
5.
Created an Independence Standards Board to actively
pursue issues involving auditor independence
48. For each of the following capsule cases, determine the
outcome and provide the rationale to support your conclusion.
1.
A group of stockholders is suing a CPA for failing to
detect a material misappropriation of customer cash receipts by
the controller of a company in which the group has invested. The
fraud occurred because the controller had access to cash as well
as the accounting records. The fraud was concealed by not
recording the receipts. To conceal the overstatement of accounts
receivable, the controller inflated sales returns and allowances
and wrote off some of the accounts as uncollectible. The CPA
failed to detect the fraud in the course of the audit.
2.
The management of a large manufacturer of exercise
equipment inflated net assets and net earnings by 1)recording
fictitious sales and fabricating the underlying documentation;
2)debiting operating expenses to several construction projects in
progress; and 3) inflating inventories by not recording sales
returns and including the inventory at full cost, and inflating
various inventory unit costs. These frauds were detected by IRS
auditors after the companys check for payment of income taxes
bounced. The independent auditors did not discover the
misrepresentation, and the new management is now suing them for
failure to detect the fraud.
3.
A CPA failed to detect a misrepresentation fraud
perpetrated by an audit client. The fraud was material in its
impact on the financial statements and was effected by debiting
operating expenses and manufacturing overhead to work orders for
various construction projects underway. The projects did not

Chapter 3 Maintaining Professional Responsibility

35

exist and the CPA examined a client-prepared analysis of the work

orders rather than the work orders themselves. Moreover, the CPA
did not ask to inspect any of the projects.
An action alleging negligence was brought against the CPA by
the bank that granted a loan to the company on the basis of the
audited financial statements. The inflated earnings figure
resulting from the misrepresentation was an integral part of the
decision to grant the loan.
The CPA had rendered an unqualified opinion on the financial
statements. This was the first year the company had been
audited. In past years, the CPA had performed only a review of
the companys financial statements; but this year the company
requested an audit as part of the banks conditions for
processing the loan application.
SOLUTION:
1.
The stockholders need to prove gross negligence by the
CPA, inasmuch as they are not privy to the contract between the
CPA and the client. The CPA appears to have been grossly
negligent in this case. First, the fraud was facilitated by
internal control weaknesses - the controller had access to cash
as well as to accounting records. The CPA should have noted the
weakness in assessing internal control and modified substantive
audit programs accordingly. Further investigation of the
accounts receivable write-offs, including contacting customers
whose accounts had been written off, should have enabled the
auditor to detect the fraud. In summary, this is a material
fraud perpetrated within the system of internal control, and
failure to detect is evidence of gross negligence.
2.
The auditors appear not to be negligent in this case.
Like Cenco v. Seidman & Seidman, the fraud was perpetrated by top
management, was cleverly concealed, and was effected by
overriding internal control. As the court stated in that case,
auditors cannot be expected to detect misstatements when
management has turned the entity into an engine of fraud.
3.
The CPA will probably lose in this case. Although not
grossly negligent, privity will likely be extended to the bank
because the CPA knew the bank was the primary beneficiary of the
audited financial statements. Negligence may be inferred by the
fact that the auditor did not examine the work orders and did not
inspect any of the additions.