AUDIT THEORY EXAM 1 (CH 1-5)
QUESTIONS AND CORRECT
ANSWERS
How to demonstrate the lack of duty to perform certain service ANSW✅✅Lack of duty to perform
the service
a. It means that the CPA firm claims that there was no implied or expressed contract.
For example, the CPA firm
might claim that misstatements were not uncovered because the firm did a review
service, not an audit. The CPA's use of an engagement letter provides a basis to
demonstrate a lack of duty to perform.
Prudent person concept ANSW✅✅o The standard of due care to which the auditor is expected to
be held, is often called the prudent person concept.
Who is a third party beneficiary? ANSW✅✅A third party who does not have privity of contract but
is known to the contracting parties and is intended to have certain rights and benefits under the
contract. A common example is a bank that has a large loan outstanding at the balance sheet date
and requires an audit as a part of its loan agreement.
Privy of Contract ANSW✅✅The relationship that exists between the promisor and the promisee
of a contract.
The difference between separate and proportionate liability and joint and several liability
ANSW✅✅• Joint and several liability: The assessment against a defendant of the full loss suffered
by a plaintiff, regardless of the extent to which other parties shared in the wrongdoing. For example,
if management intentionally misstates financial statements, an auditor can be assessed the entire
loss to shareholders if the company is bankrupt and management is unable to pay.
,• Separate and proportionate liability: The assessment against a defendant of that portion of the
damage caused by the defendant's negligence. For example, if the courts determine that an
auditor's negligence in conducting an audit was the cause of 30% of a loss to a defendant, only 30%
of the aggregate damage would be assessed to the CPA firm.
The difference between negligence, gross negligence, constructive fraud, and fraud
ANSW✅✅negligence: Absence of reasonable care that can be expected of a person in a set of
circumstances. For auditors, it is in terms of what other competent auditors would have done in the
same situation.
• Gross negligence: Lack of even slight care that can be expected of a person.
• Constructive fraud: Existence of extreme or unusual negligence even though there was no intent to
deceive or do harm. Constructive fraud is also termed recklessness.
• Fraud: Occurs when a misstatement is made and there is both the knowledge of its falsity and the
intent to deceive.
Defenses available for lawsuits from clients and third parties ANSW✅✅The CPA firm normally
uses one or a combination of four defenses when there are legal claims by clients:
1. Lack of duty to perform the service
a. It means that the CPA firm claims that there was no implied or expressed contract.
2. Nonnegligent performance
a. The CPA firm claims that the audit was performed in accordance with auditing standards. Even if
there were undiscovered misstatements, the auditor is not responsible if the audit was conducted
properly.
3. Contribu¬tory negligence
a. A defense of contributory negligence exists when the client's own actions either resulted in the
loss that is the basis for damages or interfered with the con¬duct of the audit in such a way that
prevented the auditor from discovering the cause of the loss.
, 4. Absence of causal connection.
a. To succeed in an action against the auditor, the client must be able to show that there is a close
causal connection between the auditor's breach of the standard of due care and the damages
suffered by the client.
• Contributory negligence is ordinarily not available because a third party is not in a position to
contribute to misstated financial statements.
• The preferred defense in third-party suits is nonnegligent performance. If the auditor conducted
the audit in accordance with GAAS, the other defenses are unnecessary. On the other hand,
nonnegligent performance is difficult to demonstrate to a court, especially if it is a jury trial and the
jury is made up of laypeople.
The responsibilities of auditors under 1933 Act ANSW✅✅· The auditor has the burden of
demonstrating as a defense that
· (1) an adequate audit was conducted in the circumstances or (2) all or a portion of the plaintiff's
loss was caused by factors other than the misleading finan¬cial statements. The 1933 act is the only
common or statutory law where the burden of proof is on the defendant.
· Furthermore, the auditor has responsibility for making sure that the financial state¬ments were
fairly stated beyond the date of issuance, up to the date the registration state¬ment became
effective, which could be several months later.
· Although the burden may appear harsh to auditors, there have been relatively few cases tried
under the 1933 act.
The responsibilities of auditors under 1934 act ANSW✅✅o The liability of auditors under the 1934
Act often centers on the audited financial statements issued to the public in annual reports or
submitted to the SEC as a part of annual Form 10-K reports.
o Every company with securities traded on national and over-the-counter exchanges is required to
submit audited statements annually.
QUESTIONS AND CORRECT
ANSWERS
How to demonstrate the lack of duty to perform certain service ANSW✅✅Lack of duty to perform
the service
a. It means that the CPA firm claims that there was no implied or expressed contract.
For example, the CPA firm
might claim that misstatements were not uncovered because the firm did a review
service, not an audit. The CPA's use of an engagement letter provides a basis to
demonstrate a lack of duty to perform.
Prudent person concept ANSW✅✅o The standard of due care to which the auditor is expected to
be held, is often called the prudent person concept.
Who is a third party beneficiary? ANSW✅✅A third party who does not have privity of contract but
is known to the contracting parties and is intended to have certain rights and benefits under the
contract. A common example is a bank that has a large loan outstanding at the balance sheet date
and requires an audit as a part of its loan agreement.
Privy of Contract ANSW✅✅The relationship that exists between the promisor and the promisee
of a contract.
The difference between separate and proportionate liability and joint and several liability
ANSW✅✅• Joint and several liability: The assessment against a defendant of the full loss suffered
by a plaintiff, regardless of the extent to which other parties shared in the wrongdoing. For example,
if management intentionally misstates financial statements, an auditor can be assessed the entire
loss to shareholders if the company is bankrupt and management is unable to pay.
,• Separate and proportionate liability: The assessment against a defendant of that portion of the
damage caused by the defendant's negligence. For example, if the courts determine that an
auditor's negligence in conducting an audit was the cause of 30% of a loss to a defendant, only 30%
of the aggregate damage would be assessed to the CPA firm.
The difference between negligence, gross negligence, constructive fraud, and fraud
ANSW✅✅negligence: Absence of reasonable care that can be expected of a person in a set of
circumstances. For auditors, it is in terms of what other competent auditors would have done in the
same situation.
• Gross negligence: Lack of even slight care that can be expected of a person.
• Constructive fraud: Existence of extreme or unusual negligence even though there was no intent to
deceive or do harm. Constructive fraud is also termed recklessness.
• Fraud: Occurs when a misstatement is made and there is both the knowledge of its falsity and the
intent to deceive.
Defenses available for lawsuits from clients and third parties ANSW✅✅The CPA firm normally
uses one or a combination of four defenses when there are legal claims by clients:
1. Lack of duty to perform the service
a. It means that the CPA firm claims that there was no implied or expressed contract.
2. Nonnegligent performance
a. The CPA firm claims that the audit was performed in accordance with auditing standards. Even if
there were undiscovered misstatements, the auditor is not responsible if the audit was conducted
properly.
3. Contribu¬tory negligence
a. A defense of contributory negligence exists when the client's own actions either resulted in the
loss that is the basis for damages or interfered with the con¬duct of the audit in such a way that
prevented the auditor from discovering the cause of the loss.
, 4. Absence of causal connection.
a. To succeed in an action against the auditor, the client must be able to show that there is a close
causal connection between the auditor's breach of the standard of due care and the damages
suffered by the client.
• Contributory negligence is ordinarily not available because a third party is not in a position to
contribute to misstated financial statements.
• The preferred defense in third-party suits is nonnegligent performance. If the auditor conducted
the audit in accordance with GAAS, the other defenses are unnecessary. On the other hand,
nonnegligent performance is difficult to demonstrate to a court, especially if it is a jury trial and the
jury is made up of laypeople.
The responsibilities of auditors under 1933 Act ANSW✅✅· The auditor has the burden of
demonstrating as a defense that
· (1) an adequate audit was conducted in the circumstances or (2) all or a portion of the plaintiff's
loss was caused by factors other than the misleading finan¬cial statements. The 1933 act is the only
common or statutory law where the burden of proof is on the defendant.
· Furthermore, the auditor has responsibility for making sure that the financial state¬ments were
fairly stated beyond the date of issuance, up to the date the registration state¬ment became
effective, which could be several months later.
· Although the burden may appear harsh to auditors, there have been relatively few cases tried
under the 1933 act.
The responsibilities of auditors under 1934 act ANSW✅✅o The liability of auditors under the 1934
Act often centers on the audited financial statements issued to the public in annual reports or
submitted to the SEC as a part of annual Form 10-K reports.
o Every company with securities traded on national and over-the-counter exchanges is required to
submit audited statements annually.
