Module 23: Professional and Legal Responsibilities

Overview

This module covers the general standards of care and ethics that must be followed by CPAs. CPAs are authorized to practice by the various state boards of accountancy. They must follow the rules of these bodies which generally follow the AICPA Code of Professional Conduct. The AICPA and the state societies cooperate on enforcing the ethics of the profession.

A. Regulation of the Profession

B. Disciplinary Systems of the Profession and Regulatory Bodies

C. Accountant’s Legal Liabilities

D. Legal Considerations Affecting the Accountant’s Responsibility

E. Criminal Liability

F. Responsibilities of Auditors under Private Securities Litigation Reform Act

G. Responsibilities under Sarbanes-Oxley Act

H. Additional Statutory Liability Against Accountants

I. Responsibilities of Tax Return Preparers

Key Terms

Multiple-Choice Questions

Multiple-Choice Answers and Explanations

Simulations

Simulation Solutions

Accountants’ civil liability arises primarily from contract law, the law of negligence, fraud, the Securities Act of 1933, and the Securities Exchange Act of 1934. The first three are common law and largely judge-made law, whereas the latter two are federal statutory law.

The agreement between an accountant and his/her client is generally set out in a carefully drafted engagement letter. Additionally, the accountant has a duty to conduct his/her work with the same reasonable care as an average accountant. This duty defines the standard used in a negligence case. It is important to understand

1. When an accountant can be liable to his/her client.
2. When an accountant can be liable to third parties.
3. That an accountant is liable to the client and to all third parties that relied on the financial statements when the accountant committed fraud, constructive fraud, or was grossly negligent; furthermore in these cases, the accountant can be assessed punitive damages.
4. The extent of liability under the Securities Act of 1933 and the Securities Exchange Act of 1934 as well as how they differ from each other and from common law.The CPA examination also tests the dual nature of the ownership of the accountant’s working papers. Although the accountant owns the working papers and retains them as evidence of his/her work, confidentiality must be maintained. Therefore, the CPA cannot allow this information to reach another without the client’s consent. In general, privileged communications between a CPA and the client are not sanctioned under federal statutory law or common law, but the privilege is in existence in states that have passed statutes granting such a right.

CPAs also have specific rules and regulations that affect their practice as tax preparers which are covered in this module. Before beginning the reading you should review the key terms at the end of the module.

A. Regulation of the Profession

Permits to practice for CPA firms and licenses to practice for individual CPAs are granted by the boards of accountancy in the various states and other jurisdictions. These boards also regulate the profession and may suspend or revoke a CPA or a CPA firm’s right to practice. While all boards require successful completion of the CPA examination, the requirements for education and experience vary.

1. To audit issuers (public companies) the CPA in charge of the engagement must have a license to practice issued by a state board of accountancy. In addition, that individual’s firm must have a permit to practice issued by the appropriate state board of accountancy, and the firm must be registered with the Public Company Accounting Oversight Board (PCAOB).
2. State boards have their own codes of professional ethics. However, they generally follow the AICPA Code of Professional Conduct. Therefore, violation of an AICPA rule also generally involves violation of a state board rule.
3. AICPA Code of Professional Conduct is applicable to all AICPA members, not merely those in public practice.
4. The Code provides minimum levels of acceptable conduct relating to all services performed by CPAs, unless wording of a standard specifically excludes some members.
The AICPA has developed the Uniform Accountancy Act (UAA) to provide state jurisdictions a model act to regulate CPAs. Key provisions of the UAA include
1. The state board of accountancy of the state will issue the “certified public accountant” credential to individuals meeting the experience, education, and examination requirements.
a. A bachelors degree is required for the first 5 years after the act becomes effective.
b. After 5 years from the effective date, 150 semester hours of college education is required, including a bachelors or higher degree.
2. The UAA provides that the state board issues licenses to individual CPAs and permits to CPA firms to practice in the state. Individuals and firms that perform certain services or hold themselves out as CPAs must be licensed and permitted. The only professional services for which licensing is required are
a. Attest services
(1) Audits of financial statements performed in accordance with AICPA Statements on Auditing Standards (SAS).
(2) Reviews of financial statements performed in accordance with AICPA Statements on Standards for Accounting and Review Services (SSARS).
(3) An examination of prospective financial statements performed in accordance the AICPA Statements on Standards for Attestation Engagements (SSAE).
(4) An engagement performed in accordance with standards of the Public Company Accounting Oversight Board (PCAOB).
b. Compilation of financial statements under SSARS.
3. To renew licenses and permits the UAA includes periodic peer review and continuing education requirements.
4. To facilitate interstate practice and free movement of CPAs between states, the UAA provides that individuals that have met “substantial equivalency” shall be allowed to be licensed in the state.
5. The state board will regulate and enforce the practice of accountancy in the state.
6. The UAA has ethical provisions that are typically included in the code of ethics of state societies and the AICPA, such as the requirements for confidentiality, working papers, etc.

B. Disciplinary Systems of the Profession and Regulatory Bodies

1. The AICPA Code of Professional Conduct is interpreted and enforced by the Professional Ethics Executive Committee (PEEC), a senior technical committee of the AICPA.
2. State accountancy boards ethics rules are enforced by the various state boards of accountancy.
3. If CPAs are members they must also adhere to the ethics requirements of their state societies of CPAs. The codes of ethics of these bodies are also very similar to the AICPA Code of Professional Conduct. Virtually all state societies have agreements with AICPA to allow joint enforcement of ethics complaints through the Joint Ethics Enforcement Program (JEEP). This means there is a single investigation and, if warranted, a single settlement agreement or joint trial board hearing.
a. Enforcement of rules regarding competitive bidding is excluded from the JEEP process.
4. Joint trial board may discipline CPAs—possible results include
a. No violation/dismissal
b. Admonishment (publication of the admonishment is mandatory)
c. Corrective action required (e.g., additional continuing professional education)
d. Suspension for up to two years
e. Expulsion from AICPA
(1) The CPA may still practice public accounting using valid license issued by a state
(a) Violation of state board code, however, can result in revocation of CPA certificate and loss of ability to practice public accounting. State board codes generally mirror the AICPA Code of Professional Conduct.
(2) Any member who departs from rulings or interpretations has burden justifying it in any disciplinary proceedings.
(3) A member of the AICPA may be expelled or suspended without hearing for any of the following:
(a) The member’s CPA certificate or license or permit to practice is revoked by state as a disciplinary measure.
(b) The member is convicted of a crime punishable by imprisonment for more than one year.
(c) The member files or aids in filing a fraudulent tax return for client or self.
(d) The member intentionally fails to file his or her required tax return.
(4) AICPA Professional Ethics Division may investigate ethics violations and may sanction those that are less serious using less severe remedies.
(5) In addition, court decisions have consistently held that even if an individual is not a member of AICPA, that individual is still expected to follow profession’s Code of Professional Conduct.
5. Securities and Exchange Commission actions against accountants.
a. After a hearing, the SEC can revoke or suspend an accountant from practicing before the SEC if the accountant willfully violated federal securities laws or regulations, or has acted unethically or unprofessionally. If a CPA is suspended from practicing before the SEC, he or she cannot serve as auditor for issuer (public company).
b. The SEC can revoke or suspend an accountant from practicing before the SEC upon conviction of felony or misdemeanor in which moral turpitude was involved.
c. The SEC can penalize accountants with civil fines and mandates to pay profits gained from violations of securities laws and regulations.
6. Disciplinary actions against CPA firms.
a. A state board of accountancy has the power to bar a CPA firm from practicing in the state.
b. The SEC can prohibit an accountant or an accounting firm from doing work for an issuer (public company).
c. The PCAOB investigates and sanctions registered firms for violations of standards of performance. Firms must be registered with the PCAOB to perform audits or reviews of the financial statements of issuer (public company) clients.
(1) Registered CPA firms must have inspections by the PCAOB staff.
(a) Firms with more than 100 publicly traded clients (issuers) must be inspected each year.
(b) Firms with 100 or less publicly traded clients must be inspected every three years.
(2) When investigations lead to alleged violations a hearing will be held by the PCAOB.
(3) The PCAOB hearing may result in sanctions being imposed on the firm or the individuals involved, including suspension or revocation of a firm’s registration, suspension or bar of an individual from associating with a registered public accounting firm, or civil monetary penalties.
(4) The PCAOB may also impose other remedial measures, such as
(a) Improvements in the firm’s quality control or training.
(b) Independent monitoring of the audit work of a firm or individual within a firm.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 1 THROUGH 5

C. Accountant’s Legal Liabilities

1. Common Law Liability to Clients
Common law is law that has historically been derived from court interpretations of what is fair and equitable. Most of common law has now been codified in state statutes. CPAs have responsibilities to their clients that are codified in common law.
a. Liability to clients for breach of contract
(1) The relationship between the client and the CPA is that of an employer and an independent contractor. A CPA may be held liable to a client if the accountant fails to perform substantially as agreed under contract (the engagement letter).
(a) Duties under contract may be
(1) Implied—The accountant owes duty in contract to perform in nonnegligent manner.
(2) Express—The accountant owes duty to perform under terms of the contract.
(a) This duty can extend liability beyond that which is standard under a normal audit.
(b) Typically, the terms are expressed in engagement letter that should specify clearly and in writing the following:
(i) The nature and scope of engagement to avoid misunderstandings between the CPA and client.
(ii) The procedures and tests to be used.
(iii) That the engagement will not necessarily uncover fraud, defalcations, errors, or illegal actions, unless the CPA agrees to greater responsibility.
(iv) Engagement letter should be signed by at least the client (accountant will typically sign also) but oral contract for audit still enforceable without engagement letter.
(b) An accountant (CPA) is said to be in privity of contract with client when contract exists between them.
(1) The reverse is also true (i.e., client is in privity of contract with CPA).
(c) An accountant is not an insurer of financial statements and thus does not guarantee against losses from error or fraud.
(1) A “normal” financial statement audit is not intended to uncover fraud, shortages, or defalcations, in general but is meant to provide audit evidence needed to express opinion on fairness of financial statements. The audit is designed to provide reasonable assurance of detecting material errors and fraud.
(d) An accountant is not normally liable for failure to detect fraud, etc. unless
(1) “Normal” audit or review would have detected it
(2) The accountant by agreement has undertaken greater responsibility such as a fraud audit
(3) The wording of audit report indicates greater responsibility
EXAMPLE
A CPA has been hired by a client to perform an audit. A standard engagement letter is used. During the course of the audit, the CPA fails to uncover a clever embezzlement scheme by one of the client’s employees. The CPA is not liable for the losses unless a typical, reasonable audit should have resulted in discovery of the scheme.
(e) In an audit or review of financial statements, the accountant is under duty to investigate when he or she discovers or becomes aware of suspicious items.
(1) The investigation should extend beyond management’s explanations.
(2) The client should not interfere or prevent accountant from performing.
EXAMPLE
A CPA firm issues its opinion a few days late because of its client’s failure to supply needed information. The CPA firm is entitled to the full fee agreed upon under the contract (engagement).
(3) When a breach of contract occurs
(a) The accountant is not entitled to compensation if breach is major.
EXAMPLE
Miller failed to complete the audit by the agreed date. If time is of the essence so that the client receives no benefit from the audit, Miller is not entitled to compensation.
(b) The accountant is entitled to compensation if there are only minor errors but the client may deduct from fees paid any damages caused by breach.
(c) The client may recover any damages caused by breach even if accountant is not entitled to fee.
(d) In general, punitive damages are not awarded for breach of contract.
b. Liability to clients based on negligence
(1) Elements needed to prove negligence against accountant
(a) The accountant has a duty to perform with same degree of skill and judgment possessed by average (reasonable) accountant.
(1) This is the standard used in cases involving ordinary negligence (or simply called negligence).
(2) Different phrases are used for this standard, including duty to exercise due care, duty of skill of an average, reasonable accountant (or CPA), duty to act as an average (or reasonable) accountant (or CPA) would under the circumstances, or duty of judgment of an ordinary, prudent accountant (or CPA).
(3) Standard for accountants is guided by
(a) State and federal statutes
(b) Court decisions
(c) Contract with client
(d) GAAS and GAAP (persuasive but not conclusive)
(i) Failure to follow GAAS virtually establishes lack of due care but reverse not true (i.e., following GAAS does not automatically preclude negligence but is strong evidence for presence of due care)
(e) Customs of the profession (persuasive but not conclusive)
EXAMPLE
Will, a CPA, issued an unqualified opinion on the financial statements of X Company. Included in the assets was inventory stated at cost when the market was materially below cost. This violation of GAAP can be used to establish that Will was negligent. Also, the client can sue under contract law because Will has an implied duty in the contract to not be negligent.
A CPA, while performing the annual audit, detects material errors in the previously issued audit report. The CPA has a duty to correct these material errors.
A CPA failing to warn a client of known internal control deficiency is falling below this standard.
(b) The accountant breached duty owed of average reasonable accountant.
(c) Damages or losses resulted from the breach.
(1) Damages are limited to actual losses that use of reasonable care would have avoided.
(2) Punitive damages are not normally allowed for ordinary negligence.
(3) Contributory negligence may be a complete defense by CPA in many states if client’s own negligence substantially contributed to the accountant’s failure to perform audit adequately.
EXAMPLE
A CPA failed to detect a material fraud in an audit of the client’s financial statements. However the CPA had communicated to the client for a number of years a significant deficiency in internal control that allowed the fraud to occur. The client ignored the recommendations and failed to correct the deficiency in internal control. The client’s contributory negligence may in some states prevent the client from recovering losses from the CPA for negligence. In other states it will reduce the liability of the CPA.
(d) A causal relationship must exist between fault of accountant and damages of plaintiff and the cause must be proximate (i.e., foreseeable).
EXAMPLE
A CPA negligently fails to discover during an audit that several expensive watches are missing from the client’s inventory. Subsequently, an employee is caught stealing some watches. He confesses to stealing several before the audit and more after the audit when he found out he did not get caught. Only 5 of the watches can be recovered from the employee, who is unable to pay for those stolen. The CPA may be liable for those losses sustained after the audit if discovery could have prevented them. However, the CPA normally would not be liable for the watches taken before the audit when the loss is not the proximate result of the negligent audit. But if there were watches that could have been recovered at the time of the audit but can’t be now, the CPA could be liable for those watches even though they were taken before the audit.
c. The accountant’s liability is not based solely on honest errors of judgment; liability requires at least negligence under common law.
d. Liability to client for fraud, gross negligence, or constructive fraud
(1) Common law fraud of accountant is established by the following elements:
(a) Misrepresentation of material fact or accountant’s expert opinion
(b) Scienter, shown by either
(1) Intent to mislead with accountant’s knowledge of falsity, or
(2) Reckless disregard of the truth.
(c) Reasonable or justifiable reliance by injured party
(d) Actual damages
(2) Called constructive fraud or gross negligence if when proving above four elements, reckless disregard of the truth is established instead of knowledge of falsity.
EXAMPLE
During the course of an audit, a CPA fails to verify the existence of the company’s investments which amounted to a substantial portion of the assets. Many of these, it is subsequently found, were nonexistent. Even in the absence of intent to defraud, the CPA is liable for constructive fraud based on reckless disregard of the truth.
Care and Less Co., CPAs, uncover suspicious items during the course of their audit of Blue Co. Because their audit steps did not require the additional steps needed to check into these suspicious items, the CPAs failed to uncover material errors. Even if a typical audit would not have required these additional audit steps, the CPAs are liable for the damages that result because they have a duty to look into such circumstances when they come to their attention.
(3) Contributory negligence of client is not a defense available for accountant in cases of fraud, constructive fraud, or gross negligence.
(4) Privity of contract is not required for plaintiff to prove fraud, constructive fraud, or gross negligence.
(5) Punitive Damages May Be Added To Actual damages for fraud, constructive fraud, or gross negligence.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 6 THROUGH 16
2. Common Law Liability to Third Parties (Nonclients)
a. Privity of contract.
(1) In typical accountant-client relationship, there usually is no privity of contract between the accountant and third parties who rely on the financial statements. However, in some cases the client is not the company being audited.
EXAMPLE
Dudley Company is considering acquiring Tyler Company. Dudley engages Wilson, CPA to audit Tyler to obtain assurance that Tyler’s financial statements are not materially misstated. Dudley is the client because it engaged Wilson. Accordingly, Dudley would be able to hold Wilson liable for breach of contract or ordinary negligence.
(2) Traditionally, accountants could use the defense of no privity against suing third parties in contract and negligence cases.
(a) Ultramares decision is leading case in which the accountants were held liable for ordinary negligence only to parties who primarily benefit from the audit or the audited financial statement.
EXAMPLE
First Bank requested Goodman Company to obtain an audit to receive a needed loan. Adam, CPA audited the financial statements of Goodman knowing that the Goodman was obtaining the audit to satisfy the request of First Bank. In this case, First Bank would be considered a primary beneficiary of the audit and, therefore, First Bank would have the same rights as the client under common law.
(1) This generally means only the client or third-party beneficiaries since these are in privity of contract with accountant.
(2) However, a third party who can prove fraud or constructive fraud (gross negligence) may recover from the accountant.
(b) This is a significant minority rule today.
b. More recently, many courts have expanded liability to other some third parties. The following distinctions should be understood:
(1) Foreseen party—A third party who the accountant knew would rely on financial statements, or member of limited class that accountant knew would rely on financial statements, for specified transaction.
(a) The majority rule is that the accountant is liable to foreseen third parties for ordinary negligence.
(1) The rationale for not allowing liability to more third parties is that accountants should not be exposed to liability in indeterminate amount to indeterminate class.
EXAMPLE
A CPA agrees to perform an audit for ABC Client knowing that the financial statements will be used to obtain a loan from XYZ Bank. Relying on the financial statements, XYZ Bank loans ABC $100,000. ABC goes bankrupt. If XYZ can establish that the financial statements were not fairly stated, thus causing the bank to give the loan, and if negligence can be established, most courts will allow XYZ Bank to recover from the CPA.
Assume the same facts as in the example above except that XYZ Bank was not specified. Since the CPA knew that some bank would rely on these financial statements, the actual bank is a foreseen party since it is a member of a limited class and most courts will allow for liability.
(b) The accountant is liable for fraud, constructive fraud, or gross negligence to all parties whether foreseen or not.
(2) Distinguish foreseen party and foreseeable party
(a) Foreseeable party—Any party that accountant could reasonably foresee would receive financial statements and use them.
(1) The majority rule is that accountant not liable to foreseeable parties for negligence.
EXAMPLE
A CPA is informed that financial statements after being audited will be used to obtain a loan from a bank. The audited financial statements are also shown to trade creditors and potential investors. The bank is a foreseen third party but these other third parties are not actually foreseen parties and generally cannot recover from the CPA for ordinary negligence. They may qualify as foreseeable third parties since creditors or investors are the types of parties whom an accountant should reasonably foresee as users of the audited financial statements.
(2) Some courts now hold that accountant is liable for negligence to parties that are merely foreseeable.
c. To be awarded damages against the accountant a third party must prove
(1) Losses (damages),
(2) Negligence (either ordinary or gross negligence depending on the type of party and nature of state law) by the CPA,
(3) Proximate cause (i.e., reliance on the work of the CPA caused the losses).
d. Concepts of liability
(1) In many cases in which third-parties sue the accountant, the accountant is not the only party at fault. Typically, management of the company is also responsible for the losses of third parties. It is common that both the accountant and management are named as defendants in these cases. If the defendants lose the case, state courts vary in how the obligation to pay damages is allocated.
(a) Joint liability. In a state that applies joint liability, both the accountant and management are liable up to the full amount of the obligation. If management has no funds, the entire amount may be collected from the accountant
(b) Several liability. In a state that applies several (proportionate liability), the accountant and management are only obligated to pay their respective share of the damages based on the degree of responsibility for the losses. This is the liability standard that is included in the AICPA Uniform Accountancy Act.
EXAMPLE
First bank extended a line of credit in the amount of $1,000,000 to Carey Corporation in reliance on financial statements audited by Gordon, CPA. The financial statements were materially misstated by management, and Gordon did not detect the misstatement. Assume that First Bank prevailed in a lawsuit against management and Gordon. Management was found to be 60% responsible and Gordon was found to be 40% responsible for First Bank’s losses of $1,000,000. In a state that applies the concept of several liability, management would be obligated to pay $600,000 (60% × $1,000,000) and Gordon would be obligated to pay $400,000 (40% × $1,000,000). Gordon would not be obligated to pay more even if management had no ability to pay its obligation.
(c) Joint and several liability. In a state that applies joint and several liability, each of the parties are responsible for the full amount of the obligation but may seek to get reimbursement from the other parties. Most state courts apply joint and several liability.
EXAMPLE
If the state in the previous example applies the concept of joint and several liability, First Bank could seek to collect the entire $1,000,000 from Gordon. Gordon would then have to pursue management for its $600,000 share.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 17 THROUGH 22
3. Statutory Liability to Third Parties—Securities Act of 1933
a. General information on the Securities Act of 1933
(1) Covers regulation of initial sales of securities registered under 1933 Act
(a) Requires registration of initial issuances of securities with SEC and makes it unlawful for registration statement to contain untrue material fact or to omit material fact.
(1) Material fact—One about which average prudent investor should be informed.
(2) Most potential accountant liability occurs because registration statement (and prospectus) includes audited financial statements.
(3) Accountant’s legal liability arises for untrue material fact or omission of material fact in registration statement (or prospectus).
(4) Securities Act of 1933 does not include periodic reports to SEC or annual reports to stockholders (these are in the 1934 Act below).
b. Parties that may sue
(1) Any purchaser of registered securities
(a) Plaintiff need not be initial purchaser of security.
(b) Purchaser generally must prove that specific security was offered for sale through registration statement.
(1) Exchange and issuance of stock based on a merger counts as a sale.
(2) Third parties can sue without having privity of contract with accountant under Federal Securities Acts.
c. Liability under Section 11 of the 1933 Act.
(1) This imposes liability on auditors (and other experts) for misstatements or omissions of material fact in certified financial statements or other information provided in registration statements. The registration statement is the document that is used to sell the securities and, in general, includes
(a) A description of the company’s properties and business
(b) A description of the security to be offered for sale
(c) Information about the management of the company
(d) Financial statements certified by independent accountants
(2) To be awarded damages against the accountant, the plaintiff (purchaser of the securities) must prove
(a) Damages were incurred.
(b) There was material misstatement or omission in financial statements or included in registration statement.
(c) If these two facts are proven, it is sufficient to win against the CPA and shifts burden of proof to the CPA accountant who may escape liability by proving one of the following defenses:
(1) “Due diligence,” that is, after reasonable investigation, the accountant had reasonable grounds to believe and did believe that statements were not materially misstated.
NOTE: Although the basis of liability is not negligence, an accountant who was at least negligent will probably not be able to establish “due diligence.
(2) Plaintiff knew financial statements were incorrect when investment was made.
(3) Lack of causation—loss was due to factors other than the misstatement or omission in the financial statements.
(4) Following generally accepted auditing standards is generally valid as a defense for CPA.
(d) The plaintiff need not prove reliance on financial statements unless security was purchased at least twelve months after effective date of registration statement.
(e) The plaintiff need not prove negligence or fraud.
d. Damages
(1) The difference between amount paid and market value at time of suit.
(2) If sold, difference between amount paid and sale price.
(3) Damages cannot exceed price at which security was offered to public.
(4) The plaintiff cannot recover decrease in value after suit is brought and the accountant is given the benefit of any increase in market value during the suit.
e. Statute of limitations
(1) Action must be brought against accountant within one year from discovery (or when discovery should have been made) of false statement or omission in financial statements.
(2) Or if earlier, action must be brought within three years after security offered to public.
f. This liability can arise from negligence in reviewing events subsequent to date of certified balance sheet. The CPA firm is responsible for reviewing for material events that occur up until the effective date of the registration statement.
(1) This is referred to as S-1 review when made for registration statement under securities regulations.
EXAMPLE
An accountant performed an audit and later performed an S-1 review to review events subsequent to the balance sheet date. The accountant did not detect certain material events during this S-1 review even though there was sufficient evidence to make the accountant suspicious. Further investigation was required to avoid liability.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 23 THROUGH 30
4. Statutory Liability to Third Parties—Securities Exchange Act of 1934
a. The Securities Exchange Act of 1934 regulates securities sold on national stock exchanges.
(1) Includes securities traded over-the-counter and other equity securities where the corporation has more than $10 million in total assets and the security is held by 500 or more persons at the end of a fiscal year.
(2) Requires each company to furnish to SEC an annual report (Form 10-K) which includes financial statements (not necessarily the same as an annual report to shareholders) to be audited in accordance with PCAOB standards by a registered firm. It also requires the company to file quarterly reports (Form 10-Qs) which include quarterly financial statements reviewed by a registered firm.
(3) Accountant civil liability comes from two sections—10 and 18.
(a) Section 10 (including Rule 10b-5)—makes it unlawful to
(1) Employ any device, scheme, or artifice to defraud.
(2) Make untrue statement of material fact or omit material fact.
(3) Engage in act, practice, or course of business to commit fraud or deceit in connection with purchase or sale of security.
(b) Section 18—makes it unlawful to make false or misleading statement with respect to a material statement unless done in “good faith.”
b. Purchasers and sellers of registered securities may sue under these sections. Note that under the 1933 Act only purchasers may sue.
c. Proof requirements—Section 10, including Rule 10b-5
(1) The plaintiff (purchaser or seller) must prove damages resulted in connection with purchase or sale of a registered security in interstate commerce.
(2) The plaintiff must prove there was a material misstatement or omission in information released by the issuer (public company).
(a) Information may, for example, be in the form of audited financial statements in report to stockholders or in Form 10-K.
(3) The plaintiff must prove justifiable reliance on financial information.
(4) The plaintiff must prove existence of scienter (the intent to deceive, manipulate, or defraud).
(a) Includes reckless disregard of truth or knowledge of falsity.
(b) Negligence alone will not subject accountant to liability under this section but lack of good faith will.
(5) Note that these proof requirements differ in very significant ways from proof requirements under the 1933 Act.
(6) The plaintiff cannot recover if he or she is reckless or fraudulent.
d. Proof requirements—Section 18
(1) The plaintiff (purchaser or seller) must prove
(a) That damages were incurred.
(b) There was a material misstatement or omission on report (usually Form 10-K) filed with SEC.
(c) The plaintiff read and relied on defective report.
(2) Then the burden of proof is shifted to the accountant who may escape liability by proving s/he acted in “good faith.”
(a) Although basis of liability here is not negligence, an accountant who has been grossly negligent typically will not be able to establish “good faith.”
(b) An accountant who has been only negligent will probably be able to establish “good faith.”
e. Damages
(1) Generally, damages are calculated as the difference between amount paid by the plaintiff and market value at time of suit.
(2) If sold, damages are calculated as the difference between amount paid and sale price.
5. Summary of auditors’ defenses under Securities Act of 1933 and Securities Exchange Act of 1934
  • Defenses available to auditors:
    1934 Act 1933 Act
    1. Audit was performed with due care Yes Yes
    2. Misstatement was immaterial Yes Yes
    3. Plaintiff had prior knowledge of misstatement Yes Yes
    4. Plaintiff did not rely on information Yes No
    5. Misstatement was not cause of loss Yes Yes

    Prepared by Debra R. Hopkins, Northern Illinois University

  • Due diligence is a defense for the 1933 Act only (Do not use for liability under the 1934 Act)
    NOW REVIEW MULTIPLE-CHOICE QUESTIONS 31 THROUGH 34

D. Legal Considerations Affecting the Accountant’s Responsibility

1. Accountant’s working papers
a. Consist of evidence, notes, computations, etc. that accountant accumulates when doing professional work for client.
b. Working papers are owned by accountant unless there is agreement to the contrary.
c. Ownership is essentially custodial in nature and it serves two purposes:
(1) To preserve confidentiality of client information. Without client consent, an accountant cannot allow transmission of information in working papers to another party. However, an accountant must produce working papers upon being given an enforceable subpoena, or if agreeing to provide access to working papers to a government agency is part of the agreement with the client.
(a) Subpoenas should be limited in scope and for a specific purpose.
(b) The accountant may challenge a subpoena as being too broad and unreasonably burdensome.
2. Privileged communications between accountant and client generally is not provided by state or federal laws.
a. Only a few states have enacted laws providing for privileged communications.
b. Federal law does not recognize privileged communications.
c. If the accountant is acting as agent for (hired by) an individual who has privileged communication such as an attorney, then accountant’s communications are privileged.
d. To be considered privileged, an accountant-client communication must
(1) Be located in a jurisdiction where privileged communication is recognized.
(2) Have been intended to be confidential at time of communication.
(3) Not have privilege waived by the client.
e. If considered privileged, valid grounds exist for the accountant to refuse to testify in court concerning these matters.
(1) This privilege is, in general, for benefit of client.
(2) Can be waived by client.
(3) If part of the privileged communication is allowed, all of privilege is lost.
f. ACIPA Code of Professional Conduct prohibits disclosure of confidential client data unless
(1) The client consents. If the client is a partnership, each partner is actually a client and therefore must give consent.
(2) To comply with GAAS and GAAP.
(3) To comply with enforceable subpoena (e.g., courts where privilege is not recognized).
(4) Disclosure is made in conjunction with a quality (peer) review of the CPA firm’s practice.
(5) The AICPA is responding an investigation by the AICPA ethics division or trial board.
g. An interpretation of the Code of Professional Conduct allows a CPA to provide confidential client information to a third-party service provider (e.g., a tax return preparation provider) without the client’s permission. However, the CPA must enter into a contractual agreement with the service provider to maintain the confidentiality of the information and be reasonably assured that the third-party service provider has appropriate procedures in place to prevent the unauthorized release of confidential information to others.
h. US Supreme Court has held that tax accrual files are not protected by accountant-client privilege.
3. Accountants also should be familiar with privacy laws that may affect their practice. Privacy is defined as “the rights and obligations of individuals and organizations with respect to the collection, use, retention, and disclosure of personal information.”
a. Accountants that prepare individual tax returns or provide nonbusiness tax or financial advice must be familiar with the provisions of the Gramm-Leach Bliley (Financial Modernization) Act of 1999.
(1) Accountants are prohibited from disclosing to a nonaffiliated third party any nonpublic personal information about their clients.
(2) Related FTC regulations require accountants to develop, implement, and maintain a comprehensive information security program that outlines the ways in which they protect client information.
(3) Accountants are responsible for maintaining the confidentiality of information that is outsourced for processing (e.g., outsourced tax return preparation to a firm in a foreign country).
b. The Internal Revenue Code prohibits tax preparers from “knowingly” or “recklessly” disclosing or using tax-related information other than in connection with the preparation of the return. Treasury Department regulations allow information to be used for certain other purposes but only if a consent is obtained from the individual.
4. Illegal acts by clients
a. Situations in which there may be a duty to notify parties outside the client
(1) Form 8-K disclosures. When a change is auditor is reported by a Form 8-K (as required by securities laws), the client must disclose the reason for the change and the auditor must agree with the reason stated by the client or indicate how the auditor disagrees.
(2) Disclosure to successor auditor. Upon a change in auditor, the predecessor auditor must accurately and completely respond to inquiries by the successor auditor after the client has given consent.
(3) Disclosure in response to subpoena.
(4) Disclosure to funding agency for entities receiving governmental financial assistance.
5. CPA certificates are issued under state (not federal) jurisdiction.
6. Acts of employees.
a. Accountant is liable for acts of employees in the course of employment.
EXAMPLE
XYZ, a partnership of CPAs, hires Y to help perform an audit. Y is negligent in the audit, causing the client damage. The partners cannot escape liability by showing they did not perform the negligent act.
b. Professional liability insurance typically is used to cover such losses.
7. The duty to perform an audit is not delegable because it is a contract for personal services unless client agrees to delegation.
8. Generally, the basis of relationship of accountant to his or her client is that of independent contractor.
9. Insurance
a. The accountants’ professional liability (malpractice) insurance covers their negligence.
b. A fidelity bond protects client from accountant’s fraud.
c. A client’s insurance company is subrogated to client’s rights (i.e., has same rights of recovery of loss against accountant that client had).
d. The portions of debts incurred in violation of securities laws not covered by insurance are not dischargeable in bankruptcy by the accountant.
10. Reliance by an auditor on other auditor’s work
a. The principal auditor is still liable for all work unless the audit report clearly indicates divided responsibility.
b. The principal auditor cannot rely on unaudited data; must disclaim or qualify opinion.
11. Subsequent events and subsequent discovery
a. The accountant is generally not liable for the effect of events occurring subsequent to the date of the audit report.
(1) Liability extends to effective date of registration for reports filed with SEC.
b. The accountant may be held liable if subsequently discovered facts that existed at report date indicate statements were misleading unless
(1) An immediate investigation is conducted
(2) Prompt revision of statements is possible
(3) The SEC and persons known to be relying on statements are notified by the client or the accountant
c. The accountant is liable if he or she makes assurances that there are no material changes after fieldwork or report date when in fact there are material changes. Therefore, the accountant should perform sufficient audit procedures before giving this assurance.
12. Liability from preparation of unaudited financial statements, including compiled and reviewed financial statements for nonissuers (nonpublic companies)
a. Financial statements are unaudited if
(1) No auditing procedures have been applied.
(2) Insufficient audit procedures have been applied to express an opinion (e.g., inquiries and analytical procedures applied in a review engagement).
b. The accountant may liable in these types of engagements
(1) Failure to mark each page, “unaudited,” or “See Accountant’s Compilation Report,” or “See Accountant’s Review Report.”
(2) Failure to issue a disclaimer of opinion, or an appropriately worded compilation or review report.
(3) Failure to follow appropriate AICPA Statements on Standards for Accounting and Review Services.
(4) Failure to inform client of any discovery of indications of major issues; for example, circumstances indicating presence of fraud.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 35 THROUGH 42

E. Criminal Liability

1. Sources of liability
a. Securities Act of 1933 and Securities Exchange Act of 1934
(1) An accountant can be held criminally liable for willful illegal conduct.
(a) Intentional misleading omission of material facts
(b) Putting false information in registration statement
(2) Subject to fine of up to $10,000 and/or up to five years prison
(3) Examples of possible criminal actions include
(a) CPA aids management in a fraudulent scheme.
(b) CPA covers up prior year financial statement misstatements.
b. Criminal violations of the Internal Revenue Code
(1) For willfully preparing false return (perjury)
(2) For willfully assisting others to evade taxes (tax evasion)
c. Criminal liability under RICO (Racketeer Influenced and Corrupt Organizations) Act
(1) Covers individuals affiliated with businesses or associations involved in a pattern of racketeering.
(a) Racketeering includes organized crime but also includes fraud under the federal securities laws as well as mail fraud.
(1) Accountants are subject to criminal penalty through affiliation with accounting firm or business involved in racketeering.
(b) A pattern of racketeering means at least two illegal acts of racketeering in previous ten years.
(2) RICO has also been expanded to allow civil suit by private parties.
(a) Treble damages allowed (to encourage private enforcement).
(b) It has been held to apply against accountants even without a criminal indictment or conviction.
EXAMPLE
A CPA firm is convicted of a number of violations of securities laws in a short period of time. The CPA firm could potentially be held liable under RICO for a pattern of violations of laws.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 43 THROUGH 44

F. Responsibilities of Auditors under Private Securities Litigation Reform Act

1. Auditors who audit financial statements under Federal Securities Exchange Act of 1934 are required to establish procedures to
a. Detect material illegal acts,
b. Identify material related-party transactions, and
c. Evaluate ability of firm to continue as going concern.
2. If auditor detects possible illegal activity, he or she must inform audit committee or board of directors.
a. If senior management or board fails to take remedial action and if illegal activities are material so that departure from standard audit report or auditor resignation is indicated, the auditor shall report this to board of directors.
(1) Board has one day to notify SEC of this report.
(a) If not done, auditor must furnish SEC with copy of auditor’s report to board and/or resign from audit.
3. Civil liability may be imposed by SEC for the auditor’s failures under the Act.
a. Auditors are protected from private civil suits for these reports to SEC under this Act.
4. Amends Federal Securities Act of 1933 and Federal Securities Exchange Act of 1934.
a. Law passed to reduce lawsuits against accounting firms and issuers of securities
(1) SEC’s enforcement of securities laws not affected by the Act because the law governs private litigation.
5. The act creates a “safe harbor” from legal liability for preparation of forward-looking statements.
a. Including projections of income, revenues, EPS, and company plans for products and services.
b. To fall within safe harbor, written or oral forward-looking statement should include cautions and identify assumptions and conditions that may cause projections to vary.
c. Purpose is to encourage company to give investors more meaningful information without fear of lawsuits.
6. Discourages class action lawsuits for frivolous purposes
a. Accomplished by
(1) Providing for stringent pleading requirements for many private actions under Securities Exchange Act of 1934
(2) Awards costs and attorneys’ fees against parties failing to fulfill these pleading requirements
7. Changes rules on joint and several liability, so that liability of defendants is generally proportionate to their degree of fault
a. This relieves the accountants (and others) from being “deep pockets” beyond their proportional fault.
b. Exception—joint and several liability is imposed if defendant knowingly caused harm.
EXAMPLE
Plaintiffs suffered $2 million in damages from securities fraud of a company. The auditors of the company are found to be 15% at fault. If the auditors did not act knowingly, they can be held liable for the 15% or $300,000. If they acted knowingly, they can be held liable for up to the full $2 million based on joint and several liability.
c. Accountants may be held liable for the proportionate share of damages they actually (and unknowingly) caused plus an additional 50% where principal defendant is insolvent.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 45 THROUGH 50

G. Responsibilities under Sarbanes-Oxley Act

1. Sarbanes-Oxley Act, also known as Public Company Accounting Reform and Investor Protection Act
2. New federal crimes involving willful nonretention of audit and review workpapers
a. Retention required for five years (in some cases seven years).
b. Makes illegal the destruction or falsifying of records to impede investigations.
c. Provides for fines or imprisonment up to twenty years or both.
d. Applies to an accountant who audits an issuer of securities (public company).
(1) It also applies to others such as attorneys, consultants, and company employees.
e. Act requires SEC to issue new rules and then periodically update its rules on details of retaining workpapers and other relevant records connected with audits or reviews.
3. Created the Public Company Accounting Oversight Board (PCAOB).
a. PCAOB is a nonprofit corporation not federal agency.
(1) Violation of rules of the PCAOB are treated as violation of Securities Exchange Act of 1934 with its penalties.
b. The PCAOB consists of five members.
(1) Two members must be or have been CPAs.
(2) Three members cannot be or cannot have been CPAs.
(3) None of Board members may receive pay or profits from CPA firms.
c. Board regulates firms that audit SEC registrants, not accounting firms of private companies.
d. Main functions of Board are to
(1) Register and conduct inspections of public accounting firms
(a) This replaces peer reviews for the part of a CPA firm’s practice that involves audits of issuers (public company clients).
(b) CPA firms that audit more than 100 issuers (public companies) are inspected annually.
(c) CPA firms that audit from 1 to 100 issuers (public companies) are inspected every three years.
(d) Special inspections may be performed in addition to the regular inspections.
(2) Set standards on auditing, quality control, independence, or preparation of audit reports
(a) May adopt standards of existing professional groups or new groups.
(b) Accounting firm must have second partner review and approve each audit report.
(c) Accounting firm must report on examination of internal control along with description of material weaknesses.
(3) The PCAOB may regulate the nature and extent of nonaudit services that CPA firms may perform for issuer audit clients
(4) Enforce compliance with professional standards, securities laws relating to accountants and audits
(5) Perform investigations and disciplinary proceedings on registered public accounting firms
(6) May perform any other duties needed to promote high professional standards and to improve auditing quality
(7) Material services must receive preapproval by audit committee, and fees for those services must be disclosed to investors
4. Additional responsibilities and provisions
a. A company must disclose whether it has adopted code of ethics for company’s principal executive officer, principal accounting officer, principal financial officer or controller.
(1) A company may have separate codes of ethics for different officers or may have broad code of ethics covering all officers and directors.
(2) A company is not required to adopt code of ethics but if it has not, it must disclose the reasons why.
b. Company officials found liable for fraud cannot use bankruptcy law to discharge that liability.
c. Attorneys practicing before SEC representing issuers must report evidence of material violations by the company or its officers, directors, or agents of securities laws or breach of fiduciary duties
(1) The report must be made to the chief legal officer or the chief executive officer.
(a) If management does not respond appropriately, then the attorney must report the evidence “up the ladder” to audit committee of the board of directors, another committee of independent directors, or finally to the entire board of directors.
d. The SEC adopted new rules requiring more events to be reported on Form 8-K and shortening filing deadlines for most reportable events to four business days after the date the event occurs.
(1) If the company becomes directly or contingently liable for material obligation arising from an off-balance-sheet arrangement, it must describe this matter including its material terms and nature of arrangement.
e. The company must disclose several items if a director has resigned or refused to stand for reelection because of disagreement with company’s practices, operations or policies, or if the director has been removed for cause.
(1) The company must disclose such items as circumstances regarding disagreement with company.
f. If a new executive officer is appointed, the company must disclose information such as his or her name, the position, and description of any material terms of the employment agreement between company and officer.
5. The act lists several specific service categories that the issuer’s public accounting firm cannot legally do, even if approved by audit committee, such as
a. Bookkeeping or other services relating to financial statements or accounting records
b. Financial information systems design and/or implementation
c. Appraisal services
d. Internal audit outsourcing services
e. Management functions
f. Actuarial services
g. Investment or broker-dealer services
h. Certain tax services, such as tax planning for potentially abusive tax shelters
i. Board permitted to exempt (on case by case basis) services of audit firm for audit client
Note that the act does not restrict the auditor from performing these services for to nonaudit clients or to private companies. Also, the act permits the auditor as a registered public accounting firm to perform nonaudit services not specifically prohibited (e.g., tax services) when approved by issuer’s audit committee.
6. The act prohibits the audit partner having primary responsibility for the issuer’s audit’s and the audit partner who reviews the audits from serving for more than five consecutive years (i.e., the audit partners must be rotated every five years).
a. If public company has hired an employee of an audit firm to be its CEO, CFO, or CAO within the previous year, the audit firm may not audit that public company.
7. The act requires increased disclosure of off-balance-sheet transactions.
8. The act mandates that pro forma financial disclosures be reconciled with figures done under GAAP.
9. The act creates new federal laws against destruction or tampering with audit workpapers or documents that are to be used in official proceedings.
10. The act increases protection of whistle-blowers from retaliation because of participation in proceedings against firms in securities fraud.
a. Also, provides that employees may report securities fraud directly to the audit committee and may provide the information anonymously and confidentially.
11. Public Companies may not make or modify personal loans to officers or directors with few exceptions.
12. Annual reports filed with SEC that contain financial statements need to incorporate all material corrections noted by CPA firms.
13. Each company must disclose on a current basis information on financial condition that the SEC determines is useful to public.
14. The SEC is authorized to discipline professionals practicing before SEC.
a. SEC may censure, temporarily bar or permanently bar him or her for
(1) Lack of qualifications needed
(2) Improper professional conduct
(3) Willful violation of helping another violate securities laws or regulations
15. The auditor must report to the issuer’s audit committee.
16. The auditors must retain workpapers for five years.
a. Failure to do so is punishable by prison term of up to ten years.
17. Sarbanes-Oxley Act directed SEC to perform various tasks including several studies to formulate regulations; some of these studies have deadlines in the future and are expected to be used to promulgate new important regulations—others have been completed, resulted in regulations by SEC, and have force of law including the following:
a. Require disclosure of differences between pro forma financial results and GAAP.
b. Require that “critical” accounting policies be reported from auditors to audit committee.
c. Companies are required to disclose if they have adopted a code of ethics.
d. Disclosure of names of “financial experts” who serve on a company’s audit committee.
e. Actions are prohibited that fraudulently manipulate or mislead auditors.
f. New conflict of interest rules were established for analysts.
g. The SEC may petition courts to freeze payments by companies that are extraordinary.
18. CEOs and CFOs of most large companies listed on public stock exchanges are now required to certify financial statements filed with SEC.
a. This generally means that they certify that information “fairly represents in all material respects the financial conditions and results of operations” of those companies and that
(1) The signing officer reviewed the report.
(2) The company’s report does not contain any untrue statements of material facts or does not omit any statements of material facts to the best of his or her knowledge.
(3) The company has an internal control system in place to allow honest certification of financial statements.
(a) Or if any deficiencies in internal control exist, they must be disclosed to the auditors.
19. Blackout periods were established for issuers of certain security transaction types that limit companies’ purchase, sale, or transfer of funds in individual accounts.
20. Stiffer penalties for other white-collar crimes including federal law covering mail fraud and wire fraud

H. Additional Statutory Liability Against Accountants

1. Auditors are required to use adequate procedures to uncover illegal activity of client.
2. Civil liability is proportional to degree of responsibility.
a. One type of responsibility is through the auditors’ own carelessness.
b. Another type of responsibility is based on auditor’s assisting in improper activities that he or she is aware or should be aware of.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 51 THROUGH 56

I. Responsibilities of Tax Return Preparers

1. Preparer—an individual who prepares for compensation, or who employs one or more persons to prepare for compensation, any federal tax return, or a substantial portion thereof, including income, employment, excise, exempt organization, gift, and estate tax returns.
a. Compensation must be received and can be implied or explicit (e.g., accountant who prepares individual return of the president of a company, for which he performs the audit, for no additional fee as part of a prior agreement has been compensated [implied]).
b. The performance of the following acts will not classify a person as a preparer:
(1) Preparation of a return for a friend, relative, or neighbor free of charge even though the person completing the return receives a gift of gratitude from the taxpayer;
(2) The furnishing of typing, reproducing, or other mechanical assistance in preparing a return; and
(3) Preparation by an employee of a return for his or her employer, or an officer of the employer, or for another employee if he or she is regularly employed by that employer.
c. Preparation of a tax return includes giving advice on events that have occurred at the time the advice is given if the advice is directly relevant to determining the existence, character, or amount of a schedule, entry, or other portion of a tax return.
2. AICPA Statements on Standards for Tax Services
a. Tax Return Positions
(1) With respect to tax return positions, a CPA
(a) Should determine and comply with the standards that are imposed by the applicable taxing authority with respect to recommending a tax return position, or preparing or signing a tax return.
(b) The CPA should
(1) Satisfy the reporting standard and disclosure requirements of the applicable taxing authority, or
(2) If the taxing authority has no written standard (or it is of lower level), the following should be applied:
(a) For undisclosed positions, realistic possibility of success
(b) For disclosed positions, reasonable basis
(c) In assisting the taxpayer in tax planning related to a tax shelter, the practitioner should inform the taxpayer of the penalty risks associated with the tax position recommended that does not possess sufficient authority to satisfy the more likely than not standard.
(d) Should not prepare or sign a tax return if the CPA knows the return takes a position that the CPA could not recommend under (b) above.
(e) Notwithstanding (b) and (c), a CPA may recommend a position for which there is a reasonable basis so long as the position is adequately disclosed on the return or claim for refund. In determining whether a given standard has been satisfied, a CPA should consider a well-reasoned construction of the applicable stature, well-reasoned articles or treatises, and pronouncements issued by the applicable taxing authority.
(f) Should advise the client of the potential penalty consequences of any recommended tax position.
(2) A CPA should not recommend a tax position that exploits the IRS audit process, or serves as a mere arguing position advanced solely to obtain leverage in bargaining with the IRS.
(3) A CPA has both the right and the responsibility to be an advocate for the client.
b. Realistic Possibility and More Likely Than Not Standards
(1) The CPA should consider the weight of each authority (e.g., Code, Regs., court decisions, well-reasoned treaties, article in professional tax publications, etc.) in determining whether these standards are met, and may rely on well-reasoned treatises and articles in recognized professional tax publications.
(2) Realistic possibility of success may require as much as a one-third likelihood of success.
(3) The more likely than not standard requires more than 50% probability of success.
c. Answers to Questions on Returns
(1) A CPA should make a reasonable effort to obtain from the client and provide appropriate answers to all questions on a tax return before signing as preparer.
(2) When reasonable grounds for omitting an answer exist, the CPA is not required to provide an explanation on the return of the reason for omission. Reasonable grounds for omitting an answer include
(a) Information is not readily available and the answer is not significant in terms of taxable income or tax liability.
(b) Uncertainty as to meaning of question.
(c) Answer is voluminous and return states that data will be supplied upon examination.
d. Procedural Aspects of Preparing Returns
(1) A CPA may in good faith rely without verification upon information furnished by the client or by third parties, and is not required to audit, examine, or review books, records, or documents in order to independently verify the taxpayer’s information.
(a) However, the CPA should not ignore implications of information furnished and should make reasonable inquires if information appears incorrect, incomplete, or inconsistent.
(b) When feasible, the CPA should refer to the client’s past returns.
(2) Where the IRS imposes a condition for deductibility or other treatment of an item (e.g., requires supporting documentation), the CPA should make appropriate inquiries to determine whether the condition for deductibility has been met.
(3) When preparing a tax return, a CPA should consider information known from the tax return of another client if that information is relevant to the return being prepared, and such consideration does not violate any rule regarding confidentiality.
e. Use of Estimates
(1) Where data is missing (e.g., result of a fire, computer failure), estimates of the missing data may be made by the client.
(2) A CPA may prepare a tax return using estimates if it is impracticable to obtain exact data, and the estimated amounts are reasonable.
(3) An estimate should not imply greater accuracy than actually exists (e.g., estimate $1,000 rather than $999.32).
f. Departure from Position Previously Concluded in an IRS Proceeding or Court Decision
(1) Unless the taxpayer is bound to a specified treatment in the later year, such as by a formal closing agreement, the treatment of an item as part of concluding an IRS proceeding or as part of a court decision in a prior year, does not restrict the CPA from recommending a different tax treatment in a later year’s return.
(2) Court decisions, rulings, or other authorities more favorable to the taxpayer’s current position may have developed since the prior proceeding was concluded or the prior court decision was rendered.
g. Knowledge of Error: Return Preparation
(1) The term “error” as used here includes any position, omission, or method of accounting that, at the time the return is filed, fails to meet the standards as outlined in a. and b. above. An error does not include an item that has an insignificant effect on the client’s tax liability.
(2) A CPA should inform a client promptly upon becoming aware of a material error in a previously filed return or upon becoming aware of a client’s failure to file a required return. A CPA
(a) Should recommend (either orally or in writing) measures to be taken.
(b) Is not obligated to inform the IRS of the error, and may not do so without the client’s permission, except where required by law.
(3) If the CPA is requested to prepare the client’s current return, and the client has not taken appropriate action to correct an error in a prior year’s return, the CPA should consider whether to continue a professional relationship with the client or withdraw.
h. Knowledge of Error: Administrative Proceedings
(1) When a CPA is representing a client in an IRS proceeding (e.g., examination, appellate conference) with respect to a return that contains an error of which the CPA has become aware, the CPA should promptly inform the client and recommend measures to be taken.
(2) The CPA should request the client’s permission to disclose the error to the IRS, and lacking such permission, should consider whether to withdraw from representing the client.
i. Form and Content of Advice to Clients
(1) No standard format is required in communicating written or oral advice to a client, but CPA should comply with standards of taxing authority
(2) In deciding on the form of advice provided (e.g., oral or written) the CPA should consider the importance of the transaction and the amounts, the specific or general nature or the inquiry, the technical complexity involved, the existence of authorities and precedents, the sophistication of the taxpayer, the type of transaction and whether it is subject to heightened reporting or disclosure, and the potential penalties involved.
(3) A CPA may choose to communicate with a client when subsequent developments affect previous advice. Such communication is only required when the CPA undertakes this obligation by specific agreement with the client.
3. Treasury Department Circular 230
a. Rules Governing Authority to Practice
(1) Practice before the IRS comprehends all matters connected with a presentation to the IRS including (but not limited to) preparing and filing documents, corresponding and communicating with the IRS, rendering written advice with respect to any entity, transactions, plan or arrangement, and representing a client at conferences, hearings, and meetings.
(2) Practice before the IRS is limited to CPAs, attorneys, enrolled agents (EAs), and for limited purposes enrolled actuaries, enrolled retirement plan agents, and registered tax return preparers (RTRP). Enrollment as an EA, retirement plan agent, or RTRP is granted if the individual is at least 18 years old and demonstrates competence in tax matters by passing an examination. Additionally, certain former employees of the IRS may be granted the right to practice as an enrolled agent by virtue of service and experience.
(a) Practice as a RTRP is limited to preparing and signing tax returns and claims for refund, and other documents for submission to the IRS. A RTRP may represent taxpayers before revenue agents, customer service representatives, or similar employees of the IRS during an examination if the RTRP signed the tax return or claim for refund for the taxable year or period under examination.
(b) A RTRP’s right to practice does not permit such individual to represent the taxpayer before appeals officers, revenue officers, counsel, or similar employees of the IRS. Similarly, a RTRP is not authorized to provide tax advice to a client except as necessary to prepare a tax return, claim for refund, or other documents to be submitted to the IRS.
(3) All paid tax return preparers (including CPAs, attorneys, and EAs) must register with the IRS, pay an annual fee, and obtain a Preparer Tax Identification Number (PTIN) before preparing or signing taxpayers’ tax returns or claims for refund. The IRS Office of Professional Responsibility will oversee PTIN registrations, enrollment, and renewal processes, and will oversee future testing and continuing education requirements.
(4) Individuals may appear on their own behalf before the IRS. Also, an individual who is not a practitioner may represent a taxpayer before the IRS in limited situations. This group includes members of the taxpayer’s immediate family; full-time employees may represent their employers; an officer or full-time employee may represent a corporation; a general partner or full-time employee of a partnership may represent the partnership; and trusts, receiverships, guardianships, or estates may be represented by their trustees, receivers, guardians, or executors.
b. Duties and Restrictions Relating to Practice Before the IRS
(1) A practitioner must promptly submit records or information in any matter before the IRS unless the practitioner believes in good faith and on reasonable grounds that the records or information are privileged.
(2) A practitioner must, at the request of a client, promptly return the client’s records. The client’s records include all documents and electronic media provided to the practitioner. The existence of a dispute over fees generally does not allow the practitioner to retain records.
(3) A practitioner who becomes aware that a client has not complied with the revenue laws or has made an error in or omission from any return must advise the client promptly of the fact of such noncompliance, error, or omission, and must advise the client of the consequences under the law of such noncompliance, error, or omission.
(4) A practitioner must exercise due diligence in preparing returns and documents relating to IRS matters, as well as in determining the correctness of oral and written representations to clients and the Department of the Treasury. A practitioner may rely on the work product of another person if the practitioner used reasonable care in engaging, supervising, training, and evaluating the person.
(5) A practitioner may not charge an unconscionable fee and generally may not charge a contingent fee for preparing an original return. However, a contingent fee may be charged in connection with the IRS’s examination of an original tax return, or an amended return or claim for refund or credit. Also, a contingent fee may be charged for services rendered in connection with any judicial proceeding arising under the Code.
(6) A practitioner may publish the availability of a written fee schedule including fixed fees for specific routine services, hourly rates, ranges of fees for specific services, and the fee charged for an initial consultation. The practitioner may charge no more than the published fees for at least 30 days after the last date on which the fee schedule was published.
(7) A practitioner may not use any form of public communication or private solicitation containing a false, fraudulent, or coercive statement or claim, nor a misleading or deceptive statement or claim. Enrolled agents may not utilize the word “certified” or imply an employer/employee relationship with the IRS.
(8) Tax advisors should provide clients with the highest quality representation concerning Federal tax issues by adhering to best practices in providing advice and in preparing or assisting in the preparation of a submission to the IRS.
(9) A practitioner who prepares returns may not endorse nor negotiate any federal tax refund check issued to a client by the government.
c. Standards for Returns and Advising
(1) A practitioner may not willfully, recklessly, or through gross incompetence sign a tax return or claim for refund that the practitioner reasonably should know contains a position that lacks a reasonable basis, is an unreasonable position, or is a willful attempt to understate tax liability or a reckless or intentional disregard of rules and regulations. The prohibition also applies to advising a client to take a position on a tax return or claim for refund that lacks a reasonable basis, or preparing a portion of a tax return or claim for refund containing a position that lacks a reasonable basis. The reasonable basis standard may require at least a 20% probability of a position being sustained on its merits.
(2) A practitioner may not advise a client to take a position on a document, affidavit, or other paper submitted to the IRS that is frivolous, nor advise a client to submit documents with the intent of delaying or impeding the administration of federal tax laws. A frivolous position is one without basis in fact or law, or that espouses a position that the courts have held to be frivolous or groundless.
(3) A practitioner must inform a client of any penalties that are likely to apply to a position taken on a return, and must inform the client of any opportunity to avoid penalties by disclosure and the requirements of adequate disclosure.
(4) A practitioner may rely in good faith without verification upon information furnished by the client, but must make reasonable inquiries if the information furnished appears to be incorrect, incomplete, or inconsistent with other facts.
(5) Practitioners providing written advice must adhere to specific standards. Written advice is categorized as either (1) covered opinions, or (2) all other written advice. More stringent standards apply to covered opinions because taxpayers may rely on a practitioner’s covered opinion to avoid penalties.
(a) Written advice is generally considered to be a covered opinion if it involves a listed transaction, or a place or arrangement the principal purpose of which is tax avoidance, or any plan or arrangement in which tax avoidance is a significant purpose if the advice is either a reliance opinion, a marketed opinion, subject to confi dentiality, or subject to contractual protection.
(b) Advice that does not constitute a covered opinion is subject to more relaxed standards but practitioners must not base their advice on unreasonable assumptions nor rely on unreasonable representations of the taxpayer or others.
(c) Written advice is a reliance opinion if the advice concludes that it is more likely than not (a greater than 50% likelihood) that one or more significant federal tax issues would be resolved in the taxpayer’s favor. Written advice (other than advice on listed transactions and advice having the principal purpose of tax avoidance or evasion) is not treated as a reliance opinion if the practitioner prominently discloses in the written advice that it was not intended or written by the practitioner to be used, and that it cannot be used by the taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer.
(d) As a result, most practitioners include a standard disclaimer with written correspondence that is intended as informal advice and explicitly not intended to satisfy the reliance opinion requirements. A typical disclaimer may read:
4. Preparer Penalties
a. A preparer is subject to a penalty equal to the greater of $1,000, or 50% of the income derived (or to be derived) by the preparer with respect to the return or refund claim if any part of an understatement of liability with respect to the return or claim is due to an undisclosed position on the return or refund claim for which there is not substantial authority.
(1) Substantial authority exists if the weight of authorities supporting the position is substantial in relation to the weight of those that take a contrary position. The substantial authority standard may require at least a 40% probability of being sustained on its merits.
(2) The penalty can be avoided by
(a) An adequate disclosure of the questionable position on the return or refund claim.
(b) A showing that there was a reasonable basis for the position. The reasonable basis standard may require at least a 20% probability of being sustained on its merits.
(3) A higher more likely than not standard applies if the position is with respect to a tax shelter as defined in Sec. 6662 (d)(2)(C)(ii) or a reportable transaction to which Sec. 6662A applies. This standard requires a more than 50% probability of being sustained on its merits.
(4) The penalty can also be avoided if the preparer can show there was a reasonable cause for the understatement and that the return preparer acted in good faith.
b. If any part of an understatement of liability with respect to a return or refund claim is due (1) to a willful attempt to understate tax liability by a return preparer with respect to the return or claim, or (2) to any reckless or intentional disregard of rules or regulations, the preparer is subject to a penalty equal to the greater of $5,000, or 50% of the income derived (or to be derived) by the preparer with respect to the return or refund claim.
(1) This penalty is reduced by the penalty paid in a. above.
(2) Rules and regulations include the Internal Revenue Code, Treasury Regulations, and Revenue Rulings.
c. Additional penalties may be imposed on preparers if they fail to fulfill the following requirements (unless failure is due to reasonable cause):
(1) Preparer must sign returns done for compensation.
(2) Preparer must provide a copy of the return or refund claim to the taxpayer no later than when the preparer presents a copy of the return to the taxpayer for signing.
(3) Returns and claims for refund must contain the social security number of preparer and identification number of preparer’s employer or partnership (if any).
(4) Preparer must either keep a list of those for whom returns were filed with specified information, or copies of the actual returns, for three years.
(5) Employers of return preparers must retain a listing of return preparers and place of employment for three years.
(6) Preparer must not endorse or negotiate a refund check issued to a taxpayer.
(7) Preparer must not disclose information furnished in connection with the preparation of a tax return, unless for quality or peer review, or under an administrative order by a regulatory agency.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 57 THROUGH 79

KEY TERMS

Common Law. Law that has historically been established by judicial precedents. Much common law has now been codified in state statutes. This law is the source of liability to clients and third parties (not covered by securities laws).

Constructive fraud. Failure to even use slight care. Constructive fraud is often referred to as gross negligence.

Contributory negligence. Negligence on the part of the plaintiff that contributed to that party’s losses. Contributory negligence will typically mitigate some or all of the defendant’s damages.

Due diligence. The standard of care required under filings under the Securities Act of 1933. To establish “due diligence” an accountant must have made a reasonable investigation, and must have had reasonable grounds to believe and did believe that that the registration statement (including the financial statements) were not misleading.

Fraud. A misrepresentation intended to mislead another party or a representation made with a reckless disregard for its truth.

Joint and several liability. A concept of liability that is similar to joint liability except that if all of the judgment is recovered from one defendant that party may attempt to collect from other defendants their proportionate shares of the judgment. As an example, assume a bank files suit against both the CPA firm and management for misleading financial statements, and the CPA firm is found to be 30% liable and management is found to be 70% liable. The bank may recover 100% of the judgment from the CPA firm and it is up to the CPA firm to collect from management its share of the judgment.

Joint Ethics Enforcement Program (JEEP). A joint program of the American Institute of Certified Public Accountants (AICPA) and state CPA societies to jointly investigate ethics violations.

Joint liability. A liability concept in which any joint defendant may be forced to pay the entire amount of a judgment. As an example, if a bank files suit against both the CPA firm and management for misleading financial statements, the bank may recover the entire amount from management or the CPA firm.

Negligence. Failure to perform with the level of skill and judgment possessed by a typical professional. Negligence is often referred to as ordinary negligence.

Primary beneficiary. A party other than the client who primarily benefits from the contracted services provided by the CPA. As an example, if the CPA is aware that an audit is being performed at the request of the client’s bank, the bank is a primary beneficiary of the contract between the CPA and the client. Under common law a primary beneficiary has the same rights as the client.

Privileged communication. Communication that is not subject to disclosure in court or administrative proceedings. Privilege must be established by law, and generally the communication between an accountant and a client is not privileged.

Privity. A mutual relationship established between parties typically established by a contract. The client and third-party beneficiaries are in privity with the CPA in a contract to provide services.

Public Company Accounting Oversight Board (PCAOB). A nonprofit organization created by the Sarbanes-Oxley Act to oversee the audits of public companies (issuers).

Public Company Accounting Reform and Investor Protection (Sarbanes-Oxley) Act. An act that set a new set of enhanced standards for public company boards, management, and public accounting firms. The Act established the Public Company Accounting Oversight Board (PCAOB).

Racketeer Influenced and Corrupt Organization (RICO) Act. An act designed to allow prosecution of organized criminals. However, the Act has been used to pursue CPA firms who engage in multiple instances (a pattern) of wrongful acts. Civil actions under the Act can result in recovery of treble damages.

Securities Act of 1933. A federal securities act that covers the initial registration of securities.

Securities Exchange Act of 1934. A federal securities act that covers the secondary purchase and sale of securities.

Several liability. A concept of liability in which joint defendants are responsible for only their proportionate share of the judgment. As an example, assume that a bank files suit against both the CPA firm and management for misleading financial statements, and the CPA firm is found to be 30% liable and management is found to be 70% liable. The bank may recover only 30% of the judgment from the CPA firm. The remaining amount must be recovered by the bank from management.

State boards of accountancy. State boards that regulate the practice of public accountancy in a state or jurisdiction. All individual CPAs and CPA firms must be licensed to practice in the states where they practice.

Statements on Standards for Tax Services. AICPA standards for CPAs that perform tax services for clients.

Treasury Department Circular 230. Regulatory requirements regarding the authority to practice before the Internal Revenue Service.

US Securities and Exchange Commission (SEC). A federal agency with primary responsibility for enforcing the federal securities laws and regulating the securities industry.

Multiple-Choice Questions (1–79)

A. Regulation of the Profession

1. Which of the following bodies issue permits to practice for CPAs?

a. The AICPA.

b. The SEC.

c. The state boards of accountancy.

d. The PCAOB.

2. Which of the following is not an accurate statement about the requirements of the AICPA Uniform Accountancy Act (UAA)?

a. The UAA requires all accountants to be licensed.

b. The UAA contains requirements for the issuance of CPA certificates.

c. The UAA contains a substantial equivalency provision to allow for movement between states.

d. The UAA contains provisions for continuing education.

B. Disciplinary Systems of the Profession and Regulatory Bodies

3. Which of the following is not a possible result of an AICPA investigation of a member for an ethics violation?

a. Revocation of right to prepare tax returns.

b. Admonishment.

c. Corrective action.

d. Expulsion.

4. Which of the following may not result in automatic expulsion from the AICPA?

a. Revocation of CPA certificate by an authorized body.

b. Filing a fraudulent tax return.

c. Failure to file a required tax return.

d. Conviction for a felony or a misdemeanor.

5. A member of the AICPA is convicted of filing a fraudulent tax return. What is the likely consequence of this action?

a. The CPA will likely be expelled or suspended from membership in the AICPA.

b. The CPA will likely be admonished by the AICPA.

c. The CPA will likely have his or her permit to practice revoked by the AICPA.

d. The AICPA will take no action because the court has already taken sufficient action.

C.1. Common Law Liability to Clients

6. Cable Corp. orally engaged Drake & Co., CPAs, to audit its financial statements. Cable’s management informed Drake that it suspected the accounts receivable were materially overstated. Though the financial statements Drake audited included a materially overstated accounts receivable balance, Drake issued an unqualified opinion. Cable used the financial statements to obtain a loan to expand its operations. Cable defaulted on the loan and incurred a substantial loss.

If Cable sues Drake for negligence in failing to discover the overstatement, Drake’s best defense would be that Drake did not

a. Have privity of contract with Cable.

b. Sign an engagement letter.

c. Perform the audit recklessly or with an intent to deceive.

d. Violate generally accepted auditing standards in performing the audit.

7. Which of the following statements best describes whether a CPA has met the required standard of care in conducting an audit of a client’s financial statements?

a. The client’s expectations with regard to the accuracy of audited financial statements.

b. The accuracy of the financial statements and whether the statements conform to generally accepted accounting principles.

c. Whether the CPA conducted the audit with the same skill and care expected of an ordinarily prudent CPA under the circumstances.

d. Whether the audit was conducted to investigate and discover all acts of fraud.

8. Ford & Co., CPAs, issued an unqualified opinion on Owens Corp.’s financial statements. Relying on these financial statements, Century Bank lent Owens $750,000. Ford was unaware that Century would receive a copy of the financial statements or that Owens would use them to obtain a loan. Owens defaulted on the loan.

To succeed in a common law fraud action against Ford, Century must prove, in addition to other elements, that Century was

a. Free from contributory negligence.

b. In privity of contract with Ford.

c. Justified in relying on the financial statements.

d. In privity of contract with Owens.

9. When performing an audit, a CPA

a. Must exercise the level of care, skill, and judgment expected of a reasonably prudent CPA under the circumstances.

b. Must strictly adhere to generally accepted accounting principles.

c. Is strictly liable for failing to discover client fraud.

d. Is not liable unless the CPA commits gross negligence or intentionally disregards generally accepted auditing standards.

10. When performing an audit, a CPA will most likely be considered negligent when the CPA fails to

a. Detect all of a client’s fraudulent activities.

b. Include a negligence disclaimer in the client engagement letter.

c. Warn a client of known internal control weaknesses.

d. Warn a client’s customers of embezzlement by the client’s employees.

Items 11 through 14 are based on the following:

Edgar, CPA, reviewed the financial statements of Yoke Company (a nonissuer company). In performing the review Edgar failed to discover that a supplier had been overbilling Yoke for purchases for a number of years. Yoke filed a lawsuit against Edgar for negligence in performing the review.

11. Under which of the following sources of law would this lawsuit likely be filed?

a. The Securities Act of 1933.

b. The Securities Exchange Act of 1934.

c. Common law.

d. State securities law.

12. What would be essential to proving Yoke’s case against Edgar?

a. Failure to adhere to generally accepted auditing standards.

b. Reckless disregard for professional standards.

c. Ordinary negligence in the performance of the review.

d. Gross negligence in the performance of the review.

13. Which of the following would not likely be part of Edgar’s defense in this lawsuit?

a. Contributory negligence.

b. Performance of the engagement in accordance with Statement for Accounting and Review Services.

c. A review cannot be relied upon to detect fraud.

d. Misrepresentations by management.

14. Assuming that Yoke prevails in proving negligence by Edgar in this case, which of the following is the most accurate statement about the damages that would be awarded? Assume that no other party, including Yoke, was found to be partially responsible for the losses.

a. Edgar would be responsible for all of the overbillings that occurred.

b. Edgar would be responsible for overbillings occurring since the date he should have detected the scheme.

c. Edgar would be responsible only for returning the fees for the engagement.

d. Edgar would not be held responsible for any damages unless he is also found to be in violation of some criminal law.

15. A CPA’s duty of due care to a client most likely will be breached when a CPA

a. Gives a client an oral instead of written report.

b. Gives a client incorrect advice based on an honest error of judgment.

c. Fails to give tax advice that saves the client money.

d. Fails to follow generally accepted auditing standards.

16. Which of the following elements, if present, would support a finding of constructive fraud on the part of a CPA?

a. Gross negligence in applying generally accepted auditing standards.

b. Ordinary negligence in applying generally accepted accounting principles.

c. Identified third-party users.

d. Scienter.

C.2. Common Law Liability to Third Parties (Nonclients)

17. If a CPA recklessly departs from the standards of due care when conducting an audit, the CPA will be liable to third parties who are unknown to the CPA based on

a. Negligence.

b. Gross negligence.

c. Strict liability.

d. Criminal deceit.

18. In a common law action against an accountant, lack of privity is a viable defense if the plaintiff

a. Is the client’s creditor who sues the accountant for negligence.

b. Can prove the presence of gross negligence that amounts to a reckless disregard for the truth.

c. Is the accountant’s client.

d. Bases the action upon fraud.

19. A CPA audited the financial statements of Shelly Company. The CPA was negligent in the audit. Sanco, a supplier of Shelly, is upset because Sanco had extended Shelly a high credit limit based on the financial statements which were incorrect. Which of the following statements is the most correct?

a. In most states, both Shelly and Sanco can recover from the CPA for damages due to the negligence.

b. States that use the Ultramares decision will allow both Shelly and Sanco to recover.

c. In most states, Sanco cannot recover as a mere foreseeable third party.

d. Generally, Sanco can recover but Shelly cannot.

20. Under the Ultramares rule, to which of the following parties will an accountant be liable for negligence?

Parties in privity Foreseen parties
a. Yes Yes
b. Yes No
c. No Yes
d. No No

Items 21 and 22 are based on the following:

While conducting an audit, Larson Associates, CPAs, failed to detect material misstatements included in its client’s financial statements. Larson’s unqualified opinion was included with the financial statements in a registration statement and prospectus for a public offering of securities made by the client. Larson knew that its opinion and the financial statements would be used for this purpose.

21. In a suit by a purchaser against Larson for common law negligence, Larson’s best defense would be that the

a. Audit was conducted in accordance with generally accepted auditing standards.

b. Client was aware of the misstatements.

c. Purchaser was not in privity of contract with Larson.

d. Identity of the purchaser was not known to Larson at the time of the audit.

22. In a suit by a purchaser against Larson for common law fraud, Larson’s best defense would be that

a. Larson did not have actual or constructive knowledge of the misstatements.

b. Larson’s client knew or should have known of the misstatements.

c. Larson did not have actual knowledge that the purchaser was an intended beneficiary of the audit.

d. Larson was not in privity of contract with its client.

C.3. Statutory Liability to Third Parties—Securities Act of 1933

23. Quincy bought Teal Corp. common stock in an offering registered under the Securities Act of 1933. Worth & Co., CPAs, gave an unqualified opinion on Teal’s financial statements that were included in the registration statement filed with the SEC. Quincy sued Worth under the provisions of the 1933 Act that deal with omission of facts required to be in the registration statement. Quincy must prove that

a. There was fraudulent activity by Worth.

b. There was a material misstatement in the financial statements.

c. Quincy relied on Worth’s opinion.

d. Quincy was in privity with Worth.

24. Beckler & Associates, CPAs, audited and gave an unqualified opinion on the financial statements of Queen Co. The financial statements contained misstatements that resulted in a material overstatement of Queen’s net worth. Queen provided the audited financial statements to Mac Bank in connection with a loan made by Mac to Queen. Beckler knew that the financial statements would be provided to Mac. Queen defaulted on the loan. Mac sued Beckler to recover for its losses associated with Queen’s default. Which of the following must Mac prove in order to recover?

I. Beckler was negligent in conducting the audit.

II. Mac relied on the financial statements.

a. I only.

b. II only.

c. Both I and II.

d. Neither I nor II.

Items 25 and 26 are based on the following:

Dart Corp. engaged Jay Associates, CPAs, to assist in a public stock offering. Jay audited Dart’s financial statements and gave an unqualified opinion, despite knowing that the financial statements contained misstatements. Jay’s opinion was included in Dart’s registration statement. Larson purchased shares in the offering and suffered a loss when the stock declined in value after the misstatements became known.

25. In a suit against Jay and Dart under the Section 11 liability provisions of the Securities Act of 1933, Larson must prove that

a. Jay knew of the misstatements.

b. Jay was negligent.

c. The misstatements contained in Dart’s financial statements were material.

d. The unqualified opinion contained in the registration statement was relied on by Larson.

26. If Larson succeeds in the Section 11 suit against Dart, Larson would be entitled to

a. Damages of three times the original public offering price.

b. Rescind the transaction.

c. Monetary damages only.

d. Damages, but only if the shares were resold before the suit was started.

Items 27 and 28 are based on the following:

Under the liability provisions of Section 11 of the Securities Act of 1933, a CPA may be liable to any purchaser of a security for certifying materially misstated financial statements that are included in the security’s registration statement.

27. Under Section 11, a CPA usually will not be liable to the purchaser

a. If the purchaser is contributorily negligent.

b. If the CPA can prove due diligence.

c. Unless the purchaser can prove privity with the CPA.

d. Unless the purchaser can prove scienter on the part of the CPA.

28. Under Section 11, which of the following must be proven by a purchaser of the security?

Reliance on the financial statements Fraud by the CPA
a. Yes Yes
b. Yes No
c. No Yes
d. No No

29. Ocean and Associates, CPAs, audited the financial statements of Drain Corporation. As a result of Ocean’s negligence in conducting the audit, the financial statements included material misstatements. Ocean was unaware of this fact. The financial statements and Ocean’s unqualified opin-ion were included in a registration statement and prospectus for an original public offering of stock by Drain. Sharp purchased shares in the offering. Sharp received a copy of the prospectus prior to the purchase but did not read it. The shares declined in value as a result of the misstatements in Drain’s financial statements becoming known. Under which of the following Acts is Sharp most likely to prevail in a lawsuit against Ocean?

Securities Exchange Act of 1934, Section 10(b), Rule 10b-5 Securities Act of 1933, Section 11
a. Yes Yes
b. Yes No
c. No Yes
d. No No

30. Danvy, a CPA, performed an audit for Lank Corporation. Danvy also performed an S-1 review to review events subsequent to the balance sheet date. If Danvy fails to further investigate suspicious facts, under which of these can he be found negligent?

a. The audit but not the review.

b. The review but not the audit.

c. Neither the audit nor the review.

d. Both the audit and the review.

C.4. Statutory Liability to Third Parties—Securities Exchange Act of 1934

31. Dart Corp. engaged Jay Associates, CPAs, to assist in a public stock offering. Jay audited Dart’s financial statements and gave an unqualified opinion, despite knowing that the financial statements contained misstatements. Jay’s opinion was included in Dart’s registration statement. Larson purchased shares in the offering and suffered a loss when the stock declined in value after the misstatements became known.

In a suit against Jay under the antifraud provisions of Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, Larson must prove all of the following except

a. Larson was an intended user of the false registration statement.

b. Larson relied on the false registration statement.

c. The transaction involved some form of interstate commerce.

d. Jay acted with intentional disregard of the truth.

32. Under the antifraud provisions of Section 10(b) of the Securities Exchange Act of 1934, a CPA may be liable if the CPA acted

a. Negligently.

b. With independence.

c. Without due diligence.

d. Without good faith.

33. Under Section 11 of the Securities Act of 1933, which of the following standards may a CPA use as a defense?

Generally accepted accounting principles Generally accepted fraud detection standards
a. Yes Yes
b. Yes No
c. No Yes
d. No No

34. Dart Corp. engaged Jay Associates, CPAs, to assist in a public stock offering. Jay audited Dart’s financial statements and gave an unqualified opinion, despite knowing that the financial statements contained misstatements. Jay’s opinion was included in Dart’s registration statement. Larson purchased shares in the offering and suffered a loss when the stock declined in value after the misstatements became known.

If Larson succeeds in the Section 10(b) and Rule 10b-5 suit, Larson would be entitled to

a. Only recover the original public offering price.

b. Only rescind the transaction.

c. The amount of any loss caused by the fraud.

d. Punitive damages.

D.1. Accountant’s Working Papers

35. Which of the following statements is correct with respect to ownership, possession, or access to a CPA firm’s audit working papers?

a. Working papers may never be obtained by third parties unless the client consents.

b. Working papers are not transferable to a purchaser of a CPA practice unless the client consents.

c. Working papers are subject to the privileged communication rule which, in most jurisdictions, prevents any third-party access to the working papers.

d. Working papers are the client’s exclusive property.

36. Which of the following statements is correct regarding a CPA’s working papers? The working papers must be

a. Transferred to another accountant purchasing the CPA’s practice even if the client hasn’t given permission.

b. Transferred permanently to the client if demanded.

c. Turned over to any government agency that requests them.

d. Turned over pursuant to a valid federal court subpoena.

37. To which of the following parties may a CPA partnership provide its working papers, without being lawfully subpoenaed or without the client’s consent?

a. The IRS.

b. The FASB.

c. Any surviving partner(s) on the death of a partner.

d. A CPA before purchasing a partnership interest in the firm.

38. To which of the following parties may a CPA partnership provide its working papers without either the client’s consent or a lawful subpoena?

The IRS The FASB
a. Yes Yes
b. Yes No
c. No Yes
d. No No

D.2. Privileged Communications between Accountant and Client

39. A CPA is permitted to disclose confidential client information without the consent of the client to

I. Another CPA who has purchased the CPA’s tax practice.

II. Another CPA firm if the information concerns suspected tax return irregularities.

III. A state CPA society voluntary quality control review board.

a. I and III only.

b. II and III only.

c. II only.

d. III only.

40. Thorp, CPA, was engaged to audit Ivor Co.’s financial statements. During the audit, Thorp discovered that Ivor’s inventory contained stolen goods. Ivor was indicted and Thorp was subpoenaed to testify at the criminal trial. Ivor claimed accountant-client privilege to prevent Thorp from testifying. Which of the following statements is correct regarding Ivor’s claim?

a. Ivor can claim an accountant-client privilege only in states that have enacted a statute creating such a privilege.

b. Ivor can claim an accountant-client privilege only in federal courts.

c. The accountant-client privilege can be claimed only in civil suits.

d. The accountant-client privilege can be claimed only to limit testimony to audit subject matter.

41. A violation of the profession’s ethical standards most likely would have occurred when a CPA

a. Issued an unqualified opinion on the 2002 financial statements when fees for the 2001 audit were unpaid.

b. Recommended a controller’s position description with candidate specifications to an audit client.

c. Purchased a CPA firm’s practice of monthly write-ups for a percentage of fees to be received over a three-year period.

d. Made arrangements with a financial institution to collect notes issued by a client in payment of fees due for the current year’s audit.

42. Which of the following statements concerning an accountant’s disclosure of confidential client data is generally correct?

a. Disclosure may be made to any state agency without subpoena.

b. Disclosure may be made to any party on consent of the client.

c. Disclosure may be made to comply with an IRS audit request.

d. Disclosure may be made to comply with generally accepted accounting principles.

E. Criminal Liability

43. A CPA may be held criminally liable under any of the following, except:

a. The Securities Act of 1933.

b. Common law.

c. The Racketeer Influenced and Corrupt Organizations Act.

d. Federal tax laws.

44. Which of the following acts allows civil suits with the potential recovery of treble damages?

a. The Racketeer Influenced and Corrupt Organizations Act.

b. The Securities Act of 1933.

c. The Securities Exchange Act of 1934.

d. Federal tax acts.

F. Responsibilities of Auditors under Private Securities Litigation Reform Act

45. McGee is auditing Nevus Corporation and detects probable criminal activity by one of the employees. McGee believes this will have a material impact on the financial statements. The financial statements of Nevus Corporation are under the Securities Exchange Act of 1934. Which of the following is correct?

a. McGee should report this to the Securities Exchange Commission.

b. McGee should report this to the Justice Department.

c. McGee should report this to Nevus Corporation’s audit committee or board of directors.

d. McGee will discharge his duty by requiring that a note of this be included in the financial statements.

46. Which of the following is an auditor not required to establish procedures for under the Private Securities Litigation Reform Act?

a. To develop a comprehensive internal control system.

b. To evaluate the ability of the firm to continue as a going concern.

c. To detect material illegal acts.

d. To identify material related-party transactions.

47. Which of the following is an auditor required to do under the Private Securities Litigation Reform Act concerning audits under the Federal Securities Exchange Act of 1934?

I. Establish procedures to detect material illegal acts of the client being audited.

II. Evaluate the ability of the firm being audited to continue as a going concern.

a. Neither I nor II.

b. I only.

c. II only.

d. Both I and II.

48. Lin, CPA, is auditing the financial statements of Exchange Corporation under the Federal Securities Exchange Act of 1934. He detects what he believes are probable material illegal acts. What is his duty under the Private Securities Litigation Reform Act?

a. He must inform the principal shareholders within ten days.

b. He must inform the audit committee or the board of directors.

c. He need not inform anyone, beyond requiring that the financial statements are presented fairly.

d. He should not inform anyone since he owes a duty of confidentiality to the client.

49. The Private Securities Litigation Reform Act

a. Applies only to securities not purchased from a stock exchange.

b. Does not apply to common stock of a publicly held corporation.

c. Amends the Federal Securities Act of 1933 and the Federal Securities Exchange Act of 1934.

d. Does not apply to preferred stock of a publicly held corporation.

50. Bran, CPA, audited Frank Corporation. The shareholders sued both Frank and Bran for securities fraud under the Federal Securities Exchange Act of 1934. The court determined that there was securities fraud and that Frank was 80% at fault and Bran was 20% at fault due to her negligence in the audit. Both Frank and Bran are solvent and the damages were determined to be $1 million. What is the maximum liability of Bran?

a. $0

b. $ 200,000

c. $ 500,000

d. $1,000,000

G. Responsibilities under Sarbanes-Oxley Act

51. Which of the following nonattest services are auditors allowed to perform for a public company?

a. Bookkeeping services.

b. Appraisal services.

c. Tax services.

d. Internal audit services.

52. Which of the following Boards has the responsibility to regulate CPA firms that audit public companies?

a. Auditing Standards Board.

b. Public Oversight Board.

c. Public Company Accounting Oversight Board.

d. Accounting Standards Board.

53. The Sarbanes-Oxley Act includes all of the following provisions, except:

a. Penalties for failure to retain audit workpapers.

b. Requirement for registration of CPA firms to audit public companies.

c. Requirement for inspection of public-company audits.

d. Requirement for a minimum level of experience for audit partners.

54. Under the Sarbanes-Oxley Act, which of the following individuals are required personally to certify to the accuracy of financial statements filed with the SEC?

a. The chief financial officer and the chief executive officer.

b. The chief financial officer, the chief executive officer, and the controller.

c. The audit partner and the chief executive officer.

d. The chairman of the board, the chief executive officer, and the chief financial officer.

55. Generally a Form 8-K must be filed with the SEC

a. Annually.

b. Quarterly.

c. Within four days of the occurrence of a triggering event.

d. Within 10 days of the occurrence of a triggering event.

56. The Sarbanes-Oxley Act of 2002 requires rotation of the audit partner on a public company audit at least every

a. 3 years.

b. 5 years.

c. 7 years.

d. 10 years.

I. Responsibilities of Tax Return Preparers

57. Which of the following acts constitute(s) grounds for a tax preparer penalty?

I. Without the taxpayer’s consent, the tax preparer disclosed taxpayer income tax return information under an order from a state court.

II. At the taxpayer’s suggestion, the tax preparer deducted the expenses of the taxpayers’ personal domestic help as a business expense on the taxpayer’s individual tax return.

a. I only.

b. II only.

c. Both I and II.

d. Neither I nor II.

58. Vee Corp. retained Water, CPA, to prepare its 2013 income tax return. During the engagement, Water discovered that Vee had failed to file its 2008 income tax return. What is Water’s professional responsibility regarding Vee’s unfiled 2008 income tax return?

a. Prepare Vee’s 2008 income tax return and submit it to the IRS.

b. Advise Vee that the 2008 income tax return has not been filed and recommend that Vee ignore filing its 2008 return since the statute of limitations has passed.

c. Advise the IRS that Vee’s 2008 income tax return has not been filed.

d. Consider withdrawing from preparation of Vee’s 2013 income tax return until the error is corrected.

59. To avoid tax return preparer penalties for a return’s understated tax liability due to an intentional disregard of the regulations, which of the following actions must a tax preparer take?

a. Audit the taxpayer’s corresponding business operations.

b. Review the accuracy of the taxpayer’s books and records.

c. Make reasonable inquiries if the taxpayer’s information is incomplete.

d. Examine the taxpayer’s supporting documents.

60. Kopel was engaged to prepare Raff’s 2012 federal income tax return. During the tax preparation interview, Raff told Kopel that he paid $3,000 in property taxes in 2012. Actually, Raff’s property taxes amounted to only $600. Based on Raff’s word, Kopel deducted the $3,000 on Raff’s return, resulting in an understatement of Raff’s tax liability. Kopel had no reason to believe that the information was incorrect. Kopel did not request underlying documentation and was reasonably satisfied by Raff’s representation that Raff had adequate records to support the deduction. Which of the following statements is correct?

a. To avoid the preparer penalty for willful understatement of tax liability, Kopel was obligated to examine the underlying documentation for the deduction.

b. To avoid the preparer penalty for willful understatement of tax liability, Kopel would be required to obtain Raff’s representation in writing.

c. Kopel is not subject to the preparer penalty for willful understatement of tax liability because the deduction that was claimed was more than 25% of the actual amount that should have been deducted.

d. Kopel is not subject to the preparer penalty for willful understatement of tax liability because Kopel was justified in relying on Raff’s representation.

61. A penalty for understated corporate tax liability can be imposed on a tax preparer who fails to

a. Audit the corporate records.

b. Examine business operations.

c. Copy all underlying documents.

d. Make reasonable inquiries when taxpayer information appears incorrect.

62. A tax return preparer is subject to a penalty for knowingly or recklessly disclosing corporate tax return information, if the disclosure is made

a. To enable a third party to solicit business from the taxpayer.

b. To enable the tax processor to electronically compute the taxpayer’s liability.

c. For peer review.

d. Under an administrative order by a state agency that registers tax return preparers.

63. A tax return preparer may disclose or use tax return information without the taxpayer’s consent to

a. Facilitate a supplier’s or lender’s credit evaluation of the taxpayer.

b. Accommodate the request of a financial institution that needs to determine the amount of taxpayer’s debt to it, to be forgiven.

c. Be evaluated by a quality or peer review.

d. Solicit additional nontax business.

64. Which, if any, of the following could result in penalties against an income tax return preparer?

I. Knowing or reckless disclosure or use of tax information obtained in preparing a return.

II. A willful attempt to understate any client’s tax liability on a return or claim for refund.

a. Neither I nor II.

b. I only.

c. II only.

d. Both I and II.

65. Clark, a professional tax return preparer, prepared and signed a client’s 2012 federal income tax return that resulted in a $600 refund. Which one of the following statements is correct with regard to an Internal Revenue Code penalty Clark may be subject to for endorsing and cashing the client’s refund check?

a. Clark will be subject to the penalty if Clark endorses and cashes the check.

b. Clark may endorse and cash the check, without penalty, if Clark is enrolled to practice before the Internal Revenue Service.

c. Clark may endorse and cash the check, without penalty, because the check is for less than $1,000.

d. Clark may endorse and cash the check, without penalty, if the amount does not exceed Clark’s fee for preparation of the return.

66. A CPA who prepares clients’ federal income tax returns for a fee must

a. File certain required notices and powers of attorney with the IRS before preparing any returns.

b. Keep a completed copy of each return for a specified period of time.

c. Receive client documentation supporting all travel and entertainment expenses deducted on the return.

d. Indicate the CPA’s federal identification number on a tax return only if the return reflects tax due from the taxpayer.

67. A CPA owes a duty to

a. Provide for a successor CPA in the event death or disability prevents completion of an audit.

b. Advise a client of errors contained in a previously filed tax return.

c. Disclose client fraud to third parties.

d. Perform an audit according to GAAP so that fraud will be uncovered.

68. In general, if the IRS issues a 30-day letter to an individual taxpayer who wishes to dispute the assessment, the taxpayer

a. May, without paying any tax, immediately file a petition that would properly commence an action in Tax Court.

b. May ignore the 30-day letter and wait to receive a 90-day letter.

c. Must file a written protest within 10 days of receiving the letter.

d. Must pay the taxes and then commence an action in federal district court.

69. A CPA will be liable to a tax client for damages resulting from all of the following actions except

a. Failing to timely file a client’s return.

b. Failing to advise a client of certain tax elections.

c. Refusing to sign a client’s request for a filing extension.

d. Neglecting to evaluate the option of preparing joint or separate returns that would have resulted in a substantial tax savings for a married client.

70. According to the AICPA Statement on Standards for Tax Services, which of the following statements is correct regarding the standards a CPA should follow when recommending tax return positions and preparing tax returns?

a. A CPA may recommend a position that the CPA concludes is frivolous as long as the position is adequately disclosed on the return.

b. A CPA may recommend a position in which the CPA has a good faith belief that the position has a realistic possibility of being sustained if challenged.

c. A CPA will usually not advise the client of the potential penalty consequences of the recommended tax return position.

d. A CPA may sign a tax return as preparer knowing that the return takes a position that will not be sustained if challenged.

71. According to the standards of the profession, which of the following statements is(are) correct regarding the action to be taken by a CPA who discovers an error in a client’s previously filed tax return?

I. Advise the client of the error and recommend the measures to be taken.

II. Withdraw from the professional relationship regardless of whether or not the client corrects the error.

a. I only.

b. II only.

c. Both I and II.

d. Neither I nor II.

72. According to the profession’s ethical standards, a CPA preparing a client’s tax return may rely on unsupported information furnished by the client, without examining underlying information, unless the information

a. Is derived from a pass-through entity.

b. Appears to be incomplete on its face.

c. Concerns dividends received.

d. Lists charitable contributions.

73. Which of the following acts by a CPA will not result in a CPA incurring an IRS penalty?

a. Failing, without reasonable cause, to provide the client with a copy of an income tax return.

b. Failing, without reasonable cause, to sign a client’s tax return as preparer.

c. Understating a client’s tax liability as a result of an error in calculation.

d. Negotiating a client’s tax refund check when the CPA prepared the tax return.

74. According to the standards of the profession, which of the following sources of information should a CPA consider before signing a client’s tax return?

I. Information actually known to the CPA from the tax return of another client.

II. Information provided by the client that appears to be correct based on the client’s returns from prior years.

a. I only.

b. II only.

c. Both I and II.

d. Neither I nor II.

75. According to Treasury Department Circular 230, a practitioner may

a. Charge a contingent fee for preparing a client’s original tax return.

b. Charge any amount of fixed fee for tax work.

c. Retain a client’s records for nonpayment of fees.

d. Charge a contingent fee for representing a client in connection with a judicial proceeding.

76. Circular 230 limits practice before the Internal Revenue Service to

a. Certified Public Accountants.

b. Attorneys.

c. Registered tax return preparers.

d. All of the above may practice before the IRS.

77. A practitioner is in violation of Circular 230 if the practitioner

a. Publishes the availability of a written schedule of fees containing hourly rates.

b. Charges a contingent fee for filing an original tax return.

c. Informs a client of the possible penalties that may apply to a position taken on a tax return.

d. Relies, without verification, upon information furnished by the client.

78. Circular 230 defines practice before the Internal Revenue Service to include

a. Preparing and filing documents with the IRS.

b. Corresponding and communicating with the IRS.

c. Representing a client during an examination at IRS offices.

d. All of the above are considered practice before the IRS.

79. According to Circular 230, practitioners must not sign a tax return if the return takes a position that does not have

a. A more-likely-than-not probability of being sustained.

b. Substantial authority.

c. A realistic possibility of being sustained.

d. A reasonable basis.

Multiple-Choice Answers and Explanations

Answers

image

Explanations

1. (c) The requirement is to identify the body that issues permits to practice. Answer (c) is correct because only state boards of accountancy (or similar authorities) may issue permits to practice. The other organizations do not.

2. (a) The UAA only requires accountants who perform attest services or compilations of financial statements to be licensed. Answers (b), (c), and (d) are incorrect because they are all requirements of the UAA.

3. (a) The requirement is to identify the item that is not a possible result of an AICPA ethics investigation. Answer (a) is correct because the AICPA cannot revoke the right to prepare a tax return.

4. (d) The requirement is to identify the item that may not result in automatic expulsion from the AICPA. Answer (d) is correct because conviction for a misdemeanor would not result in automatic expulsion.

5. (a) The requirement is to identify the likely result of a member of the AICPA being convicted of filing a fraudulent tax return. Answer (a) is correct because this is one of the situations that can result in suspension or expulsion without a hearing.

6. (d) A CPA is not automatically liable for failure to discover a materially overstated account. The CPA can be liable if the failure to discover was due to the CPA’s own negligence. Although performing an audit in accordance with GAAS does not guarantee that there is no negligence, it is normally a good defense against negligence. Answer (a) is incorrect because there was privity of contract with Cable. There was an oral agreement constituting a contractual relationship, therefore this would not be a good defense. Answer (b) is incorrect because an oral contract for an audit is still enforceable without a signed engagement letter. Answer (c) is incorrect because a CPA does not have to perform an audit recklessly or with an intent to deceive to be liable for negligence. Negligence simply means that a CPA failed to exercise due care owed of the average reasonable accountant in performing an audit.

7. (c) In order to meet the required standard of due care in conducting an audit of a client’s financial statements, a CPA has the duty to perform with the same degree of skill and judgment expected of an ordinarily prudent CPA under the circumstances. Answer (a) is incorrect because the client’s expectations do not guide the standard of due care. Rather, the standard of due care is guided by state and federal statute, court decisions, the contract with the client, GAAS and GAAP, and customs of the profession. Answer (b) is incorrect because it is generally the client’s responsibility to prepare its financial statements in accordance with generally accepted accounting principles. Answer (d) is incorrect because a CPA is not normally liable for failure to detect fraud or irregularities unless (1) a “normal” audit would have detected it, (2) the accountant by agreement has undertaken greater responsibility, or (3) the wording of the audit report indicates greater responsibility.

8. (c) The following elements are needed to establish fraud against an accountant: (1) misrepresentation of the accountant’s expert opinion, (2) scienter shown by either the accountant’s knowledge of falsity or reckless disregard of the truth, (3) reasonable reliance by injured party, and (4) actual damages. Answer (a) is incorrect because contributory negligence of a third party is not a defense available for the accountant in cases of fraud. Answers (b) and (d) are incorrect because privity of contract is not a requirement for an accountant to be held liable for fraud.

9. (a) In the performance of an audit, a CPA has the duty to exercise the level of care, skill, and judgment expected of a reasonably prudent CPA under the circumstances. Answer (b) is incorrect because a CPA performing an audit must adhere to generally accepted auditing standards. It is the client’s responsibility to prepare its financial statements in accordance with generally accepted accounting principles. Answer (c) is incorrect because an accountant is not liable for failure to detect fraud unless (1) a “normal” audit would have detected it, (2) the accountant by agreement has undertaken greater responsibility such as a defalcation audit, or (3) the wording of the audit report indicates greater responsibility for detecting fraud. Answer (d) is incorrect because a CPA can be liable for negligence, which is simply a failure to exercise due care in performing an audit. The CPA does not have to be grossly negligent or intentionally disregard generally accepted auditing standards to be held liable for negligence.

10. (c) A CPA will be liable for negligence when s/he fails to exercise due care. The standard for due care is guided by state and federal statutes, court decisions, contracts with clients, conformity with GAAS and GAAP, and the customs of the profession. Per the AICPA Professional Standards, AU 325, requires that if the auditor becomes aware of weaknesses in the design or operation of the internal control structure, these weaknesses, termed reportable conditions, be communicated to the audit committee of the client. Answer (a) is incorrect because a CPA is not normally liable for failure to detect fraud. Answer (b) is incorrect because including a negligence disclaimer in an engagement letter has no bearing on whether the CPA is negligent. Answer (d) is incorrect because generally a CPA is not required to inform a client’s customers of embezzlements although knowledge of the embezzlements may adversely affect the CPA’s audit opinion.

11. (c) The requirement is to identify the source of law under which the lawsuit would likely be filed. Answer (c) is correct because lawsuits by clients for negligence are filed under common law. Answer (a) is incorrect because suits by investors in securities issued by a public company would be filed under this law. Answer (b) is incorrect because suits by individuals who purchase or sell securities of a public company would be filed under this law. Answer (d) is incorrect because suits by individuals who purchase or sell securities regulated by a state would be filed under these laws.

12. (c) Since Yoke is the client and in privity of contract with Edgar, Yoke need only prove ordinary negligence on the part of Edgar. Therefore, answer (c) is correct. Answer (a) is incorrect because Edgar was not performing an audit. Answer (b) is incorrect because this would not be necessary; ordinary negligence would be sufficient. Answer (d) is incorrect because this would not be necessary; ordinary negligence would be sufficient.

13. (d) The requirement is to identify the item that would not likely be part of Edgar’s defense. Answer (d) is correct because there is no indication that management made any misrepresentations. Answer (a) is incorrect because if Edgar can show that management was negligent in establishing control, some of the responsibility for the losses may be shifted to management. Answer (b) is incorrect because performance of the engagement in conformity with professional standards would establish that Edgar was not negligent. Answer (c) is incorrect because Edgar would try to establish the limitations of the engagement.

14. (b) The requirement is to identify the accurate statement about damages. The court tries to establish a link between (causation) the losses and the defendant’s negligence. Therefore, answer (b) is correct because Edgar should be held responsible for the losses that have occurred since Edgar should have discovered the scheme. Answer (a) is incorrect because Edgar should not be held liable for losses that were incurred prior to the time he should have detected the scheme. Answer (c) is incorrect because Edgar would be responsible for more than just returning the fees. Answer (d) is incorrect because in civil proceedings there is no need to provide criminal liability.

15. (d) A CPA’s duty of due care is guided by the following standards: (1) state and federal statutes, (2) court decisions, (3) contract with the client, (4) GAAS and GAAP, and (5) customs of the profession. Therefore, failure to follow GAAS constitutes a breach of a CPA’s duty of due care. Answer (a) is incorrect because issuance of an oral rather than written report does not necessarily constitute a failure to exercise due care. Answers (b) and (c) are incorrect because the standard of due care requires the CPA to exercise the skill and judgment of an ordinary, prudent accountant. An honest error of judgment or failure to provide money saving tax advice would not breach the duty of due care if the CPA acted in a reasonable manner.

16. (a) A CPA’s liability for constructive fraud is established by the following elements: (1) misrepresentation of a material fact, (2) reckless disregard for the truth, (3) reasonable reliance by the injured party, and (4) actual damages. Gross negligence constitutes a reckless disregard for the truth. Answer (b) is incorrect because ordinary negligence is not sufficient to support a finding of constructive fraud. Answer (c) is incorrect because the liability for constructive fraud does not depend upon the identification of third-party users. Answer (d) is incorrect because the presence of the intent to deceive is needed to satisfy the scienter requirement for fraud. However, even in the absence of the intent to deceive, the CPA can be liable for constructive fraud based on reckless disregard of the truth.

17. (b) A foreseeable third party is someone not identified to the CPA, but who may be expected to receive the accountant’s audit report and rely upon it. Even though this party is unknown to the CPA, the CPA is liable for gross negligence or fraud.

18. (a) Lack of privity can be a viable defense against third parties in a common law case of negligence or breach of contract. A client’s creditor is not in privity of contract with the accountant. Answers (b) and (d) are incorrect because plaintiffs who are suing for fraud, constructive fraud, or gross negligence, which involves a reckless disregard for the truth, need not show privity of contract. Answer (c) is incorrect because the accountant’s client is in privity of contract with the accountant due to their contractual agreement.

19. (c) Since Sanco was a foreseeable third party instead of an actually foreseen third party by the CPA, Sanco in most states cannot recover. Answer (a) is incorrect because most states do not extend liability to mere foreseeable third parties for simple negligence. Answer (b) is incorrect because the Ultramares decision limited liability to parties in privity of contract with the CPA. Answer (d) is incorrect because the client can recover for damages caused to it when negligence is established.

20. (b) Under the Ultramares rule, the accountant is held liable only to parties whose primary benefit the financial statements are intended. This generally means only the client or third-party beneficiaries who are in privity of contract with the accountant. Many courts have more recently departed from the Ultramares decision to allow foreseen third parties to recover from the accountant. However, those courts that adhere to the Ultramares rule do not expand liability to foreseen parties.

21. (a) In order to establish common law liability against an accountant based upon negligence, it must be proven that (1) the accountant had the duty to exercise due care, (2) the accountant breached the duty of due care, (3) damage or loss resulted, and (4) a causal relationship exists between the fault of the accountant and the resulting damages. The accountant may escape liability if due care can be established. The standard for due care is guided by state and federal statute, court decisions, contract with client, GAAS and GAAP, and customs of the profession. Although following GAAS does not automatically preclude negligence, it is strong evidence for the presence of due care. Answer (b) is incorrect because although the client may be aware of the misstatement, the auditor has the responsibility to detect the material misstatement if it is such that an average, reasonable accountant should have detected it. Answer (c) is incorrect because the client and Larson intended for the opinion and the financial statements to be used by purchasers. Therefore, a purchaser is considered a third-party beneficiary and is in privity of contract. Answer (d) is incorrect because the accountant need not know the specific identity of a third-party beneficiary to be held liable for negligence.

22. (a) To establish a CPA’s liability for common law fraud, the following elements must be present: (1) misrepresentation of a material fact or the accountant’s expert opinion, (2) scienter, shown by either an intent to mislead or reckless disregard for the truth, (3) reasonable or justifiable reliance by injured party, and (4) actual damages resulted. If Larson did not have actual or constructive knowledge of the misstatements, the scienter element would not be present and thus Larson would not be liable. Answers (b) and (d) are incorrect because neither contributory negligence of the client nor lack of privity of contract are defenses available to the accountant in cases of fraud. Answer (c) is incorrect because an accountant is generally liable to all parties defrauded. Therefore, the accountant need not have actual knowledge that the purchaser was an intended beneficiary.

23. (b) The Securities Act of 1933 requires that a plaintiff need only prove that damages were incurred and that there was a material misstatement or omission in order to establish a prima facie case against a CPA. The Act does not require that the plaintiff prove that s/he relied on the financial information or that there was negligence or fraud present. The Securities Act of 1933 eliminates the necessity for privity of contract.

24. (c) Mac is a third party that the accountant knew would rely on the financial statements. Queen’s financial statements contained material misstatements. Mac can recover by showing that the accountant was negligent in the audit. Mac also needs to establish that it did rely on the financial statements in order to recover from the accountant for the losses on Queen.

25. (c) Under the Securities Act of 1933, a CPA is liable to any third-party purchaser of registered securities for losses resulting from misstatements in the financial statements included in the registration statement. The plaintiff (purchaser) must establish that damages were incurred, and that the misstatements were material misstatements of facts. Answer (a) is incorrect because under the 1933 Act it is not necessary for the purchaser of securities to prove “scienter,” or knowledge of material misstatement, on the part of the CPA. Answers (b) and (d) are incorrect because under the 1933 Act, the plaintiff need not prove negligence on the part of the CPA or that there was reliance by the plaintiff on the financial statements included in the registration statement.

26. (c) In a Section 11 suit under the 1933 Act, the plaintiff may recover damages equal to the difference between the amount paid and the market value of the stock at the time of the suit. If the stock has been sold, then the damages are the difference between the amount paid and the sale price. Answer (a) is incorrect because damages of triple the original price are not provided for under this act. Answer (b) is incorrect because rescission is not a remedy under this act. Answer (d) is incorrect because if the shares have not been sold before the suit, then the court uses the difference between the amount paid and the market value at the time of the suit.

27. (b) Under Section 11 of the 1933 Act, if the plaintiff proves damages and the existence of a material misstatement or omission in the financial statements included in the registration statement, these are sufficient to win against the CPA unless the CPA can prove one of the applicable defenses. Due diligence is one of the defenses. Answer (a) is incorrect because contributory negligence is not a defense under Section 11. Answer (c) is incorrect because the purchaser need not prove privity with the CPA. Answer (d) is not correct because the purchaser needs to prove the above two elements but not scienter.

28. (d) To impose liability under Section 11 of the Securities Act of 1933 for a misleading registration statement, the plaintiff must prove the following: (1) damages were incurred, and (2) a material misstatement or omission was present in financial statements included in the registration statement. The plaintiff generally is not required to prove the defendant’s intent to deceive nor must the plaintiff prove reliance on the registration statement.

29. (c) The proof requirements necessary to establish an accountant’s liability under the Securities Act of 1933, Section 11 are as follows: (1) the plaintiff must prove damages were incurred, and (2) the plaintiff must prove there was a material misstatement or omission in financial statements included in the registration statement. To establish an accountant’s liability under the Securities Exchange Act of 1934, Section 10(b), Rule 10b-5, the following elements must be proven: (1) damages resulted to the plaintiff in connection with the purchase or sale of a security in interstate commerce, (2) a material misstatement or omission existed in information released by the firm, (3) the plaintiff justifiably relied on the financial information, and (4) the existence of scienter. Because Sharp can prove that damages were incurred and that the statements contained material misstatements, Sharp is likely to prevail in a lawsuit under the Securities Act of 1933, Section 11. However, Sharp would be unable to prove justifiable reliance on the misstated information or the existence of scienter; thus, recovery under the Securities Exchange Act of 1934, Section 10(b), Rule 10b-5, is unlikely.

30. (d) If an accountant is negligent, s/he may have liability not only for a negligently performed audit but also for a negligently performed review when there were facts that should require the accountant to investigate further because of their suspicious nature. This is true even though a review is not a full audit.

31. (a) In order to establish a case under the antifraud provisions of Section 10(b) and Rule 10b-5 of the 1934 Act, the plaintiff has to prove that the defendant either had knowledge of the falsity in the registration statement or acted with reckless disregard for the truth. In addition, the plaintiff must show that the transaction involved interstate commerce so that there is a constitutional basis for using this federal law. S/he also must prove justifiable reliance. The plaintiff need not prove that s/he was an intended user of the false registration statement.

32. (d) Under Rule 10b-5 of Section 10(b) of the Securities Exchange Act of 1934, a CPA may be liable if s/he makes a false statement of a material fact or an omission of a material fact in connection with the purchase or sale of a security. Scienter is required which is shown by either knowledge of falsity or reckless disregard for the truth. Of the four answers given, lack of good faith best describes this scienter requirement. Answer (a) is incorrect because negligence is not enough under this rule. Answer (b) is incorrect because independence is not the issue under scienter. Answer (c) is incorrect because although due diligence can be a defense under Section 11 of the Securities Act of 1933, it is not the standard used under Section 10(b) of the Securities Exchange Act of 1934.

33. (b) Under Section 11 of the Securities Act of 1933, the CPA may be liable for material misstatements or omissions in certified financial statements. The CPA may escape liability by showing due diligence. This can often be proven by the CPA showing that s/he followed Generally Accepted Accounting Principles. There are not generally accepted fraud detection standards that the CPA can use as a defense.

34. (c) In a civil suit under Section 10(b) and Rule 10b-5, the damages are generally the difference between the amount paid and the market value at the time of suit, or the difference between the amount paid and the sales price if sold. Answer (a) is incorrect because recovery of the full original public offering price is not used as the damages. Answer (b) is incorrect because the above described monetary damages are used. Answer (d) is incorrect because punitive damages are not given under this rule.

35. (b) In general, the accountant’s workpapers are owned by the accountant. However, the CPA’s ownership of the working papers is custodial in nature and the CPA is required to preserve confidentiality of the client’s affairs. Normally, the CPA firm cannot allow transmission of information included in the working papers to third parties without the client’s consent. This prevents a CPA firm from transferring workpapers to a purchaser of a CPA practice unless the client consents. Answer (c) is incorrect because the privileged communication rule does not exist at common law and has only been enacted by a few states. Additionally, the privileged communications rule only applies to communications which were intended to be privileged at the time of communication. Answer (a) is incorrect because working papers may be obtained by third parties without the client’s consent when they appear to be relevant to issues raised in litigation (through a subpoena).

36. (d) The working papers are owned by the CPA, but the CPA must preserve confidentiality. They cannot be transmitted to another party unless the client consents or unless the CPA is required to under a valid court or governmental agency subpoena. Answers (a) and (c) are incorrect because these do not preserve the confidentiality. Answer (b) is incorrect because the CPA retains the working papers as evidence of the work done.

37. (c) Any of the partners of a CPA partnership can have access to the partnership’s working papers. Third parties outside the firm need to have the client’s consent or a legal subpoena.

38. (d) To preserve confidentiality, a CPA (including a CPA partnership) may not allow transmission of information in the working papers to other parties. Exceptions are consent of the client or the production of an enforceable subpoena. There are no exceptions for the IRS or the FASB, thus making answers (a), (b), and (c) incorrect.

39. (d) In a jurisdiction having an accountant-client privilege statute, the CPA generally may not turn over workpapers without the client’s permission. It is allowable to do so, however, for use in a quality review under AICPA authorization or to be given to the state CPA society quality control panel. Answers (a), (b), and (c) are incorrect because the client would have to give permission for the CPA to turn over the confidential workpapers to the purchaser of the CPA practice, as well as to another CPA firm in regard to suspected tax return irregularities.

40. (a) Privileged communications between the accountant and client are recognized only in a few states. Therefore, if a state statute has been enacted creating such a privilege, Ivor will be able to prevent Thorp from testifying. Answer (b) is incorrect because federal law does not recognize accountant-client privileged communication. Answer (d) is incorrect because Ivor will not be able to prevent Thorp from testifying about the nature of the work performed in the audit unless a privileged communication statute has been enacted in that state. Answer (c) is incorrect because privileged communication does not exist at common law but must be created by state statute. Criminal law is based on common law and varies by state. However, as a general rule, in states that recognize accountant-client privilege, it can be claimed in both civil and criminal suits.

41. (a) The requirement is to identify the situation in which it is most likely that a violation of the profession’s ethical standards would have occurred. Answer (a) is correct because independence is impaired if fees remain unpaid for professional services of the preceding year when the report on the client’s current year is issued. Accordingly, no report should have been issued on the 2002 financial statements when fees for the 2001 audit were unpaid. Answer (b) is incorrect because CPAs may recommend a position description (ET 191) without violating the profession’s ethical standards. Answer (c) is incorrect because a practice may be purchased for a percentage of fees to be received. Answer (d) is incorrect because the Code of Professional Conduct does not prohibit arrangements with financial institutions to collect notes issued by a client in payment of professional fees.

42. (b) A CPA must not disclose confidential information of a client unless the client gives consent to disclose it to that third party. Answer (a) is incorrect because state agencies need a subpoena before the CPA must comply. Answer (c) is incorrect because the IRS does not have the right to force a CPA to turn over confidential information of a client without either the client’s consent or an enforceable subpoena. Answer (d) is incorrect because although the CPA can use the client information to defend a lawsuit, the CPA is not normally requested to disclose confidential information to comply with generally accepted accounting principles.

43. (b) The requirement is to identify the source of law which may not result in criminal liability. Answer (b) is correct because common law can only result in civil liability.

44. (a) The requirement is to identify the act that provides for possible treble damages. Answer (a) is correct because only the Racketeer Influenced and Corrupt Organizations Act provides for potential treble damages.

45. (c) Under the Private Securities Litigation Reform Act, the auditor should inform first the audit committee or the board of directors. Answer (a) is incorrect because the Securities Litigation Reform Act does not require that the SEC be informed unless after the audit committee or board of directors is informed, no remedial action is taken. Answer (b) is incorrect because the Justice Department need not be informed of this under the Private Securities Litigation Reform Act. Answer (d) is incorrect because inclusion of the problem in a note of the financial statements is not enough; the audit committee or the board of directors should be informed.

46. (a) The Private Securities Litigation Reform Act requires that auditors of firms covered under the Securities Exchange Act of 1934 establish procedures to do the items in (b), (c), and (d). Developing a comprehensive internal control system is not specifically mentioned, although part of this would be helpful in accomplishing the three stated items.

47. (d) Under the Private Securities Litigation Reform Act, an auditor who audits financial statements under the Federal Securities Exchange Act of 1934 is required to establish procedures to (1) detect illegal acts, (2) identify material related-party transactions, and (3) evaluate the ability of the firm to continue as a going concern.

48. (b) Under the Private Securities Litigation Reform Act, he is required to report this to the audit committee of the firm or the board of directors. Answer (a) is incorrect because he need not report this to the shareholders but to the audit committee or the board of directors. Answers (c) and (d) are incorrect because he is required under the Reform Act to inform the audit committee or the board of directors.

49. (c) The Private Securities Litigation Reform Act amends both the 1933 and 1934 Acts. Answer (a) is incorrect because it applies to the 1933 and 1934 Acts which apply to stocks sold on a stock exchange. Answers (b) and (d) are incorrect because this Reform Act applies to securities covered under the 1933 and 1934 Acts which may include both common and preferred stock of a publicly held corporation.

50. (b) Bran is liable under the Private Securities Litigation Reform Act for her proportionate fault of the liability since she acted unknowingly. Answer (a) is incorrect because Bran was determined to be 20% at fault. Answers (c) and (d) are incorrect because the Reform Act changes the joint and several liability for unknowing conduct and substitutes proportionate liability.

51. (c) The Sarbanes-Oxley Act of 2002 established a number of nonattest services that may not be performed by the auditor for a public company. Tax services may be performed but must be approved by the company’s audit committee.

52. (c) The Sarbanes-Oxley Act established the Public Accounting Oversight Board to regulate CPA firms that audit public companies.

53. (d) The requirement is to identify the provision that is not part of the Sarbanes-Oxley Act of 2002. Answer (d) is correct because Sarbanes-Oxley does not contain a provision for minimum partner experience. All of the others items are provisions of Sarbanes-Oxley.

54. (a) The requirement is to identify the individuals who must personally certify to the accuracy of the financial statements filed with the SEC. Answer (a) is correct because only the chief financial officer and the chief executive officer must certify.

55. (c) The requirement is to identify when a Form 8-K must be filed with the SEC. Answer (c) is correct because the form generally must be filed within 4 days of the occurrence of the triggering event.

56. (b) The requirement is to identify the required partner rotation period under the Sarbanes-Oxley Act. Answer (b) is correct because the act requires rotation at least every 5 years.

57. (b) The requirement is to determine which act(s) constitute(s) grounds for a tax preparer penalty. A return preparer will be subject to penalty if the preparer knowingly or recklessly discloses information furnished in connection with the preparation of a tax return, unless such information is furnished for quality or peer review, under an administrative order by a regulatory agency, or pursuant to an order of a court. Additionally, a return preparer will be subject to penalty if any part of an understatement of liability with respect to a return or refund claim is due to the preparer’s willful attempt to understate tax liability, or to any reckless or intentional disregard of rules and regulations.

58. (d) The requirement is to determine Water’s responsibility regarding Vee’s unfiled 2008 income tax return. A CPA should promptly inform the client upon becoming aware of the client’s failure to file a required return for a prior year. However, the CPA is not obligated to inform the IRS and the CPA may not do so without the client’s permission, except where required by law. If the CPA is requested to prepare the current year’s return (2013) and the client has not taken action to file the return for the earlier year (2008), the CPA should consider whether to withdraw from preparing the current year’s return and whether to continue a professional relationship with the client. Also, note that the normal statue of limitations for the assessment of a tax deficiency is three years after the due date of the return or three years after the return is filed, whichever is later. Thus, the statute of limitations is still open with regard to 2008 since there is no time limit for the assessment of tax if no tax return was filed.

59. (c) The requirement is to determine which action a tax return preparer must take to avoid tax preparer penalties for a return’s understated tax liability due to a taxpayer’s intentional disregard of regulations. A return preparer may, in good faith, rely without verification upon information furnished by the client or by third parties, and is not required to audit, examine, or review books, records, or documents in order to independently verify the taxpayer’s information. However, the preparer should not ignore the implications of information furnished and should make reasonable inquiries if the furnished information appears incorrect, incomplete, or inconsistent.

60. (d) According to the Statements on Standards for Tax Services, in preparing a tax return a CPA may in good faith rely upon information furnished by the client or third parties without further verification.

61. (d) The requirement is to determine the correct statement regarding the imposition of a preparer penalty for understated corporate tax liability. A return preparer may in good faith rely without verification upon information furnished, and is not required to audit, examine, or review books, records, or documents in order to independently verify a taxpayer’s information. However, the preparer should not ignore the implications of information furnished and should make reasonable inquiries if information appears incorrect, incomplete, or inconsistent.

62. (a) A tax return preparer is subject to a penalty for knowingly or recklessly disclosing corporate tax return information, if the disclosure is made to enable a third party to solicit business from the taxpayer. Taxpayer return information can be disclosed by the preparer without penalty if the disclosure is made to enable the tax processor to electronically compute the taxpayer’s liability, for purposes of the tax return preparer’s peer review, or if the disclosure is made under an administrative order by a state agency that registers tax return preparers.

63. (c) The requirement is to determine the correct statement regarding a tax return preparer’s disclosure or use of tax return information without the taxpayer’s consent. Generally, a tax return preparer who knowingly or recklessly discloses any information furnished to him in connection with the preparation of a return, or uses any such information other than to prepare, or to assist in preparing a return, is guilty of a misdemeanor, and upon conviction may be subject to fine and/or imprisonment. A limited exception permits the disclosure or use of tax return information for purposes of being evaluated by quality or peer reviews.

64. (d) A penalty of up to $1,000 may be assessed against a tax return preparer who knowingly or recklessly discloses or uses any tax return information other than to prepare, or assist in preparing a return. Additionally, a penalty equal to the greater of $5,000, or 50% of the income to be derived by the return preparer from the return or refund claim will be assessed against a return preparer who willfully attempts to understate any client’s tax liability on a return or claim for refund.

65. (a) Under Internal Revenue Code Section 6695(f) any person who is an income tax return preparer who endorses or otherwise negotiates any check which is issued to a taxpayer shall pay a penalty of $500.

66. (b) A CPA who prepares a federal income tax return for a fee must keep a completed copy of the return for a minimum of three years. Answer (a) is incorrect because prior to preparing a tax return the CPA would not be required to file certain notices and powers of attorney with the IRS. Answer (c) is incorrect because a CPA would only be required to ask the client if documentation of these expenses exists. The CPA would not have to actually receive and examine this documentation. Answer (d) is incorrect because the CPA’s federal identification number would be required on any federal income tax return prepared for a fee.

67. (b) A CPA generally does owe a duty to inform a client that there are errors in a previously filed tax return so that the client may file an amended tax return. Answer (a) is incorrect because the client chooses his/her own CPA. Answer (c) is incorrect because CPAs are not required to disclose fraud by the client but are usually engaged to give an opinion on the fairness of the financial statements. Answer (d) is incorrect because although the CPA has a duty to perform an audit in accordance with GAAS and consistent with GAAP, the CPA is not under a duty to discover fraud in the audit unless the fraud would have been uncovered in the process of an ordinary audit or unless the CPA agreed to greater responsibility to uncover fraud.

68. (b) If the IRS issues a 30-day letter to an individual taxpayer who wishes to dispute the assessment, the taxpayer may ignore the 30-day letter and wait to receive a 90-day letter. Answer (a) is incorrect because a taxpayer must receive a 90-day letter before a petition can be filed in Tax Court. Answer (c) is incorrect because a taxpayer has a 30-day period during which to file a written protest. Answer (d) is incorrect because a taxpayer is not required to pay the taxes and commence an action in federal district court.

Generally, upon the receipt of a 30-day letter, a taxpayer who wishes to dispute the findings has 30 days to (1) request a conference with an appeals officer or file a written protest letter, or (2) may elect to do nothing during the 30-day period and await a 90-day letter. The taxpayer would then have 90 days to file a petition with the Tax Court. Alternatively, a taxpayer may choose to pay the additional taxes and file a claim for refund. When the refund claim is disallowed, the taxpayer could then commence an action in federal district court.

69. (c) A CPA will be liable to a tax client for damages resulting from the following activities: (1) failure to file a client’s return on a timely basis, (2) gross negligence or fraudulent conduct resulting in client losses, (3) erroneous advice or failure to advise client of certain tax elections, and (4) wrongful disclosure or use of confidential information. A CPA will not be liable to a tax client for refusing to sign a client’s request for a filing extension, therefore answer (c) is correct.

70. (b) According to the AICPA Statements on Standards for Tax Services, a CPA should not recommend a position unless there is a realistic possibility of it being sustained if it is challenged. Furthermore, a CPA should not prepare or sign an income tax return if the CPA knows that the return takes a position that will not be sustained if challenged. Therefore, answer (d) is incorrect. Also, a CPA should advise the client of the potential penalty consequences of any recommended tax position. Therefore, answer (c) is incorrect. Answer (a) is incorrect as a CPA may not recommend a position that is frivolous even if the position is adequately disclosed on the return.

71. (a) While performing services for a client, a CPA may become aware of an error in a previously filed return. The CPA should advise the client of the error (as required by the Statements on Standards for Tax Services) and the measures to be taken. It is the client’s responsibility to decide whether to correct the error. In the event that the client does not correct an error, or agree to take the necessary steps to change from an erroneous method of accounting, the CPA should consider whether to continue a professional relationship with the client.

72. (b) A CPA may in good faith rely without verification upon information furnished by the client when preparing the client’s tax return. However, the CPA should not ignore implications of information furnished and should make reasonable inquiries if information appears incorrect, incomplete, or inconsistent.

73. (c) Answer (a) is incorrect because IRC §6695(a) imposes a $50 penalty upon income tax return preparers who fail to furnish a copy of the return to the taxpayer. Answer (b) is incorrect because IRC §6695(b) imposes a $50 penalty upon income tax return preparers who fail to sign a return, unless the failure is due to reasonable cause. Answer (d) is incorrect because IRC §6695(f) imposes a $500 penalty upon income tax return preparers who endorse or otherwise negotiate a client’s tax refund checks. There is no code section imposing a penalty for the understating of a client’s tax liability due to an error in calculation.

74. (c) A CPA should consider both: (1) information actually known to the CPA from the tax return of another client; and (2) information provided by the client that appears to be correct based on the client’s returns from prior years. In preparing or signing a return, a CPA may in good faith rely without verification upon information furnished by the client or by third parties. However, the CPA should not ignore the implications of information furnished and should make reasonable inquires if the information furnished appears to be incorrect, incomplete, or inconsistent either on its face or on the basis of other facts known to the CPA.

75. (d) The requirement is to identify the correct statement regarding Treasury Department Circular 230. Answer (d) is correct because a practitioner may charge a contingent fee for representing a client in connection with a judicial proceeding. Answer (a) is incorrect because a practitioner may not charge a contingent fee for preparing a client’s original tax return. Answer (b) is incorrect because a practitioner may not charge an unconscionable fee. Answer (c) is incorrect because a practitioner may not retain a client’s records for nonpayment of fees.

76. (d) Circular 230 limits practice before the Internal Revenue Service to certified public accountants, attorneys, enrolled agents, enrolled actuaries, enrolled retirement plan agents, and registered tax return preparers.

77. (b) A practitioner is in violation of Circular 230 if the practitioner charges a contingent fee for preparing and filing an original tax return. However, a contingent fee may be charged in representing a client in connection with an IRS examination of an original return, or an amended return or claim for refund or credit. Additionally, a contingent fee may be charged for services rendered in connection with any judicial proceeding arising under the Code.

78. (d) Circular 230 defines practice before the IRS to include all matters connected with a presentation to the IRS relating to a taxpayer’s rights, privileges, or liabilities including preparing and filing documents, corresponding and communicating with the IRS, rendering written advice with respect to any transaction having a potential for tax avoidance or evasion, and representing a client at conferences, hearings, and meetings.

79. (d) According to Circular 230, practitioners must not sign a tax return or claim for refund that the practitioner knows or reasonably should know contains a position that lacks a reasonable basis, is an unreasonable position, or is a willful attempt by the practitioner to understate tax liability. The reasonable basis standard comprehends at least a 20% probability of being sustained, while the more likely than not (more than 50% probability), substantial authority (40% probability), and realistic possibility (33% probability) are higher standards. Answer (b) is incorrect since a position lacking substantial authority can be taken so long as there is adequate disclosure and there is a reasonable basis for the position.

Simulations

Task-Based Simulation 1

image

Situation

Under Section 11 of the Securities Act of 1933 and Section 10(b), Rule 10b-5, of the Securities Exchange Act of 1934, a CPA may be sued by a purchaser of registered securities.

Items 1 through 6 relate to what a plaintiff who purchased securities must prove in a civil liability suit against a CPA. For each item determine whether the statement must be proven under Section 11 of the Securities Act of 1933, under Section 10(b), Rule 10b-5, of the Securities Exchange Act of 1934, both Acts, or neither Act.

image

Task-Based Simulation 2

image

A CPA sole practitioner has tax preparers’ responsibilities when preparing tax returns for clients.

Items 1 through 9 each represent an independent factual situation in which a CPA sole practitioner has prepared and signed the taxpayer’s income tax return. For each item, select from the following list the correct response regarding the tax preparer’s responsibilities. A response may be selected once, more than once, or not at all.

Answer List
P. The tax preparer’s action constitutes an act of tax preparer misconduct subject to the Internal Revenue Code penalty.
E. The Internal Revenue Service will examine the facts and circumstances to determine whether the reasonable cause exception applies; the good-faith exception applies; or both exceptions apply.
N. The tax preparer’s action does not constitute an act of tax preparer misconduct.
image

Simulation Solutions

Task-Based Simulation 1

image
image

Explanations

1. (C) Section 11 of the Securities Act of 1933 imposes liability on auditors for misstatements or omissions of a material fact in certified financial statements or other information provided in registration statements. Similarly, under Section 10(b), Rule 10b-5 of the Securities Exchange Act of 1934, the plaintiff must prove there was a material misstatement or omission in information released by the firm such as audited financial statements. Actually, if the examiners wish to emphasize the phrase “filed document” in the question, then the answer would be (A). Under Section 10(b), the material misstatement may occur in information released by the firm rather than filed. Since the requirements state “. . . must allege or prove,” technically the answer would be (D), since the plaintiff could allege or prove omission of material facts instead of material misstatements stated in the question. Therefore, this question depends upon how technical one decides to get on these points.

2. (C) Under both Section 11 of the 1933 Act and Section 10(b) of the 1934 Act, the plaintiff must allege or prove that s/he incurred monetary damages.

3. (D) Under Section 11 of the 1933 Act, the burden of proof is shifted to the defendant, accountant. The accountant may then defend him- or herself by establishing due diligence. The plaintiff does not have to show lack of due diligence by the CPA. Under Section 10(b), the plaintiff must prove scienter.

4. (D) The plaintiff does not have to prove that s/he was in privity with the CPA under either section.

5. (B) Under Section 10(b), the plaintiff must prove justifiable reliance on the financial information. This is not true under Section 11 in which the plaintiff need prove only the items in item 1. and item 2. discussed above.

6. (B) The plaintiff does have to prove that the CPA had scienter under Section 10(b) of the 1934 Act. Scienter is not needed under the 1933 Act, however.

Task-Based Simulation 2

image

For items 1 through 9, candidates were asked to determine for each item whether (P) the tax preparer’s action constitutes an act of tax preparer misconduct subject to the Internal Revenue Code penalty; (E) the IRS will examine the facts and circumstances to determine whether the reasonable cause exception applies, the good faith exception applies, or both exceptions apply; or, (N) the tax preparer’s action does not constitute an act of tax preparer misconduct.

image

Explanations

1. (N) A return preparer will be subject to penalty if the preparer knowingly or recklessly discloses information furnished in connection with the preparation of a tax return, unless such information is furnished for quality or peer review, under an administrative order by a regulatory agency, or pursuant to an order of a court.

2. (E) The reasonable cause and good faith exception applies if the return preparer relied in good faith on the advice of an advisory preparer who the return preparer had reason to believe was competent to render such advice.

3. (P) A return preparer will be subject to penalty if the preparer endorses or otherwise negotiates (directly or through an agent) any refund check issued to a taxpayer (other than the preparer) if the preparer was the preparer of the return or claim for refund which gave rise to the refund check.

4. (N) A return preparer may in good faith rely without verification upon information furnished by the client or third parties, and is not required to audit, examine, or review books, records, or documents in order to independently verify the taxpayer’s information. If the IRS requires supporting documentation as a condition for deductibility, the return preparer should make appropriate inquiries to determine whether the condition has been met.

5. (P) A return preparer will be subject to penalty if there is a willful attempt in any manner to understate the tax liability of any taxpayer. A preparer is considered to have willfully attempted to understate liability if the preparer disregards information furnished by the taxpayer to wrongfully reduce the tax liability of the taxpayer.

6. (N) A return preparer will be subject to penalty if the preparer knowingly or recklessly discloses information furnished in connection with the preparation of a tax return, unless such information is furnished for quality or peer review, under an administrative order by a regulatory agency, or pursuant to an order of a court.

7. (E) Under these facts, a position taken on a return which is consistent with incorrect instructions does not satisfy the realistic possibility standard. However, if the preparer relied on the incorrect instructions and was not aware of the announcement or regulations, the reasonable cause and good faith exception may apply depending upon the facts and circumstances.

8. (P) A return preparer will be subject to penalty if the preparer knowingly or recklessly discloses information furnished in connection with the preparation of a tax return, unless such information is furnished for quality or peer review, under an administrative order by a regulatory agency, or pursuant to an order of a court.

9. (P) A return preparer will be subject to penalty if there is a willful attempt in any manner to understate the tax liability of any taxpayer or there is a reckless or intentional disregard of rules or regulations. The penalty will apply if a preparer knowingly deducts the expenses of the taxpayer’s domestic help as wages paid in the taxpayer’s business.

..................Content has been hidden....................

You can't read the all page of ebook, please click here login for view all page.
Reset
3.147.71.94