Maintaining Professional Responsibility: Regulation and Legal Liability

MULTIPLE CHOICE: 1. A CPA firm studies its personnel advancement experience to ascertain whether individuals meeting stated criteria are assigned increased degrees of responsibility. This is evidence of the firm's adherence to prescribed standards of a. Supervision and review. b. Continuing professional education. c. Professional development. d. uality control. A!S"#$% '. &

"hich one of the following( if present( would support a finding of constructive fraud on the part of a CPA) a. Privity of contract. b. *ntent to deceive. c. $ec+less disregard. d. ,rdinary negligence. C

A!S"#$% -.

The CPA firm of .nox and .nox has been subpoenaed to testify and produce its correspondence and wor+papers in connection with a lawsuit brought by a third party against one of their clients. .nox considers the subpoenaed documents to be privileged communication and therefore see+s to avoid admission of such evidence in the lawsuit. "hich of the following is correct) a. /ederal law recogni0es such a privilege if the accountant is a Certified Public Accountant. b. The privilege is available regarding the wor+papers since the CPA is deemed to own them. c. The privileged communication rule as it applies to a CPA1client relationship is the same as that of attorney2client. d. *n the absence of a specific statutory provision( the law does not recogni0e the existence of the privileged communication rule between a CPA and his client. A!S"#$% &

20

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Chapter 3 Maintaining Professional Responsibility

3.

,f the following statements( which best distinguishes ordinary negligence from gross negligence) a. /ailure to detect material errors( whether internal control is strong or wea+( suggests gross negligence. b. /ailure to exercise reasonable care denotes ordinary negligence( whereas failure to exercise minimal care indicates gross negligence. c. 4ross negligence is most probable when the auditor fails to detect errors that occurred under conditions of strong internal control. d. The more material the undetected error the greater the li+elihood of ordinary negligence. A!S"#$% 5

6.

,n 7uly 1( '88'( .ent purchased common stoc+ of Salem Corp. in an offering sub9ect to the Securities Act of 1:--. ;ane < Co.( CPAs( rendered an un=ualified opinion on the financial statements of Salem which were included in Salem's registration statement filed with the S#C on ;arch 1( '88' .ent has commenced an action against ;ane based on the Securities Act of 1:-- provisions dealing with omissions of facts re=uired to be stated in the registration statement. "hich of the following elements of a cause of action under the Securities Act of 1:-- must be proved by .ent) a. .ent relied upon ;ane's opinion. b. .ent was the initial purchaser of the stoc+ and gave value for it. c. ;ane's omission was material. d. ;ane acted negligently or fraudulently. A!S"#$% A

>.

The limitation of auditor liability under contract law is +nown as a. b. c. d. Privity of contract. Contributory liability. Statutory liability. Common law liability. A

A!S"#$%

Chapter 3 Maintaining Professional Responsibility ?.

22

@nder the Securities Act of 1:--( the registration of securities which are offered to the public in interstate commerce is a. &irected toward preventing the mar+eting of securities which pose serious financial ris+s to the prospective investor. b. !ot re=uired unless the issuer is a corporation. c. ;andatory unless the cost to the issuer is AprohibitiveA as defined in the S#C regulations. d. $e=uired unless there is an applicable exemption. A!S"#$% &

B.

The auditor's defense of contributory negligence is most li+ely to prevail when a. b. c. d. Third party in9ury has been minimal. The auditor fails to detect fraud resulting from management override of the control structure. The client is privately held as contrasted with a public company. @ndetected errors have resulted in materially misleading financial statements. 5

A!S"#$% :.

The ob9ective of =uality control mandates that a public accounting firm should establish policies and procedures for professional development which provide reasonable assurance that all entry2level personnel a. Prepare wor+ing papers which are standardi0ed in form and content. b. Cave the +nowledge re=uired to enable them to fulfill responsibilities assigned. c. "ill advance within the organi0ation. d. &evelop specialties in specific areas of public accounting. A!S"#$% 5

10. A plaintiff wishes to recover damages from the issuer for losses resulting from material misstatements in a securities registration statement. *n order to be successful( one of the elements the plaintiff must prove is that the a. Plaintiff was in privity of contract with the issuer or that the issuer +new of the plaintiff. b. Plaintiff ac=uired the securities.

23

Chapter 3 Maintaining Professional Responsibility c. d. *ssuer acted negligently. *ssuer acted fraudulently. 5

A!S"#$% 11.

A basic ob9ective of a CPA firm is to provide professional services that conform with professional standards. $easonable assurance of achieving this basic ob9ective is provided through a. A system of peer review. b. Continuing professional education. c. A system of =uality control. d. Compliance with generally accepted reporting standards. A!S"#$% C

12. ;ix and Associates( CPAs( issued an un=ualified opinion on the financial statements of 4lass Corp. for the year ended &ecember -1( '88'. *t was determined later that 4lass' treasurer had embe00led D-88(888 from 4lass during '88'. 4lass sued ;ix because of ;ix's failure to discover the embe00lement. ;ix was unaware of the embe00lement. "hich of the following is ;ix's best defense) a. The audit was performed in accordance with 4AAS. b. The treasurer was 4lass' agent and( therefore( 4lass was responsible for preventing the embe00lement. c. The financial statements were presented in conformity with 4AAP. d. ;ix had no actual +nowledge of the embe00lement. A!S"#$% 1-. A

"hich of the following is not a condition for membership in the &ivision for CPA /irms) a. Participating in peer review. a. #mploying only CPAs. b. Conforming to specified continuing professional education re=uirements. c. ;aintaining ade=uate levels of liability insurance. 5

A!S"#$% 13.

4old( CPA( rendered an un=ualified opinion on the '888 financial statements of #astern Power Co. #gan purchased

Chapter 3 Maintaining Professional Responsibility

24

#astern bonds in a public offering sub9ect to the Securities Act of 1:--. The registration statement filed with the S#C included the financial statements. 4old is being sued by #gan under Section 11 of the Securities Act of 1:-- for the misstatements contained in the financial statements. To prevail( #gan must prove a. b. c. d. A!S"#$% 16. A Scienter !o !o Ees Ees $eliance !o Ees !o Ees

The $usch /actors and $hode *sland Cospital Trust cases further defined the doctrine of privity by stating that a. b. c. d. Stoc+holders( as owners of the company( are also parties to the contract between auditor and client. Privity extends to primary third party beneficiaries +nown by the auditor to be relying on the financial statements. The doctrine of privity is bro+en when management intentionally misrepresents financial position and1or results of operations. Privity extends to third parties only in cases involving auditor negligence. 5

A!S"#$% 1>.

*n connection with the element of professional development( a CPA firm's system of =uality control should ordinarily provide that all personnel a. b. c. d. Cave the +nowledge re=uired to enable them to fulfill responsibilities assigned. Possess 9udgment( motivation( and ade=uate experience. See+ assistance from persons having appropriate level of +nowledge( 9udgment( and authority. &emonstrate compliance with peer review directives. A

A!S"#$% 1?.

*n the case of /ischer v. .let0 FEale #xpressG( the auditors were charged with fraud for failing to inform

25

Chapter 3 Maintaining Professional Responsibility users of nonexistent accounts receivable. Although the case was settled out of court( it did encourage the profession to issue a Statement on Auditing Standards relating to a. b. c. d. $elated party transactions. Auditor responsibility for detecting illegal acts. Audit ris+ assessment. Subse=uent discovery of facts existing at the date of the audit report. &

A!S"#$%

18. Accounting firms should establish =uality control procedures for professional development in order to provide reasonable assurance that d. Persons promoted possess the appropriate characteristics to perform competently. b. Personnel will have the +nowledge re=uired to fulfill responsibilities assigned. c. The extent of supervision and review in a given instance will be appropriate. d. Association with a client whose management lac+s integrity will be minimi0ed. A!S"#$% 1:. 5

The factor that distinguishes constructive fraud from actual fraud is a. ;ateriality. b. uality of internal control. c. Type of error or irregularity. d. *ntent. A!S"#$% &

'8.

4leam is contemplating a common law action against ;oore < Co. CPAs( based upon fraud. 4leam loaned money to Hilly < Co. relying upon Hilly's financial statements which were audited by ;oore. 4leam's action will fail if a. 4leam shows only that ;oore failed to meticulously follow 4AAS. b. ;oore can establish that they fully complied with the statute of frauds. c. The alleged fraud was in part committed by oral misrepresentations and ;oore pleads the parol evidence

Chapter 3 Maintaining Professional Responsibility

26

d.

rule. 4leam is not a third party beneficiary in light of the absence of privity. A

A!S"#$% '1.

*n the Continental Iending ;achine Corporation case( the court argued that a footnote appearing in the company's annual report was confusing and misleading. As a result( the accounting profession a. #ncouraged practitioners to carry ade=uate liability insurance. b. *ssued a Statement on Auditing Standards defining related party transactions and assigning auditor responsibility for detecting material related party transactions and determining that the economic substance of such transactions is properly reflected in the financial statements. c. *ssued a Statement on Auditing Standards re=uiring auditor presence at the client's physical inventory ta+ing and auditor confirmation of customer accounts receivable. d. ;ore clearly defined Aprivity of contractA between auditor and client.

A!S"#$% 5 ''. "or+ing papers prepared by a CPA in connection with an audit engagement are owned by the CPA( sub9ect to certain limitations. The rationale for this rule is to a. Protect the wor+ing papers from being subpoenaed. b. Provide the basis for excluding admission of the wor+ing papers as evidence because of the privileged communication rule. c. Provide the CPA with evidence and documentation which may be helpful in the event of a lawsuit. d. #stablish a continuity of relationship with the client whereby indiscriminate replacement of CPAs is discouraged. A!S"#$% '-. &ex C

;ead Corp. orally engaged &ex < Co.( CPAs( to audit its financial statements. The management of ;ead informed that it suspected that the accounts receivable were materially overstated. Although the financial

27

Chapter 3 Maintaining Professional Responsibility

statements audited by &ex did( in fact( include a materially overstated accounts receivable balance( &ex issued an un=ualified opinion. ;ead relied on the financial statements in deciding to obtain a loan from City 5an+ to expand its operations. City relied on the financial statements in ma+ing the loan to ;ead. As a result of the overstated accounts receivable balance( ;ead has defaulted on the loan and has incurred a substantial loss. *f ;ead sues &ex for negligence in failing to discover the overstatement( &ex's best defense would be that a. !o engagement letter had been signed by &ex. b. The audit was performed by &ex in accordance with generally accepted auditing standards. c. &ex was not in privity of contract with ;ead. d. &ex did not perform the audit rec+lessly or with an intent to deceive. A!S"#$% '3. 5

&ic+ens( a CPA firm's personnel partner( periodically studies the CPA firm's personnel advancement experience to ascertain whether individuals meeting stated criteria are assigned increased degrees of responsibility. This is evidence of the CPA firm's adherence to prescribed a. Standards of due professional care. b. uality control standards. c. Supervision and review standards. d. $eporting standards. A!S"#$% '6. 5

"est < Co.( CPAs( was engaged by Sand Corp. to audit its financial statements. "est issued an un=ualified opinion on Sand's financial statements. Sand has been accused of ma+ing negligent misrepresentations in the financial statements( which $eed relied upon when purchasing Sand stoc+. "est was not aware of the misrepresentations nor was it negligent in performing the audit. *f $eed sues "est for damages based upon Section 18FbG and rule 18b26 of the Securities #xchange Act of 1:-3( "est will a. Hose( because $eed relied upon the financial statements. b. Hose( because the statements contained negligent misrepresentations.

Chapter 3 Maintaining Professional Responsibility c. d. Prevail( because some element of scienter must be proved. Prevail( because $eed was not in privity of contract with "est. C

28

A!S"#$% '>.

A CPA establishes =uality control policies and procedures for deciding whether to accept a new client or continue to perform services for a current client. The primary purpose for establishing such policies and procedures is a. To enable the auditor to attest to the integrity or reliability of a client. b. To comply with the =uality control standards established by regulatory bodies. c. To lessen the exposure to litigation resulting from failure to detect irregularities in client financial statements. d. To minimi0e the li+elihood of association with clients whose management lac+s integrity. A!S"#$% &

'?.

"hich of the following statements is correct concerning corporations sub9ect to the reporting re=uirements of the Securities #xchange Act of 1:-3) a. The annual report Fform 182.G need not include audited financial statements. b. The annual report Fform 182.G must be filed with the S#C within '8 days of the end of the corporation's fiscal year. c. A =uarterly report Fform 182 G need only be filed with the S#C by those corporations that are also sub9ect to the registration re=uirements of the Securities Act of 1:--. d. A monthly report Fform B2.G must be filed with the S#C after the end of any month in which a materially important event occurs. A!S"#$% &

'B.

*n a common law action against an accountant( the lac+ of privity is a viable defense if the plaintiff a. 5ases his action upon fraud. b. *s the accountant's client. c. *s a creditor of the client who sues the accountant for negligence.

29

Chapter 3 Maintaining Professional Responsibility d. Can prove the presence of gross negligence which amounts to a rec+less disregard for the truth. C

A!S"#$% ':.

&onn < Co. is considering the sale of D11 million of its common stoc+ to the public in interstate commerce. *n this connection( &onn has been correctly advised that registration of the securities with the S#C is a. !ot re=uired if the states in which the securities are to be sold have securities acts modeled after the federal act and &onn files in those states. b. $e=uired in that it is necessary for the S#C to approve the merits of the securities offered. c. !ot re=uired if the securities are to be sold through a registered bro+erage firm. d. $e=uired and must include audited financial statements as an integral part of its registration. A!S"#$% -8. &

Tulip Corp. is a registered and reporting corporation under the Securities #xchange Act of 1:-3. As such it a. Can offer and sell its securities to the public without the necessity of registering its securities pursuant to the Securities Act of 1:--. b. Cannot ma+e a tender offer for the e=uity securities of another registered and reporting corporation without the consent of the S#C. c. ;ust file annual reports F/orm 182.G with the S#C. d. ;ust distribute a copy of the annual report F/orm 182 .G to each of its shareholders. A!S"#$% C

-1.

A CPA firm issues an un=ualified opinion on financial statements not prepared in accordance with 4AAP. The CPA firm will have acted with scienter in all the following circumstances except where the firm a. *ntentionally disregards the truth. b. Cas actual +nowledge of fraud. c. !egligently performs auditing procedures. d. *ntends to gain monetarily by concealing the fraud. A!S"#$% C

Chapter 3 Maintaining Professional Responsibility -'. "hich of the following conditions suggests auditor negligence) a. b. c. d. /ailure to detect material errors under conditions of wea+ internal control. /ailure to detect collusive fraud perpetrated by members of middle management. /ailure to detect collusive fraud perpetrated by members of top management. /ailure to detect errors occurring outside the internal control structure. A

30

A!S"#$% --.

The registration of a security under the Securities Act of 1:-- provides an investor with a. A guarantee by the S#C that the facts contained in the registration statement are accurate. b. An assurance against loss resulting from purchasing the security. c. *nformation on the principal purposes for which the offering's proceeds will be used. d. *nformation on the issuing corporation's trade secrets. A!S"#$% C

-3.

The principal purpose of the registration re=uirements of the Securities Act of 1:-- is to a. Prevent public offerings of securities in which management fraud or unethical conduct is suspected. b. Provide the S#C with the information necessary to determine the accuracy of the facts presented in the financial statements. c. Assure that investors have ade=uate information upon which to base investment decisions. d. Provide the S#C with the information necessary to evaluate the financial merits of the securities being offered. A!S"#$% C

COMPLETION%

31

Chapter 3 Maintaining Professional Responsibility A committee formed in 1::: to Jfocus on the problem of managed earnings( coo+ie29ar reserves( purchased $<& write2 offs( and abuse of the materiality conceptK is +nown as the LLLLLLLLLL LL LLLLLLL LLLLLLLLLLLLL. A!S"#$% PA!#H ,! A@&*T #//#CT*I#!#SS

35.

->.

A disparity between users' and CPAs' perceptions of auditor responsibility is referred to as the . A!S"#$% #MP#CTAT*,! 4AP

-?.

@ltimate authority to set accounting and auditing standards rests with the . A!S"#$% S#C@$*T*#S A!& #MCCA!4# C,;;*SS*,!

-B.

is defined as negligence so flagrant as to border on deceit. A!S"#$% C,!ST$@CT*I# /$A@&

-:.

The primary difference between contractual liability to clients and civil liability to third parties is that( under civil liability( the auditor is not liable to third parties for . A!S"#$% ,$&*!A$E !#4H*4#!C#

38.

4iven the Securities #xchange Act of 1:-3 and the concept of Aintegrated disclosureA( information may be LLLLLLLLLLLL LLL in /orm 182.. A!S"#$% *!C,$P,$AT#& 5E $#/#$#!C# .

31.

The legal term for Aintent to deceiveA is A!S"#$% SC*#!T#$

3'.

Auditor liability under the Securities acts is referred to as liability. A!S"#$% STAT@T,$E

43. *n responding to an underwriter's re=uest for a LLLLLLLLLL

Chapter 3 Maintaining Professional Responsibility LLLLLLLLL( the auditor will li+ely apply certain limited procedures to the financial data arising subse=uent to the most recent audit. A!S"#$% 33. C,;/,$T H#TT#$

32

*n the #rnst and #rnst v. Cochfelder case( the @.S. Supreme Court held that auditors are not liable for under $ule 18526 of the Securities #xchange Act of 1:-3( but only for . A!S"#$% !#4H*4#!C#( SC*#!T#$ F/$A@&G

MATCHING: 36. ;atch each of the responsibilities enumerated below with the bodies charged with that responsibility. a. b. c. d. e. f. g. h. State board of accountancy S#C Practice Section Public ,versight 5oard Securities and #xchange Commission A*CPA uality Control Standards 5oard *ndependence Standards 5oard #merging *ssues Tas+ /orce Panel on Audit #ffectiveness

LLLL 1. ,versee peer review for public companies. LLLL '. *ssue a guideline for reviewing accounting firm personnel for promotion. LLLL -. *ssue recommendations directed toward improving the =uality of independent audits. LLLL 3. $ecommend that the executive committee of the S#C Practice Section sanction a member for failing to comply with the SectionNs peer review standards. LLLL 6. *ssue a standard prohibiting an accounting firm from accepting an accounting service engagement from an audit client on the basis that performing both types of service might impair ob9ectivity. LLLL >. $eview prospectus and registration statement of

33

Chapter 3 Maintaining Professional Responsibility company contemplating an initial public offering.

LLLL ?. $evo+e license of member for committing a discreditable act. LLLL B. ;onitor /AS5 deliberations concerning the proper accounting treatment to be applied to derivatives. S,H@T*,!% 1. '. -. 3. 6. >. ?. B. ESS ! 3>.An auditor is sued for negligence by the stoc+holders of an audit client. The auditor had issued an un=ualified opinion on the clientNs financial statements. *t was later determined that the statements were materially distorted due to errors and fraud. $e=uired% a. @nder what conditions( in common law may an auditor be held liable to third parties for negligence) b. &escribe two approaches for differentiating between ordinary negligence and gross negligence. Cite examples to support your approaches. c. S,H@T*,!% a. The doctrine of privity states that auditors are liable to third parties for fraud but not for negligence. Subse=uent court decisions( such as @ltramares v. Touche( however( have construed gross negligence as constructive fraud. Auditors( therefore( may be held liable to in9ured third parties for gross negligence( but not for ordinary negligence. *n addition( privity may extend to specifically identified third parties +nown by the auditor to be relying on the audited financial statements. "ho will prevail in the present case) b e h c f d a g

Chapter 3 Maintaining Professional Responsibility

34

b. Two approaches to distinguishing ordinary negligence from gross negligence are materiality and internal control. Performing an audit with due care should permit the auditor to detect a material misstatement not cleverly concealed. /or example( an inventory extension error Fprice x =uantityG that overstates the ending inventory by '6 percent and results in a material overstatement of net income should be detected in the ordinary course of the audit. #rrors or fraud perpetrated because of wea+ internal controls are more li+ely to be detected by the auditor than errors or fraud perpetrated outside the existing system of internal control. /or example( material misstatements caused by classification errors related to repairs and maintenance expenditures versus property( plant( and e=uipment additions may occur because the persons charged with determining the appropriate accounts to be debited have not been ade=uately trained. This constitutes an internal control wea+nessO and the auditors should have detected the wea+ness and modified their substantive audit testing accordingly. Contrast this with a material misstatement caused by management intentionally overriding existing internal control for the purpose of inflating earnings. As part of the scheme( documentation supporting fictitious sales may have been fabricated. @nder these conditions( the prudent auditor is less li+ely to detect the fraud. c. To prevail in the present case( the plaintiffs must demonstrate that the auditor was grossly negligent and must also prove that the plaintiffs were in9ured by the auditorsN negligence. 3?. A. Cow does the level of =uality maintenance within the accounting profession impact the expectations gap) Cite examples in your answer. 5. "hat is the alternative to self2regulation) Cite two measures the profession has ta+en in recent years to meet the challenges posed by the threat of a widening expectations gap) S,H@T*,!% The goal of self2regulation within the accounting profession is to maintain the =uality of accounting services at a level that will satisfy the users of these services. The expectations gap is the disparity between usersN and CPAsN perceptions of the =uality of these services. Therefore( a decline in either the =uality of services rendered by CPAs or

35

Chapter 3 Maintaining Professional Responsibility

usersN perceptions of =uality causes a widening of the expectations gap. Such diminishments occur( for example( when courts find auditors negligent in the performance of audits or when the financial press reports incidents of alleged audit failures. Cases involving Phar ;or( Hincoln Savings and Hoan( Cra0y #ddie( and ;iniscribe can be cited as illustrations. CPA consulting services for audit clients impair the appearance of independence( and is another means for widening the expectations gap and undermining the perceived effectiveness of self2 regulation. The alternative to self2regulation is external regulation by the S#C or a similar public body. ,ne must remember that the S#C already has the authority granted by the securities acts to regulate the accounting profession( but has declined to fully exercise that authority. *f the expectations gap were to widen significantly( however( and self2regulation is perceived to be ineffective( the S#C may well decide to actively pursue its regulatory powers. To meet the challenges posed the threat of a widening expectations gap and more external regulation( the profession( in recent years( has% 1. Assigned the auditor responsibility for planning the audit to provide reasonable assurance of detecting material financial statement errors and fraudO '. $e=uired auditors to evaluate the ability of each audit client to continue as a going concernO -. #ncouraged clients to appoint audit committees to monitor internal control and arbitrate disputes between management and the external auditorsO 3. *ssued a new SAS that provides more explicit guidance to auditors for detecting fraud and communicating the findings to management and the board of directorsO 6. Created an *ndependence Standards 5oard to actively pursue issues involving auditor independence 3B. /or each of the following capsule cases( determine the outcome and provide the rationale to support your conclusion. 1. A group of stoc+holders is suing a CPA for failing to detect a material misappropriation of customer cash receipts by the controller of a company in which the group has invested. The fraud occurred because the controller had access to cash as well as the accounting records. The fraud was concealed by not recording the receipts. To conceal the overstatement of accounts receivable( the controller inflated sales returns and allowances and wrote off some of the accounts as uncollectible. The CPA failed to detect the fraud in the course of the audit.

Chapter 3 Maintaining Professional Responsibility

36

'. The management of a large manufacturer of exercise e=uipment inflated net assets and net earnings by 1Grecording fictitious sales and fabricating the underlying documentationO 'Gdebiting operating expenses to several construction pro9ects in progressO and -G inflating inventories by not recording sales returns and including the inventory at full cost( and inflating various inventory unit costs. These frauds were detected by *$S auditors after the companyNs chec+ for payment of income taxes Jbounced.K The independent auditors did not discover the misrepresentation( and the new management is now suing them for failure to detect the fraud. -. A CPA failed to detect a misrepresentation fraud perpetrated by an audit client. The fraud was material in its impact on the financial statements and was effected by debiting operating expenses and manufacturing overhead to wor+ orders for various construction pro9ects underway. The pro9ects did not exist and the CPA examined a client2prepared analysis of the wor+ orders rather than the wor+ orders themselves. ;oreover( the CPA did not as+ to inspect any of the pro9ects. An action alleging negligence was brought against the CPA by the ban+ that granted a loan to the company on the basis of the audited financial statements. The inflated earnings figure resulting from the misrepresentation was an integral part of the decision to grant the loan. The CPA had rendered an un=ualified opinion on the financial statements. This was the first year the company had been audited. *n past years( the CPA had performed only a review of the companyNs financial statementsO but this year the company re=uested an audit as part of the ban+Ns conditions for processing the loan application. S,H@T*,!% 1. The stoc+holders need to prove gross negligence by the CPA( inasmuch as they are not privy to the contract between the CPA and the client. The CPA appears to have been grossly negligent in this case. /irst( the fraud was facilitated by internal control wea+nesses 2 the controller had access to cash as well as to accounting records. The CPA should have noted the wea+ness in assessing internal control and modified substantive audit programs accordingly. /urther investigation of the accounts receivable write2offs( including contacting customers whose accounts had been written off( should have enabled the auditor to detect the fraud. *n summary( this is a material

37

Chapter 3 Maintaining Professional Responsibility

fraud perpetrated within the system of internal control( and failure to detect is evidence of gross negligence. '. The auditors appear not to be negligent in this case. Hi+e Cenco v. Seidman < Seidman( the fraud was perpetrated by top management( was cleverly concealed( and was effected by overriding internal control. As the court stated in that case( Jauditors cannot be expected to detect misstatements when management has turned the entity into an Pengine of fraud.NK -. The CPA will probably lose in this case. Although not grossly negligent( privity will li+ely be extended to the ban+ because the CPA +new the ban+ was the primary beneficiary of the audited financial statements. !egligence may be inferred by the fact that the auditor did not examine the wor+ orders and did not inspect any of the additions.