Exam 3: Legal Liability

You are the auditor of Jehello Incorporated, a public company with a December year end. Your firm has audited Jehello for the past three years. The following issues were documented in the working paper files for the prior year audit: • The company had incurred expenditures of $400 000 related to the development of a new sound system. The large majority of the costs were related to development of software, hardware, and presentation of the results to customers who participated in focus groups. Management had been optimistic that the new sound system would work well, even though focus group results had been poor. These costs had been fully capitalized. • About 40% of the company's revenues were from one customer. That contract had been due for renewal on May 15, ten days after the audit report had been issued. Documents on file indicated that the customer seemed likely to renew the contract, although quality control disputes were escalating. On May 14, Jehello was informed that the contract would not be renewed. Jehello has defaulted on its bank loans and the bank is suing you, saying that the financial statements presented last year were false and misleading. Required: A) Which defences should the auditor use? B) Do you believe that the auditor will lose the suit? Why or why not?

PA was engaged by Microcomputer Distributor Limited (MDL) to conduct a review engagement. The financial statements are used primarily by the shareholders, management, and by the bank. Recently, an employee was fired for stealing computer parts, primarily chips and boards that could easily be placed in a pocket. MDL is suing PA because they believed that audit procedures, such as counting inventory, would have detected this fraud. What is PA's best defence?

The leading precedent-setting case in third-party liability was a 1931 U.S. case, Ultramares v. Touche. What is the key aspect of this case?

What rights do secondary investors (i.e. those who purchase shares after an initial offering) have to sue an auditor?

Small Town Lumberyard Limited (STLL) needed an additional bank loan to finance its operations. To make its financial statements look better, the company overstated its inventory and overstated its accounts payable. The auditors did not detect this deliberate misstatement because they conducted limited tests of inventory and did not confirm accounts payable. Other auditors agreed that the procedures conducted during this audit were inadequate. The auditors of STLL would likely be considered to be

Bigland and Betton, PAs, is being sued by a bank for potential negligence during an audit engagement that was completed over five years ago. Which of the following actions during that audit engagement will help ensure that the suit is fairly assessed?

The King Surety Company wrote a general fidelity bond covering defalcations by the employees of Wilson, Inc. Thereafter, Cooney, an employee of Wilson, embezzled $17 200 of company funds. When the activities were discovered, King paid Wilson the full amount in accordance with the terms of the fidelity bond, and then sought recovery against Wilson's auditors, Lynch & Merritt, public accountants. Which of the following would be Lynch & Merritt's best defence?

Individuals who accept fees (or property) and know or are willfully blind to the fact that the property was obtained illegally can be charged with money laundering, a criminal offence. Which of the following techniques will help a PA prevent such charges?

The principal issue to be resolved in cases involving alleged negligence is usually

An investor suing an auditor for not discovering that the financial statements of a company were materially misstated is an example of

While performing services for their clients, professionals have always had a duty to provide a level of care that is

In the auditing environment, failure to meet generally accepted auditing standards is often

There are a number of things that a practising auditor can do to reduce liability in lawsuits. One of them is to

The standard of due care to which the auditor is expected to be held is referred to as the

Your firm has been the auditor of Chappello Design and Construction Limited for several years. During the current year, a consultant on staff at your firm assisted Chappello in the selection and implementation of a new computer system. The audit staff were not involved in this process. The new system was an enterprise-wide system that was to be implemented without modification using the direct cut-over approach (the old system was discontinued and the new one continued the next day). Unfortunately, staff had extreme difficulty using the system and discontinued it after two months. During that time, Chappello was unable to document and bill its work for progress billings, and borrowed heavily to continue to pay its employees while work continued. The company reverted to its old system and claims that it has lost hundreds of thousands of dollars in revenues as it was unable to issue quotes and bid on new contracts. Chappello has sued your firm for negligence with respect to the implementation of the computer system. Required: Which defences should the firm use? Support your answer with reasons.