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Business Failure

when a business is unable to pay lenders or meet expectations of stockholders

usually because of unexpected competition, poor management, or economic conditions.

Audit Failure

when an auditor issues an incorrect opinion because they failed to comply with GAAS


Audit Risk

the possibility that after conducting an adequate audit, they determine that the financial statements are fairly stated, when they are actually misstated.

*unavoidable - because of test basis, concealed fraud

Expectation Gap

Difference between what auditors do, and what users of financial information think they do.

The wider the gap, the more liability the auditors have.

Prudent-Person Concept

conducted audit with due care

Privileged Communication

1. AICPA Ethics
2. Subpeona
3. Professional Standards (look up recording)
4. Quality Control

*Must be expressed at the point of communication

Ordinary Negligence

Absence of resonable care that can be expected of a person in a set of circumstances - for auditors it is generally in terms of what other auditors would have done. - lack of reasonable care

Gross Negligence

Lack of even slight care that can be expected of a person. - lack of minimal care

Constructive Fraud

existence of extreme, or unusual, negligence even through there was NO INTENT to deceive or do harm.


when a misstatement is made and there is both the KNOWLEDGE of its falsity and the INTENT to deceive.

Breach of Contract

Failure of one or both parties in a contract to fulfill the requirements of the contract.

Privity of Contract

Parties who have a relationship that is established by a contract.

*must have privity before litigation.

Third-party beneficiary

A third party who does not have privity of contract but is known to the contracting parties and is intended to have certain rights and benefits under the contract.

*i.e. a bank that has a large loan outstanding at the balance sheet date and requires an audit as a part of its loan ageement.

Common Law

Laws developed through court decisions rather than through government statutes.


Statutory Law

Laws that have been passed by US congress and other governmental units. SOX, SEC act of 1934

Joint and Several Liability

the assessment against a defendant of the full loss suffered by a plaintiff, regardless of the extent to which other parties shared in the wrongdoing.

i.e. management intentionally falsifies financial statements, an auditor can be assessed the entire loss to shareholders if the company is bankrupt and management is unable to pay.

Separate and proportionate liability

the assessment against a defendant of that portion of the damage caused by the defendant's negligence.

i.e. courts determine that an auditor's negligence in conducting an audit was the cause of 30%of a loss to a defendant, only 30% of the aggregate damage will be assessed to the CPA firm.+

Tort Liability

Obligation based on failure to exercise appropriate level of professional care.


person who posesses the intent to deceive with fraud - must be proven

T or F: The distinction between constructive fraud and fraud is that fraud has a greater degree of recklessness

False: Fraud needs intent

failure of one or both parties to fulfill the requirements of a contract. (legal term)

Breach of Contract

Recklessness (legal term)

Gross Negligence OR Constructive Fraud

Parties who share a contractual relationship (legal term)


Laws passed by Congress or Governmental Units (legal term)


The assessment of a full loss suffered by a plaintiff irrespective of shared wrongdoing (legal term)

joint sever loss

knowledge of a material misstatement with intent to deceive (legal term)


The concept that the audtitor is expected to conduct the audit with due care and is not expected to be perfect

prudent person concept

Elements to be proven by plaintiff for conviction of common law negligence (4)

1. Duty of care existed
2. Breach of that Duty
3. Injury to Plaintiff
4. proximate cause of injury was the breach (2)

Elements to be proven by plaintiff for conviction of common law fraud

1. Material misrepresentation of fact
2. knowledge and intent to deceive - scienter
3. Reliance
4. Injury

Elements to be proven by plaintiff for conviction of constructive fraud

1. Omission
2. Disregard
3. Reliance
4. Injury

Proof and Defenses: liable for ordinary negligence, gross negligence constructive fraud and fraud

Lack of duty - never in contract
non-negligent performance
causation - auditor didn't cause injury
contributory negligence - clients partially responsible

___ is not a viable defense in a suit against the CPA by the client.


If a stockholder sues a CPA for common law fraud based on false statements contained in the financial statements audited by the CPA, which of the following would be the best defense?

a. Stockholder's lack of privity
b. the false statements are immaterial (answer)
c. the cpa did not financially benefit from the alleged fraud.
d. the contributory negligence of the client


ordinary negligence is insufficient for liabilities to third parties, because of lack of privity

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

Gross Negligence/Constructive Fraud

Under Common Law, which of the following statements most accurately reflects the liability of a CPA who fraudulently gives an opinion on an audit client's financial statements?

The CPA probably is liable to any person who suffered a loss as a result of the fraud

What is the best defense a CPA firm can assert in a suit for common law fraud based on its unqualified opinion on materially false financial statements?

Lack of scienter

Securities act of 1933

regulates initial issuance of securities by registrants to investing public

registration statment must include f/s

Section 11 of 1933

plaintiff must prove
1. material missrepresentation or omission in registration statement.
2. prove loss suffered


Under section 10b and 10b5 of the sec 1934 act - what must be proven by a stock purchaser in a suit against a CPA?

1. Intentional conduct by the cpa designed to deceive investors

2. Materiality.

distinction between Sec 1934 Act. 10b and Sec act 1933 section 11?

sec act 1934 requires intent to deceive, section 11 burden of proof lies on defendant

sources of legal liability for auditors

third party under common law
federal statutory

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