The following questions relate to the auditors' legal liability. Select the best response.

a. DMO Enterprises, Inc., engaged the accounting firm of Martin, Seals & Anderson to perform its annual audit. The firm performed the audit in a competent, nonnegli- gent manner and billed DMO for $16,000, the agreed fee. Shortly after delivery of the audited financial statements, Hightower, the assistant controller, disappeared, taking with him $28,000 of DMO's funds. It was then discovered that Hightower had been engaged in a highly sophisticated, novel defalcation scheme during the past year. He had previously embezzled $35,000 of DMO funds. DMO has refused to pay the accounting firm's fee and is seeking to recover the $63,000 that was stolen by Hightower. Which of the following is correct? 

1. The accountants can not recover their fee and are liable for $63,000. 

2. The accountants are entitled to collect their fee and are not liable for $63,000. 

3. DMO is entitled to rescind the audit contract and thus is not liable for the $16,000 fee, but it can not recover damages. 

4. DMO is entitled to recover the $28,000 defalcation, and is not liable for the $16,000 fee. 

b. If a CPA firm is being sued for common law fraud by a third party based upon materially false financial statements, which of the following is the best defense which the accountants could assert? 

1. Lack of a contractual relationship. 

2. Lack of reliance. 

3. A disclaimer contained in the engagement letter. 

4. Contributory negligence on the part of the client.

c. Lewis & Clark, CPAs, rendered an unqualified opinion on the financial statements of a company that sold common stock in a public offering subject to the Securities Act of 1933. Based on a false statement in the financial statements, Lewis & Clark are being sued by an investor who purchased shares of this public offering. Which of the following represents a viable defense? 

1. The investor has not met the burden of proving fraud or negligence by Lewis & Clark.

2. The investor did not actually rely upon the false statement. 

3. Detection of the false statement by Lewis & Clark occurred after their audit report date. 

4. The false statement is immaterial in the overall context of the financial statements. 

d. Gibson is suing Simpson & Sloan, CPAs, to recover losses incurred in connection with Gibson's transactions in Zebra Corporation securities. Zebra's Annual Form 10-K Report contained material false and misleading statements in the financial statements audited by Simpson & Sloan. To recover under the Securities and Exchange Act of 1934, Gibson must, among other things, establish that 

1. All of his past transactions in Zebra securities, both before and after the auditors' report date, resulted in a net loss. 

2. The transaction in Zebra securities that resulted in a loss occurred within 90 days of the auditors' report date. 

3. He relied upon the financial statements in his decision to purchase or sell Zebra securities. 

4. The market price of the stock dropped significantly after corrected financial statements were issued by Zebra. 

e. Donalds & Company, CPAs, audited the financial statements included in the annual report submitted by Markum Securities, Inc., to the Securities and Exchange Commission. The audit was improper in several respects. Markum is now insolvent and unable to satisfy the claims of its customers. The customers have instituted legal action against Donalds based upon section 10b and rule 10b-5 of the Securities Exchange Act of 1934. Which of the following is likely to be Donalds' best defense? 

1. They did not intentionally certify false financial statements. 

2. Section 10b does not apply to them. 

3. They were not in a contractual relationship with the creditors. 

4. Their engagement letter specifically disclaimed any liability to any party which resulted from Markum's fraudulent conduct.