VI. William Potter and Co, CPAs, was engaged to audit Ruffin Electronics Company. Several staff were involved in the audit and all had attended the firms training on effective audit methods. Throughout the audit, Potter spent most of his time in the field planning the audit, supervising the staff, and reviewing their work. A significant portion of the audit involved verifying the physical count, cost, and summary of inventory. Inventory was highly significant to the statements, and Potter knew the inventory was pledged as collateral for a large loan from Third Bank. In reviewing Ruffins inventory count procedures, Potter and the company president discussed how undesirable it was to count inventory at different locations on different days. The president argued it was impractical to count all inventory on the same day because of personnel shortages and customer preferences. After much discussion, Potter agreed to permit the practice if the president would sign a statement that no other method was practical. The CPA firm had at least one staff member at each site to audit the inventory count procedures and the actual count. There were more than 40 locations. Twelve months later, Potter found out that the worst had happened. Management below the presidents level had conspired to materially overstate inventory as a means of covering up obsolete inventory and losses from mismanagement. The misstatement occurred by physically transporting inventory at night to other locations once it had been counted at a given location. The accounting records did not uncover these illegal transfers. Both Ruffin Electronics Company and Third Bank sued William Potter and Co.

A. What elements must be established to support a cause of action based on negligence? Describe the evidence to prove the elements.

B. What defense should William Potter & Co. use in the suit by Ruffin?

C. What defense should William Potter & Co. use in the suit by Third Bank?

D. Would the issues or outcome be significantly different if the suit were brought under the Securities Exchange Act of 1934?