The following questions deal with liability under the 1933 and 1934 securities acts. Choose the best response.

1.. Major, Major, & Sharpe, CPAs, are the auditors of MacLain Technologies. In connection with the public offering of $10 million of MacLain securities, Major expressed an unqualified opinion as to the financial statements. Subsequent to the offering, certain misstatements were revealed. Major has been sued by the purchasers of the stock offered pursuant to the registration statement that included the financial statements audited by Major. In the ensuing lawsuit by the MacLain investors, Major will be able to avoid liability if

(1) the misstatements were caused primarily by MacLain.
(2) it can be shown that at least some of the investors did not actually read the audited financial statements.
(3) it can prove due diligence in the audit of the financial statements of MacLain.
(4) MacLain had expressly assumed any liability in connection with the public offering.

2. Under the 1933 Securities Act, which of the following must be proven by the purchaser of the security? 

Reliance on the Financial Statements   Fraud by The CPA
(1) Yes                                                     Yes
(2) Yes                                                     No
(3) No                                                      Yes
(4) No                                                      No

3. Donalds & Company, CPAs, audited the financial statements included in the annual report submitted by Markum Securities, Inc. to the SEC. 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 on 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 privity of contract with the creditors.

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

4 .Lauren Yost & Co., a medium-sized CPA firm, was engaged to audit Stuart Supply Company. Several staff were involved in the audit, all of whom had attended the firm's in-house training program on effective auditing methods. Throughout the audit, Yost spent most of her time in the field planning the audit, supervising the staff, and reviewing their work.

A significant part of the audit entailed verifying the physical count, cost, and summarization of inventory. Inventory was highly significant to the financial statements, and Yost knew the inventory was pledged as collateral for a large loan to First City National Bank. In reviewing Stuart's inventory count procedures, Yost told the president she believed the method of counting inventory at different locations on different days was highly undesirable. The president stated that it was impractical to count all inventory on the same day because of personnel shortages and customer preference. After considerable discussion, Yost 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 person at each site to audit the inventory count procedures and actual count. There were more than 40 locations.

Eighteen months later, Yost found out that the worst had happened. Management below the president's level had conspired to materially overstate inventory as a means of covering up obsolete inventory and inventory losses resulting from mismanagement. The misstatement occurred by physically transporting inventory at night to other locations after it had been counted in a given location. The accounting records were inadequate to uncover these illegal transfers.

Both Stuart Supply Company and First City National Bank sued Lauren Yost & Co.Answer the following questions, setting forth reasons for any conclusions stated:

Required

a. What defense should Lauren Yost & Co. use in the suit by Stuart?

b. What defense should Lauren Yost & Co. use in the suit by First City National Bank?

c. Is Yost likely to be successful in her defenses?

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

5. Watts and Williams, a firm of CPAs, audited the accounts of Sampson Skins, Inc., a corporation that imports and deals in fine furs. Upon completion of the audit, the auditors supplied Sampson Skins with 20 copies of the audited financial statements. The firm knew in a general way that Sampson Skins wanted that number of copies of the auditor's report to furnish to banks and other potential lenders.

The balance sheet in question was misstated by approximately $800,000. Instead of having a $600,000 net worth, the corporation was insolvent. The management of Sampson Skins had doctored the books to avoid bankruptcy. The assets had been overstated by $500,000 of fictitious and nonexisting accounts receivable and $300,000 of nonexisting skins listed as inventory when in fact Sampson Skins had only empty boxes. The audit failed to detect these fraudulent entries. Martinson, relying on the audited financial statements, loaned Sampson Skins $200,000. He seeks to recover his loss from Watts and Williams.

State whether each of the following is true or false and give your reasons:

Required
 a. If Martinson alleges and proves negligence on the part of Watts and Williams, he will be able to recover his loss.
 b. If Martinson alleges and proves constructive fraud (that is, gross negligence on the part of Watts and Williams), he will be able to recover his loss.
 c. Martinson does not have a contract with Watts and Williams.
 d. Unless actual fraud on the part of Watts and Williams can be shown, Martinson cannot recover.
 e. Martinson is a third-party beneficiary of the contract Watts and Williams made with Sampson Skins.