It is often difficult for courts to interpret the negligence standard in deciding whether an act or omission by the auditor constitutes a simple error, negligence, or gross negligence. Often the courts look to the standards of prudent professionals in the conduct of auditing to provide guidance.

Required

For each situation listed, briefly describe whether you think the act or omission constitutes negligence, gross negligence, or neither. Support your answer with a brief rationale. Assume that each of the situations led to material errors in the financial statement and to a lawsuit against the auditors.

a. The auditor failed to note that a confirmation signature was a forgery.

b. The auditor had the client mail out the accounts receivable confirmations in order to expedite completion of the audit and to save audit fees. The client and auditor had agreed, in advance, to this procedure as a way to reduce audit fees.

c. The auditor failed to recognize that the client’s warranty accrual was understated. The understatement was due to a new product introduction with which the client had no experience.

d. The client’s loan loss reserve (allowance for uncollectible loans) was materially understated. Many of the client’s loans were not documented and were not properly collateralized.

e. The auditor failed to discover a material misstatement of sales and accounts receivable. The auditor had noted a large increase in yearend sales and receivables, but did not plan any special procedures because previous audits had not indicated any errors. Most of the year-end sales were fictitious.

f. The client had inappropriately charged a material amount of new capital equipment to repairs and maintenance expense. The client did so in order to minimize its tax liability. The auditor did not perform a detailed review of repairs and maintenance, but did note that the account had risen only 15% above the previous year, and that sales had increased 5%.

g. Same situation as part (f), except that the auditor assigned an inexperienced auditor to the audit of maintenance. It was the auditor’s first time on the job, and she failed to recognize that items should have been capitalized because she was not familiar with the industry or the client’s capitalization policy.