Question

1. What is the difference between the Securities Act of 1933 and the Securities Exchange Act of 1934 with respect to what they regulate? What factors do the purchasers of securities under the Securities Act of 1933 need to prove to recover losses from the CPA? What would be a viable defense by the CPA?

2. Many CPA firms are taking a business risk approach to audits. Define what is meant by business risk. Provide an example of a business risk that could result in a risk of material misstatement of the financial statements.

Answer 1

1. The Securities Act of 1933 was the first federal legislation used to regulate the stock market. The act took power away from the states and put it into the hands of the federal government. The act also created a uniform set of rules to protect investors against fraud. It was signed into law by President Franklin D. Roosevelt and is considered part of the New Deal passed by Roosevelt.

The Securities Act of 1933 is governed by the Securities and Exchange Commission, which was created a year later by the Securities Exchange Act of 1934. Several amendments to the Securities Act of 1933 have passed since its creation. Amendments have been passed to update rules numerous times over the years, with the latest enacted in 2018.

The Securities Act of 1933 was created and passed into law to protect investors after the stock market crash of 1929. The legislation had two main goals: to ensure more transparency in financial statements so investors could make informed decisions about investments; and to establish laws against misrepresentation and fraudulent activities in the securities markets.

The Securities Exchange Act of 1934 (SEA) was created to govern securities transactions on the secondary market, after issue, ensuring greater financial transparency and accuracy and less fraud or manipulation.

The SEA authorized the formation of the Securities and Exchange Commission (SEC), the regulatory arm of the SEA. The SEC has the power to oversee securities—stocks, bonds, and over-the-counter securities—as well as markets and the conduct of financial professionals, including brokers, dealers, and investment advisors. It also monitors the financial reports that publicly traded companies are required to disclose.

• The Securities Exchange Act of 1934 was enacted to govern securities transactions on the secondary market.
• All companies listed on a stock exchange must follow the requirements outlined in the SEA of 1934.
• The purpose of the requirements of the Securities Exchange Act of 1934 is to ensure an environment of fairness and investor confidence.

Under the Securities Act of 1933 purchasers of securities who sustain losses need only prove that the financial statements contained in the registration statement were misleading. Then the burden is shifted to the auditors to prove that they performed the audit with "due diligence."

A CPA may avoid liability under the 1933 Act by proving that their negligence was not the proximate cause of the plaintiff's loss. Accordingly, a finding that the false statement is immaterial would in all circumstances represent a viable defense.

2. The business risk approach to auditing involves examining the business in it’s entirely and evaluating the various risks to which it is exposed. The business risks are factors which affect the company’s ability to meet its goals. The risks may be controllable (to some extent) or uncontrollable (for example, external factors). It may be possible to trade-off some risks (e.g. insurance). The auditor is concerned about those risks which may impact upon the financial statements and therefore needs a full understanding of the business and its risks in order to do this. The auditor will then plan the audit strategy with these business risks clearly focused in mind.

The following is a list of business risk examples, though not comprehensive, typically faced by companies. Each example also explains how the business risk may lead to risk of material misstatement of the financial statements.

Improving Technology

Businesses are exposed to the risk of being left behind in the race for constantly improving technology. Their methods, techniques and products will become outdated thus resulting in lost sales or inefficient production. A new method of production may lead to superior quality products resulting in impairment of inventory already held by a business. The corresponding risk of material misstatement is that inventory is overstated in balance sheet and cost of sales understated in income statement.

Laws and Regulations

Laws and regulations are almost entirely out of a company’s control. Due to changing legislation and volatile political environment, businesses are constantly at risk of higher taxes, ever stringent regulations and risk of inadvertently breaching laws. These may lead to a range of material misstatements in the financial statements. For example, those related to taxation, legal obligations and provisions etc.

Financing

A company may find itself in shortage of cash. The management of the company may find themselves compelled to show a better picture of the business in the financial statements in order to secure additional financing. There will be a risk of management bias in estimates and accounting policies.

Competition

Fierce competition may result in a company finding it difficult to stay in business. If the company’s financial statements are prepared on going concern basis, there is a risk that the company might not actually be a going concern and therefore the financial statements will be materially misstated.

Fraud

Businesses are at risk of fraud being committed by management, employees or those outside the organization. Fraud will most likely result in financial impact and therefore may result in a risk of material misstatement in the financial statements.