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Learning Objectives Understand the litigious environment in which CPAs practice. Explain why the failure of financial statement users to differentiate among business failure, audit failure, and audit risk has resulted in lawsuits. Use the primary legal concepts and terms concerning accountants’ a basis for studying legal liability of auditors.
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Legal Liability Considerations for Auditors
Chapter 4 Legal Liability Considerations for Auditors 1 Learning
Objectives Understand the litigious environment in which CPAs
practice. Explain why the failure of financial statement users to
differentiate among business failure, audit failure, and audit risk
has resulted in lawsuits. Use the primary legal concepts and terms
concerning accountants a basis for studying legal liability of
auditors. Learning Objectives Describe accountants liability to
clients and related defenses. Describe accountants liability to
third parties under common law and related defenses. Describe
accountants civil liability under the federal securities laws and
related defenses. Learning Objectives Specify what constitutes
criminal liability for accountants. Describe how the profession and
individual CPAs can reduce the threat of litigation. Understand the
litigious environment in which CPAs practice.
1 Understand the litigious environment in which CPAs practice.
Changed Legal Environment
Audit professionals have a contractual responsibility with clients.
Auditors are liable for negligence. The number of lawsuits and
sizes of awards remain high. Audit professionals have a
responsibility under common law to fulfil implied or expressed
contracts with clients. They are liable to their clients for
negligence and/or breach of contract should they fail to provide
the services or not exercise due care in their performance. Despite
efforts by the profession to address the legal liability of CPAs,
both the number of lawsuits and sizes of awards to plaintiffs
remain high. Changed Legal Environment
Major contributors: Growing awareness by financial statement users
Increased consciousness of the SEC Complexity in business drives
complexity in auditing and accounting functions Litigious society
Growing awareness of responsibilities of public accountants by
users of financial statements. Increased consciousness of the
Securities and Exchange Commission (SEC) for its responsibility for
protecting investors interests. Complexity of auditing and
accounting functions caused by increasing size of businesses,
globalization of business, and complexities of business operations.
Tendency of society to accept lawsuits by injured parties against
anyone who might be able to provide compensation, regardless of
fault (deep-pocket concept of liability) Large civil court
judgments against CPA firms awarded in a few cases encourage
attorneys to provide legal services on a contingent-fee basis
offers the injured party a potential gain when the suit is
successful, but minimal losses when it is not Willingness of many
CPA firms to settle legal problems out of court in an attempt to
avoid costly legal fees and adverse publicity, rather than
resolution through judicial process Judges and jurors difficulty in
understanding and interpreting technical accounting and auditing
matters Changed Legal Environment
Major contributors (cont.): Global recession and tough economic
times Large civil court judgments against CPA firms Willingness of
CPA firms to settle out of court Judges and jurors difficulty in
understanding technical accounting and auditing matters Growing
awareness of responsibilities of public accountants by users of
financial statements. Increased consciousness of the Securities and
Exchange Commission (SEC) for its responsibility for protecting
investors interests. Complexity of auditing and accounting
functions caused by increasing size of businesses, globalization of
business, and complexities of business operations. Tendency of
society to accept lawsuits by injured parties against anyone who
might be able to provide compensation, regardless of fault
(deep-pocket concept of liability). Large civil court judgments
against CPA firms awarded in a few cases encourage attorneys to
provide legal services on a contingent-fee basis offers the injured
party a potential gain when the suit is successful, but minimal
losses when it is not. Willingness of many CPA firms to settle
legal problems out of court in an attempt to avoid costly legal
fees and adverse publicity, rather than resolution through judicial
process. Judges and jurors difficulty in understanding and
interpreting technical accounting and auditing matters. 2 Explain
why the failure of financial statement users to differentiate among
business failure, audit failure, and audit risk has resulted in
lawsuits. Business Failure, Audit Failure, and Audit Risk
A business is unable to meet its obligations or investor
expectations due to economic or business conditions. It occurs when
a business is unable to repay its lenders or meet the expectations
of its investors because of economic or business conditions.
Business Failure, Audit Failure, and Audit Risk
Auditor issues an incorrect opinion from a failure to follow GAAS.
Audit failure occurs when the auditor issues an incorrect audit
opinion because it failed to comply with the requirements of
auditing standards. Business Failure, Audit Failure, and Audit
Risk
The risk that the auditor fails to find a material misstatement and
issues an unqualified opinion. Audit risk represents the risk that
the auditor will conclude that the financial statements are fairly
stated and an unqualified opinion can be issued when, in fact, they
are materially misstated. 3 Use the primary legal concepts and
terms concerning accountants liability as a basis for studying
legal liability of auditors. Legal Concepts Affecting
Liability
Prudent person concept Liability for the acts of others Lack of
privileged communication The standard of due care is often called
the prudent person concept. Under an LLP or LLC, the liability for
one owners actions does not extend to another owners personal
assets unless the other owner was directly involved in the actions
of the owner causing the liability. CPAs do not have the right to
withhold information from the courts on the grounds that the
information is privileged. Legal Terms Affecting CPAs
Liability
Terms related to negligence and fraud: Ordinary negligence Gross
negligence Constructive fraud Fraud Ordinary negligence is the
absence of reasonable care that can be expected of a person in a
set of circumstances. Gross negligence is the lack of even slight
care tantamount to reckless behavior that can be expected of a
person. Constructive fraud is the existence of extreme or unusual
negligence even though there was no intend to deceive or do harm.
Fraud occurs when a misstatement is made and there is both the
knowledge of its falsity and the intent to deceive. Legal Terms
Affecting CPAs Liability
Contract Law Breach of contract Third party beneficiary A breach is
the failure of one or both parties in a contract to fulfill the
requirements of the contract. A third party beneficiary is one who
does not have the privity of contract but is known to the
contractingparties and is intended to have certain rights and
benefits under the contract. Legal Terms Affecting CPAs
Liability
Other terms: Common law Statutory law Joint and several liability
Common law and laws that have been developed through court
decisions rather than through government statutes. Statutory law
are laws that have been passed by the U.S. Congress and other
governmental units. Joint and several liability is the assessment
against a defendant of the full loss suffered by a plaintiff,
regardless of the extent to which other parties shared in the
wrongdoing. Separate and proportionate liability is the assessment
against a defendant of that portion of the damage caused by the
defendants negligence. Separate and proportionate liability
Describe accountants liability to clients and related
defenses.
4 Describe accountants liability toclients and related defenses.
Four Major Sources of Auditors Legal Liability Liability to Clients
The most common source of lawsuits
against CPAs is from clients. Auditors Defenses Against Client
Suits
Lack of duty to perform Nonnegligent performance Contributory
negligence Absence of causal connection Lack of duty to perform
means that the CPA firm claims that there was no implied or
expressed contract. Non-negligent performance means that the CPA
firm claims that the audit was performed in accordance with
auditing standards.Even if there were undiscovered misstatements,
the auditor is not responsible if the audit was conducted properly.
Contributory negligence exists when the auditor claims the clients
own actions either resulted in the loss that is the basis for
damages or interfered with the conduct of the audit in such a way
that prevented the auditor from discovering the cause of the loss.
To succeed in an action against the auditor, the client must be
able to show that there is a close causal connection between the
auditors failure to follow auditing standards and the damages
suffered by the client.In defense of such litigation, the auditor
would attempt to refute any connection.This defense is called an
Absence of causal connection. 5 Describe accountants liability
tothird parties under common law and related defenses. Liability to
Third Parties Under Common Law
Ultramares doctrine Foreseen users Ultramares ---the creditors of
an insolvent corporation relied on the audited financials and
subsequently sued the accountants alleging that they were guilty of
negligence and fraudulent misrepresentation. The court held that
the accountants had been negligent but ruled that accountants would
not be liable to 3rd parties for honest blunders beyond the bounds
of the original contract unless they were primary beneficiaries.
Foreseen users are members of a limited class of users that the
auditor knows will rely on the financial statements. Foreseen Users
Credit alliance Restatement of torts Foreseeable user
A case against Arthur Andersen decided that to be liable, the
auditor must know and intend that the work productwould be used by
the third party for a specific purpose, and the knowledge and
intent must be evidenced by the auditors product. Restatement of
torts states that foreseen users must be members of a reasonably
limited and identifiable group of users that have relied on the
CPAs work. Foreseeable users are any users the auditor should have
reasonably been able to foresee as likely users of the client's
financial statements. Auditor Defenses Against Third-Party Suits 6
Describe accountants civil liability under the federal securities
lawsand related defenses. Securities Act of 1933 The Securities Act
imposes an
unusual burden on the auditor. Any 3rd party who purchased
securities described in the registration statement may sue the
auditor for material misrepresentations or omissions in the audited
financial statements included in the registration statement. Users
must only prove that the audited financial statements contained a
material misrepresentation or omission. Auditor must demonstrate
that an adequate auditor was conducted or all or a portion of the
plaintiffs loss was caused by factors other than the misleading
financial statements. Section 11 of the 1933 act defines the rights
of third parties and auditors. Securities Exchange Act of
1934
Auditor liability under this act often centers on the audited
financial statements issued to the public in annual reports The
liability of auditors under this act often centers on the audited
financial statements issued to the public in annual reports or
submitted to the SEC as a part of annual Form 10-K reports. Rule
10b-5 of the Securities Exchange Act of 1934
Section 10 and rule 10b-5 are often called the antifraud provisions
of the 1934 act. Scienter states that auditors must have the
knowledge and intent to deceive in order to be liable for violation
of Rule 10b-5. In Hochfelder v. Ernst, the U. S. Supreme Court
ruled that scienter, which is the knowledge and intent to deceive,
is required before CPAs can be held liable for violation of Rule
10b-5. SEC and PCAOB Sanctions
SEC and PCAOB can sanction or suspend practitioners. SEC has
temporarily suspended a number of individual CPAs from auditing SEC
clients. The SEC has the power in certain circumstances to sanction
or suspend practitioners from doing audits for SEC companies. In
recent years, the SEC has temporarily suspended a number of
individual CPAs from doing any audits on SEC clients. Foreign
Corrupt Practices Act of 1977
Bribing a foreign official for the purpose of exerting business
related influence is illegal. This act makes it illegal to offer a
bribe to an official of a foreign country for the purpose of
exerting influence and obtaining or retaining business.
Sarbanes-Oxley Act of 2002 CEO and CFO are required to
certify
financial statements filed with the SEC. Management must report on
the effectiveness of internal controls over financial reporting.
This act requires the CEO and CFO to certify the annual and
quarterly financial statements filed with the SEC. Management must
report its assessment of the effectiveness of internal control over
financial reporting. The auditor must issue an opinion on the
effectiveness of internal control over financial reporting .
Auditors must provide an opinion on internal controls over
financial reporting. Specify what constitutes criminal liability
for accountants.
7 Specify what constitutes criminal liability for accountants.
Criminal Liability Sarbanes-Oxley Act This act makes it a felony to
destroy
or create documents to impede or obstruct a federal investigation.
Auditor Defenses 1933 & 1934 Acts 8 Describe how the profession
andindividual CPAs can reduce the threat of litigation. The
Professions Response to Legal Liability
Seek protection from nonmeritorious litigation Improve auditing to
better meet users needs Educate users about the limits of auditing
The IAASB, AICPA, and PCAOB must constantly set standards and
revise them to meet the changing needs of auditing. The AICPA
leaders of CPA firms, and educators should educate investors and
others who read financial statement as to the meaning of an
auditors opinion and to the extent of and nature of the auditors
work. The Professions Response to Legal Liability
Standard and rule setting Oppose lawsuits Education of users
Sanction members for improper conduct and performance Lobby for
changes in laws A profession must police its own membership.The
AICPA and PCAOB have made progress in dealing with problems of
inadequate CPA performance, but more rigorous review of alleged
failures is still needed. Since the 1990s several changes in state
and federal laws have favorable impacted the legal environment for
the profession.The passage of the Private Securities Litigation
Reform Act of 1995 and the Securities Litigation Uniform Standards
Act of 1998 significantly reduced potential damages in federal
securities related litigation by providing for proportionate
liability in most instances. Protecting Individual CPAs from Legal
Liability
Honest Clients Qualified Personnel Deal only with clients
possessing integrity Hire qualified personnel Follow the standards
of the profession Maintain independence A CPA firm needs procedures
to evaluate the integrity of clients and should dissociate itself
from clients found lacking integrity. Independence requires an
attitude of responsibility separate from the clients interest.
Follow Professional Standards Maintain Independence Protecting
Individual CPAs from Legal Liability
Deal only with clients possessing integrity Maintain independence
Understand the clients business Perform quality audits Document the
work properly Exercise professional skepticism Lack of knowledge of
industry practices and client operations has been a major factor in
audit failures (e.g., Adelphia fraud). Quality audit documentation
is essential if an auditor has to defend an audit in court.
Protecting Individual CPAs from Legal Liability
Carry adequate insurance Seek legal counsel Choose a form of
organization with limited liability Auditors are often liable when
they are presented with information indicatinga problem that they
fail to recognize.Auditors need to strive to maintain a healthy
level of skepticism so that they can recognize misstatements when
they exist. Are there any questions? Copyright All rights reserved.
No part of this publication may be reproduced, stored in a
retrieval system, or transmitted, in any form or by any means,
electronic, mechanical, photocopying, recording, or otherwise,
without the prior written permission of the publisher. Printed in
the United States of America.
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