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In this chapter, we will focus on the legal responsibilities of auditors as reflected in actual cases. This chapter will help you

understand chartered professional accountants’ (CPAs’) legal liability for professional work, as dictated by the courts.

LEARNING OBJECTIVESAfter completing this chapter, you will be able to do the following:

LO1 List some examples of potential civil and criminal litigation facing public accountants.

LO2 Apply and integrate the chapter topics to analyze a practical auditing situation/case/scenario.

LO3 Explain how anti-corruption laws have influenced auditor liabilities.

LO4 Recognize U.S. Securities and Exchange Commission (statutory) law liability issues.

Legal Liability Cases

C H A P T E R 2 0

EcoPak Inc.

The time has come for EcoPak to expand its main factory onto the adjacent land that was contaminated by the opera-

tions of its prior owner, Waterfalls Inc. EcoPak’s current use of the land was permitted to be continued from the previ-

ous owners without additional environmental remediation. However, if EcoPak wants to expand onto the adjacent land,

it will be required to do extensive remediation work to comply with environmental laws. Development approvals will

require complete restoration of the land by removal and replacement of all the contaminated soil before any new con-

struction can be started. Mike and Kam had obtained audited financial statements as part of their due diligence before

purchasing the property, and the audited financial statements said nothing about the problem even though Waterfalls

was aware of it. EcoPak has engaged Rachel Roy, a lawyer who specializes in environmental law, to advise on this mat-

ter. Rachel advises EcoPak’s board that it may have a claim against Waterfalls and the auditors of the financial state-

ments they had relied on. Rachel outlines the following case EcoPak could make against Waterfalls’ auditor, G&Q.

G&Q had a legal duty of care to Kam and Mike as prospective purchasers of the property, since Waterfalls had spe-

cifically engaged the auditor for the StyreneTech subsidiary to facilitate its sale to a new investor. There was a breach in

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that duty because the financial statements had omitted a material, known liability for site cleanup, so they did not com-

ply with generally accepted accounting principles (GAAP) in this regard. Instead, G&Q provided an unmodified audit opin-

ion stating that the financial statements were fairly presented in accordance with GAAP. Either their audit was deficient

in not turning up this omitted liability, or they were negligent and complicit with the company in covering up the material

information. In the latter case, they have associated themselves with misleading information, clearly a breach of their

duty to users of the information as well as a violation of the standards of auditing and the rules of professional ethics.

EcoPak will easily be able to prove they suffered damage by showing the amount that must be spent on the

site restoration to proceed with their planned expansion onto land they had purchased with the understanding it

was suitable for any reasonable use their business would have for it in the future. The claim should be for the full

amount of the cleanup plus EcoPak’s legal costs of obtaining a fair remedy for Waterfalls’ wrong. EcoPak can also

easily show a connection between the breach of duty and the resulting damage, as the losses occurred subsequent

to G&Q’s audit and could have been avoided if the audit had been done properly.

After a thorough discussion, EcoPak’s board votes in favour of pursuing the lawsuit against both Waterfalls and

its auditor.

Essentials of More-Advanced Issues in Legal LiabilityThis chapter is a continuation of the legal liability overview coverage in Chapter 3. Most liability under common and statutory law arises from liability to third parties. This helps explain the importance of the three-party accountability concept for auditors—the legal system has been signalling to auditors what society’s expectations are. The four ele-ments of negligence introduced in Chapter 3 are here shown to have arisen by various court precedents that have been established for each element. The history of court cases shows that negligence liability can apply to any services provided by CPAs, including review and compilation services. Statutory law in the form of securities legislation is also influencing legal liability, as discussed in Chapter 3, but as we see here other statutory law can also affect CPA liabil-ity, including for association with corruption and money-laundering activities. The last section gives an overview of U.S. securities legislation that affects clients whose securities are traded in the United States and that has influenced Canadian law. Essentially auditor liability is growing with the increased responsibilities under statutory law.

Liability under Common Law CasesLO1 List some examples of potential civil and criminal litigation facing public accountants.

As discussed in Chapter 3, legal liabilities of public accountants (PAs) arise from lawsuits brought on the basis of the law of contracts or as tort actions for negligence. Most lawsuits stem from a breach-of-contract claim that accounting or auditing services were not performed in the manner agreed.

Characteristics of Common Law ActionsWhen an injured party considers himself or herself damaged by a PA and brings a lawsuit, he or she generally asserts all possible causes of action, including breach of contract, tort, deceit, fraud, or whatever else may be relevant to the claim.

Burden of Proof on the PlaintiffActions brought under common law place most of the burdens of affirmative proof on the plaintiff, who must prove (1) that he or she was damaged or suffered a loss, (2) that there was a beneficiary relationship with

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the defendant, (3) that the financial statements were materially misleading or that the accountant’s advice was faulty, (4) that he or she relied on the statements or advice, (5) that the statements were the direct cause of the loss, and (6) that the accountant was negligent, grossly negligent, deceitful, or otherwise responsible for dam-ages. The last section of this chapter reviews the U.S. securities acts, a U.S. statutory law regulating the public accounting profession. There you will find that some of the U.S. statutes shift some of these burdens of affirma-tive proof to the PA.

Clients may bring a lawsuit for breach of contract. The relationship of direct involvement between parties to a contract is also known as privity. Privity means the auditor can be sued for breach of contract. When privity exists, a plaintiff usually need only show that the defendant accountant was negligent—showed lack of reason-able care in the performance of professional accounting tasks. If negligence is proved, the accountant may be liable, provided the client did not contribute to his or her own harm.

Smith v. London Assurance Corp. (1905)This was the first North American case involving an auditor. The auditor sued for an unpaid fee, and the com-pany counterclaimed for a large sum that had been embezzled by one of its employees, which they claimed would not have occurred except for the auditor’s breach of contract. The evidence indicated that the auditors indeed failed to audit cash accounts at one branch office as stipulated in an engagement contract. The court rec-ognized the auditors as skilled professionals and held them liable for embezzlement losses that could have been prevented by non-negligent performance under the contract.

Over eighty years ago, it was very difficult for parties other than contracting clients to succeed in lawsuits against auditors. Other parties not in privity had no cause of action for breach of contract. However, the court opinion in the case known as Ultramares expressed the view that, if negligence is so great that it constitutes gross negligence—lack of minimum care in performing professional duties, indicating reckless disregard for duty and responsibility—grounds might exist for concluding that the accountant had engaged in constructive fraud. Actual fraud, on the other hand, is an intentional act designed to deceive, mislead, or injure the rights of another person.

Ultramares Corporation v. Touche (1931)The Ultramares decision set out the criteria for an auditor’s liability to third parties for deceit (a tort action). In order to prove deceit, (1) a false representation must be shown, (2) the tortfeasor (the wrongdoer) must possess scienter (either knowledge of falsity or insufficient basis of information), (3) intent to induce action in reliance must be shown, (4) the damaged party must show justifiable reliance on the false representation, and (5) dam-age must have resulted. The court held that an accountant could be liable when he or she did not have sufficient information (audit evidence) to lead to a sincere or genuine belief. In other words, an audit report is deceitful when the auditor purports to speak from knowledge when he or she has none. The court also wrote that the degree of negligence might be so gross, however, as to amount to a constructive fraud. Then the auditor could be liable in tort to a third-party beneficiary.

An important result of the Ultramares case was that the accountants were not liable to third parties for ordinary negligence under common law for the next 35 years. As a result of this case, U.S. Congress was influ-enced in its passage of the Securities and Exchange Commission (SEC) acts of 1933 and 1934 so that a statutory responsibility to third parties was created where none existed under common law.

Most auditor legal responsibilities arise from the law of negligence, the part of the common law known as the law of torts. Negligence is the failure to perform a duty with the requisite standard care (due care as it relates to one’s public calling or profession). Under the common law of torts for negligence, all of the four ele-ments of negligence in the next section must be established by the plaintiff if he or she is to successfully sue the auditor.

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Four Elements of NegligenceLO2 Apply and integrate the chapter topics to analyze a practical auditing situation/case/scenario.

The four elements of negligence are as follows:

I. There must be a legal duty of care to the plaintiff. II. There must be a breach in that duty (e.g., failure to follow generally accepted auditing standards [GAAS]

and/or GAAP). III. There must be proof that damage resulted (otherwise the plaintiff is limited to the amount of the audit fee). IV. There must be a reasonably proximate connection between the breach of duty and the resulting damage

(e.g., losses must occur subsequent to the firm’s audit).

The auditor’s defence is to demonstrate that at least one of the preceding elements is missing. The auditor may also argue that the plaintiff contributed to his or her own loss by, for example, not correcting internal control weaknesses. However, this defence applies only to parties having a contractual relationship with the auditor. Just to keep things straight, the auditor is the first party, the contractual client (who hires the auditor for the audit engagement and thus has privity of contract with the auditor) is the second party, and other audited finan-cial statement users are third parties.

I. Duty of Care to Whom?A key issue in establishing liability against auditors is to whom they owe a duty of care. The contractual client (the second party to the contract) is owed a duty of care due to privity of contract. The client is the organization (corporation, proprietorship, partnership) that appoints the auditor. The engagement letter is critical in specify-ing the contractual obligation, particularly for non-audit engagements. This explains the importance of having the engagement letter in the first place: it is the basis for establishing the liability of the auditor to second parties.

Under the Foss v. Harbottle (1842) principle, financial stakeholders cannot sue for losses simply because the corporation they hold a stake in has suffered losses. This is the flip side of the protection that the stakeholder has against suits by the corporation’s creditors. The corporation itself, as a “legal person,” has to claim any damages. In the case of auditors, the owners are not viewed as having privity of contract with the auditors; only the corpora-tion has privity of contract. Thus, shareholders can take action only as third parties, and then they must establish damages separate from those to the corporation. Establishing separate damages has greatly limited legal liability to Canadian accountants from shareholders (even though the audit report is addressed to the shareholders).

The most significant source of liability to auditors, however, is from third parties. This relates to a prin-ciple of common law that was transplanted from third-party liability for acts causing injury or physical damage (Heaven v. Pender [1883]). Until recently, courts were unwilling to compensate for pure economic losses, that is, where there was no physical injury or damage to a plaintiff’s person or property. The Ultramares v. Touche (1931) case confirmed that there is no third-party liability for financial losses caused by ordinary auditor neg-ligence. Only if the auditors had committed fraud or constructive fraud (gross negligence) could they be held liable to third parties. However, that situation has changed dramatically. The leading case for extending tort law to cover pure economic loss is Hedley Byrne v. Heller & Partners, which is described in the following box.

Hedley Byrne & Co. Ltd. v. Heller & Partners Ltd. (1964) A.C. 562 (H.L.)In this case, a bank acting on behalf of its client, Hedley Byrne, asked Heller & Partners if one of that company’s custom-ers was financially healthy. Heller & Partners replied in the affirmative but disclaimed all responsibility. On the basis of this, Hedley Byrne then entered into a contract with that customer, suffering losses when the customer subsequently filed for bankruptcy. The United Kingdom’s highest court (House of Lords) decided that Heller & Partners would have owed a duty of care to Hedley Byrne had they not made the disclaimer of responsibility. The duty arises from professional advisers whose negligence gives rise to third-party damages.

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Another reason that Hedley Byrne v. Heller is so important to the public accounting profession is that it established the precedent of third-party liability for (ordinary) negligence to “reasonably foreseeable third par-ties.” These third parties would eventually include, as a result of subsequent cases, present shareholders and lenders as well as limited classes of prospective shareholders and prospective lenders.

This precedent-setting decision was upheld by the Supreme Court of Canada in Haig v. Bamford (1976). The Supreme Court concluded that auditors owe a duty to third parties where they have “actual knowledge of the limited class that will use and rely on the statements.” The details of this are given in the following box.

Haig v. Bamford et al. (1976) 72 D.L.R. (3d) 68In Haig, the accountants were asked by Saskatchewan Development Corporation to prepare financial statements for Bam-ford. On the basis of these statements, Saskatchewan Development Corporation gave a loan to Bamford. The negligently prepared financial statements showed a profit that should have been reported as a loss. The court held that, where an accountant has negligently prepared financial statements and a third party relies on them to his or her disadvantage, a duty of care in an action for negligent misstatement will arise in the following circumstances: the accountant knows that the results will be shown to and relied on by the plaintiff, who is also a member of a known limited class, and the statements have been prepared primarily for guidance of that limited class and for purposes the plaintiff did in fact rely on them for; the fact that the accountant did not know the identity of the plaintiff is not material as long as the accountant was aware that the person intended to supply the financial statements to others of this very limited class.

Caparo Industries Plc. v. Dickman et al. (1991) 2. W.L.R. 358 (H.L.)Caparo acquired Fidelity based on its audited financial statements. Fidelity’s financial statements were misstated to show a profit of £1.3 million instead of a loss of £400,000. Caparo sued the auditors for negligence. The United Kingdom’s highest court decided that the auditor owed no duty of care to Caparo, primarily because the auditor had no knowledge of Caparo’s intended use of the financial statements to acquire Fidelity.

The Toromont v. Thorne (1975) case also upheld the Hedley Byrne precedent, as it applied to Canada, of liability to known third parties (in this case a prospective investor, Toromont). Auditor liability in Canada was further extended to prospective investors (reasonably foreseeable third parties) in Dupuis v. Pan American Mines (1979), the details of which are given in the following box.

Dupuis v. Pan American MinesOn June 15, 1971, a draft prospectus pertaining to Pan American Mines Ltd. and its wholly owned subsidiary, Central Mining Corporation, was filed with the Quebec Securities Commission. Included in the prospectus was a consolidated balance sheet of Pan Am and its subsidiary, which had been audited by the accounting firm of Thorne, Gunn, Helliwell & Christenson, and upon which Thorne, Gunn had expressed an unqualified opinion. On June 16, 1971, the securities com-mission authorized trading in Pan Am shares and distribution of the prospectus. Pan Am was then listed on the Canadian Stock Exchange, but in November 1971 trading in the shares was suspended, and in February 1972 Pan Am was delisted.

The plaintiff, Albert Dupuis, brought an action claiming that he had suffered a loss on shares of Pan Am purchased between the time the shares were listed and the time trading was suspended. His action was based on the alleged falsity of some of the information contained in the prospectus, including the auditors’ report and the notes to the consolidated financial statement.

The judge’s decision was worded in part as follows: “When an auditor prepares a balance sheet which he knows is going to be inserted in a company prospectus offering stock for sale, I believe he has a duty to make sure that the contents of that balance sheet are accurate so that prospective investors will not be led into error by it.” In conclusion, the judge gave the plaintiff judgment against Thorne, Gunn for $89,266.91, with interest from October 15, 1971, and costs.

Source: H. Rowan, “Legal cases,” CA Magazine, August 1979, pp. 36–39. Reproduced by permission from CA Magazine, published by CPA Canada, Toronto, Canada. [Emphasis added.]

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In summary, Canadian courts had gradually widened auditors’ liability under common law to include limited classes of third parties through 1979. As shown in the box above, the Caparo Industries Plc. v. Dickman case in the United Kingdom, however, began a reversal of the increasing liability to third parties by limiting liability to those third parties the auditors had knowledge of.1 This reversal was largely completed in the Hercules Manage-ments Ltd. v. Ernst & Young (1997) case when the Supreme Court of Canada ruled that “an audit is not prepared in order to assist shareholders in making investment decisions but rather ‘to assist the collectivity of sharehold-ers of the audited companies in their task of overseeing management’ (paragraph 49).” This controversial deci-sion is described in the box that follows.

Auditors Not Legally Liable To Investors, Top Court RulesAn auditor who signs a company’s financial statements has no legal liability to shareholders or investors. That is the thrust of a rul-ing by the Supreme Court of Canada brought down Thursday in the case of Hercules Managements Ltd. et al. v. Ernst & Young et al.

The court’s concern, observers say, is to protect auditors from unlimited liability to thousands of investors who may use the audit opinion for many different purposes.

The annual financial statement is now a joke, says Al Rosen, a professor of accounting at York University in Toronto and a partner in Rosen & Vettese Ltd., forensic accountants. “Public accountants may think this is a wonderful win for them,” Rosen added, “but in the long run I see this as a disaster. Who really needs an audit of financial statements that is not useful for investor decision making?”

The court’s ruling was applauded by Michael Rayner, president of the Canadian Institute of Chartered Accountants. “The decision leaves the profession in a legal environment in which it can maximize its contribution to the capital markets,” Rayner said yesterday. The court has “tried to provide a reasonable amount of liability for auditors,” he added. “We believe the responsibility of auditors is important . . . and there are still significant redresses available through the courts for audi-tors who are engaged in a situation where there is clear negligence on their part.”

The effect of the court’s ruling could be short lived. Brenda Eprile, executive director of the Ontario Securities Commission—Canada’s leading securities regulator—says provincial regulators are working on a legal framework that will re-establish the legal liability of auditors to investors.

Hercules Managements was the 80 percent shareholder of Manitoba-based Northguard Acceptance Ltd., which lent money on mortgages in the 1970s and early 1980s. Ernst & Young was the auditor. In 1984, Northguard went into receiv-ership. Hercules sued Ernst & Young, alleging negligence. The action was dismissed by the Manitoba Court of Queen’s Bench, and by the Manitoba Appeal Court. It was heard by the Supreme Court on December 6. The Canadian Institute of Chartered Accountants gained status with the court to argue in favour of protecting auditors from liability.

The court’s ruling does not declare whether Ernst & Young was negligent.On the issue of liability, the court said audited financial reports only call for “a duty of care” by the auditors when they

are used “as a guide for the shareholders, as a group, in supervising or overseeing management.”For this reason, there appears to be no direct liability to the shareholders for any reduction in value of their equity,

jointly or individually.“The law in Canada in respect of the responsibility of auditors is basically consistent with the United Kingdom, the

United States and many other countries,” Rayner said.“I feel that I have been run over by a truck,” said Mark Schulman, of the Winnipeg law firm of Schulman and Schulman,

who acted for Hercules. He points out that one motions judge, three judges of the court of appeal, and seven judges in the Supreme Court all ruled against Hercules, and thoroughly entrenched the principle of no general auditor liability.

Eprile pointed out that auditors are already liable, under securities acts, to investors, in the narrow case when the audited financial statements appear in a prospectus.

“We are recommending that we amend our securities legislation . . . to call for liability in the [entire] secondary market,” she said.That would mean that the public company, the auditor, the directors, and possibly the underwriters would be liable for

any negligent disclosure when investors buy a company’s shares through a stock exchange.“The legislation has been drafted,” Eprile said. “It would be uniform across Canada and may take a year or two to get

through provincial legislatures,” she said.

Source: Philip Mathias, “Auditors not legally liable to investors, top court rules,” The Financial Post, May 24, 1997, p. 3. © 2015 National Post, a division of Postmedia Network Inc.

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The legislation referred to at the end of the Hercules box (see above) is Ontario’s Bill 198. The intent of Bill 198 (and similar legislation) is to make it easier for investors to recover damages from accountants, directors, and others associated with misleading financial reporting. This bill was passed in 2002 and is discussed in Chapter 3.

It should be noted that despite the Hercules case’s precedent under common law, auditors may still be liable under common law to third parties if the specific reliance of the third parties is made known to the auditors at the beginning of the engagement and the third parties can be said to be a “limited class” as per Haig v. Bamford. This is shown in the following cases.

State Street Trust Co. v. Ernst (1938)In this case, accountants were found to be liable, even without deliberate or active fraud. A representation certi-fied as true to the knowledge of the accountant when the accountant has no knowledge is a reckless misstate-ment or an opinion based on grounds so flimsy as to lead to the conclusion that there was no genuine belief in its truth, all of which is sufficient to base liability on. A refusal to see the obvious, a failure to investigate the doubtful, if sufficiently gross, may furnish evidence leading to an inference of fraud so as to impose liability for losses suffered by those who rely on the balance sheet. In other words, heedlessness and reckless disregard of consequences may take the place of deliberate intention. In this connection we are to bear in mind the principle already stated, that negligence or blindness, even when not equivalent to fraud, is nonetheless evidence to sus-tain an inference of fraud. At least, this is so if the negligence is gross.

Primary beneficiaries are the third parties for whom the audit or other accounting service is primarily per-formed. A beneficiary will be identified, or reasonably foreseeable, by the accountant prior to or during the engage-ment, and the accountant will know that his or her work will influence the primary beneficiary’s decisions. For example, an audit firm may be informed that the report is needed for a bank loan application. Many cases indicate that proof of ordinary negligence may be sufficient to make accountants liable for damages to primary beneficiaries.

CIT Financial Corp. v. Glover (1955)In this case, auditors were found liable to third parties for ordinary negligence if their reports are for the primary benefit of the third party. Thus, the privity criterion may not serve as a defence when third-party beneficiaries are known.

PAs may also be liable to foreseeable beneficiaries—creditors, investors, or potential investors who rely on accountants’ work. If the PA is reasonably able to foresee a limited class of potential users of his or her work (e.g., local banks, regular suppliers), liability may then be imposed for ordinary negligence. This, however, is an uncertain area, and liability in a particular case depends entirely on the unique facts and circumstances. These types of beneficiaries and all other injured parties may recover damages if they are able to show that a PA was grossly negligent and perpetrated a constructive fraud.

Rusch Factors Inc. v. Levin (1968)With respect to the plaintiff’s negligence theory, this case held that an accountant should be liable in negli-gence for careless financial misrepresentations relied upon by actually foreseen and limited classes of persons. According to the plaintiff’s complaint in the case, the defendant knew that his certification was to be used for, and had as its very aim and purpose, the reliance of potential financiers of the Rhode Island corporation.

Rosenblum Inc. v. Adler (1983)Giant Stores Corporation acquired the retail catalogue showroom business owned by Rosenblum, giving stock in exchange for the business. Fifteen months after the acquisition, Giant Stores declared bankruptcy. Its financial

primary beneficiaries:third parties for whose primary benefit the audit or other accounting service is performed

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statements had been audited and had received unqualified (i.e., “clean” or unmodified) opinions in several prior years. These financial statements turned out to be misstated because Giant Stores had manipulated its books.

In finding for the plaintiffs on certain motions, the New Jersey Supreme Court held that independent audi-tors have a duty of care to all persons whom the auditor should reasonably foresee as recipients of the state-ments from the company for proper business purposes, provided that the recipients rely on those financial statements. It is well recognized that audited financial statements are made for the use of third parties who have no direct relationship with the auditor. Auditors have responsibility not only to the client who pays the fee but also to investors, creditors, and others who rely on the audited financial statements. (The case went back to the trial court for further proceedings.)

In summary, the current status of auditor third-party legal liability under common law appears to be as follows. The courts have attempted to strike a fair balance between reliable information for users of financial statements and unreasonable risk to the auditor. This balance has resulted in Canadian auditors currently being liable for negligent error to limited classes of third parties. Third parties are often classified in the following categories:

(a) Known third parties (b) Reasonably foreseeable third parties (c) All third parties relying on financial statements

The trend in litigation suggests the courts will most likely draw the line between categories (a) and (b) to decide whom auditors owe a duty of care to under common law. This summary applies to ordinary negligence. For gross negligence or fraud on the part of the auditor, the third-party liability is much broader.

Fraudulent misrepresentation is a basis for liability in tort (established in Haig v. Bamford), so parties not in privity with the accountant may have causes of action when negligence is gross enough to amount to construc-tive fraud. These other parties include primary beneficiaries, actual foreseen and limited classes of persons, and all other injured parties.

II. Due Care: Its MeaningA key aspect to the second element of negligence is due care. Due professional care implies the careful applica-tion of all the standards of the profession (GAAS, GAAP) and observance of all the rules of professional conduct. The courts have interpreted due care to be reasonably prudent practice; therefore, neither the highest possible standards nor the minimum standards would be considered due care. This suggests that following the rules of professional conduct or the CPA Canada Handbook may not always be sufficient, as these would be minimum standards. In fact, over the years the courts have helped shape audit practice by their interpretation of due care. For example, the concept of testing (less than 100% examination of the accounts) was first accepted as reasonable by the precedent-setting decision in London v. General Bank (1895). This case was also the first to acknowledge that there is some limit on the auditor’s responsibility for the detection of fraud and the duty to take increased care in the presence of suspicious circumstances. This case influenced the development of later professional announcements and hundreds of subsequent cases (e.g., 1136 Tenants [1967]). However, the general legal standard is that an auditor is “a watchdog not a bloodhound” (in Kingston Cotton Mill Company [1896]). This means that it is reasonable for auditors to assume management’s honesty as a working hypothesis as long as the auditor can provide documented reasons for this assumption.

Nonetheless, auditors need to be alert to factors (evidence) that conflict with this hypothesis, in which case auditors must take additional precautions under the due care requirement, as discussed in Chapters 3 and 18. CAS 240 characterizes this approach as presuming the possibility of management’s dishonesty, but that such presumption is refutable by the evidence. Of course, such evidence must be documented in the audit file.

The courts have also influenced auditing standards (and, therefore, influenced due care provisions) in the requirement that the auditor corroborate management assertions with his or her own evidence. The auditor

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cannot just rely on management’s words; he or she must justify reliance through checking, testing, and other audit procedures. This practice, following from the third examination standard, has been shaped by decisions in many court cases, such as Continental Vending (1969) and the Canadian case Toromont v. Thorne (1975).

Another example of court influence in determining what constitutes auditor due care is McKesson & Rob-bins (1939), which also ultimately influenced the creation of CAS 501 and similar sections in U.S. standards. In that case, the auditor failed to observe inventory or confirm receivables. It is evident that the due care provi-sion of negligence has significantly shaped and probably will continue to influence the development of audit standards. One impact of the Continental Vending case rests on the courts’ decision not to accept the auditor’s defence that he followed GAAP (i.e., the auditor was able to establish that the footnote in the financial statement was in accordance with GAAP). Instead, the courts expected the auditor to use some higher standard of fair-ness in deciding on proper disclosure. This has led to greater diligence on the part of standard setters designing disclosure standards for various types of information. In the meantime, it may help for auditors to take a more structured framework, such as critical thinking, to deal with such situations.

A sense of the importance of this issue of fairness was introduced to Canadian courts via the Kripps v. Touche Ross case discussed in the following box.

Auditor’s Liability When Associated with Misleading Financial InformationIf the courts conclude that the auditor is associated with misleading financial statements, even if these statements are in conformity with GAAP, they may conclude that the auditors are fraudulently negligent. If auditors are found guilty of a fraudulent misrepresentation, then there are no limits on third-party liability. In U.S. courts, through common law and in statutory law via the U.S. securities acts, the concept of gross negligence (constructive fraud) has expanded auditor liability to larger classes of third parties. As a result, there have been several cases in the United States in which auditors have been found guilty of fraud when they otherwise would have been found only negligent (e.g., Continental Vending in Chapter 3).

Accounting Profession Has a Duty to ShareholdersBefore buying shares in a company, investors usually rely on an important safeguard—the auditor’s opinion of its financial statements. And that opinion usually declares that the statements are both “presented fairly” and “in accordance with generally accepted accounting principles (GAAP).” For decades, though, auditors have tried to duck legal liability to the investors they serve. Auditors appear to want what does not exist: authority without responsibility.

Two Canadian lawsuits promise to clarify the trust that investors can place in auditors. One case, Stephen Kripps et al. v. Touche Ross (now Deloitte & Touche) et al., emerged from the B.C. Court of Appeal. In 1985, Kripps et al. relied on the audited financial statements of a mortgage company to buy $1.9 million of its debentures. The company went into receiv-ership, and the investors lost $2.7 million, including interest. The investors sued the auditor, lost in a lower court, and won at appeal.

A 2-to-1 appeal court majority ruled that “Touche had actual knowledge that a simple application of GAAP would . . . lead to financial statements that could not be said to have fairly represented the financial position” of the company. “Auditors cannot hide behind [the formula] ‘according to GAAP,’” the court declared, “if the auditors know . . . that the financial state-ments are misleading.” It ruled against Touche. The court’s point is correct—GAAP is too loose a standard to be a sufficient safeguard by itself. That is why the financial statements must also be “presented fairly,” to use the actual language of the auditor’s opinion. Despite the ruling’s validity, some accountants want the Canadian Institute of Chartered Accountants (CICA) to support an appeal by Touche to the Supreme Court.

Postscript: On November 6, 1997, the Supreme Court of Canada denied Deloitte & Touche’s right to appeal the negli-gence ruling against it by the B.C. Court of Appeal. However, as discussed earlier, the Supreme Court made it much more difficult for investors to sue Canadian auditors under common law in its Hercules decision.

Source: “Accounting profession has a duty to shareholders,” The Financial Post, May 20, 1997, p. 14. © 2015 National Post, a division of Post-media Network Inc.

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The Ontario Securities Commission (OSC) appears to be interested in increasing auditors’ legal respon-sibility to shareholders by revising the securities acts in Ontario. This is a way of expanding auditor liability to wider classes of third parties. This, combined with the increasing influence of the Charter of Rights and Freedoms legislation on the courts, may make the Canadian legal environment more comparable to that of the United States in the near future. In addition, class action legislation has been approved in Quebec (1979), Ontario (1993), and British Columbia (1995). Contingent fees are another issue being considered by the Ontario Law Society; implementing them would also make the Ontario environment more comparable to that of the United States. Thus, many of the problems of high litigation rates and insurance premiums and costly court decisions may soon be imported to at least parts of the Canadian legal environment. Other requirements that expand auditor responsibilities for detecting money-laundering schemes further add to the liabilities burden.

Legal Liability for Failure to Disclose Illegal ActsCAS 250 provides expanded guidance on detecting and disclosing illegal or possibly illegal acts with the objec-tive of reducing the auditor’s exposure to legal liability. It does this by (1) reducing the risk that GAAS will be misinterpreted by auditors and the courts, (2) establishing recommendations that reduce the likelihood of an audit’s failing to detect a material misstatement arising from the consequences of an illegal act, and (3) provid-ing a defence for the auditor if he or she fails to detect a material misstatement despite conducting the audit in accordance with the standards.2

Illegal acts are another area where potential ethical and legal conflicts may be expected to grow. Accord-ing to an article by M. Paskell-Mede, the whistle-blowing responsibility of the auditor to third parties may grow even in the absence of a regulator, since plaintiffs are raising the issues of association more frequently in law-suits. It is Paskell-Mede’s impression that plaintiffs whose lawyers recognize that their case is weak—as a result of inability to demonstrate either actual reliance on the financial statements or that a direct duty of care was owed with respect to those statements—are now compensating for this weakness by presenting the claim as one based on association. The plaintiff’s lawyer will argue that their client relied on the auditor’s reputation. How-ever, the courts so far have upheld the obligation for auditors to maintain client confidentiality. For example, in Transamerica Financial Corporation, Canada v. Dunwoody & Company, the judge decided that client confi-dentiality overrode whistle-blowing to a third-party plaintiff, especially since the plaintiff was already aware of irregularities at the client. For Paskell-Mede, this is evidence that the courts are becoming more careful about assigning blame to auditors—that they are becoming more sophisticated in analyzing the causal connection between the illegal misrepresentation and damages.3

Liability in Compilation and Review ServicesYou may find it easy to think about common law liability in connection with audited financial statements, but PAs also render compilation and review services and are associated with unaudited financial information (see Chapter 17, available on Connect). People expect PAs to perform these services in accordance with profes-sional standards, and courts can impose liability for accounting work judged to be substandard. PAs have been assessed damages for work on such statements, as shown in 1136 Tenants’ Corporation v. Max Rothenberg & Co. Approximately 11% of losses in the American Institute of Certified Public Accountants (AICPA) profes-sional liability insurance plan involve compilation and review engagements relating to unaudited financial statements.

1136 Tenants’ Corporation v. Max Rothenberg & Co. (1967)Despite the defendant’s claims to the contrary, the court found that he was engaged to audit and not merely write up the plaintiff’s books and records. The accountant had, in fact, performed some limited auditing procedures,

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including preparation of a worksheet entitled “Missing Invoices 1/1/63–12/31/63.” These were items claimed to have been paid but not. The court held that, even if accountants were hired only for write-up work, they had a duty to inform plaintiffs of any circumstances that gave reason to believe that a fraud had occurred (e.g., the record of “missing invoices”). The plaintiffs recovered damages of about $237,000.

One significant risk is that the client may fail to understand the nature of the service being given. Accoun-tants should use a meeting and an engagement letter to explain clearly that a compilation service (write-up) involves little or no investigative work, and that it is lesser in scope than a review service. Similarly, a review service should be explained as being less extensive than a full audit service. Clarity at the outset can prevent later disagreements between accountants and clients.

Even with these understandings, PAs cannot merely accept unusual or misleading client-supplied informa-tion. A court has held that a PA’s preparation of some erroneous and misleading journal entries without suffi-cient support was enough to trigger common law liability for negligence, even though the PA was not associated with any final financial statements. CPA Canada standards for compilations require PAs to obtain additional information if client-supplied accounting data are incorrect, incomplete, or otherwise unsatisfactory. Courts may hold PAs liable for failure to obtain additional information in such circumstances.

When financial statements are reviewed, PAs’ reports state, “Based on my review, nothing has come to my attention that causes me to believe that these financial statements are not, in all material respects, in accordance with generally accepted accounting principles” (CPA Canada Handbook, paragraph 8200.42). Courts can look to the facts of a case and rule on whether the review was performed properly. Generally, the same four ele-ments of negligence must be met, both for review engagements and for audit engagements. The only difference is that “due care” in review engagements should follow the standards for review engagements rather than the standards for audits. Generally, it would appear that third-party liability continues to flow to the same classes of persons who would be relying on the financial statements.4 Some courts might decide a PA’s review was sub-standard if necessary adjustments or “material modifications” should have been discovered. These risks tend to cause PAs to work beyond superficial inquiry procedures.

A 1987 New York case, however, may create an attitude more favourable for PAs’ review work on unau-dited financial statements. In 1985, William Iselin & Company sued the Mann Judd Landau (MJL) accounting firm, claiming damages for having relied on financial statements reviewed by MJL. Iselin had used the finan-cial statements of customers for its factoring-financing business. A customer had gone bankrupt, and Iselin’s loans became worthless. A New York appeals court dismissed the case, saying that third parties (Iselin) cannot rely on reviewed, rather than audited, financial statements for assurance that a company is financially healthy. The court observed that MJL expressed no opinion on the reviewed financial statements. Iselin’s lawyer was reported to have observed, “Accountants and their clients will find that reviews are useless, since no one can rely on them.”

Review Checkpoints 20-1 What must the plaintiff prove in a common law action seeking recovery of damages from an independent

auditor of financial statements? What must the defendant accountant do in such a court action?

20-2 What legal theory is derived from the Ultramares decision? Can auditors rely on the Ultramares decision

today?

20-3 Define and explain privity, primary beneficiary, and foreseeable beneficiary in terms of the degree of

negligence on the part of a PA that would trigger the PA’s liability.

20-4 What proportion of lawsuits against PAs relate to compilation and review (unaudited financial statements)

practice?

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Confidentiality versus Misleading Financial StatementsIn Chapter 4, we noted that there may be a potential conflict between rules dealing with confidentiality and rules dealing with association with misleading financial statements. A conflict between similar rules in the U.S. code of ethics for American CPAs has been the focus of two court cases in the United States: Consolidata Services v. Alexander Grant (1981) and Fund of Funds v. Arthur Andersen (1982). In Consolidata, the courts ruled that auditors should have preserved confidentiality, and in Fund of Funds, the courts ruled that the confidential information should have been used to prevent misleading reports. The inconsistent legal results from these two cases illustrate that the rules can be just as difficult for the courts to resolve as they are for practising auditors. In both cases, however, it was the auditors who lost—and paid. (The court awarded $80 million in damages to Fund of Fund’s shareholders, the largest judgment ever made against a public accounting firm until that time.)

III. Third and IV. Fourth Elements of NegligenceThe two remaining elements of negligence have also proved to be material issues in various court cases. The third element is that some damage must occur to the third party; otherwise, only the audit fee can be recovered. This was the situation in Toromont v. Thorne.

The last element of negligence requires that there be a causal link between the breach of duty and the result-ing damage. Thus, for example, if losses occur before the time of the audit, or if it can be proved that the plaintiff did not rely on the audited information to any significant degree, the lawsuit will fail. A Canadian case illustrat-ing the need for a causal link to damages suffered is given in the following box.

The interesting questions are whether the Canadian courts will continue to take this narrow approach (other British Columbia decisions suggest so), and whether regulatory agencies, such as the OSC, will succeed in con-vincing legislatures to make companies, their directors, and auditors legally responsible to shareholders under revised securities acts for all misleading documents (as in the United States). Currently, Canadian auditors’ legal liability to third parties follows largely from common law (e.g., Toromont v. Thorne et al.). Nevertheless, financial press articles during the 1990s made it clear that litigation against auditors in Canada was reaching alarming pro-portions. There are several major lawsuits against PAs outstanding in Canada. It will take years to resolve them.

Auditor’s Liability under Statutory LawA great deal of liability for American auditors arises from statutory law under the SEC. These laws give the SEC the legal right to decide what constitutes GAAP for public companies. There is nothing comparable in Canadian legislation, yet increasingly the OSC and Quebec regulators are seeking more enforcement power over profes-sionals, such as CPAs, operating in the capital markets. The latest Canadian developments are discussed in Chapter 3. In this section we review the increasingly influential implications for auditors of other statutory laws that affect their liability.

Flanders v. Mitha 1992In August 1992, Justice Holmes of the B.C. Supreme Court ruled in Flanders v. Mitha (1992) that “disgruntled investors suing a B.C. accounting firm, Buckett & Sharpley, for negligently preparing a housing co-op’s financial statements must show that they actually relied on those statements when making their investment decision.” During the court proceedings, none of the plaintiffs were found to have actually relied on the financial statements in purchasing an apartment. They either relied on the realtor or had made the purchase decision prior to requesting and receiving the financial statements from the realtor. Flanders v. Mitha (1992) thus limits the auditor’s liability to when his or her work is used by a client to solicit investments from the public.

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Three Important Laws to Prevent CorruptionLO3 Explain how anti-corruption laws have influenced auditor liabilities.

This section reviews three laws mentioned in the chapter. The latest legislation is the Sarbanes-Oxley Act (SOX), but since it relates to corporate governance we discuss it with the corporate governance principles in Appendix 6B. The other two laws are concerned with the worldwide growth and sophistication of money-laundering schemes and the even broader concerns of corruption in general. This concern with corruption has a natural extension to corporate corruption and how to control it. So we end this chapter with an overview of corporate governance principles that are being developed to prevent the kind of unethical and criminal behaviour introduced in Appendix 1B. Increas-ingly, auditors need to consider various aspects of corporate governance, and the second half of this chapter gives you more background on this aspect of the audit environment. As you know from Chapter 2, the audit context, such as corporate governance and legislation like SOX affecting governance, is important for critical thinking. The vari-ous stakeholders in corporate governance reflect the various perspectives that are also needed in critical thinking.

This section integrates corporate governance with bribery and money-laundering legislation. This legisla-tion is designed to prevent corporations and other organizations from facilitating the proscribed activities. The challenge is controlling global corruption (cheating) in all its many forms. This chapter gives additional context of the audit environment via the historical influence of SEC legislation on auditors.

Numerous laws affect accountants and business people in the United States, but two of them deserve spe-cial mention. The Foreign Corrupt Practices Act of 1977 (FCPA) and the Racketeer Influenced and Corrupt Organization Act (RICO) have changed the landscape of much audit practice and have influenced the nature of lawsuits. There are two Canadian counterparts to these laws. They are Bill C-22, the Proceeds of Crime (Money Laundering) and Terrorist Financing Act (PCMLTFA), and Canada’s Corruption of Foreign Officials Act. These two laws are modelled after RICO and the FCPA, respectively. These are the focus of the next part of this chap-ter. However, some recent developments should also perhaps be mentioned at this point. One is a change in SEC rules that requires the auditor to inform the SEC of material illegal acts if a client fails to inform the SEC within one business day of the auditor’s discovery of the illegal acts. Another development is the increased global con-cern about corruption and auditors’ responsibility to report on it. The United States was the first nation to make it illegal to bribe foreign officials. This was implemented through the landmark FCPA of 1977, discussed below.

Foreign Corrupt Practices Act of 1977In 1976, under a program of voluntary disclosure, some 250 American companies notified the SEC that they had made illegal or questionable payments in the United States and abroad. Millions of dollars were involved in some cases, as were high officials in the United States, Europe, and Japan. The pattern of payments involved contribu-tions to American and foreign politicians, bribes to win overseas contracts, and under-the-table payments to expedite performance of services. Some payments were made with the apparent consent of CEOs, while others were authorized at lower management levels without the knowledge of top executives. Some disbursements

came from general corporate funds and others from secret “slush funds” maintained off the books. A rising tide of public indignation and impatience with wrongdoing prompted enactment of the

FCPA. This law—an amendment of the Securities Exchange Act of 1934—makes it a criminal offence for U.S. companies to bribe a foreign official, a foreign political party, or a candidate for foreign

political office to influence decisions in favour of the business interests of the company. Companies may be fined up to $2 million; individuals may be fined up to $100,000 and imprisoned up to five years for violations. In 1997, Canada signed a convention with the Organisation for Economic Co-operation and Development (OECD) to fight foreign corruption, and in 2001 Canada passed legislation similar to FCPA.

The U.S. also amended the Securities and Exchange Act of 1934 to include some accounting and internal control standards. These provisions require companies registered with the SEC to keep books, records, and

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accounts that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the company’s assets. Companies must also devise and maintain a system of internal accounting control. The effect of the FCPA was to make a company’s failure to establish and maintain a control system a violation of federal law in addition to being a mere matter of poor business practice. However, the monetary fines and prison terms that apply to bribes do not apply to violations of the accounting and internal control requirements.

The law gives the SEC another way to bring action against companies and accountants. Only three months after the law was passed, the SEC charged a company’s officers with making false entries in the books and records and failing to maintain an adequate accounting control system. The case was settled with an injunction—the SEC’s most frequent settlement method—in which the company, without admitting or denying a violation of law, agreed not to violate the law in the future. Accountants’ disciplinary proceedings are also settled frequently with injunctions. You might think this kind of agreement is not a harsh penalty. However, the public notoriety of the proceedings singles out the defendants, and an injunction has some teeth. If a company or an accountant later breaks the law, they can be charged with criminal contempt of court. Penalties for such contempt can be severe.

When companies or accountants are taken to court with FCPA or other charges of securities acts violations, the case is litigated (decided by a judge). The SEC got its first litigated decision under FCPA in 1983 and won. However, the SEC is not interested in harassment or in unnecessarily expensive responses to internal control needs. In the first five years, the SEC brought only 26 FCPA cases against American companies, and the U.S. Jus-tice Department brought only 8 cases. The principal purpose of FCPA is to reach knowing and reckless manage-rial misconduct and managers’ efforts to “cook the books.” As one judge put it, FCPA was enacted on the principle that reasonably accurate recordkeeping is essential to promote management responsibility and thwart manage-ment misfeasance, misuse of corporate assets, and other conduct reflecting adversely on management’s integrity.

The FCPA is a law directed at company management. Independent auditors have no direct responsibility under the law. They may advise clients about faulty control systems, but they are under no express obligation to report on deficient systems. The law cast a spotlight on companies and their internal auditors. It had the effect of making internal audit departments more important and more professional. The internal auditors often got the assignment to see that their companies complied with FCPA. Under SOX this has become a more urgent task, which is one reason internal auditors became more important after SOX.

Under anti-bribery legislation, auditors are responsible for detecting foreign bribes insofar as they have a material effect on financial statements. Materiality here needs to consider not only the amount of the bribe but also any fines, jail terms for guilty executives, and related consequences for the reputation of the firm and busi-ness risk. The auditor’s responsibilities include that material contingencies be properly disclosed, that any find-ings be disclosed to management and the audit committee, and that there be proper consultation with lawyers (the client’s, the auditor’s, or both).

Bill C-22 and the Racketeer Influenced and Corrupt Organization ActAnother important Canadian statutory law is Bill C-22, which met with controversy when it was first proposed, as described in the following box.

Proposed Federal Crime Legislation Puts Accountants at Risk of Being Prosecutedvancouver—Amendments to Canada’s Criminal Code could jeopardize unwary financial professionals, legal experts warn.

Bill C-22, known informally as the “proceeds of crime” legislation, is so sweeping that unsuspecting accountants could be guilty of a criminal offence for simply giving advice, the lawyers say.

The proceeds of crime legislation, which is now contained in Part XII.2 of the Criminal Code, is based on American anti-racketeering statutes and is designed to deprive criminals of their ill-gotten gains.

(continued)

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The auditor’s responsibilities overlap those of fraud and illegal act detection and are covered in Chapter 21 (available on Connect). If client organizations do not comply with the legislation, they risk fines of up to $2 million and their management and employees can be imprisoned. Auditors should be aware of these risks, their reporting responsibilities to outside agencies, and the need to avoid being considered accomplices under the legislation.

Bill C-22 has been influenced by RICO and similar legislation in the United States. RICO is not a law adminis-tered by the SEC. It is a general federal law, and it has both civil and criminal features. Lawsuits are often char-acterized as “civil RICO” or “criminal RICO.” The original intent of the law was to provide an avenue for criminal prosecution of organized crime activities. However, clever lawyers have found ways to apply it in other cases, including malpractice lawsuits against accountants.

The civil RICO provisions permit plaintiffs to allege and attempt to prove (a) fraud in the sale of securities and (b) mail, wire (e.g., telephone), or electronic messaging fraud related to audit or tax practice, but RICO provides a perverse twist. If the plaintiffs in a lawsuit can prove a “pattern of racketeering activity,” they can, if successful, win triple damages, court costs, and legal fees reimbursement. These potential losses raise consider-ably the risk of the lawsuit.

You might think that accountants may not be in great danger of being found to have participated in a “pat-tern of racketeering activity.” Think again! Such a “pattern” can be established if a defendant accountant has engaged, whether convicted or not, in two racketeering acts—fraud in the sales of securities, mail fraud, wire fraud—within the past 10 years. An accounting firm can meet this test by losing a malpractice lawsuit that involved clients’ mailing misleading financial statements and using the telephone during the audit. Since all the major CPA firms have lost malpractice lawsuits, they are exposed to civil RICO lawsuits. In fact, RICO has been included among the charges in numerous lawsuits against accountants, and one accounting firm lost such a law-suit resulting in a judgment of about $10 million.

RICO is hated and feared not only because of the monetary effect on a lawsuit. PAs do not wish to be char-acterized as “racketeers.” It’s not good for business. When the RICO threat is included in a lawsuit, PAs are more eager to settle with the plaintiffs before trial, paying damages that might not be won in a courtroom.

But, although the new law may seem well intentioned, Bill C-22 is so broadly worded that, if accountants know or even suspect that a client has illegal profits, they could be guilty of a crime if they act for that client.

The amendments contained in the Bill create two new offences—money laundering and possession of property derived through drug trafficking.

Money laundering is defined as dealing with any property with intent to conceal or convert it while knowing that it was derived as a result of a “designated drug offence” or an “enterprise crime.”

The Criminal Code describes “designated drug offences” as virtually any drug infraction other than simple possession. “Enterprise crimes” are generally profit-motivated offences and include things such as bribery, fraud, gambling, and stock manipulation.

Under the criminal law doctrine of “wilful blindness,” people are deemed to know they are dealing with the proceeds of crime if they are suspicious about the source of any property but choose to remain ignorant rather than make further inquiries.

The effect of the legislation is that accountants who accept any property, including fees, from a client, knowing or being wilfully blind to the fact the property was obtained illegally, could be charged with possession or laundering.

Problems could also arise if accountants become suspicious about a client’s finances during an ongoing engage-ment. If they continue to act and their advice relates to property obtained through a crime, they could be committing an offence.

Accountants will be particularly vulnerable because they are often aware of the intimate details of a client’s financial dealings.

Source: Brad Dusley, The Bottom Line, November 1990, p. 6. Reprinted with permission.

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Liability under Securities and Exchange Commission (Statutory) LawLO4 Recognize U.S. Securities and Exchange Commission (statutory) law liability issues.

The purpose of this section is to acquaint you with U.S. statutory law. (Some of your future clients may fall under U.S. jurisdiction.) Some influential U.S. statutory law cases are reviewed as well. There is nothing com-parable to this U.S. statutory liability in Canada because Canada does not have a national securities regulator. Securities regulation has so far been a provincial matter because several provinces are strongly opposed to a national regulator. The effect of this has been somewhat offset by having increased audit regulator activism at the Canadian Public Accountability Board (CPAB), which is strengthening the monitoring role of PAs throughout Canada. The Public Company Accounting Oversight Board (PCAOB) has a similar effect on the auditors of U.S. public companies.

In this section, we review in detail the SEC legislation that has so influenced the Canadian Securities Admin-istrators (CSA) and Ontario’s Securities Act (OSA). OSA has the potential to empower the OSC with oversight authority similar to that of the SEC. Under this legislation, the OSC has been delegated the responsibility to decide how actively regulated the Ontario accounting profession will be. These recent changes clearly indicate the increased uncertainties and complexities facing auditors in the post-Enron world.

Several federal statutes provide sources of potential liability for accountants, including the Federal False Statements Statute, Federal Mail Fraud Statute, Federal Conspiracy Statute, Securities Act of 1933 (Securities Act), and Securities and Exchange Act of 1934 (Exchange Act).

The securities acts contain provisions defining certain civil and criminal liabilities of accountants. Because a significant segment of accounting practice is under the jurisdiction of the securities acts, the following discus-sion will concentrate on duties and liabilities under these laws. First, however, you should become familiar with the scope and function of the securities acts and the SEC.

Federal securities regulation in the United States was enacted in 1933 not only as a reaction to the events of the early years of the Great Depression but in the spirit of the New Deal era and as a culmination of attempts at “blue-sky” regulation by the states. The Securities Act of 1933 and the Securities and Exchange Act of 1934 require disclosure of information needed for informed investment decisions. The securities acts and the SEC operate for the protection of investors and for the facilitation of orderly capital markets. Even so, no govern-ment agency, including the SEC, rules on the quality of investments. The securities acts have been characterized as “truth-in-securities” law. Their spirit favours the otherwise uninformed investing public, while caveat vendor is applied to the issuer—let the seller beware of violations.

Securities and Exchange Commission Regulation of Accountants and AccountingThe SEC has made rules governing the conduct of persons practising before it. Rule 2(e) of its Rules of Prac-tise provides a means of public regulation discipline. Through these rules, the SEC can apply direct regulatory authority to individual accountants and accounting firms.

Both the Securities Act and the Exchange Act give the SEC power to establish accounting rules and regulations. Regulation S-X contains accounting requirements for audited annual and unaudited interim financial statements filed under both the Securities Act and the Exchange Act. Equally important, Regu-lation S-K contains requirements relating to all other business, analytical, and supplementary financial disclosures. In general, Regulation S-X governs the content of the financial statements themselves, and Regulation S-K governs all other disclosures in financial statement footnotes and other places in reports required to be filed.

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For almost 80 years, the SEC has followed a general policy of relying on the organized accounting pro-fession to establish GAAP. However, the SEC makes its influence and power known in the standard-setting process. Its chief accountant monitors the development of Financial Accounting Standards Board (FASB) standards, meets with FASB staff, and decides whether a proposed pronouncement is reasonable. The SEC view is communicated to the FASB, and the two organizations try to work out major differences before a new Statement on Financial Accounting Standards (SFAS) is made final. Usually, the two bodies reach agreement.

In the past, however, the SEC itself has made a few accounting rules because (1) the SEC could act faster when an emerging problem needed quick attention and (2) the SEC thought GAAP were deficient and wanted to prod the FASB to act. Consequently, GAAP and Regulation S-X differ in a few respects, but not many. Examples where Regulation S-X requires more than GAAP are non-equity classification of redeemable preferred shares; separate presentation of some income tax details; and additional disclosures about compensating balances, inventories, and long-term debt maturities. Otherwise, “SEC accounting” is not fundamentally different from GAAP accounting. The spirit of the force and effect of accounting principles and the respective roles of FASB and SEC are explained by an early SEC policy statement as follows:5

1. When financial statements filed with the commission are prepared according to principles that have no authoritative support, they will be presumed to be misleading. Other disclosures or footnotes will not cure this presumption.

2. When financial statements involve a principle on which the commission disagrees but has promulgated no explicit rules or regulations, and the principle has substantial authoritative support, then supplementary disclosures will be accepted in lieu of correction of the statements.

3. When financial statements involve a principle that (a) has authoritative support in general, but (b) the com-mission has ruled against, then the statements will be presumed misleading. Supplementary disclosures will not cure this presumption.

The biggest difference between SEC practice and other accounting practice involves the disclosures required by Regulation S-K. These requirements are detailed, and accountants must be well aware of them. In many respects, Regulation S-K goes beyond GAAP because FASB pronouncements usually do not specify as much detail about footnote disclosures. Also, accountants must keep up to date on the SEC’s Financial Report-ing Releases (FRR—a new name for the Accounting Series Releases issued through 1982), which express new rules and policies about accounting and disclosure. Finally, accountants must keep up to date on the SEC’s Staff Accounting Bulletins (SAB), which are unofficial but important interpretations of Regulation S-X and Regulation S-K.

Integrated Disclosure SystemUnder the integrated disclosure system, companies must give annual reports to shareholders, file annual reports on Form 10-K (discussed later in this section), and file registration statements (also discussed later in this sec-tion) when securities are offered to the public. However, companies can prepare the annual report to sharehold-ers in conformity with Regulation S-X and Regulation S-K and use it to provide most of the other information required for the Form 10-K annual report. Some companies can also use these as the basic reports required in a Securities Act registration statement, because the integrated disclosure system has basically made the 10-K requirements the same as the registration statement disclosure requirements.

The integrated disclosure system is intended to simplify and coordinate various reporting requirements. It has also had the not-too-subtle effect of making most of Regulation S-X and Regulation S-K required in annual reports to shareholders, making them GAAP for companies that want to obtain the benefits of integration.

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Regulation of Auditing StandardsIn contrast to its concern for the quality of accounting principles, the SEC’s involvement in auditing standards and procedural matters has been minimal since the developments of the McKesson and Robbins affair. Follow-ing an investigation of McKesson, the SEC ruled that auditors’ reports must state that an audit was performed in accordance with GAAS. At that time (1938), the 10 standards had not yet been issued by the AICPA. They were written and adopted soon afterward.

The SEC’s chief accountant also monitors the development of auditing standards by the AICPA Auditing Standards Board (ASB). A member of the chief accountant’s staff attends ASB meetings, analyzes new pro-posals, and decides whether an issue of relevance to SEC-registered public companies is involved. The chief accountant discusses differences of opinion with the ASB, and the two try to work them out. Under SOX, the PCAOB is now the monitoring and standard-setting arm of the SEC regarding the external audit function.

Regulation of Securities SalesFor the most part, the Securities Act regulates the issue of securities, and the Exchange Act regulates trading in securities. Neither these securities laws nor the SEC approve or guarantee investments. The laws and the SEC’s

Enthusiasm for Private Stock OfferingsAriad Pharmaceuticals Inc. raised $46 million in a private share sale. Specialists in small-company finance say that the sale is a sign of growing interest in private financings that could benefit many companies.

Ariad’s shares were offered only to a small number of wealthy investors. They had to attest that they had a net worth of at least $1 million (excluding homes) or otherwise met government tests (SEC Regulation D) aimed at protecting small investors. Ariad obtained about 21% from institutional investors and the rest from individuals.

Many companies prefer to sell shares privately to avoid the need for public disclosure about proprietary technology or trade practices.

Source: The Wall Street Journal, March 27, 1992.

McKesson & Robbins Inc.An SEC investigation resulted in these conclusions expressed in Accounting Series Release No. 19 (1940): First, the audi-tors failed to employ that degree of vigilance, inquisitiveness, and analysis of the evidence available that is necessary in a professional undertaking and is recommended in all well-known and authoritative works on auditing. Meticulous verifica-tion was not needed to discover the inventory fraud. Second, although the auditors are not guarantors and should not be responsible for detecting all fraud, the discovery of gross overstatements in the accounts is a major purpose in an audit, despite the fact that every minor defalcation might not be disclosed.

General Securities and Exchange Commission DefinitionsNon-public offering (private placement): The sale of securities to a small number of persons or institutional investors (usu-ally not more than 35), who can demand and obtain sufficient information without the formality of SEC registration.Non-public company: A company with less than $5 million in assets and fewer than 500 shareholders. Not required to register and file reports under the Exchange Act.Accredited investors: Financial institutions, investment companies, large tax-exempt organizations, directors, and execu-tives of the issuer, and individuals with a net worth of $1 million or more, or income of $200,000 or more.

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regulations concentrate on disclosure of information to investors, who are responsible for judging investment risk and reward potential. The Securities Act provides that no person may lawfully buy, sell, offer to buy, or offer to sell any security by means of interstate commerce, unless a registration statement is “effective” (a legal term meaning, essentially, “filed and accepted”). This prohibition should be interpreted literally: no person can buy or sell any security by means of interstate commerce (e.g., telephone, mail, electronic, highway, national bank) unless a registration statement is effective.

A registration statement must be filed and must be effective before a sale is lawful. The SEC has adopted a series of forms for use in registrations. The forms most commonly used for general public offerings are Forms S-1, S-2, and S-3. These forms are related to the integrated disclosure system discussed earlier. They are not sets of “forms” as in an income tax return, however. A “registration form” is a list of financial statement and disclo-sure requirements cross-referenced to Regulation S-X and Regulation S-K.

Form S-1 is the general registration form. It is available to all issuers but must be used by issuers who do not qualify to use Form S-2 or S-3. A certain set of financial statements and disclosures (Part I) in an S-1 is known as the prospectus, which must be distributed to all purchasers. Investors can obtain the complete S-1, containing all the required information, from the SEC.

Form S-3 represents the SEC’s acknowledgment of “efficient markets” for widely distributed information about well-known companies. Part I (the prospectus) can be concise—containing information about the terms of the securities being offered, the purpose and use of proceeds, the risk factors, and some other information about the offering. The remainder of the financial information is “incorporated by reference.” Financial statements are not enclosed with the prospectus, but reference is merely made to reports filed earlier (10-K, 10-Q, and 8-K reports, which will be discussed later). The information in these reports is presumed to have been obtained and used by securities analysts and already impounded in current securities prices. Form S-3 can be used by compa-nies that have made timely reports under the Exchange Act for 36 months, that have not recently defaulted on obligations, and that have $150 million of shares trading or $100 million of shares trading with annual trading volume of 3 million shares. These requirements describe reasonably large, “seasoned” companies.

There are other forms as well: S-2 is for smaller seasoned companies, and S-18 is for smaller companies mak-ing an initial public offering (IPO). These forms are simpler and processed much faster to facilitate access to public securities markets by smaller companies.

Regulation of Periodic ReportingThe Exchange Act primarily regulates daily trading in securities and requires registration of most companies whose securities are traded in interstate commerce. Companies having total assets of $5 million or more and 50 or more shareholders are required to register under the Exchange Act. The purpose of these size and share cri-teria is to define securities in which there is a significant public interest. (From time to time, these criteria may be changed.)

For auditors and accountants, the most significant aspect of the Exchange Act is the requirement for annual reports, quarterly reports, and periodic special reports. These reports are referred to by the form numbers 10-K, 10-Q, and 8-K, respectively. Under the integrated disclosure system, a company’s regular annual report to share-holders may be filed as a part of the 10-K to provide part or all of the information required by law. The 10-Q quar-terly report is filed after each of the first three fiscal quarters, and its contents are largely financial statement information. Form 8-K, the “special events report,” is required whenever certain significant events occur, such as changes in control, legal proceedings, and changes in accounting principles. These 8-K reports are “filed” with the SEC but are not usually sent to all shareholders and creditors. They can be obtained from the SEC and, therefore, are considered publicly available information. Frequently, 8-Ks consist of news releases distributed by the company. Commercial information services also obtain the filings and disseminate the information to cli-ents and newsletter subscribers. Anyone can obtain the filings by requesting them and paying a fee, or accessing them through the SEC’s website.

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One of the events considered significant for an 8-K report is a change of auditors. Companies that change auditors must report the reasons for the change. Most often, they cite personality conflicts, high fees, growth of the business and need for a larger audit firm, geographical expansion and need to have a firm with several offices, new international operations and need for a firm with foreign offices or affiliates, and other similar reasons. When companies grow and go public for the first time, investment bankers involved in the public offering often suggest changing to a Big Four firm for added credibility. This bias to large public accounting firms has long been a sore point with the other public accounting firms. They and the AICPA have declared that audits by firms other than the Big Four are professionally competent and that the investment bankers should recognize the fact. Nevertheless, large and growing companies often switch to the larger public accounting firms. The PCAOB and CPAB monitor-ing processes are further discouraging smaller public accounting firms from audits of publicly listed companies.

In the past, some auditor changes have occurred for the purpose of getting an auditor who will agree with management’s treatment of a troublesome revenue recognition or expense deferral treatment. Such changes are suspect, and a few of them have turned out to be cases of audit failure on the part of the new auditor. Thus, auditor changes in the context of a disagreement with management are thought to be of interest to inves-tors. Whenever a company changes auditors, the company must report the fact and state whether in the past 24 months there has been any disagreement with the auditors concerning matters of accounting principles, financial statement disclosure, or auditing procedure. At the same time, the former auditor must submit a letter stating whether the auditor agrees with the explanation and, if the auditor disagrees, giving particulars. These documents are available to the public on request, and their purpose is to make information available about client-auditor conflicts that may have a bearing on financial presentations and consequent investment decisions. Reported disagreements have included disputes over recoverability of asset cost, revenue recognition timing, expense recognition timing, amounts to be reported as liabilities, and necessity for certain auditing procedures. These disclosures must also provide information about “opinion shopping” consultations with a new auditor.

Liability Provisions: Securities Act of 1933Section 11 of the Securities Act is of great interest to auditors because it alters significantly the duties and responsibilities otherwise required by common law. This section contains the principal criteria defining civil liabilities under the statute. Portions of Section 11 pertinent to auditors’ liability are discussed next.

Section 11—General LiabilityThe Securities Act (1933) is applicable only when a company files a registration statement (e.g., S-1, S-2, S-3, S-18) to issue securities. The sections that follow explain the practical meaning of the act.

Securities Act (1933) Registration FormsForm S-1 General registration form available to all companiesForm S-2 Registration form for small “seasoned” companiesForm S-3 Registration form for large “seasoned” companiesForm S-18 Registration form for relatively small IPOs

Exchange Act (1934) Periodic ReportsForm 10-K Annual reportForm 10-Q Quarterly reportForm 8-K Periodic report of selected special events

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In Section 11, the accountant is considered the “expert” on the financial statements that are covered by the audit report and, therefore, must perform a reasonable investigation—an audit in accordance with GAAS using due professional care. All other people who might be included in a registration legal action do not need to prove that they made a “reasonable investigation” of the financial statements, since they relied on the authority of the expert (the accountant who provided the audit report). Thus, the other parties would like the accountant to expand the audit report to cover as much as possible, while the accountant must be careful to specify exactly which statements, including footnotes, are covered by the audit report.

The effect of Section 11 is to shift the major burdens of affirmative proof from the injured plaintiff to the expert accountant. Recall that under the common law, the plaintiff had to allege and prove damages, mislead-ing statements, reliance, direct cause, and negligence. Under Section 11, the plaintiff still has to show that he or she was damaged and has to allege and show proof that financial statements in the registration statement were materially misleading, but here the plaintiff’s duties essentially end. Exhibit 20–1 summarizes these common law and statutory duties.

Privity Not RequiredThe plaintiff does not have to be in privity with the auditor. Section 11 provides that any purchaser may sue the accountant. The purchaser-plaintiff does not need to prove that he or she relied on the financial statements in the registration statement. In fact, the purchaser may not have even read them.6 The purchaser is not required to show that the misleading statements caused him or her to make an unwise decision and, thus, suffer a loss.

Section 11 was written with the protection of the investing public in mind, not the protection of the expert auditor. The first significant court case under Section 11 was Escott et al. v. BarChris Construction Corporation et al. The ruling in this case was that the auditors did not conduct a reasonable investigation and, thus, did not satisfy Section 11(b)(B).

*Proof of purchaser’s reliance may be required if a 12-month earnings statement had been issued.

**Upon failing to prove a proper audit, due diligence, or good faith, the accountant may try to prove that the plaintiff’s loss was caused by something other than the misleading financial statements, for example, actions by the plaintiff such as contributory negligence or loss from some other cause.

EXHIBIT 20–1

Comparison of Common Law and Statutory Litigation

UNDER COMMON LAWUNDER SECURITIES ACT,

SECTION 11UNDER EXCHANGE ACT,

SECTION 10(B)

Plaintiff

Proves damages or loss Same as common law. Same as common law

Proves necessary privity or beneficiary relationships Any purchaser may sue the accountant

Any purchaser or seller may sue the accountant

Alleges and shows evidence and the court decides whether financial statements were misleading

Same as common law Same as common law

Proves reliance on misleading statements Not required* Same as common law

Proves misleading statements the direct cause of his or her loss

Not required Same as common law

Proves the requisite degree of negligence by the accountant

Not required Must allege and prove that the accountant knew about the scheme or device to defraud

Defendant Accountant

Offers evidence to counter above, such as no privity, statements not misleading, and audit conducted in accordance with GAAS with due care.**

Must prove a reasonable investigation was performed (due diligence)**

Must prove acted in good faith and had no knowledge of the misleading statements**

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Section 11 ExemptionFinancial reporting has changed since 1933. The SEC now requires some larger companies to present interim financial statements and encourages the presentation of forecasts. To remove the legal liability barrier to auditor association with such information, the SEC has exempted auditors from Section 11 liability related to interim information and has enacted a “safe harbour” with respect to forecasts. (A safe harbour means that plaintiffs in a lawsuit must show that the auditor did not act in good faith when reporting on a forecast, effectively placing the burden of proof on the plaintiff.) The FASB requires some kinds of supplementary information outside the basic financial statements (oil and gas reserve information), and auditing standards require implicit reporting. (Implicit reporting means that auditors modify the standard audit report only when some exception is taken to the presentation of the supplementary information; otherwise, the report is silent.) The SEC has not exempted auditors’ implicit reports on supplementary information from Section 11 liability exposure.

Statute of LimitationsSection 13 of the Securities Act defines the statute of limitations in such a way that suit is barred if not brought within five years after discovery of the misleading statement or omission, or in any event if not brought within three years after the public offering. These limitations and the reliance limitation related to a 12-month earnings statement restrict auditors’ liability exposure to a determinable time span. Often, the statute of limitations is the best defence available to auditors. (In the case of fraud the time span is extended to two years after discovery and five years after the fraudulent act occurred.)

Due Diligence DefenceSection 11 also states the means by which auditors can avoid liability. Section 11(b) describes the “due dili-gence” defence. If the auditor can prove that a reasonable examination was performed, then the auditor is not liable for damages. Section 11(c) states the standard of reasonableness to be that degree of care required of a prudent person in the management of his or her own property. In a context more specific to auditors, a rea-sonable investigation would be shown by the conduct of an audit in accordance with GAAS in both form and substance.

Section 11 also gives a diligence defence standard for portions of a registration statement made on the authority of an expert. Any person who relies on an “expert” is not required to conduct a reasonable inves-tigation of his or her own, but only to have no reasonable grounds for disbelief. Thus, the auditor who relies

Escott v. BarChris Construction Corp. (1968)The court ruled that the auditors were the only experts under Section 11 and specifically ruled that the attorneys were not considered experts. In individual findings against all defendants (except the auditors), the court generally ruled that they had not conducted reasonable investigations to form a basis for belief and that they had not satisfied the diligence upon the portions of the prospectus expertised by the auditors [a lesser diligence requirement under Section 11(b)(C)]. The court ruled that the auditors had also failed to perform a diligent and reasonable investigation [Section11(b)(B)]. The court found that the auditor had spent “only” 20.5 hours on the subsequent events review, had read no important documents, and “He asked questions, he got answers that he considered satisfactory and he did nothing to verify them. . . . He was too easily satisfied with glib answers to his inquiries.” The court also said: “Accountants should not be held to a standard higher than that recognized in their profession. I do not do so here. The senior accountant’s review did not come up to that standard. He did not take some of the steps [the] written program prescribed. He did not spend an adequate amount of time on a task of this magnitude.”

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on the opinion of an actuary or engineer need not make a personal independent investigation of that expert’s area. Similarly, any officer, director, attorney, or underwriter connected with a registration has a far lesser diligence duty for any information covered by an auditor’s expert opinion. In the BarChris judgment, officers, directors, attorneys, and underwriters were found lacking in diligence except with respect to audited financial statements.

Causation DefenceSection 11(e) defines the last line of defence available to an auditor when lack of diligence has been proved. This defence is known as the causation defence. Essentially, if auditors can prove that the plaintiff’s damages (all or part) were caused by something other than the misleading and negligently prepared registration statement, then all or part of the damages will not have to be paid. This defence may create some imaginative “other reasons.” In the BarChris case, at least one plaintiff had purchased securities after the company had gone bankrupt. The presumption that the loss in this instance resulted from events other than the misleading registration statement is fair, but this claim was settled out of court, so there is no judicial determination for reference.

Section 17—Anti-fraudSection 17 of the Securities Act is the anti-fraud section. The wording and intent of this section are practically identical to Section 10(b) and Rule 10b-5 under the Exchange Act. The difference between the two acts is the Securities Act references to “offer or sale” and the Exchange Act reference to “use the securities exchanges.”

Section 24—Criminal LiabilitySection 24 sets forth the criminal penalties imposed by the Securities Act. Criminal penalties are characterized by monetary fines or prison terms, or both. The key words in Section 24 are wilful violation and wilfully causing misleading statements to be filed.

Liability Provisions: Securities and Exchange Act of 1934Section 10 of the Exchange Act is used against accountants quite frequently. Like Section 17 of the Securities Act, Section 10 is a general anti-fraud section.

The Fischer v. Kletz ruling and the Hochfelder decisions have more to say about Section 10. An important point about Section 10 liability is that plaintiffs must prove scienter—that an accountant acted with intent to deceive—in order to impose liability under the rule. Mere negligence is not enough cause for liability. The basic comparison of Section 10 with common law and with Section 11 of the Securities Act is shown in Exhibit 20–1. (Note how much importance the court’s reasoning puts on context—in this case the degree of recklessness equivalent to scienter.)

United States v. Benjamin (1964)The judgment in this case resulted in conviction of an accountant for willingly conspiring by use of interstate commerce to sell unregistered securities and to defraud in the sale of securities, in violation of Section 24 of the 1933 Securities Act. The accountant had prepared pro forma balance sheets and claimed that use of the words pro forma absolved him of responsibility. He also claimed that he did not know his reports would be used in connection with securities sales. The court found otherwise, showing that he did in fact know about the use of his reports and that certain statements about asset values and acquisitions were patently false and that the accountant knew they were false. The court made two sig-nificant findings: (1) that the wilfulness requirements of Section 24 may be proved by showing that due diligence would have revealed the false statements and (2) that use of limiting words such as pro forma does not justify showing false ownership of assets in any kind of financial statements.

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Section 18—Civil LiabilitySection 18 sets forth the pertinent civil liability definition under the Exchange Act.

Good-Faith DefenceUnder Rule 10b-5 and Section 18, a plaintiff has to prove reliance on misleading statements and damages caused thereby—the same requirement as under common law. As a defence, the auditor must then prove action in good faith and no knowledge of the misleading statement. This requirement appears to be the Ultramares rule written into statute, to the extent that proving good faith is equivalent to showing that any negligence was no greater than ordinary negligence. The Ultramares case is discussed at the beginning of this chapter.

Fischer v. Kletz (popularly known as the Yale Express case, 1967)The judge ruled that “aiding and abetting” allegations were sufficient grounds for proceeding to trial on the merits of the lawsuit. This decision is the court’s ruling to deny the defendant’s motion to dismiss the suit. No other public record exists because the suit was later settled without trial. The plaintiff’s allegations were based on common law deceit, Section 18 of the Exchange Act, and Section 10(b) and Rule 10B-5 under the Exchange Act. The case was complicated by the accounting firm’s involvement in a consulting services engagement after the financial statement audit.

The court’s findings dealt with the following subjects: (1) the accounting firm’s role of consultant may have interfered with duties as statutory independent auditor, (2) silence and inaction rather than affirmative misrepresentations may be criteria for deceit, (3) “aiding and abetting” may trigger Section 10(b) and Rule 10b-5 liability, and (4) auditors may have public responsibilities in connection with unaudited interim financial statements.

Section 18, Securities and Exchange Act of 1934Section 18(a): Any person who shall make or cause to be made any statement . . . which . . . was at the time and in the light of the circumstances under which it was made false or misleading with respect to any material fact shall be liable to any person (not knowing that such statement was false or misleading) who, in reliance upon such statement, shall have purchased or sold a security at a price which was affected by such statement, for damages caused by such reliance, unless the person sued shall prove that he acted in good faith and had no knowledge that such statement was false or misleading.

Ernst & Ernst v. Hochfelder (U.S. Supreme Court, 1976)The decision in this case established precedent for the plaintiff’s needs to allege and prove scienter to impose Section 10(b) liability under the Exchange Act. The point of law at issue in the case was whether scienter is a necessary element for a cause of action under 10(b) or whether negligent conduct alone is sufficient. Scienter refers to a mental state embrac-ing intent to deceive, manipulate, or defraud. Section 10(b) makes unlawful the use or employment of any manipulative or deceptive device or contrivance in contravention of SEC rules. The respondents (Hochfelder) specifically disclaimed any allegations of fraud or intentional misconduct on the part of Ernst & Ernst, but they wanted to see liability under 10(b) imposed for negligence.

The court reasoned that Section 10(b) in its reference to “employment of any manipulative and deceptive device” meant that intention to deceive, manipulate, or defraud is necessary to support a private cause of action under Section 10(b), and negligent conduct is not sufficient. This decision is considered a landmark for accountants because it relieved them of liability for negligence under Section 10(b) of the Exchange Act and its companion SEC Rule 10b-5. Mere negligence is not enough. However, reckless professional work might yet be a sufficient basis for 10(b) liability even though scienter is not clearly established.

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Section 32—Criminal LiabilitySection 32 states the criminal penalties for violation of the Exchange Act. Like Section 24 of the Securities Act, the critical test is whether the violator acted “wilfully and knowingly.”

The defendant accountants in the Continental Vending case (United States v. Simon) and in United States v. Natelli were charged with violation of Section 32.

Legal Liability Implications for Auditor PracticeAs a result of the increasingly litigious climate as outlined in this chapter and in Chapter 3, auditors ought to take the following precautions in their engagements in order to better protect themselves from legal liability:

(a) Be wary of what kinds of clients are accepted. (b) Know (thoroughly) the client’s business. (c) Perform quality audits:

(i) Use qualified, properly trained and supervised, and motivated personnel. (ii) Obtain sufficient appropriate evidence (including proper elicitation of oral evidence and documentation

of client’s oral evidence). (iii) Prepare good working papers. (iv) Obtain engagement and representation letters.

Increased litigation has also caused improvements in audit working paper files through use of (a) Forceful management letters that are “unambiguous and couched in terms of alarm with respect to problem-

atic internal controls or sloppy bookkeeping” (b) Detailed memos in the working papers describing the conversation with the client and accompanied by a

follow-up letter to the client (c) A letter to the client or note to the file documenting discussions to reduce audit fees or change to a review

engagement7

United States v. Simon (popularly known as the Continental Vending case, 1969)The circumstances were judged to be evidence of wilful violation of the Exchange Act. GAAP were viewed by the judge as persuasive but not necessarily conclusive criteria for financial reporting.

In affirming the conviction, the appeals court stated that it should be the auditor’s responsibility to report factually when-ever corporate activities are carried out for the benefit of the president of the company and when “looting” has occurred.

United States v. Natelli (popularly known as the National Student Marketing case, 1975)Circumstances and actions on the part of accountants were construed to amount to wilful violation of the Exchange Act.

The court stated, “It is hard to probe the intent of a defendant. . . . When we deal with a defendant who is a professional accountant, it is even harder at times to distinguish between simple errors of judgment and errors made with sufficient crimi-nal intent to support a conviction, especially when there is no financial gain to the accountant other than his legitimate fee.”

Nevertheless, the court affirmed one accountant’s conviction by the lower trial court because of his apparent motive and action to conceal the effect of some accounting adjustments. A footnote in particular, as it was written, failed to reveal what it should have revealed—the write-off of $1 million of “sales” (about 20% of the amount previously reported) and the large operating income adjustment ($210,000 compared to $388,031 originally reported). The court concluded that the concealment of the retroactive adjustments to the company’s 1968 revenues and earnings was properly found to have been intentional for the very purpose of hiding earlier errors.

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The business press provides much anecdotal evidence that there are sometimes serious problems in many auditor-client relationships. For example, according to a vice-president of finance of a major Canadian com-pany, “it’s very easy for management to browbeat an auditor at any time in the audit,” and “anything goes unless there is a rule to the contrary (in the CPA Canada Handbook).”

To combat these problems, auditors should report to a company’s audit committee (or equivalent), standard setters should reduce the number of accounting alternatives in GAAP, auditors need more guidance on how to report on a company’s ability to continue, and auditors need to better document high-risk clients and be ready to take immediate defensive measures. Some firms now even “fire” their troublesome clients. Some warning signs of potentially troublesome clients are financial or organizational difficulty, involvement in suspicious transac-tions, uncooperativeness, fee pressures, refusal to sign engagement and representation letters, and frequent involvement in litigation.

Before accepting clients, PAs should ask why clients are changing accountants, visit the client’s business, meet their accounting and tax personnel, and check their references. A useful client acceptance checklist could be used that documents whether a client should be accepted for an engagement. This form should be prepared before the engagement letter is submitted. If this screening does not result in rejection of an existing or pro-spective client, it may also be used to identify engagements that require extra precautions, such as very precise engagement letters and advance collection of fees.8 In the current environment, these recommendations have become standard practice and will likely be mandatory once the various new accountability boards and newly empowered regulators develop their own tightened requirements.

S U M M A R Y

• Litigation against accountants has created huge costs for chartered professional accountants (CPAs) in the United States and to a lesser extent in Canada. Damage claims of hundreds of millions of dol-lars have been paid by public accounting firms and their insurers. Insurance is expensive and hard to obtain. The Securities and Exchange Commission (SEC) has sued several of the largest accounting firms for securities fraud. One of these firms, Arthur Andersen, paid fines of $7 million and later was convicted of “obstructing justice” and forced into bankruptcy. Accountants are not alone in this rash of litigation, which affects manufacturers, architects, doctors, and people in many other walks of life. The professional accounting organizations have joined with other interest groups pushing for “tort reform” of various types (e.g., limitation of damages, identification of liability) in an effort to stem the tide. Other effects of this climate take the form of changing the nature of organizations in which public accountants (PAs) practise (such as to limited liability partnerships). LO1

• Accountants’ liability to clients and third parties under common law has expanded. Over eighty years ago, a strict privity doctrine required other parties to be in a contract with and known to the accoun-tant before they could sue for damages based on negligence. LO2

• Of course, if an accountant was grossly negligent in such a way that his or her actions amounted to con-structive fraud, liability exists as it would for anyone who committed a fraud. Over the years, the priv-ity doctrine was modified in many jurisdictions, leading to liability for ordinary negligence to primary beneficiaries (known users) of the accountants’ work product, and then to liability based on ordinary negligence to foreseen and foreseeable beneficiaries (users not so easily known). While the general movement has been to expand accountants’ liability for ordinary negligence, some jurisdictions have held closer to the privity doctrine of the past. The treatment can vary from province to province. The Kripps v. Touche Ross case discussed in this chapter has also called into question the sufficiency of

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conformity with generally accepted auditing principles (GAAP) defence in Canada, but it is unclear what alternative standards auditors will be held to. Future court cases will likely clarify this issue. LO2

• Under common law, a plaintiff suing an accountant had to bring all the proof of the accountant’s neg-ligence to the court and convince the judge or jury. In the case of a public offering of securities reg-istered in a registration statement filed under a U.S. or Ontario securities act, the plaintiff only needs to show evidence of a loss and that the financial statements were materially misleading—case rested. Then, the accountant shoulders the burden of proof of showing that the audit was performed properly or that the loss resulted from some other cause. The burden of proof has thus shifted from the plain-tiff to the defendant. The securities acts also impose criminal penalties in some cases. As indicated throughout the chapter, many commentators feel that the profession is in the midst of a liability crisis that imposes major changes on auditor responsibilities. LO2

• Accountants’ liability under statutory law is also growing rapidly, especially the potentially wide influ-ence of the Ontario Securities Act (in effect since 2005) on other Canadian provinces, the changes in the Canada Business Corporations Act (CBCA), and the Proceeds of Crime (Money Laundering) and Terrorist Financing Act (PCMLTFA) legislation, which can label accountants as “racketeers.” Regu-latory laws in the United States greatly changed the obligations of PAs. Canadian PAs whose clients obtain financing from the United States may be affected by these laws, and these laws have also had an influence on Canadian laws, such as Bill 198. LO3

• This chapter also outlines the PCMLTFA legislation and other statutory laws affecting accountants and corporate governance in Canada and the United States. It also reviews U.S. statutory law in some detail because many court cases setting legal precedents for accountants were launched as a result of this legislation. LO4

K E Y T E R Mprimary beneficiaries

M U LT I P L E - C H O I C E Q U E S T I O N S F O R P R A C T I C E A N D R E V I E W

MC 20-1 LO3 Under the FCPA,

a. companies must refrain from bribing foreign politicians for commercial advantage. b. independent auditors must audit all elements of a company’s internal control system. c. companies must hire auditors to keep books, records, and accounts properly. d. independent auditors must establish control systems to keep books, records, and accounts properly.

MC 20-2 LO3 The management accountants employed by Robbins Inc. wrongfully charged execu-tives’ personal expenses to the overhead on a government contract. Their activities can be characterized as

a. errors in the application of accounting principles. b. irregularities of the type independent auditors should plan an audit to detect. c. irregularities of the type independent auditors have no responsibility to plan an audit to detect. d. illegal acts of a type independent auditors should be aware might occur in government contract

business.

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MC 20-3 LO4 Which of these laws does the U.S. SEC not administer?

a. Securities Act of 1933 b. Securities and Exchange Act of 1934 c. Internal Control Act of 1937 d. Foreign Corrupt Practices Act of 1977

MC 20-4 LO4 Good Gold Company sold $20 million worth of preferred shares. The company should have registered the offering under the Securities Act of 1933 if it were sold to

a. 150 accredited investors. b. one insurance company. c. 30 investors all resident in one state. d. diverse customers of a brokerage firm.

MC 20-5 LO4 When a company registers a security offering under the Securities Act of 1933, the law pro-vides an investor with

a. an SEC guarantee that the information in the registration statement is true. b. insurance against loss from the investment. c. financial information about the company audited by independent PAs. d. inside information about the company’s trade secrets.

MC 20-6 LO2 A group of investors sued Anderson, Olds & Watershed, PAs (AOW), for alleged damages suffered when the company they held common shares in went bankrupt. In order to avoid liability under the common law, AOW must prove which of the following?

a. The investors actually suffered a loss. b. The investors relied on the financial statements audited by AOW. c. The investors’ loss was a direct result of their reliance on the audited financial statements. d. The audit was conducted in accordance with GAAS and with due professional care.

MC 20-7 LO4 The SEC document that governs accounting in financial statements filed with the SEC is

a. Regulation D. b. Form 8-K. c. Form S-18. d. Regulation S-X.

MC 20-8 LO4 Able Corporation plans to sell $10 million worth of common shares to investors. The company can do so without filing an S-1 registration statement under the Securities Act (1933) if Able sells the shares

a. to an investment banker who then sells them to investors in its national retail network. b. to no more than 75 investors solicited at random. c. only to accredited investors. d. only to 35 accredited investors and an unlimited number of unaccredited investors.

MC 20-9 LO4 A public company subject to the periodic reporting requirements of the Exchange Act (1934) must file an annual report with the SEC known as

a. Form 10-K. b. Form 10-Q. c. Form 8-K. d. Form S-3.

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MC 20-10 LO4 When investors sue auditors for damages under Section 11 of the Securities Act (1933), they must allege and prove

a. scienter on the part of the auditor. b. that the audited financial statements were materially misleading. c. that they relied on the misleading audited financial statements. d. that their reliance on the misleading financial statements was the direct cause of their loss.

E X E R C I S E S A N D P R O B L E M S

EP 20-1 Responsibility for Errors and Irregularities. LO2 Huffman & Whitman (H&W), a large regional public accounting firm, was engaged by the Ritter Tire Wholesale Company to audit its financial statements for the year ended January 31. H&W had a busy audit engagement schedule from December 31 through April 1, and they decided to audit Ritter’s purchase vouchers and related cash disbursements on a sample basis. They instructed staff accountants to select a ran-dom sample of 130 purchase transactions and gave directions about the important deviations, including missing receiving reports. Boyd, the assistant in charge, completed the working papers, properly documenting the fact that 13 of the purchases in the sample had been recorded and paid without the receiving report (required by stated internal control procedures) being included in the file of supporting documents. Whitman, the partner in direct charge of the audit, showed the findings to Lock, Ritter’s chief accountant. Lock appeared surprised but promised that the miss-ing receiving reports would be inserted into the files before the audit was over. Whitman was satisfied, noted in the working papers that the problem was solved, and did not say anything to Huffman about it.

Unfortunately, H&W did not discover the fact that Lock was involved in a fraudulent scheme in which he diverted shipments to a warehouse leased in his name and sent the invoices to Ritter for payment. He then sold the tires for his own profit. Internal auditors discovered the scheme dur-ing a study of slow-moving inventory items. Ritter’s inventory was overstated by about $500,000 (20%)—the amount Lock had diverted.

Required: a. With regard to the 13 missing receiving reports, does a material weakness in internal control exist? If

so, does H&W have any further audit responsibility? Explain. b. Was the audit conducted in a negligent manner?

EP 20-2 Responsibility for Errors and Irregularities. LO2 Hannah McCoy is the president of McCoy Forging Corporation. For the past several years, Donovan & Company, PAs, has done the company’s compilation and some other accounting and tax work. McCoy decided to have an audit. Moreover, McCoy had recently received a disturbing anonymous letter that stated, “Beware, you have a viper in your nest. The money is literally disappearing before your very eyes! Signed, a friend.” She told no one about the letter.

McCoy Forging engaged Donovan & Company, PAs, to render an opinion on the financial statements for the year ended June 30, 20X3. McCoy told Donovan she wanted to verify that the financial statements were “accurate and proper.” She did not mention the anonymous letter. The usual engagement letter providing for an audit in accordance with GAAS was drafted by Donovan & Company and signed by both parties.

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The audit was performed in accordance with GAAS. The audit did not reveal a clever defalca-tion plan. Harper, the assistant treasurer, was siphoning off substantial amounts of McCoy Forg-ing’s money. The defalcations occurred both before and after the audit. Harper’s embezzlement was discovered by McCoy’s new internal auditor in October 20X3, after Donovan had delivered the audit report. Although the scheme was fairly sophisticated, it could have been detected if Dono-van & Company had performed additional procedures. McCoy Forging demanded reimbursement from Donovan for the entire amount of the embezzlement, some $40,000 of which occurred before the audit and $65,000 after. Donovan has denied any liability and refuses to pay.

Required:Discuss Donovan’s responsibility in this situation. Do you think McCoy Forging would prevail in whole or in part in a lawsuit against Donovan under common law? Explain your conclusions.

(© 2000, American Institute of CPAs. All Rights Reserved. Adapted by permission.)

EP 20-3 Common Law Liability Exposure. LO2 A public accounting firm was engaged to examine the financial statements of Martin Manufacturing Corporation for the year ending December 31. Martin needed cash to continue its operations and agreed to sell its common share investment in a subsidiary through a private placement. The buyers insisted that the proceeds be placed in escrow because of the possibility of a major contingent tax liability that might result from a pending government claim against Martin’s subsidiary. The payment in escrow was completed in late November. The president of Martin told the audit partner that the proceeds from the sale of the subsidiary’s common shares, held in escrow, should be shown on the balance sheet as an unrestricted current account receivable. The president was of the opinion that the government’s claim was groundless and that Martin needed an “uncluttered” balance sheet and a “clean” audi-tor’s opinion to obtain additional working capital from lenders. The audit partner agreed with the president and issued an unqualified opinion on the Martin financial statements, which did not refer to the contingent liability and did not properly describe the escrow arrangement.

The government’s claim proved to be valid, and, pursuant to the agreement with the buyers, the purchase price of the subsidiary was reduced by $450,000. This adverse development forced Martin into bankruptcy. The public accounting firm is being sued for deceit (fraud) by several of Martin’s unpaid creditors, who extended credit in reliance on the public accounting firm’s unquali-fied opinion on Martin’s financial statements.

Required: a. What deceit (fraud) do you believe the creditors are claiming? b. Is the lack of privity between the public accounting firm and the creditors important in this case? c. Do you believe the public accounting firm is liable to the creditors? Explain.

(© 2000, American Institute of CPAs. All Rights Reserved. Adapted by permission.)

EP 20-4 Common Law Liability Exposure. LO2 Risk Capital Limited, an Alberta corporation, was considering the purchase of a substantial amount of treasury shares held by Sunshine Corporation, a closely held corporation. Initial discussions with Sunshine Corporation began late in 20X2.

Wilson and Wyatt, Sunshine’s accountants, regularly prepared quarterly and annual unaudited financial statements. The most recently prepared financial statements were for the year ended September 30, 20X2.

On November 15, 20X2, after extensive negotiations, Risk Capital agreed to purchase 100,000 shares of no par, class A capital shares of Sunshine at $12.50 per share. However, Risk Capital insisted on audited statements for calendar year 20X2. The contract that was made available to

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Wilson and Wyatt specifically provided, “Risk Capital shall have the right to rescind the purchase of said shares if the audited financial statements of Sunshine for the calendar year 20X2 show a material adverse change in the financial condition of the corporation.”

The audited financial statements furnished to Sunshine by Wilson and Wyatt showed no such mate-rial adverse change. Risk Capital relied on the audited statements and purchased the treasury shares of Sunshine. It was subsequently discovered that, as of the balance sheet date, the audited statements were incorrect and that in fact there had been a material adverse change in the financial condition of the corporation. Sunshine is insolvent, and Risk Capital will lose virtually its entire investment.

Risk Capital seeks recovery against Wilson and Wyatt.

Required:Assuming that only ordinary negligence is proved, will Risk Capital prevail a. Under the Ultramares decision? b. Under the Rusch Factors decision?

EP 20-5 Common Law Liability Exposure. LO2 Smith, PA, is the auditor for Juniper Manufacturing Corporation, a privately owned company that has a June 30 fiscal year-end. Juniper arranged for a substantial bank loan, which depended on the bank’s receiving, by September 30, audited financial statements showing a current ratio of at least 2 to 1. On September 25, just before the audit report was to be issued, Smith received an anonymous letter on Juniper’s stationery indicat-ing that a five-year lease by Juniper, as lessee, of a factory building that was accounted for in the financial statements as an operating lease was in fact a capital lease. The letter stated that there was a secret written agreement with the lessor modifying the lease and creating a capital lease.

Smith confronted the president of Juniper, who admitted that a secret agreement existed but said it was necessary to treat the lease as an operating lease to meet the current ratio requirement of the pending loan and that nobody would ever discover the secret agreement with the lessor. The president said that if Smith did not issue his report by September 30, Juniper would sue Smith for substantial damages that would result from not getting the loan. Under this pressure and because the working papers contained a copy of the five-year lease agreement supporting the operating lease treatment, Smith issued his report with an unqualified opinion on September 29. In spite of the fact that the loan was received, Juniper went bankrupt. The bank is suing Smith to recover its losses on the loan and the lessor is suing Smith to recover uncollected rents.

Required:Answer the following, setting forth reasons for any conclusions stated. a. Is Smith liable to the bank? b. Is Smith liable to the lessor? c. Was Smith independent?

(© 2000, American Institute of CPAs. All Rights Reserved. Adapted by permission.)

EP 20-6 Common Law Liability Exposure. LO2 Farr and Madison, PAs, audited Glamour Inc. Their audit was deficient in several respects:

1. Farr and Madison failed to properly audit certain receivables, which later proved to be fictitious. 2. With respect to other receivables, although they made a cursory check, they did not detect

many accounts that were long overdue and obviously uncollectible. 3. No physical inventory was taken of the securities claimed to be in Glamour’s possession, which,

in fact, had been sold. Both the securities and cash received from the sales were listed on the balance sheet as assets.

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There is no indication that Farr and Madison actually believed the financial statements were false. Subsequent creditors, not known to Farr and Madison, are now suing based on the deficien-cies in the audit described above. Farr and Madison moved to dismiss the lawsuit against it on the basis that the firm did not have actual knowledge of falsity and, therefore, did not commit fraud.

Required:May the creditors recover without demonstrating that Farr and Madison had actual knowledge of falsity? Explain.

EP 20-7 Liability in a Review Engagement. LO2 Mason and Dilworth (M&D), PAs, were the accoun-tants for Hotshot Company, a closely held corporation owned by 30 residents of the area. M&D had been previously engaged by Hotshot to perform some compilation and tax work. Bubba Crass, Hotshot’s president and holder of 15% of the shares, said he needed something more than these services. He told Mason, the partner in charge, that he wanted financial statements for internal use, primarily for management purposes, but also to obtain short-term loans from finan-cial institutions. Mason recommended a “review” of the financial statements. Mason did not pre-pare an engagement letter.

During the review work, Mason had some reservations about the financial statements. Mason told Dilworth at various times that she was “uneasy about certain figures and conclusions” but that she would “take Crass’s word about the validity of certain entries, since the review was pri-marily for internal use in any event and was not an audit.” M&D did not discover a material act of fraud committed by Crass. The fraud would have been detected had Mason not relied so much on the unsupported statements made by Crass concerning the validity of the entries about which she had felt so uneasy.

Required: a. What potential liability might M&D have to Hotshot Company and other shareholders? b. What potential liability might M&D have to financial institutions that used the financial statements in

connection with making loans to Hotshot Company?(© 2000, American Institute of CPAs. All Rights Reserved. Adapted by permission.)

EP 20-8 Regulation D Exemption. LO3 One of your firm’s clients, Fancy Fashions Inc., is a highly successful, rapidly expanding company. It is owned predominantly by the Munster family and key corporate officials. Although additional funds would be available on a short-term basis from its bankers, this would only represent a temporary solution of the company’s need for capital to finance its expansion plans. In addition, the interest rates being charged are not appealing. Therefore, Jane Munster, Fancy’s chair of the board, in consultation with the other shareholders, has decided to explore the possibility of raising additional equity capital of approximately $15–16 million. This will be Fancy’s first public offering to investors, other than the Munster family and the key management personnel.

At a meeting of Fancy’s major shareholders, its lawyers and a PA from your firm spoke about the advantages and disadvantages of going public and registering a share offering in the United States. One of the shareholders suggested that Regulation D under the Securities Act of 1933 might be a preferable alternative.

Required: a. Assume Fancy makes a public offering for $16 million and, as a result, more than 1,000 persons own

shares of the company. What are the implications with respect to the Exchange Act of 1934?

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b. What federal civil and criminal liabilities may apply in the event that Fancy sells the securities without registration and a registration exemption is not available?

c. Discuss the exemption applicable to offerings under Regulation D, in terms of two kinds of investors, and how many of each can participate.

(© 2000, American Institute of CPAs. All Rights Reserved. Adapted by permission.)

EP 20-9 Applicability of Securities Act (1933) and Exchange Act (1934). LO3

Required: 1. The partnership of Zelsch & Company, PAs, has been engaged to audit the financial statements

of Snake Oil Inc., in connection with filing an S-1 registration statement under the Securities Act. Discuss the following two statements made by the senior partner of Zelsch & Company.

(a) “The partnership is assuming a much greater liability exposure in this engagement than exists under common law.”

(b) “If our examination is not fraudulent, we can avoid any liability claims that might arise.”

2. Xavier, Francis, & Paul is a growing, medium-size partnership of PAs located in the Midwest. One of the firm’s major clients is considering offering its shares to the public. This will be the firm’s first client to go public. State whether the following are true or false. Explain each.

(a) The firm should thoroughly familiarize itself with the securities acts, Regulation S-X, and Regulation S-K.

(b) If the client is unincorporated, the Securities Act will not apply. (c) If the client will be listed on an organized exchange, the Exchange Act will not apply. (d) The Securities Act imposes an additional potential liability on firms such as Xavier,

Francis, & Paul. (e) So long as the company engages in exclusively intrastate business, the federal securities

laws will not apply.

EP 20-10 Section 11 of Securities Act (1933) Liability Exposure. LO3, 4 The Chriswell Corpora-tion decided to raise additional long-term capital by issuing $20 million of 12% subordinated deben-tures to the public. May, Clark & Company, PAs, the company’s auditors, were engaged to examine the June 30, 20X3, financial statements, which were included in the bond registration statement.

May, Clark & Company submitted an unqualified auditor’s report dated July 15, 20X3. The registration statement was filed and became effective on September 1, 20X3. On August 15, one of the partners of May, Clark & Company called in at Chriswell and had lunch with the financial vice-president and the controller. He questioned both officials on the company’s operations since June 30 and inquired whether there had been any material changes in the company’s financial position since that date. Both officers assured him that everything had proceeded normally and that the financial condition of the company had not changed materially.

Unfortunately, the officers’ representation was not true. On July 30 a substantial debtor of the company failed to pay the $400,000 due on its account and indicated that it would probably be forced into bankruptcy. This receivable was shown on the June 30 financial statements as a collateralized loan secured by shares of the debtor corporation, which at the time the financial statements were prepared had a value in excess of the loan but was virtually worthless at the effective date of the registration statement. This $400,000 account receivable was material to the financial condition of Chriswell Corp., and the market price of the subordinated debentures decreased by nearly 50% after the foregoing facts were disclosed.

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The debenture holders of Chriswell are seeking recovery of their loss against all parties connected with the debenture registration.

Required:Is May, Clark & Company liable to the Chriswell debenture holders under Section 11 of the Securities Act (1933)? Explain.

(© 2000, American Institute of CPAs. All Rights Reserved. Adapted by permission.)

EP 20-11 Rule 10b-5 Liability Exposure under the Exchange Act (1934). LO3, 4 Gordon & Gro-ton (G&G), PAs, were the auditors of Bank & Company, a brokerage firm and member of a national stock exchange. G&G examined and reported on the financial statements of Bank, which were filed with the SEC.

Several of Bank’s customers were swindled by a fraudulent scheme perpetrated by Bank’s president, who owned 90% of the voting shares of the company. The facts establish that G&G were negligent in the conduct of the audit but neither participated in the fraudulent scheme nor knew of its existence.

The customers are suing G&G under the anti-fraud provisions of Section 10(b) and Rule 10b-5 of the Exchange Act for aiding and abetting the fraudulent scheme of the president. The customers’ suit for fraud is predicated exclusively on the negligence of G&G in failing to conduct a proper audit, thereby failing to discover the fraudulent scheme.

Required:Answer the following, setting forth reasons for any conclusions stated. a. What is the probable outcome of the lawsuit? b. What might be the result if plaintiffs had sued under a common law theory of negligence? Explain.

(© 2000, American Institute of CPAs. All Rights Reserved. Adapted by permission.)

EP 20-12 Foreign Corrupt Practices Act. LO1, 3 Major Manufacturing Company is a large diversi-fied international corporation whose shares trade on the New York Stock Exchange. The U.S. Department of Justice and the SEC have investigated the Global Oil Well Equipment Company, a subsidiary of Major. The agencies allege that Global has engaged in activities clearly in viola-tion of the FCPA.

Tobias (Global president), Wilton (vice-president), and Clark (regional manager of opera-tions in Nogoland) have conspired to make payments to influential members of Nogoland’s Parlia-ment in order to influence legislation in Global’s favour. The agencies allege that Tobias, Wilton, and Clark met secretly in Geneva and decided to give inducements to Ms. Rock, the Speaker of Nogoland’s Parliament. They made a $750,000 loan to Ms. Rock’s manufacturing business at a 2% interest rate. They gave a $10,000 watch to Mr. Rock as a memento of the Rocks’ wedding anni-versary. They paid Jenny Rock’s tuition to medical school. These expenditures were classified as investments, commissions, and promotion expenses in the Global financial statements. Their nature and purpose were not otherwise disclosed.

Required: a. What provisions of the FCPA have apparently been violated by these actions by Global and its officers? b. What penalties might be assessed on the corporation, if convicted? on Tobias, Wilton, and Clark?

(© 2000, American Institute of CPAs. All Rights Reserved. Adapted by permission.)

EP 20-13 Management Fraud Probability Assessment. LO3, 4 This is an exercise designed to reveal some facts of reasoning and decision making. The “fraud involvement procedure” is fictional.

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A team of accountants and psychologists has developed a procedure to test for management involvement in fraudulent activities. The procedure consists of developing a personality profile of key managers and comparing each profile with a master profile of a number of individuals who have perpetrated material frauds. If the manager’s profile is sufficiently similar to the mas-ter profile, the procedure signals “fraud.” In the last 18 months, the procedure has been tested extensively in the field by a national public accounting firm and has found the following:

• If a key manager has been involved in a material fraud, the procedure indicates “fraud” 8 times out of 10.

• If a key manager has not been involved in a material fraud, the procedure will nonetheless indicate “fraud” 20 times out of 100.

• The evidence indicates that about 10 key managers in 100 have been involved in material fraud.

Required:Based on these results, what is your assessment of the probability that a key manager who receives a “fraud” test signal is actually involved in fraudulent activities?

EP 20-14 Audit Report and Legal Liabilities. LO2 The auditor’s report below was drafted by Smith, a staff accountant at the firm of Wong & Wilson, PAs, at the completion of the audit of the finan-cial statements of PPC Ltd., a publicly held company, for the year ended March 31, 20X3. The report was submitted to the engagement partner, who reviewed the audit working papers and properly concluded that an unqualified opinion should be issued. In drafting the report, Smith considered the following:

• During the fiscal year, PPC changed its amortization method for capital assets. The engagement partner concurred with this change in accounting principles and its justification, and Smith included an explanatory paragraph in the auditor’s report.

• The 20X3 statements were affected by an uncertainty concerning a lawsuit, the outcome of which cannot currently be estimated. Smith has included an explanatory paragraph in the auditor’s report.

• The financial statements for the year ended March 31, 20X2, are to be presented for comparative purposes. Wong & Wilson had previously audited these statements and expressed an unqualified opinion.

The report that Smith drafted appears below:Independent Auditor’s ReportTo the Board of Directors of PPC Ltd.:We have audited the accompanying balance sheet of PPC Ltd., as of March 31, 20X3 and 20X2, and statements of income and retained earnings for the year then ended. These financial state-ments are the responsibility of the company’s management.

We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are fairly presented. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing significant estimates made by management, as well as evaluating the over-all financial statement presentation. We believe that our audits provide a basis for determining whether any material modifications should be made to the accompanying financial statements.

As discussed in Note X to the financial statements, the company changed its method of com-puting amortization in fiscal 20X3. In our opinion, except for the accounting change, with which

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we concur, the financial statements referred to above present fairly, in all material respects, the financial position of PPC Ltd. as of March 31, 20X3, and the results of its operations for the year then ended in conformity with generally accepted accounting principles.

As discussed in Note Y to the financial statements, the company is a defendant in a lawsuit alleging infringement of certain copyrights. The company has filed a counteraction, and prelimi-nary hearings on both actions are in progress. Accordingly, any provision for liability is subject to adjudication of this matter.

Wong & Wilson, PAsMay 5, 20X3

Required:Identify the deficiencies in the order in which they appear in the auditor’s report as drafted by Smith. Do not redraft the report.

(Adapted from External Auditing (AU1), June 2011, with permission from Chartered Pro-fessional Accountants of Canada, Toronto, Canada. Any changes to the original material are the

sole responsibility of the author (and/or publisher) and have not been reviewed or endorsed by the Chartered Professional Accountants of Canada.)

EP 20-15 Money Laundering, Auditor Responsibilities. LO1, 3 PA is the audit intermediate on the current year’s audit of Bluroot Inc., a publicly traded sugar importer and refiner. During the audit of Bluroot’s cash records and bank account reconciliations, PA notes numerous instances where a large dollar amount was deposited into one of the company’s bank accounts and then an identical amount was transferred out, usually on the same or the next day. PA presents a list of these “unusual transactions” to the company treasurer for further explanation. The treasurer, who is very busy, takes the list and says she will get back to PA as soon as possible. Several hours later, the treasurer tosses the list on PA’s desk and says, somewhat impatiently, “I don’t know why you wasted expensive audit time making up this list. All of these transactions offset, so there is no net effect on our cash balance. Most of them relate to intercompany transfers with our many foreign subsidiary companies, for cash management purposes. As you note, we have 12 bank accounts with four different banks in order to facilitate cash transfers with our subsidiaries. Also, some of these are probably just bank errors that the bank discovered and subsequently corrected. That happens quite frequently because of the complexity of our bank-ing arrangements. For your audit purposes, all you need to record in your audit file is that the transactions offset and all our intercompany balances agree at year-end. What happens between year-ends is of no significance to your audit! So please get on with completing the nec-essary audit tests and stop wasting your time and our money!”

PA is upset by this response. Of particular concern is that several of the sugarcane-producing countries where Bluroot has subsidiaries are listed on a list of “Non-Cooperating Countries and Territories” issued by the OECD’s Financial Action Task Force on Money Laundering, a topic that PA covered in a recent staff training course. And, in other audit tests of the management travel expenses, PA noticed that the treasurer and two of her assistants travelled to these countries on numerous occasions during the year.

PA records all of the details of this investigation in the audit working papers and discusses the situation with the audit manager the following morning. The audit manager says she will take PA’s concerns to the audit partner and also to the public accounting firm’s forensic audit special-ists. Several months later, PA learns that the RCMP has undertaken a confidential investigation of Bluroot’s financial transactions under suspicion of illegal money laundering activities and PA is asked to answer some questions by the officers investigating the case.

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Required: a. Evaluate the actions of PA and other members of the public accounting firm in the above case in dealing

with the possible illegal acts that they discovered during their audit. What actions and procedures did PA take that uncovered this situation? What different actions might PA have taken that would have allowed the potential money laundering to go undetected?

b. What difficulties can arise for an auditor in whistle-blowing as illustrated in the above case? Can you identify other difficulties that might arise when an auditor suspects illegal acts at a client, more generally?

EP 20-16 Critical Thinking. Legal Liability and Conflict of Professional Ethics Rules. LO2 Use the critical thinking framework to help resolve the confidentiality versus

misleading financial statements conflict discussed in this chapter.

EP 20-17 Critical Thinking and Legal Liability. LO2 Do you think Ontario’s Bill 198 appropriately limits PA legal liability to protect the public interest? Discuss the pros and cons within a principles-based umbrella framework such as critical thinking.

E N D N O T E S

1 M. Paskell-Mede, “Duty of care revisited,” CA Magazine, December 1993, pp. 34–35.

2 V. Murusalu, “Drawing the line,” CA Magazine, January/February 1995, pp. 68–69.

3 M. Paskell-Mede, “Tales of Sherwood Forest,” CA Magazine, August 1994, pp. 47–48.

4 “The jury’s still out on review engagement liability,” CA Magazine, June 1988.

5 Accounting Series Release No. 4 (1938) of SEC law. Also, Accounting Series Release No. 150 (1973) affirmed that pronouncements of the FASB will be considered to constitute substantial authoritative support of accounting principles, standards, and practices (FRR No. 1, Section 101).

6 This matter of reliance is modified by Section 11(a) to the extent that when enough time has elapsed and the registrant has filed an income statement covering a 12-month period beginning after the effective date, when the plaintiff must prove that he or she purchased after that time in reliance on the registration statement. However, the plaintiff may prove reliance without proof of actually hav-ing read the registration statement.

7 M. Paskell-Mede, “So sue me,” CA Magazine, February 1991, pp. 36–38; M. Paskell-Mede, “What liabil-ity crisis,” CA Magazine, May 1994, pp. 42–43.

8 M. F. Murray, “When a client is a liability,” Journal of Accountancy, September 1992, pp. 54–58.