Legal Liability

Chapter 5

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Learning Objective 1
Understand the litigious environment in which CPAs practice.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Changed Legal Environment

Audit professionals have a responsibility under common law to fulfill implied or expressed contracts with clients. They are liable to their clients for negligence and/or breach of contract should they fail to provide the services or not exercise due care in their performance.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Changed Legal Environment

Despite efforts by the profession to address the legal liability of CPAs Both the number of lawsuits and sizes of awards to plaintiffs remain high.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Learning Objective 2
Explain why the failure of financial statement users to differentiate among business failure, audit failure, and audit risk has resulted in lawsuits.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Business Failure, Audit Failure, and Audit Risk

Business failure It occurs when a business is unable to repay its lenders or meet the expectations of its investors because of economic or business conditions.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Business Failure, Audit Failure, and Audit Risk

Audit failure It occurs when the auditor issues an incorrect audit opinion because it failed to comply with the requirements of auditing standards.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Business Failure, Audit Failure, and Audit Risk

Audit risk It represents the risk that the auditor will conclude that the financial statements are fairly stated and an unqualified opinion can be issued when, in fact, they are materially misstated.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Learning Objective 3
Use the primary legal concepts and terms concerning accountants liability as a basis for studying legal liability of auditors.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Legal Concepts Affecting Liability

Prudent person concept Liability for the acts of others Lack of privileged communication

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Legal Terms Affecting CPAs Liability

Terms related to negligence and fraud: Ordinary negligence Gross negligence Constructive fraud Fraud

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Legal Terms Affecting CPAs Liability

Terms related to contract law: Breach of contract Third-party beneficiary

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Legal Terms Affecting CPAs Liability

Other terms: Common law Statutory law Joint and several liability Separate and proportionate liability

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Four Major Sources of Auditors Legal Liability

Liability to clients Liability to third parties Federal securities laws

Criminal liability

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Learning Objective 4
Describe accountants liability to clients and related defenses.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Liability to Clients
The most common source of lawsuits against CPAs is from clients.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Auditors Defenses Against Client Suits

Lack of duty to perform Nonnegligent performance Contributory negligence

Absence of causal connection

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Learning Objective 5
Describe accountants liability to third parties under common law and related defenses.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Liability to Third Parties Under Common Law

Ultramares doctrine Foreseen users

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Foreseen Users
Credit alliance Restatement of torts Foreseeable user

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Auditor Defenses Against Third-Party Suits

The preferred defense is nonnegligent performance.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Learning Objective 6
Describe accountants civil liability under the federal securities laws and related defenses.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Securities Act of 1933

The Securities Act imposes an unusual burden on the auditor. Section 11 of the 1933 act defines the rights of third parties and auditors.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Securities Exchange Act of 1934

The liability of auditors under this act often centers on the audited financial statements issued to the public in annual reports or submitted to the SEC as a part of annual Form 10-K reports.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Rule 10b-5 of the Securities Exchange Act of 1934

Section 10 and rule 10b-5 are often called the antifraud provisions of the 1934 act.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Auditor Defenses 1934 Act

Nonnegligent performance Lack of duty Absence of causal connection

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SEC Sanctions
The SEC has the power in certain circumstances to sanction or suspend practitioners from doing audits for SEC companies. In recent years, the SEC has temporarily suspended a number of individual CPAs from doing any audits on SEC clients.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Foreign Corrupt Practices Act of 1977

This act makes it illegal to offer a bribe to an official of a foreign country for the purpose of exerting influence and obtaining or retaining business.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Sarbanes-Oxley Act of 2002

This act requires the CEO and CFO to certify the annual and quarterly financial statements filed with the SEC.
Management must report its assessment of the effectiveness of internal control over financial reporting. The auditor must provide an opinion on managements assessment.
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Learning Objective 7
Specify what constitutes criminal liability for accountants.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Criminal Liability
CPAs can be held liable under criminal liability for accountants. CPAs can be found guilty for criminal action under both federal and state laws.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Sarbanes-Oxley Act
This act makes it a felony to destroy or create documents to impede or obstruct a federal investigation.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Learning Objective 8
Describe what the profession and the individual CPA can do and what is being done to reduce the threat of litigation.

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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The Professions Response to Legal Liability

Research in auditing Standard and rule setting Set requirements to protect auditors Establish peer review requirements

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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The Professions Response to Legal Liability

Oppose lawsuits Education of users Sanction members for improper conduct and performance Lobby for changes in laws

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Protecting Individual CPAs from Legal Liability

Deal only with clients possessing integrity Hire qualified personnel Follow the standards of the profession Maintain independence

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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Protecting Individual CPAs from Legal Liability

Understand the clients business Perform quality audits Document the work properly Obtain an engagement and a representation letter Maintain confidential relations
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Protecting Individual CPAs from Legal Liability

Carry adequate insurance Seek legal counsel Choose a form of organization with limited liability Exercise professional skepticism

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End of Chapter 5

2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder

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