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CHAPTER 4 ∙ Professional Liability and the Need for Quality Auditor

Judgments and Ethical Decisions
Breach of contract
Failure to perform a contractual duty that has not been excused; for
audit firms, the parties to a contract normally include clients and
designated third-party beneficiaries.
Class action lawsuits
Lawsuits that are brought on behalf of a large group of plaintiffs to
consolidate suits and to encourage consistent judgments and minimize
litigation costs; plaintiff shareholders may bring suit for themselves
and all others in a similar situation, that is, all other shareholders of
record at a specific date.
Common law
Liability concepts are developed through court decisions based on
negligence, gross negligence, or fraud.
Confidential information
Information obtained during the conduct of an audit related to the
client’s business or business plans; the auditor is prohibited from
communicating confidential information except in very specific
instances defined by the Code or with the client’s specific
Contingent fee
A fee established for the performance of any service in which a fee will
not be collected unless a specified finding or result is attained, or in
which the amount of the fee depends on the finding or results of such
Contingent-fee cases
Lawsuits brought by plaintiffs with compensation for their attorneys
being contingent on the outcome of the litigation.
Contract law
Liability occurs where there is a breach of contract. The contract is
usually between the external auditor and the client for the
performance of the financial statement audit.
Covered member
An individual on the audit engagement team, an individual in a position
to influence the audit engagement, or a partner in the office in which
the lead audit engagement partner primarily practices in connection
with the audit engagement.
Deep-pocket theory
The practice of suing another party not based on the level of their true
fault in a legal action, but based instead on the perceived ability of that
party to pay damages.
Direct financial interest

CHAPTER 4 ∙ Professional Liability and the Need for Quality Auditor 9 Judgments and Ethical Decisions A financial interest owned directly by. . but recognized by general knowledge as current and potential creditors and investors who will use them. an ethically correct action may conflict with an individual’s immediate selfinterest. Ethical dilemma A situation in which moral duties or obligations conflict. regardless of the level of fault. evidence may not be present. Gross negligence Failure to use even minimal care or evidence of activities that show a recklessness or careless disregard for the truth. causing damage to the deceived person. through knowledge gained from interactions with the client. Fraud Intentional concealment or misrepresentation of a material fact with the intent to deceive another person. Joint and several liability A type of liability that apportions losses among all defendants who have an ability to pay for the damages. Foreseen user Individually unknown third parties who are members of a known or intended class of third-party users who the auditor. an individual or entity or beneficially owned through an investment vehicle. Identified user Third-party beneficiaries and other users when the auditor has specific knowledge that known users will be utilizing the financial statements in making specific economic decisions. estate. can foresee will use the statements. or trust when the beneficiary controls the intermediary or has the authority to supervise or participate in the intermediary’s investment decisions. Foreseeable user Those not known specifically by the auditor to be using the financial statements. but may be inferred by a judge or jury because of the carelessness of the defendant’s conduct. Indirect financial interest A financial interest in which the beneficiary neither controls the intermediary nor has the authority to supervise or participate in the intermediary’s investment decisions. Expectations gap A misunderstanding whereby shareholders mistakenly believe that they are entitled to recover losses on investments for which the auditor provided an unqualified opinion on the financial statements. or under the control of.

issued as part of a public offering of debt or equity and used to solicit prospective investors in a new security issue containing. intent. that they are false. Rights theory An ethical theory that identifies a hierarchy of rights that should be considered in solving ethical dilemmas. The Securities Act of 1933 imposes liability for misstatements in a prospectus. Stakeholders . it allows no exceptions to confidentiality. thereby causing harm to another or to property. Privileged communication Information about a client that cannot be subpoenaed by a court of law to be used against a client. the rules have evolved over time as members of the profession have encountered specific ethical dilemmas in complying with the principles of the Code. to act with integrity and objectivity. Objectivity An impartial. among other items. Principles of professional conduct Broad principles that articulate auditors’ responsibilities and their requirements to act in the public interest. Rules of conduct Detailed guidance to assist the auditor in applying the broad principles contained in the AICPA’s Code of Professional Conduct. to exercise due care. audited financial statements. to be independent. at the time they are made. Proportionate liability Payment by an individual defendant based on the degree of fault of the individual.CHAPTER 4 ∙ Professional Liability and the Need for Quality Auditor 10 Judgments and Ethical Decisions Negligence Failure to exercise reasonable care. and to perform an appropriate scope of services. Professional judgment The application of relevant professional knowledge and experience to the facts and circumstances in order to reach a conclusion or make a decision. unbiased mental attitude that auditors should maintain. Scienter Knowledge on the part of the person making the representations. Prospectus The first part of a registration statement filed with the SEC.

such as the Securities Act of 1933 and the Securities Exchange Act of 1934.CHAPTER 4 ∙ Professional Liability and the Need for Quality Auditor 11 Judgments and Ethical Decisions Those parties who have a vested interest in. constructive fraud. Statutory law Laws developed through legislation. Utilitarian theory An ethical theory that systematically considers all the potential stakeholders who may be affected by an ethical decision and seeks to measure the effects of the decision on each party. Third-party beneficiary A person who was not a party to a contract but is named in the contract as one to whom the contracting parties intended that benefits be given. or are affected by. based on negligence. Tort A civil wrong. or fraud. it seeks to facilitate decisions resulting in the greatest amount of good for the greatest number of people. the decision resulting from an ethical dilemma. other than breach of contract. .