Chapter 20

Legal Liability

Fall /2023

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 Intro

Historical Perspective
Claims against Global credit crisis leads to
auditors were The recession of 1990-1992 the Dodd-Frank Act of 2010
relatively uncommon led to another upsurge in and increases scrutiny into
before the 1970’s. litigation against auditors. auditing profession again.

1970 1980 1990 2002 2010

Due to a slump in the economy
in the early 1970’s and the
recession of the 1980’s, it
became more common for
auditors to be sued.
Due to several high-profile
frauds, Congress refocused
attention on auditors in the
Sarbanes-Oxley Act of 2002.

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Historical Perspective
 LO# 1

Overview
There are four general stages in the initiation and
disposition of audit-related disputes:
(1) the occurrence of events that result in losses for users
of the financial statements;
(2) the investigation by plaintiff attorneys before filing suit
to link the user losses with allegations of material
omissions or misstatements of financial statements;
(3) the legal process that commences with the filing of the
suit; and
(4) the final resolution of the dispute.
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 Overview
- Auditors can be sued by clients, investors, creditors, and the
government for failure to perform professional services with due
professional care.
Auditors can be held liable under two broad categories of law:

1. Common law. Case law developed over time by judges who

issue legal opinions when deciding a case (the legal principles
announced in these cases become precedent for judges
deciding similar cases in the future).

2. Statutory law. Written law enacted by the legislative branch of

federal and state governments.
 LO# 2

Overview

Two Classes of Law

Common Law Statutory Law

Written law
Case law
enacted by the
developed over
legislative branch
time by judges
of government
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 LO# 2

Overview

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 LO# 2

Overview

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 LO# 3

Common Law—Clients

Requires Due Types of Liability

Care to the Client

•Negligence
•Gross negligence
May be held liable
•Fraud (acting
for breach of
with knowledge
contract
and intent to
deceive)

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 LO# 3

Breach of Contract

Breach-of-contract
liability is based on
the auditor’s failing to
complete the services
agreed to in the
contract with the
client.

When the auditor is found to have breached the contract, the

auditor is only liable for damages caused by the breach.
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 LO# 3

Negligence

If an engagement is
performed without due
Requires Due care, the CPA may be
Care held liable for an
actionable tort in
negligence.

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 LO# 3

Common Law Negligence: Client

Client
Must Prove

1. A duty was owed to the client.

2. Failure to act in accordance with that duty.
3. A causal connection between the auditor’s
negligence and the client’s damage.
4. Actual loss or damage to the client.

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 LO# 3

Common Law Negligence: Client

Auditor’s
Defense

1. No duty was owed to the client.

2. The client was negligent.
3. The auditor’s work was performed in accordance with
professional standards.
4. The client suffered no loss.
5. Lack of causal connection between auditor negligence and
the client loss.
6. The claim is invalid because the statute of limitations has
expired.
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 LO# 3

Fraud—Client Claims

An auditor can be held liable

to clients for fraud when he
or she acted with
knowledge and intent to
deceive.
Generally, however, actions
alleging fraud on the part of
the auditor result from
lawsuits by third parties
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 LO# 4

Common Law—Third Parties

Ordinary Negligence
Four common law
Legal Standards for
determining the Third
Parties

Privity

Near Privity
Reasonably
Foreseen Foreseeable
3rd Parties 3rd Parties

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 LO# 4

Common Law—Third Parties Ordinary Negligence

Four Legal
Standards for Third
Parties
Privity

Privity means that a contract or specific agreement exists

between two parties.

The most restrictive view under common law is that

auditors have no liability for ordinary negligence to third
parties who do not have a privity relationship with the
auditor. (can sue auditors for proved gross negligence and fraud)

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 LO# 4

Common Law—Third Parties Ordinary Negligence

Four Legal
Standards for Third
Parties
Near Privity

The Credit Alliance case lists the following tests that must be satisfied for
holding auditors liable for ordinary negligence to third parties: (1) the
accountant must be aware that the financial statements are to be used
for a particular purpose or purposes, (2) in the furtherance of which a
known party or parties was intended to rely, and (3) there must have
been some conduct on the part of the accountants linking them to that
party or parties, which provides evidence of the accountants’
understanding of intended reliance. (Calls and fees?)
It is important to remember that third-party plaintiffs in all
jurisdictions are able to successfully sue auditors for gross
negligence or fraud, regardless of their privity status.
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 LO# 4

Common Law—Third Parties Ordinary Negligence

Four Legal
Foreseen Standards for Third
3rd Parties Parties

- a person or limited group of persons whose reliance is actually foreseen

- “Public responsibility” reasons for expanding the scope beyond near privity:
(1) the increased liability of other professionals to non-privity users of their services,
(2) the lack of fairness of imposing the burden of economic loss on innocent financial
statement users,
(3) the assumption that expanded liability will cause auditors to improve their auditing
procedures,
(4) the ability of auditors to obtain insurance against the increased risks, and
(5) the ability of the auditors to pass the increased audit costs and insurance
premiums on to their clients.

The Restatement broadens the auditor’s liability beyond those with privity or
near privity to a small group of persons and classes who are or should be
foreseen by the auditor as relying on the financial information.
Check Travelers v. Reznick case 20-18
 LO# 4

Common Law—Third Parties Ordinary Negligence

Four Legal
Reasonably Standards for Third
Foreseeable
3rd Parties Parties

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 LO# 4

Common Law—Third Parties

Reasonably
Foreseen 3rd Parties Foreseeable 3rd Parties
Near Privity 3rd parties whose 3rd parties whose
3rd parties whose reliance should be reliance should be
relationship with the foreseen, even if the reasonably foreseeable,
CPA approaches privity. specific person is even if the specific
unknown to the auditor. person is unknown to
the auditor.
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 LO# 4

Common Law Doctrines for Third Parties

Suing Auditors for Ordinary Negligence

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 LO# 4

Common Law—Third Parties

Negligence
Third Party
Must Prove

1. The auditor had a duty to the plaintiff to exercise due care.

2. The auditor breached that duty by failing to act with due
professional care.
3. There was a direct causal connection between the auditor’s
negligence and the third party’s injury.
4. The 3rd party suffered an actual loss as a result.

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 LO# 4

Common Law—Third Parties

Negligence
Auditor’s
Defense

1. No duty was owed to the 3rd party (level of duty required

depends on the case law followed by the courts).
2. The 3rd party was negligent.
3. The auditor’s work was performed in accordance with
professional standards.
4. The 3rd party suffered no loss.
5. Lack of causal connection between auditor negligence and
the client loss.
6. The claim is invalid because the statute of limitations has
expired. 20-23
 LO# 4

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 LO# 4

Fraud

If an auditor has
acted with
knowledge and
intent to deceive a
third party, he or
she can be held
liable for fraud.
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 LO# 4

Fraud

Third Party
Must Prove

1. A false representation by the CPA.

2. Knowledge or belief by the CPA that the representation was
false.
3. The CPA intended to induce the 3rd party to rely on the false
representation.
4. The 3rd party relied on the false representation.
5. The 3rd party suffered damages.

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 LO# 8

Sarbanes-Oxley Act of 2002

Creation of PCAOB

Stricter independence Most sweeping

rules securities law
Audits of internal since 1934
controls
Increased reporting
responsibilities
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LO# 5-8

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 LO# 9

SEC and PCAOB Sanctions

Suspend
Practicing
Privilege Impose
Fines
Remedial
Measures

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 LO# 10

Foreign Corrupt Practices

Act (FCPA)
Passed in 1977 in response to the discovery of
bribery and other misconduct on the part of
more than 300 American companies.
An auditor may be
subject to
administrative
proceedings, civil
liability, and civil
penalties.
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 LO# 11

Racketeer Influenced and Corrupt

Organizations Act (RICO)
Passed in 1970 to combat the infiltration of
legitimate businesses by organized crime.

RICO provides
for civil and
criminal
sanctions for
certain illegal
acts.
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 LO#
8 & 12

Criminal Liability
Auditors can be held criminally liable under
the laws discussed in the previous section.
Criminal prosecutions require that some
form of criminal intent be present, such as
fraud. However, gross negligence can also
be deemed criminal.

Gross
Fraud
Negligence

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End of Lecture

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