Legal Liability

Chapter 5

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5-1

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

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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.

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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5-3

 Changed Legal Environment
Major contributors:
o Growing awareness of responsibilities of public accountants by users of financial
statements
o Increased consciousness of the Securities and Exchange Commission (SEC) for its
responsibility for protecting investors interests
o Complexity of auditing and accounting functions caused by increasing size of
businesses, globalization of business, and complexities of business operations
oTendency of society to accept lawsuits by injured parties against anyone who might
be able to provide compensation, regardless of fault (deep-pocket concept of liability)
o Large civil court judgments against CPA firms awarded in a few cases encourage
attorneys to provide legal services on a contingent-fee basis offers the injured party
a potential gain when the suit is successful, but minimal losses when it is not
o Willingness of many CPA firms to settle legal problems out of court in an attempt to
avoid costly legal fees and adverse publicity, rather than resolution through judicial
process
o Judges and jurors difficulty in understanding and interpreting technical accounting
and auditing matters
2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5-4
 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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5-5

 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.

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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.

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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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5-8

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

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 Legal Concepts Affecting
Liability
Prudent person concept

Liability for the acts of others

Lack of privileged communication

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 Legal Terms Affecting
CPAs Liability
Terms related to negligence and fraud:

Ordinary negligence

Gross negligence

Constructive fraud

Fraud

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 Legal Terms Affecting
CPAs Liability
Terms related to contract law:

Breach of contract

Third-party beneficiary

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 Legal Terms Affecting
CPAs Liability
Other terms:

Common law

Statutory law

Joint and several liability

Separate and proportionate liability

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 Four Major Sources of Auditors
Legal Liability
Liability to clients

Liability to third parties

Federal securities laws

Criminal liability

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

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 Liability to Clients

The most common source of lawsuits

against CPAs is from clients.

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 Auditors Defenses Against
Client Suits
Lack of duty to perform

Nonnegligent performance

Contributory negligence

Absence of causal connection

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

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 Liability to Third Parties Under
Common Law
Ultramares doctrine

Foreseen users

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 Foreseen Users

Credit alliance

Restatement of torts

Foreseeable user

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 Auditor Defenses Against
Third-Party Suits
The preferred defense is
nonnegligent performance.

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

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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.

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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.

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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.

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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.

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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.

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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 issue an opinion on the

effectiveness of internal control over
financial reporting .
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 Learning Objective 7
Specify what constitutes criminal
liability for accountants.

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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.

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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.

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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.

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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

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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

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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

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