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CAEA 3228

ADVANCED AUDITING

Legal Liability Considerations for


Auditors

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Understand the litigious environment in
which CPAs practice.

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Changed Legal Environment

Audit professionals have a


contractual responsibility with clients.

Auditors are liable for negligence.

The number of lawsuits and sizes of


awards remain high.

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Changed Legal Environment

Major contributors:

Growing awareness by financial statement


users
Increased consciousness of the SEC
Complexity in business drives complexity in
auditing and accounting functions
Litigious society
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Changed Legal Environment

Major contributors (cont.):

Large civil court judgments against CPA firms


Willingness of CPA firms to settle out of court
Judges and jurors difficulty in understanding
technical accounting and auditing matters

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

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Business Failure, Audit Failure,
and Audit Risk
Business failure

A business is unable to meet its


obligations or investor expectations due
to economic or business conditions.

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Business Failure, Audit Failure,
and Audit Risk
Audit failure

Auditor issues an incorrect opinion from


a failure to follow GAAS.

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Business Failure, Audit Failure,
and Audit Risk
Audit risk

The risk that the auditor fails to find a


material misstatement and issues an
unqualified opinion.

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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

Contract Law

Breach of Third party


contract 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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Describe accountants liability to
clients and related defenses.

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Four Major Sources of Auditors
Legal Liability

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

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Liability to Third Parties Under
Common Law

Ultramares Foreseen
doctrine users

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Foreseen Users

Credit alliance

Restatement of torts

Foreseeable user

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Auditor Defenses Against
Third-Party Suits

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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
Auditor liability under this act often
centers on the audited financial statements
issued in annual 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.

Scienter states that auditors must have


the knowledge and intent to deceive in
order to be liable for violation of
Rule 10b-5.

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SEC Sanctions

SEC can sanction or suspend practitioners.

SEC has temporarily suspended a number of


individual CPAs from auditing SEC clients.

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Foreign Corrupt
Practices Act of 1977

Bribing a foreign official for the purpose


of exerting business related influence
is illegal.

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Sarbanes-Oxley Act of 2002

CEO and CFO are required to certify


financial statements filed with the SEC.

Management must report on the


effectiveness of internal controls over
financial reporting.

Auditors must opine on internal controls


over financial reporting.
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Learning Objective 7

Specify what constitutes criminal


liability for accountants.

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Criminal Liability

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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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Auditor Defenses
1933 & 1934 Acts

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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

Qualified
Honest Clients
Personnel

Follow
Maintain
Professional
Independence
Standards

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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 4

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