Legal Liability

Chapter 5
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©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5-1

 Learning Objective 1

Understand the litigious environment in

which CPAs practice.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5-2

 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.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5-3

 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
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5-4
 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

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5-5

 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.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5-6

 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.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5-7

 Business Failure, Audit Failure,
and Audit Risk
 Audit failure

Auditor issues an incorrect opinion from

a failure to follow GAAS.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5-8

 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.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5-9

 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

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5 - 11

 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

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5 - 13

 Legal Terms Affecting
CPAs’ Liability
Other terms:

 Common law

 Statutory law

 Joint and several liability

 Separate and proportionate liability

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 Learning Objective 4

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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 Auditor’s Defenses Against
Client Suits
Lack of duty to perform

Nonnegligent performance

Contributory negligence

Absence of causal connection

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5 - 18

 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 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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 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
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.
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5 - 29
 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.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5 - 34

 The Profession’s Response
to Legal Liability
 Research in auditing

Standard and rule setting

Set requirements to protect auditors

Establish peer review requirements

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5 - 35

 The Profession’s Response
to Legal Liability
 Oppose lawsuits

 Education of users

 Sanction members for improper conduct

and performance

 Lobby for changes in laws

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5 - 36

 Protecting Individual CPAs
from Legal Liability

Qualified
Honest Clients
Personnel

Follow
Maintain
Professional
Independence
Standards

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5 - 37

 Protecting Individual CPAs
from Legal Liability
 Understand the client’s business

Perform quality audits

Document the work properly

Obtain an engagement and a representation letter

Maintain confidential relations

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5 - 38

 Protecting Individual CPAs
from Legal Liability
 Carry adequate insurance

Seek legal counsel

Choose a form of organization with limited liability

Exercise professional skepticism

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5 - 39

 End of Chapter 5

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5 - 40