Chapter 17

Professional Liability
 What is the public accountant’s
responsibility?
The responsibility of public
accountants to safeguard the public's
interest has increased as the number of
investors has increased, as the
relationship between corporate
managers and stockholders has
become more impersonal, and as
government increasingly relies on
accounting information.
 Discuss Auditor Liability
Auditor liability to their clients and third party user
groups is derived from the following laws:
 Contract law - Liability is based on breach of
contract. The contract is usually between the public
accounting firm and the client for performance of a
professional service, such as an audit performed
according to GAAS
 Common law - Liability concepts developed through
court decisions and based on auditor negligence,
gross negligence or fraud
 Statutory law - Liability based on state statutes or
Federal securities laws. The most important of these
to the auditing profession are the Securities Act of
1993 and the Securities and Exchange Act of 1934
 Factors leading to increased
litigation against auditors:
User awareness of the possibilities and rewards of
litigation
 Joint and several liability statutes that permit a
plaintiff to collect the full amount of the settlement
from any defendant, even those only partially
responsible for the loss (i.e. deep pockets theory)
 Increased audit complexity caused by computerized
systems, new types of transactions and operations,
more complicated accounting standards, more
international business
 More demanding audit standards for detection of
errors and fraud
 Factors leading to increased
litigation against auditors:
 Pressures to reduce audit time and improve
audit efficiency
 Misunderstanding by users that an
unqualified opinion is an insurance policy
against misstatements (expectations gap)
 Contingent-fee-based compensation for law
firms, especially in class action lawsuits
 Class action lawsuits which allow law firms
to combine defendants into one legal action
 Punitive damages
 Discuss Potential Liability
To understand the potential liability, the
auditor must understand:
Concepts of breach of contract and tort
Parties who may bring suit
Legal precedence and statutes that
may be as a standard against which
auditor performance may be evaluated
Auditor defenses
 Discuss Causes of Legal Action
Causes of legal action
 Breach of contract
 Negligence: failure to exercise a reasonable
level of care that causes damage to another
 Gross negligence: failure to exercise even a
minimal level of care (reckless disregard) but
without intent to harm or damage anyone
 Fraud: intentional concealment or
misrepresentation of material facts that
cause damages to those deceived (scienter)
 Comment on Civil Liability
Auditors may be held civilly liable by
clients and third parties who use
audited financial statements. This
civil liability is based
Contract law
Common law
Statute
 Define Breach of Contract
Breach of Contract occurs when auditor
fails to perform a contractual duty
Breach actions include
failing to complete the engagement within
the agreed-upon time
withdrawing from the engagement without
sufficient justification
violating client confidentiality
failing to provide professional quality work
Parties to the contract can file suit
 Define Breach of Contract
 Court remedies to a breach include
 order auditors to fulfill the contract (specific
performance)
 issue injunction to prohibit the auditor from
continuing the breach
 order auditor to pay compensatory (actual)
damages
 Auditor defenses include
 auditor did not breach the contract
 client was contributory negligent
 client losses were not caused by the breach
Review Common Law Liability
To prevail, a plaintiff must generally prove four
things:
 Existence and amount of damages
 Financial statements were materially
misleading
 Plaintiff relied on the statements and as a
result, suffered damages (causality)
 Auditor misconduct - the level of misconduct
that must be proved depends on who the
plaintiff is, and the jurisdiction in which the
suit is filed
 Who are the plaintiffs under
common law?
The courts have ruled auditors can be held liable by
clients and third parties reasonably expected to rely
on audited statements.
Generally, courts have classified third party users into
3 groups:
 Identified users are specific individual users who the
auditor knows will use the statements to make a
specific decision
 Foreseen users while not individually known, belong
to a specific group of users whom the auditor knows
will use the statements
 Foreseeable users belong to a general class of users
whose members may or may not use the financial
statements
 Level of Auditor Misconduct
The level of auditor misconduct a third party plaintiff
must prove depends on which group the plaintiff
belongs to and the jurisdiction in which the case is
tried:

Restatement Citizens State

User Credit Alliance of Torts Bank/Rosenblum
Identified Negligence Negligence Negligence
Foreseen Gross negligence Negligence Negligence
Foreseeable Gross negligence Gross negligence Negligence
 Auditor Liability
Auditor liability under Federal statute was established
by the Securities Act of 1933, and the Securities
Exchange Act of 1934, and most recently modified
by Sarbanes/Oxley Act of 2002
Auditors found to be unqualified, unethical, or in willful
violation can be disciplined by the SEC. Sanctions
include
 Temporarily or permanently revoking the firm's
registration with the Public Company Accounting
Oversight Board
 Civil penalties of up to $750,000 per violation
 Require continuing education of firm personnel
Investors in public companies may sue auditors under
common law, statutory law, or both.
 Securities Act of 1933
Requires companies to file S-1 Registration statement with
SEC before they issue new securities to the public
Audited financial statements are included in the Registration
statement (and prospectus)
Because it covers the issue of new securities, the Act requires
a very high standard of care. Plaintiffs need prove only
 financial statements were materially misleading
 plaintiff suffered damages
 plaintiffs do not need to prove reliance on the statements or
auditor misconduct
Auditor defenses include
 proving financial statements were not materially misstated
 proving plaintiff damages were not caused by the
misleading financial statements
 proving auditor acted with due professional care
Securities Exchange Act of 1934
The Securities Act of 1934 regulates trading of
securities after their initial issuance (secondary
market) and the filing of periodic reports with the
SEC. These reports include annual reports and 10-
Ks, quarterly financial reports and 10-Qs, and 8-Ks.
The 1934 Act holds auditors to a much lower standard
of care than the 1933 Act. Under the 1934 Act,
plaintiffs must prove
 Existence and amount of damages
 Financial statements were materially misleading
 Plaintiff relied on the statements and as a result,
suffered damages (causality)
Securities Exchange Act of 1934
 Auditor misconduct - the level of misconduct
that must be proved is the subject of much
debate. In Ernst & Ernst v. Hochfelder, the
U.S. Supreme Court held that
 Congress had intended that the plaintiff prove the
auditor acted with scienter
 However, the Court reserved judgment as to
whether gross negligence would be
sufficient to impose liability
 In several cases following Hochfelder, judges
and juries have used a standard of "reckless
conduct" to hold auditors liable
Criminal Liability to Third Parties
Both the 1933 and 1934 Acts provide for
criminal actions against auditors -
guilty persons can be fined or
imprisoned for up to five years.
Key cases regarding auditor criminal
liability
Continental Vending (U.S. v Simon)
Equity Funding
U.S. v Duncan
 Policies to Help Assure Auditor
Independence
Periodic rotation of audit engagement partner
 Prohibit certain non-audit services for public
company audit clients
 Restrict other non-audit services for audit clients
 Firm policies including training programs that
emphasize auditor independence and requiring each
auditor to sign a statement of independence
 External quality reviews: Sarbanes/Oxley Act
requires the PCAOB perform quality reviews of
registered public accounting firms
 Internal reviews: concurring partner reviews and
interoffice reviews
 Approaches to Mitigate Liability
Exposure (Defensive Auditing)
Defensive auditing means taking special actions to
avoid lawsuits. In addition to establishing good
quality controls and quality/peer reviews, firms can
take other actions
 Use engagement letters for all financial statement
and consulting engagements
 Client screening
 Do not accept engagements for which the firm is not
qualified
 Maintain complete and accurate audit documentation
 Limited liability partnerships
 Carry sufficient professional liability insurance
 Tort reform