CHAPTER 8

AUDITOR’S LEGAL LIABILITY

I. Review Questions

1. Examples of typical lawsuits against CPAs are

a) Alleged misstatements that the auditor did not detect in the financial
statements involving
1) improper or inadequate disclosure
2) inappropriate valuations
b) Alleged failure to detect defalcation as a result of negligence in the
conduct of the audit
c) Alleged failure to complete the audit on the agreed-on date
d) Alleged inappropriate withdrawal from an audit

2. Refer to page 324, 1st paragraph of the textbook.

3. Refer to page 329 of the textbook.

4. Refer to page 341 of the textbook.

5. The increase in litigation against auditors seems to be happening for two

reasons: a general increase in litigation in society, and the fact that investors
and creditors who suffer losses will look for “deep pockets” to pay for those
losses. Most accounting firms appear to have “deep pockets.”

6. Due (professional) care is the standard by which the courts and the profession
expect a CPA to practice. A CPA who is found to have exercised due
professional care in an engagement should not have any liability to others.

7. The four gradations are none, negligence, gross negligence (sometimes

referred to as constructive fraud), and fraud. At one extreme is the auditor
who performs an appropriate audit and issues an appropriate report. This
auditor’s degree of wrongdoing is “none.” An auditor who commits fraud is at
the other extreme, since he or she knows that the financial statements are
misstated and yet issues an unqualified opinion. An auditor is negligent if he
or she does not do what a reasonably prudent auditor should do in the
circumstances. An auditor is grossly negligent if he or she consistently fails to
follow the standards of the profession on an engagement.
8. Auditors are responsible to clients for negligence, gross negligence, or fraud.
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9. Refer to page 334.

10. In some jurisdictions, auditors can use contributory negligence as a defense

when a client is suing for a tort.

11. Most courts have held that an auditor has a higher responsibility to
communicate information beyond that required by generally accepted
accounting principles and generally accepted auditing standards. Courts have
held that compliance with generally accepted accounting principles is
persuasive but not conclusive evidence.

12. An auditor should (a) follow the Philippine Standards on Auditing, the Code of
Ethics for Professional Accountants in the Philippines, and where appropriate,
generally accepted accounting principles; (b) establish and follow appropriate
quality control procedures; (c) evaluate whether a client has the necessary
integrity and appropriate reputation in the community; (d) evaluate carefully
why a client wants an audit; (e) conduct the audit with appropriate professional
skepticism; (f) provide for appropriate levels of consultation for issues; and (g)
provide for appropriate review of the audit.

13. The prudent man concept states that a man is responsible for conducting a job
in good faith and with integrity, but is not infallible. Therefore, the auditor is
expected to conduct an audit using due care, but does not claim to be a
guarantor or insurer of financial statements.

14. Many CPA firms willingly settle lawsuits out of court in an attempt to
minimize legal costs and avoid adverse publicity. This has a negative effect
on the profession when a CPA firm agrees to settlements even though it
believes that the firm is not liable to the plaintiffs. This encourages others to
sue CPA firms where they probably would not to such an extent if the firms
had the reputation of contesting the litigation. Therefore, out-of-court
settlements encourage more lawsuits and, in essence, increase the auditor’s
liability because many firms will pay even though they do not believe they are
liable.

15. Five general ways public accountants can get into legal difficulty:
1. Misinterpretation or ignorance of accounting principles. The accountant
may not have observed the letter and spirit of PSAs, thus not insisting on
completely adequate disclosure of information later determined to be
important.

2. Misinterpretation or ignorance of auditing standards. The accountant may

not know to do some important part of the audit (e.g., obtain client
representations and lawyers’ letters.).

3. Failure to implement audit procedures properly. The accountant may

perform an audit in a negligent or worse manner.
 Auditor’s Legal Liability 8-3

4. Failure to discover client fraud. The auditor may fail to be observant or

properly skeptical.

5A. Commission of fraud or actual participation. The accountant may commit

an illegal act such as actively conspiring with the client to publish
misleading financial statements. Accountants have also done such things
as offer bribes, fail to file tax returns and commit securities fraud.

5B. Misunderstandings of the nature of the engagement. Particularly in

compilation or review engagements, clients might expect more than the
accountant thought he agreed to deliver and might claim damages from
the accountant.

16. Errors – basically defined as unintentional mistakes, including mathematical

or clerical mistakes in the accounting records, mistakes in the application of
accounting principles, and oversight or misinterpretation of facts that existed at
the time the financial statements were prepared.

Irregularities – refers to intentional distortion of financial statements,

including deliberate misrepresentations by management (sometimes referred to
as management fraud), or misappropriations of assets (sometimes referred to as
defalcations). Irregularities may result from misrepresentation or omission of
the effects of events or transactions; manipulations, falsification or alteration
of records or documents; omission of significant information from records or
documents; recording of transactions without substance; intentional
misapplications of accounting principles; or misappropriation of assets for the
benefit of management, employees or third parties.

Clients’ Illegal Acts – are defined in auditing standards as violations of laws or

government regulations, not including personal misconduct by client personnel
unrelated to their business activities.

17. Audit risk is the risk that the auditor will conclude that the financial statements
are fairly stated and issue an unqualified repot when, in fact, the financial
statements are materially misstated. An audit failure occurs when the auditor,
as a result of his or her failure to follow PSAs, issues an erroneous audit report.
18. There are many steps individual practitioners can take to minimize legal
liability including:
• Deal only with clients possessing integrity.
• Hire qualified personnel and train and supervise them properly.
• Follow the standards of the profession.
• Maintain independence.
• Understand the client’s business.
• Perform quality audits.
• Document the work properly.
• Obtain an engagement letter and a representation letter.
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• Maintain confidential relations.
• Carry adequate insurance.
• Seek legal counsel.
• Choose a form of organization with limited liability.

19. The expectation gap refers to the difference in the beliefs of auditors and users
of financial statements concerning the role of the auditor. Most auditors
believe that the conduct of the audit in accordance with GAAS is all that can
be expected of them, whereas many users of financial statements believe that
the auditor guarantees the financial viability of the company.

II. Multiple Choice Questions

1. b 7. a 13. c 19. b 25. a 31. b

2. c 8. c 14. d 20. d 26. c 32. b
3. a 9. a 15. c 21. b 27. c
4. b 10. b 16. a 22. c 28. a
5. a 11. a 17. a 23. a 29. a
6. c 12. d 18. d 24. a 30. c

III. Comprehensive Cases

Case 1. The answers provided in this section are based on the assumption that the
traditional legal relationship exists between the CPA firm and the third party
user. That is, there is no privity of contract, the known versus unknown third
party user is not a significant issue, and high levels of negligence are required
before there is liability.
a. False. There was no privity of contract between Tan and Cañada,
therefore, ordinary negligence will usually not be sufficient for a
recovery.
b. True. If gross negligence is proven, the CPA firm can and probably
will be held liable for losses to third parties.

c. True. See a.

d. False. Gross negligence (constructive fraud) is treated as actual fraud

in determining who may recover from the CPA.

e. False. JC is an unknown third party and will probably be able to

recover damages only in the case of gross negligence or fraud.

Assuming a liberal interpretation of the legal relationship between auditors and

third parties, the answers to a and d would probably both be true. The other
answers would remain the same.
 Auditor’s Legal Liability 8-5
Case 2. Yes. Normally a CPA firm will not be liable to third parties with whom it
has neither dealt nor for whose benefit its work was performed. One notable
exception to this rule is fraud. When the financial statements were
fraudulently prepared, liability runs to all third parties who relied upon the
false information contained in them. Fraud can be either actual or
constructive. Here, there was no actual fraud on the part of Dantes or the firm
in that there was no deliberate falsehood made with the requisite intent to
deceive. However, it would appear that constructive fraud may be present.
Constructive fraud is found where the auditor’s performance is found to be
grossly negligent. That is, the auditor really had either no basis or so flimsy a
basis for his or her opinion that he or she has manifested a reckless disregard
for the truth. Dantes’ disregard for standard auditing procedures would seem
to indicate such gross negligence and, therefore, the firm is liable to third
parties who relied on the financial statements and suffered a loss as a result.

Case 3. a. Yes. Carlos was a party to the issuance of false financial statements
and as such is a joint tortfeasor. The elements necessary to establish an
action for common law fraud are present. There was a material
misstatement of fact, knowledge of falsity (scienter), intent that the
plaintiff bank rely on the false statement, actual reliance, and damage to
the bank as a result thereof. If the action is based upon fraud there is no
requirement that the bank establish privity of contract with the CPA.
Moreover, if the action by the bank is based upon ordinary negligence,
which does not require a showing of scienter, the bank may recover as a
third-party beneficiary (an exception to the strict privity requirement).
Thus, the bank will be able to recover its loss from Carlos under either
theory.

b. No. The lessor was a party to the secret agreement. As such, the lessor
cannot claim reliance on the financial statements and cannot recover
uncollected rents. Even if he or she was damaged indirectly, his or her
own fraudulent actions led to his or her loss, and the equitable principle of
“unclean hands” precludes him or her from obtaining relief.

c. Yes. Carlos had knowledge that the financial statements did not follow
generally accepted accounting principles and willingly prepared an
unqualified opinion. The financial statements were not in accordance with
generally accepted accounting principles. That is a criminal act because
there was an intent to deceive.

Case 4. a. Base, Umapas & Cañada is potentially liable to its client because of
the possible negligence of its agent, the in-charge accountant on audit, in
carrying out duties that were within the scope of his or her employment.
Should there be a finding of negligence, liability would be limited to those
losses that would have been avoided had reasonable care been exercised.
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There being no evidence of the assumption of a greater responsibility, the
in-charge accountant’s conduct is governed by the usual standard; that is,
that the accountant perform his or her duties with the profession’s
standards of competence and care. A question of fact arises as to whether
the duty of reasonable care was breached when the in-charge accountant
failed to investigate further after being apprised by a competent
subordinate of exceptions to 6 percent of the vouchers payable examined.
Moreover, a question of causation arises as to whether further actions by
the in-charge accountant would have disclosed the fraud. If both lack of
due care and causation are established, recovery for negligence will be
available to the client.

b. In a properly organized liability partnership, the partner(s) and staff

responsible for the engagement and the firm would be liable, as discussed
in part a. However, other partners would not be liable.

Case 5. Ordinarily, users of financial statements, other than those who contracted
for the audit and those known in advance to the auditor, may not recover for
ordinary negligence by the auditor in the performance of an audit. Recovery
of damages by third parties must usually be based on fraud. Actual knowledge
of falsity (scienter) is also generally required for an action based on fraud;
however, this requirement may be satisfied by the auditor’s reckless disregard
for the truth or gross negligence.

It appears that the three deficiencies in the audit by Gonzales & Esteban might
be sufficient to satisfy either approach. Failure to check the existence of
certain receivables, collectibility of other receivables, and existence of security
investments, taken collectively if not individually, appear to show a reckless
disregard for the truth by the auditor. In fact, the audit probably lacks
sufficient competent evidential matter as a reasonable basis for an opinion
regarding the financial statements under examination.

The audit appears to have been conducted in a woefully inadequate fashion,

without regard to the usual auditing standards and procedures necessary to
exercise due professional care. Therefore, the auditors were grossly negligent
in the performance of their duties.

Case 6. Corpuz has stated that the CPA firm has “reviewed the books and records
of Flores Ventures,” when in fact no such “review” has occurred. A “review”
of financial statements consists of limited investigatory procedures designed to
provide statement users with a limited degree of assurance that the financial
statements are in conformity with generally accepted accounting principles.
Corpuz’s actions are similar to issuing an auditors’ report without first
performing an audit. Such an action may well be considered an act of criminal
fraud, intended to mislead users of the financial statements. If the financial
statements of Flores Ventures turn out to be misleading, there is little doubt
that any court would find the CPA firm guilty of at least constructive fraud and
 Auditor’s Legal Liability 8-7
liable to any third party who sustains a loss as a result of reliance upon the
statements.

The fact that Corpuz violated Vasquez’s policy of submitting all reports for
Vasquez’s review would not lessen the CPA firm’s liability. The concept of
mutual agency allows Corpuz, as a partner, to commit the firm to contracts,
including auditors’ reports and accountants’ reports. The fact that this report
was not submitted for Vasquez’s review might be introduced as evidence
against Corpuz in the event he is accused of criminal fraud.

Case 7. (1) Yes, but only to the extent of P70,000. Beta is a third-party
beneficiary of the contract between Mega and its auditors, and may
therefore recover from the auditors losses caused by the CPAs’ ordinary
negligence. However, the original P50,000 loan was made prior to Beta’s
reliance upon the negligently audited financial statements. Thus, the
auditors’ negligence was not the proximate cause of this portion of Beta’s
loss. The auditors’ negligence may, however, be considered the proximate
cause of the P70,000 loss incurred as a result of reliance upon the
misleading statements.

(2) The prospects for Manila’s recovery of its P30,000 loss are substantially
less than those of Beta. Manila was not a third-party beneficiary to the
contract. Thus, in many jurisdictions following Ultramares, Manila
cannot recover losses attributable to the CPAs’ ordinary negligence.
Similarly, it is doubtful that Manila would qualify as a foreseen third party
as necessary under the Restatement approach. Even in a jurisdiction
accepting the Rosenblum precedent, which allows third parties to recover
losses caused by the auditors’ ordinary negligence, Manila would have to
prove that it was a “foreseeable third party relying upon the financial
statements for routine business purposes.” It is questionable whether the
loan by Manila was either “reasonably foreseeable” or “routine,” as
Manila was a customer of Mega, not a lender.