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Principle of Auditing Ch4

yaoyaolyf 2011-01-26 (13 ) 7181 173

Chapter
04 - Lega
l Liabilit

y of CPA
s
4-9

4-34

SOLUTI
ON: Th
omas &
Ross, CP

As (Esti
mated ti
me: 15
minutes)

(a)
(1)

Under c
ommon l
aw in a j
urisdicti

on that a
dheres to
the

Ultram
ares
doctrine
, the

stockhol
ders mus
t show th
at they i

ncurred l
osses, th
at the CP

As were
grossly
negligen
t, and th

at this gr
oss negli
gence w
as the pr

oximate
cause of
the stock
holders'

losses.
(2)

Under c
ommon l
aw, the d
efendant

is "presu
med inn
ocent un
til prove

n guilty,"
and
therefore
bears no

burden o
r affirma
tive proo
f. The a

uditors
will, ho
wever, i
ntroduce

evidence
refuting
the plain

tiffs' alle
gations.
(b)

(1)
In a suit
brought
under th

e Securit
ies Act o
f 1933, i
nitial pur

chasers
of the se
curity

must sho
w only t
hat they
had a los

s and tha
t the fina
ncial stat
ements

were mis
leading.
(2)

The audi
tors, in o
rder to a
void liab

ility, mu
st prove
either th
at they p

erformed
their
audit wit
h "due di

ligence"
(that is,
were not
negligen

t) or that
their neg
ligence
was not

the proxi
mate cau
se of the

plaintiffs
' losses.
(c)

(1)
In a suit
brought
under th

e Securit
ies Exch
ange Act
of 1934,

the plain
tiffs nor
mally

must pro
ve relian
ce upon t
he misle

ading fin
ancial st
atements
, as well

as that th
ey
sustaine
d a loss

and that
the state
ments w

ere misle
ading.
(2)

To avoid
liability,
the audit
ors must

prove eit
her that t
hey "act
ed in go

od faith"
(were
not gross
ly neglig

ent), and
that their
gross ne
gligence

was not t
he proxi
mate cau
se of

the plain
tiffs' loss
es.

4-35
SOLUTI
ON: Ch
arles Wo

rthington
, CPA (E
stimated

time: 20
minutes)

Craft has
stated th
at the CP
A firm h

as "revie
wed the
books an
d record

s of Flac
k Ventur
es," whe
n in

fact no s
uch "revi
ew" has
occurred

. A "rev
iew" of f
inancial
statemen

ts consis
ts of limi
ted

investiga
tory proc
edures d
esigned t

o provid
e statem
ent users
with a li

mited de
gree of a
ssurance
that

the finan
cial state
ments ar
e in conf

ormity w
ith gener
ally acce
pted acc

ounting
principle
s. Craft'
s

actions a
re simila
r to issui
ng an au

ditors' re
port with
out first
performi

ng an au
dit. Suc
h an acti
on may

well be c
onsidere
d an act
of crimi

nal fraud
, intende
d to misl
ead user

s of the f
inancial
statemen
ts. In

addition,
Craft's a
ctions vi
olate Rul

es 102, 2
02, and
501 of th
e AICPA

Code o
f Profe
ssional

Condu
ct
.

If the fin
ancial st
atements
of Flack

Ventures
turn out t
o be misl
eading, t

here is li
ttle doub
t that an
y

court wo
uld find t
he CPA f
irm guilt

y of at le
ast const
ructive f
raud and

liable to
any third
party wh
o

sustains
a loss as
a result o
f relianc

e upon t
he state
ments.

The fact
that Craf
t violate
d Worthi

ngton's p
olicy of
submitti
ng all re

ports for
Worthin
gton's

review
would n
ot lessen
the CPA

firm's lia
bility. T
he conce
pt of mut

ual agen
cy allow
s Craft, a
sa

partner, t
o commi
t the fir
m to con

tracts, in
cluding
auditors'
reports a

nd accou
ntants' re
ports. T
he fact

that this
report w
as not su
bmitted f

or Worth
ington's
review
might be

introduc
ed as evi
dence ag
ainst

Craft in t
he event
he is acc
used of c

riminal f
raud.

Chapter
04 - Lega
l Liabilit

y of CPA
s
4-10

4-36

SOLUTI
ON: Un
audited
Stateme

nts (Esti
mated ti
me: 30
minutes)

(a)
The com
pilation (

preparati
on) of fi
nancial s
tatement

s is quite
different
from an

audit, an
d it is
importan
t that the

client un
derstand
this. Or
al comm

itments,
such as t
elephone

conversa
tions,
can ofte
n be mis

understo
od and s
hould be
followed

up by a
written e
ngageme

nt letter
spelling
out the n
ature an

d limitati
ons of th
e service
s to be p

erformed
.
(b)

Even a r
egular a
udit can
not be re

lief upon
to disclo
se defalc
ations, a

nd in an
engagem
ent

involvin
g the co
mpilatio
n of una

udited fi
nancial s
tatement
s, the CP

As do no
t even pe
rform

any audi
t proced
ures. Th
e fact tha

t the CP
A intend
s to perf
orm no i

nvestigat
ive proc
edures

and will
rely upo
n the rep
resentati

ons of th
e managi
ng agent
should s

pecifical
ly be set
forth in

the writt
en engag
ement le
tter.

Of cours
e, if the
CPA has
reason to

suspect t
hat the r
epresent
ations of

the mana
ging
agent are
erroneou

s, the co
ncept of
due prof
essional

care req
uires tha
t she inf

orm her
client of
her reser
vations.

(c)
The wor
d "Audit

" should
be avoid
ed in ref
erring to

all engag
ements o
ther than
audits.

Otherwis
e, it may
appear t
hat the C

PAs hav
e led the
client to
believe t

hat they
were acti
ng as

auditors,
in which
case the
y may be

held acc
ountable
for cond
ucting th

eir work
in accor
dance

with gen
erally ac
cepted a
uditing s

tandards.
The CP
A should
explain t

his situat
ion to th
e

client an
d persua
de the cli
ent to ch

ange the
account t
itle to "
Accounti

ng Fees.
"
(d)

While D
ay does
not have
a respon

sibility t
o perfor
m audit
procedur

es when
compilin
g

unaudite
d financi
al statem
ents, he

does hav
e a respo
nsibility
to exerci

se due pr
ofession
al care.

This wo
uld inclu
de advisi
ng the cl

ient of a
ny situat
ion that
might su

ggest a p
roblem f
or the
client.

The CPA
should al
ert his cl
ient to th

e missin
g invoic
es in wri
ting and

advise th
e client
to follow
up on th

e matter,
or, if the
client wi
shes, the

CPA cou
ld invest
igate the

matter as
an
addition
al accou

nting ser
vice. Th
e key poi
nt is that

the CPA
must not
fail to al

ert the cl
ient to
the unde
rlying po

tential fo
r fraud.
4-37

SOLUTI
ON: Ma
rk Willia
ms, CPA

(Estimat
ed time:
20 minut
es)

(a)
CPAs as
members

of a prof
ession ar
e obligat
ed to exe

rcise due
professio
nal care.
Thus, a

CPA ma
y be held
liable to
the clien

t for the
damages
resulting
from the

CPA's or
dinary
negligen
ce.

Since Ja
ckson Fi
nancial
was the

client, Ja
ckson ca
n recove
r losses

proximat
ely caus
ed

by Willi
ams' neg
ligence.
It would

appear t
hat Jacks
on Finan
cial coul

d also re
cover th
e audit

fee as da
mages b
ecause o
f Willia

ms' brea
ch of co
ntract.

(b)
The first
argumen
t which

Williams
' attorne
y would
make is t

hat Apex
had no ri
ghts und
er the

contract
between
Jackson
and Will

iams. In
most juri
sdictions
, an "oth

er" third
party is a
ble to

recover l
osses att
ributable
to the au

ditor's gr
oss negli
gence, b
ut not or

dinary n
egligenc
e.

A secon
d argum
ent is tha
t Willia

ms' negli
gence w
as not th
e proxim

ate cause
of Apex'
s

loss. Th
e loss ap
parently
occurred

prior to t
he audit
by Willi
ams and

could no
t have be
en

prevente
d even if
Williams
had disc

overed t
he defalc
ations.
Finally, t

he attorn
ey woul
d argue

contribut
ory negli
gence on
the part

of Apex.
Normall
y losses
are alloc

ated bet
ween the
parties

when bo
th partie
s are neg
ligent.

Chapter
04 - Lega
l Liabilit

y of CPA
s
4-11

Whether
the first
argumen
t that Jac

kson has
no rights
under th
e contrac

t will pre
vail is
an intere
sting que

stion. T
here is li
ttle auth
ority on t

he precis
e situatio
n in the

problem.
Althoug
h Apex i

s not the
client an
d is not
mention

ed as a b
eneficiar
y in the
engagem

ent letter
,
it is the c
ompany

whose fi
nancial s
tatement
s were a

udited.
Whether
this fact

creates t
he duty
of care o
wed by

Williams
to Jacks
on Finan
cial is, at

present,
unclear.
(c)

No. A C
PA firm
is not pr
evented

from rec
overing
against it
s insurer.

This is
precisely
the

purpose
of this ty
pe of ins
urance; i

t serves t
o protect
the insur
ed firm f

rom its o
wn negli
gence.

CPAs m
ay be bar
red from
recoveri

ng from
their ins
urers, ho
wever, if

they are
found gu
ilty of

criminal
fraud.
4-38

SOLUTI
ON: Cra
gsmore
& Comp

any, CP
As (Esti
mated ti

me: 20
minutes)

The lega
l proble
ms for C
ragsmor

e & Com
pany inv
olve pos
sible cri

minal lia
bility, as
well as c
ivil

liability,
for fraud
. The fa
cts in the

Marlowe
Manufac
turing, I
nc. audit

bear mar
ked simi
larities t
o the

facts in t
he

Contin
ental V
ending
case. In

Contin
ental V
ending

, the cou
rt found
two part

ners and
a
manager
of a CPA

firm guil
ty of cri
minal fra
ud for fa

iling to i
nsist upo
n adequa
te disclo

sure of t
he
uncollect
ibility of

a substa
ntial rec
eivable f
rom an a

ffiliate.
Mr. Crag
smore's
conduct

has impl
ications
of a cons
piracy w

ith mana
gement a
nd owne
rs of Ma

rlowe to
conceal t
he relate
d-party

aspects o
f the
lease bet
ween M

arlowe a
nd Acme
Leasing
Compan

y. Altho
ugh the i
nadequat
e disclos

ure of th
e facts
of the le
ase is no

t the pro
ximate c
ause of l
osses to

Marlowe
's credito
rs becau
se of the

company
's
bankrupt
cy, it is c

onceivab
le that a
finding o
f fraud a

gainst Cr
agsmore
& Comp
any with

respect t
o the
lease dis
closure

would le
ad to rec
overy of
damages

against t
he CPA
by the cr
editors o

f Marlo
we.
Generall
y, there i

s no requ
irement t
hat finan
cial state

ments or
notes dis
close the

lack of fi
re
insuranc
e. Many

compani
es do not
obtain in
surance

coverage
by choic
e; others

cannot o
btain
coverage
because

of the ha
zards of
their pro
ducts or

locations
. Accor
dingly, t
he unqua

lified opi
nion
of Crags
more &

Compan
y does n
ot appea
r to be in

appropri
ate beca
use of M
arlowe's

lack of i
nsurance
coverage
.

4-39
(SOLUT
ION: Se

curities
Acts Lia
bility (E
stimated

time: 15
minutes)
(a)

(3) Secti
on 11 of
the Secu
rities Ac

t of 1933
imposes
liability
on audit

ors for m
isstatem
ents or

omission
s of a ma
terial fac
t in certif

ied finan
cial state
ments or
other inf

ormation
provided
in

registrati
on state
ments.
Similarl

y, under
Section
10(b), R
ule 10b-

5 of the
Securitie
s Exchan
ge

Act of 1
934, the
plaintiff
must pro

ve there
was a m
aterial m
isstatem

ent or o
mission i
n

informat
ion relea
sed by th
e compa

ny, such
as audite
d financi

al statem
ents.
(b)

(3) Unde
r both Se
ction 11
of the 19

33 Act a
nd Secti
on 10(b)
of the 19

34 Act, t
he plaint
iff

must alle
ge or pro
ve that s/
he incurr

ed mone
tary dam
ages.

(c)
(1) Und
er Sectio
n 11 of t

he 1933
Act, the
burden o
f proof is

shifted t
o the def
endant,

accounta
nt. The
accounta
nt may t

hen defe
nd himse
lf or hers
elf by est

ablishing
due dilig
ence.

The plai
ntiff doe
s not hav
e to sho

w lack o
f due dili
gence by
the CPA

Under S
ection 1
0, the

plaintiff
must pro
ve scient
er.

(d)
(4) The
plaintiff

does not
have to p
rove that
s/he was

in privit
y with th
e CPA u

nder eith
er
section.

(e)
(2) Und
er Sectio
n 10(b),

the plain
tiff must
prove ju
stifiable

reliance
on the fi
nancial

informat
ion. Thi
s is not t
rue unde

r Section
11 in wh
ich the p
laintiff n

eed prov
e only th
e items

in item (
a) and (b
) discuss

ed above
.
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