Chapter 4: Legal Liability

Chapter 4 objectives
• Sources of legal liability
• Distinguish between a business failure and
an audit failure
• Concept of privileged communication
• Who can sue the auditor, and discuss the
auditor’s potential defences
• Accounting professions responds to legal
liability
 Sources of legal liability
• Why do you believe that an auditor might
be sued or liable?
Confusing business and audit failure

• Business failure: when a business cannot

repay its debts, perhaps due to poor
management, a shift in demand, or
economic factors
• Audit failure: when the auditor issues an
incorrect audit opinion (e.g. an unqualified
opinion when it should be qualified)
 Role of audit risk
• The auditor uses audit risk to help decide
how much evidence to collect
• Audit risk is the risk that the auditor will
conclude that the financial statements are
fairly stated, when they are not
 Expectation gap
• There is an expectation gap when two
different groups expect different outcomes
in a particular situation
• Here, we use the term ‘expectation gap’ to
refer to the difference between what users
actually expect and what the audit report
actually provides
 What do users expect?
• Think about the different users of financial
statements
• What might the difference in expectations
be among these users with respect to the
auditor’s report?
 Terminology
• We will focus on three of these:
– Prudent person
– Limited Liability Partnership
– Lack of privileged communication
 Prudent person
• The auditor is not expected to be perfect
• How is the standard of performance set?
• According to the courts it is based upon
“reasonable care and diligence in the
performance of obligations” – this means
that the auditor does his/her best given the
training and experience required
 Joint and several liability
• The partner in charge of an audit
engagement is responsible for his/her
employees, other partners on the
engagement, as well as work performed by
other audit firms, internal auditors or
specialists
• Limited liability could be present if the firm
formed a limited liability partnership
 Lack of privileged communication

• Lawyers may refuse to provide information

to the courts that was given to them by their
clients (called privileged communication)
• Accountants do not have this right
• They must provide information to the courts
when subpoenaed
 Who can sue the auditor?
• Clients (the business entity or organization that hired
the auditor)
• Third parties:
– Owners or shareholders (existing or potential)
– Vendors
– Bankers, Canada Revenue Agency or other creditors
– Customers
– Employees, etc.
 Five possible defenses against
third-party suits
• Lack of duty of care
• Absence of misstatement
• Non-negligent performance
• Absence of causal connection
• Contributory negligence

Preferably used in the above order during a

suit.
 Lack of duty of care (also called
“lack of privity”)
• The auditor claims that there was no duty to
the party that is suing
• There is a duty of reasonable care to the
client
• An engagement letter helps identify that
there is no duty of care to find fraud
 Absence of misstatement
• The statements were in accordance with
GAAP
• There were no material errors in the
financial statements
• The financial statements accurately portray
the financial statements of the organization
 Non-negligent performance
• The audit was done in accordance with
generally accepted auditing standards
• The auditors are not responsible for
undiscovered errors or fraud because their
audit was done appropriately
• CICA Assurance Handbook or expert
witness used to support this defence
 Absence of causal connection
• This defence claims that there is no
connection between the auditor’s breach
(i.e. an audit failure) and the client’s loss
• For example, the client relied upon others
(such as a banker) or upon their own
expertise when deciding to invest or lend
money
 Contributory negligence
• The auditor accepts partial blame, i.e.
accepts that the audit was not conducted in
accordance with GAAS
• However, the auditor also places blame on
the party that is suing the auditor, e.g.
management did not correct internal control
weaknesses
 No damages
• There is one additional defence that arises
from the definition of a tort action for
negligence (p. 86), and it is simply:
• “No damages”
• This defence is simply the fact that the
plaintiff did not lose any money by relying
upon the financial statements
 Preventing excess legal costs
• Both the accounting profession and the
individual practitioner need to respond to
the potential of legal liability
 The profession’s response to legal
liability
• Conduct research in auditing
• Set standards and rules
• Set requirements to protect auditors
• Establish practice inspection requirements
• Defend unjustified lawsuits
• Educate users
• Sanction members for improper conduct or
performance
• Lobby for changes in laws
 The individual practitioner’s
response to legal liability
• 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
 The individual practitioner’s
response to legal liability (cont’d)
• Document the work properly
• Obtain an engagement letter and a
management representation letter
• Maintain confidential relations
• Carry adequate insurance
• Seek legal counsel (when warranted)