Legal Liability

Chapter 5

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Learning Objective 1
Understand the litigious environment in which CPAs practice.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Changed Legal Environment

Audit professionals have a responsibility under common law to fulfill implied or expressed contracts with clients. They are liable to their clients for negligence and/or breach of contract should they fail to provide the services or not exercise due care in their performance. Despite efforts by the profession to address the legal liability of CPAs, both the number of lawsuits and sizes of awards to plaintiffs remain high.
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Changed Legal Environment

Major contributors:
o Growing awareness of responsibilities of public accountants by users of financial statements o Increased consciousness of the Securities and Exchange Commission (SEC) for its responsibility for protecting investors interests o Complexity of auditing and accounting functions caused by increasing size of businesses, globalization of business, and complexities of business operations oTendency of society to accept lawsuits by injured parties against anyone who might be able to provide compensation, regardless of fault (deep-pocket concept of liability) o Large civil court judgments against CPA firms awarded in a few cases encourage attorneys to provide legal services on a contingent-fee basis offers the injured party a potential gain when the suit is successful, but minimal losses when it is not o Willingness of many CPA firms to settle legal problems out of court in an attempt to avoid costly legal fees and adverse publicity, rather than resolution through judicial process o Judges and jurors difficulty in understanding and interpreting technical accounting and auditing matters
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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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Business Failure, Audit Failure, and Audit Risk

 Business failure It occurs when a business is unable to repay its lenders or meet the expectations of its investors because of economic or business conditions.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Business Failure, Audit Failure, and Audit Risk

 Audit failure It occurs when the auditor issues an incorrect audit opinion because it failed to comply with the requirements of auditing standards.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Business Failure, Audit Failure, and Audit Risk

 Audit risk It represents the risk that the auditor will conclude that the financial statements are fairly stated and an unqualified opinion can be issued when, in fact, they are materially misstated.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Learning Objective 3
Use the primary legal concepts and terms concerning accountants liability as a basis for studying legal liability of auditors.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Legal Concepts Affecting Liability

Prudent person concept Liability for the acts of others Lack of privileged communication

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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

Terms related to contract law:  Breach of contract  Third-party beneficiary

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Legal Terms Affecting CPAs Liability

Other terms:  Common law  Statutory law  Joint and several liability  Separate and proportionate liability
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Four Major Sources of Auditors Legal Liability

 Liability to clients  Liability to third parties  Federal securities laws  Criminal liability

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Learning Objective 4
Describe accountants liability to clients and related defenses.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Liability to Clients
The most common source of lawsuits against CPAs is from clients.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Auditors Defenses Against Client Suits

 Lack of duty to perform  Nonnegligent performance  Contributory negligence  Absence of causal connection

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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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 doctrine  Foreseen users

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Foreseen Users
 Credit alliance  Restatement of torts  Foreseeable user

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Auditor Defenses Against ThirdThird-Party Suits

The preferred defense is nonnegligent performance.

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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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Securities Exchange Act of 1934

The liability of auditors under this act often centers on the audited financial statements issued to the public in annual reports or submitted to the SEC as a part of annual Form 10-K reports.

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Rule 10b-5 of the Securities 10bExchange Act of 1934

Section 10 and rule 10b-5 are often called the antifraud provisions of the 1934 act.

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Auditor Defenses 1934 Act

 Nonnegligent performance  Lack of duty  Absence of causal connection

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SEC Sanctions
The SEC has the power in certain circumstances to sanction or suspend practitioners from doing audits for SEC companies. In recent years, the SEC has temporarily suspended a number of individual CPAs from doing any audits on SEC clients.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Foreign Corrupt Practices Act of 1977

This act makes it illegal to offer a bribe to an official of a foreign country for the purpose of exerting influence and obtaining or retaining business.

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SarbanesSarbanes-Oxley Act of 2002

This act requires the CEO and CFO to certify the annual and quarterly financial statements filed with the SEC. Management must report its assessment of the effectiveness of internal control over financial reporting. The auditor must issue an opinion on the effectiveness of internal control over financial reporting .
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Learning Objective 7
Specify what constitutes criminal liability for accountants.

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Criminal Liability
CPAs can be held liable under criminal liability for accountants. CPAs can be found guilty for criminal action under both federal and state laws.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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SarbanesSarbanes-Oxley Act
This act makes it a felony to destroy or create documents to impede or obstruct a federal investigation.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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The Professions Response to Legal Liability

 Research in auditing  Standard and rule setting  Set requirements to protect auditors  Establish peer review requirements

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The Professions Response to Legal Liability

 Oppose lawsuits  Education of users  Sanction members for improper conduct and performance  Lobby for changes in laws
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Protecting Individual CPAs from Legal Liability

 Deal only with clients possessing integrity  Hire qualified personnel  Follow the standards of the profession  Maintain independence

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Protecting Individual CPAs from Legal Liability

 Understand the clients business  Perform quality audits  Document the work properly  Obtain an engagement and a representation letter  Maintain confidential relations
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Protecting Individual CPAs from Legal Liability

 Carry adequate insurance  Seek legal counsel  Choose a form of organization with limited liability  Exercise professional skepticism

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End of Chapter 5

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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