Transcript Chapter 5 – Legal Liability

Legal Liability
Chapter 5
©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder
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Learning Objective 1
Understand the litigious
environment in which
CPAs practice.
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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.
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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.
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Business Failure, Audit Failure,
and Audit Risk
Business
failure
Audit
failure
Audit
risk
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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.
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Business Failure, Audit Failure,
and Audit Risk
Audit failure
It occurs when the auditor issues an
erroneous audit opinion as the result
of an underlying failure to comply
with the requirements of generally
accepted auditing standards (GAAS).
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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.
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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.
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Legal Concepts Affecting Liability
Prudent person concept
Lack of privileged communication
Liability for the acts of others
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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
Constructive
fraud
Fraud
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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
Client
Third party
Federal
securities laws
Criminal
liability
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Learning Objective 4
Describe accountants’ liability to
clients and related defenses.
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Liability to Clients
The most common source of lawsuits
against CPAs is from clients.
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Auditor’s Defenses Against
Client Suits
Lack of duty to perform
Nonnegligent performance
Contributory negligence
Absence of causal connection
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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
Third-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.
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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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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.
Rule 2(e) of the SEC’s Rules of Practice says:
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SEC Sanctions
The commission may deny, the privilege of
appearing or practicing before it in any way to
any person who is found by the commission…
(1) not to possess the requisite qualifications to
represent others, or (2) to be lacking in character
or integrity or to have engaged in unethical or
improper professional conduct.
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Racketeer Influenced and
Corrupt Organization Act
This act allows an injured party to seek treble
(triple) damages and recovery of legal fees
in cases where it can be demonstrated
that the defendant was engaged in a
“pattern of racketeering activity.”
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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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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.
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Sarbanes-Oxley Act
This Act makes it a felony to destroy
or create documents to impede or
obstruct a federal investigation.
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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.
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The Profession’s 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 Profession’s 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 client’s 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
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