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This chapter on legal liability and the preceding one on professional ethics highlight
the environment in which CPAs operate. These chapters provide an overview of the
importance of protecting the professions reputation of high ethical standards, highlight
consequences accountants face when others believe they have failed to live up to those
standards, and show how CPAs can be held legally liable for the professional services they
provide. In this chapter we focus on legal liability for CPAs both on a conceptual level and in
terms of specific legal suits that have been filed against CPAs. We also discuss actions
available to the profession and individual practitioners to minimize liability while, at the
same time, maintaining high ethical and professional standards and meeting the needs of
Professionals have always been required to provide a reasonable level of care while
performing work for those they serve. Under common law, audit professionals have a
responsibility to fulfill implied or expressed contracts with clients. Should auditors fail to
provide the services or not exercise due care in their performance, they are liable to their
clients for negligence and/or breach of contract, and, in certain circumstances, to parties other
than their clients. Although the criteria for legal actions against auditors by third parties vary
by state, the auditor generally owes a duty of care to third parties who are part of a limited
group of persons whose reliance is foreseen by the auditor. In addition to common law
liability, auditors may be heldliable to third parties under statutory law. In rare cases, auditors
have even been held liable for criminal acts. A criminal conviction against an auditor can
result when plaintiffs demonstrate that the auditor intended to deceive or harm others. Despite
efforts by the profession to address legal liability of CPAs, both the number of lawsuits and
sizes of awards to plaintiffs remain high, including suits involving third parties under both
common law and the federal securities acts. No simple reasons explain this trend, but the
following factors are major contributors:
1. Growing awareness of the responsibilities of public accountants by users of financial
2. An increased consciousness on the part of the Securities and Exchange Commission
(SEC) for its responsibility for protecting investors interests
3. The complexity of auditing and accounting functions caused by the increasing size of
businesses, the globalization of business, and the complexities of business
4. The tendency of society to accept lawsuits by injured parties against anyone who
might be able to provide compensation, regardless of who was at fault, coupled with
the joint and several liability doctrine (often called the deep-pocket concept of liability)
5. Large civil court judgments against CPA firms awarded in a few cases, encouraging
attorneys to provide legal services on a contingent-fee basis, which offers the injured
party a potential gain when the suit is successful, but minimal losses when it is not
6. Many CPA firms being willing to settle legal problems out of court in an attempt to
avoid costly legal fees and adverse publicity, rather than pursuing resolution through
the judicial process
7. The difficulty judges and jurors have understanding and interpreting technical
accounting and auditing matters
Many accounting and legal professionals believe that a major cause of lawsuits
against CPA firms is financial statement users lack of
understanding of two concepts:
1. The difference between a business failure and an audit failure
2. The difference between an audit failure and audit risk
A business failure : occurs when a business is unable to repay its lenders or meet the
expectations of its investors because of economic or business conditions, such as a
recession, poor management decisions, or unexpected competition in the industry.
Audit failure : occurs when the auditor issues an incorrect audit opinion because it failed to
comply with the requirements of auditing standards.
Audit risk represents the possibility that the auditor concludes after conducting an
adequate audit that the financial statements were fairly stated when, in fact, they were
materially misstated. Audit risk is unavoidable, because auditors gather evidence only on a
test basis and because well-concealed frauds are extremely difficult to detect. An auditor
may fully com ply with auditing standards and still fail to
uncover a material misstatement due to fraud.
Accounting professionals tend to agree that in most cases, when an audit has failed to
uncover material misstatements and the wrong type of audit opinion is issued, it is
appropriate to question whether the auditor exercised due care in performing the audit. In
cases of audit failure, the law often allows parties who suffered losses to recover some or all
of the losses caused by the audit failure. In practice, because of the complexity of auditing, it
is difficult to determine when the auditor has failed to use due care. Also, legal precedent
makes it difficult to determine who has the right to expect the benefit of an audit and recover
losses in the event of an audit failure. Nevertheless, an auditors failure to follow due care
often results in liability and, when appropriate, damages against the CPA firm.

A CPA is responsible for every aspect of his or her public accounting work, including
auditing, taxes, management advisory services, and accounting and bookkeeping services.
If a CPA failed to correctly prepare and file a clients tax return, the CPA can be held liable
for any penalties and interest that the client was required to pay plus the tax preparation fee
charged. In some states, the court can also assess punitive damages. Most of the major
lawsuits against CPA firms have dealt with audited or unaudited financial statements. The
discussion in this chapter is restricted primarily to those two aspects of public accounting.
restricted primarily to those two aspects of public accounting. First, we examine several legal
concepts pertinent to lawsuits involving CPAs.
Prudent Person Concept
There is agreement within the profession and the courts that the auditor is not a
guarantor or insurer of financial statements. The auditor is expected only to conduct the
audit with due care, and is not expected to be perfect. This standard of due care is often
called the prudent person concept.
Liability for the Acts of Others
Generally, the partners, or shareholders in the case of a professional corporation, are
jointly liable for the civil actions against any owner. It is different, however, if the firm
operates as a limited liability partnership (LLP), a limited liability company (LLC), a general
corporation, or a professional corporation with limited liability. Under these business
structures, the liability for one owners actions does not extend to another owners personal
assets, unless the other owner was directly involved in the actions of the owner causing the
liability. Of course, the firms assets are all subject to the damages that arise.

Lack of Privileged Communication
Several states have statutes that permit privileged communication between the client
and auditor. Even then, the intent at the time of the communication must have been for the
communication to remain confidential. A CPA can refuse to testify in a state with privileged
communications statutes. However, that privilege does not extend to federal courts.
Sources of Legal Liability
The remainder of this chapter addresses the four sources of auditors legal liability:
1. Liability to clients
2. Liability to third parties under common law
3. Civil liability under the federal securities laws
4. Criminal liability

A typical lawsuit brought by a client involves a claim that the auditor did not discover
an employee theft as a result of negligence in the conduct of the audit. The lawsuit can be
for breach of contract, a tort action for negligence, or both. Tort actions are more common
because the amounts recoverable under them are normally larger than under breach of
contract. Tort actions can be based on ordinary negligence, gross negligence, or fraud.

In addition to being sued by clients, CPAs may be liable to third parties under
common law. Third parties include actual and potential stockholders, vendors, bankers and
other creditors, employees, and customers. A CPA firm may be liable to third parties if a loss
was incurred by the claimant due to reliance on misleading financial statements. A typical
suit occurs when a bank is unable to collect a major loan from an insolvent customer and the
bank then claims that misleading audited financial statements were relied on in making the
loan and that the CPA firm should be held responsible because it failed to perform the audit
with due care.

Auditor Defenses Against Third-Party Suits
Three of the four defenses available to auditors in suits by clients are also available
in third-party lawsuits: lack of duty to perform the service, nonnegligent performance, and
absence of causal connection. Contributory negligence is ordinarily not available because a
third party is not in a position to contribute to misstated financial statements. A lack of duty
defense in third-party suits contends lack of privity of contract. The extent to which privity of
contract is an appropriate defense and the nature of the defense depend heavily on the
approach to foreseen users in the state and the judicial jurisdiction of the case.
The Securities Act of 1933 imposes an unusual burden on the auditor. Section 11 of
the 1933 act defines the rights of third parties and auditors, which are summarized as
1. Any third party who purchased securities described in the registration statement may
sue the auditor for material misrepresentations or omissions in audited financial
statements included in the registration statement.
2. Third-party users do not have the burden of proof that they relied on the financial
statements or that the auditor was negligent or fraudulent in doing the audit. Users
must only prove that the audited financial statements contained a material
misrepresentation or omission.
3. The auditor has the burden of demonstrating as a defense that (1) an adequate audit
was conducted or (2) all or a portion of the plaintiffs loss was caused by factors other
than the misleading financial statements. The 1933 act is the only common or
statutory law where the burden of proof is on the defendant.

A fourth way CPAs can be held liable is under criminal liability for accountants.
CPAs can be found guilty for criminal action under both federal and state laws. Under state
law, the most likely statutes to be enforced are the Uniform Securities Acts, which are similar
to parts of the SEC rules. The more relevant federal laws affecting auditors are the 1933 and
1934 securities acts, as well as the Federal Mail Fraud Statute and the Federal
False Statements Statute.

Unfortunately, a few notorious criminal cases have involved CPAs. Historically, one
of the leading cases of criminal action against CPAs is United States v. Simon, which
occurred in 1969.

The AICPA and the profession as a whole can do a number of things to reduce
practitioners exposure to lawsuits:
1. Seek protection from nonmeritorious litigation
2. Improve auditing to better meet users needs
3. Educate users about the limits of auditing
Practicing auditors may also take specific action to minimize their liability. Some of
the more common actions are as follows:
1. Deal only with clients possessing integrity. There is an increased likelihood of
having legal problems when a client lacks integrity in dealing with customers,
employees, units of government, and others. A CPA firm needs procedures to
evaluate the integrity of clients and should dissociate itself from clients found lacking
2. Maintain independence. Independence is more than merely financial. Independence
requires an attitude of responsibility separate from the clients interest. Much litigation
has arisen from auditors too-willing acceptance of client representations or from
client pressure. The auditor must maintain an attitude of healthy professional
3. Understand the clients business. In several cases, the lack of knowledge of
industry practices and client operations has been a major factor in auditors failing to
uncover misstatements.
4. Perform quality audits. Quality audits require that auditors obtain appropriate
evidence and make appropriate judgments about the evidence. It is essential, for
example, that the auditor understands the clients internal controls and modify the
evidence to reflect the findings.
5. Improved auditing reduces the likelihood of failing to detect misstatements and the
likelihood of lawsuits.
6. Document the work properly. The preparation of good audit documentation helps
the auditor perform quality audits. Quality audit documentation is essential if an
auditor has to defend an audit in court, including an engagement letter and a
representation letter that define the respective obligations of the client and the
7. Exercise professional skepticism. Auditors are often liable when they are presented
with information indicating a problem that they fail to recognize. Auditors need to
strive to maintain a healthy level of skepticism, one that keeps them alert to potential
misstatements, so that they can recognize misstatements when they exist.

The purpose of an audit is to provide financial statement users with an opinion by the
auditor on whether the financial statements are presented fairly, in all material respects, in
accordance with the applicable financial accounting framework.
Distinguish managements responsibility for the financial statements and internal
control from the auditors responsibility for verifying the financial statements and
effectiveness of internal control. The responsibility for adopting sound accounting policies,
maintaining adequate internal control, and making fair representations in the financial
statements rests with management rather than with the auditor. Because they operate the
business daily, a companys management knows more about the companys transactions
and related assets, liabilities, and equity than the auditor. In contrast, the auditors
knowledge of these matters and internal control is limited to that acquired during the audit.
The overall objectives of the auditor are:
(a) To obtain reasonable assurance about whether the financial statements as a whole
are free from material misstatement, whether due to fraud or error, thereby enabling
the auditor to express an opinion whether the financial statements are prepared, in all
material respects, in accordance with an applicable financial reporting framework;
(b) To report on the financial statements, and communicate as required by auditing
standards, in accordance with the auditors findings.

Material Versus Immaterial Misstatements Misstatements are usually considered
material if the combined uncorrected errors and fraud in the financial statements would likely
have changed or influenced the decisions of a reasonable person using the statements.
Reasonable Assurance Assurance is a measure of the level of certainty that the auditor
has obtained at the completion of the audit.
The auditor is responsible for reasonable, but not absolute, assurance for several reasons:
1. Most audit evidence results from testing a sample of a population such as accounts
receivable or inventory. Sampling inevitably includes some risk of not uncovering a
material misstatement. Also, the areas to be tested; the type, extent, and timing of
those tests; and the evaluation of test results require significant auditor judgment.
Even with good faith and integrity, auditors can make mistakes and errors in
2. Accounting presentations contain complex estimates, which inherently involve
uncertainty and can be affected by future events. As a result, the auditor has to rely
on evidence that is persuasive, but not convincing.
3. Fraudulently prepared financial statements are often extremely difficult, if not
impossible, for the auditor to detect, especially when there is collusion among
Errors Versus Fraud Auditing standards distinguish between two types of misstatements:
errors and fraud. An error is an unintentional misstatement of the financial statements,
whereas fraud is intentional. For fraud, there is a distinction between misappropriation of
assets, often called defalcation or employee fraud, and fraudulent financial
reporting, often called management fraud.
Professional Skepticism Auditing standards require that an audit be designed to provide
reasonable assurance of detecting both material errors and fraud in the financial statements.

Auditors Responsibilities for Detecting Material Errors
Auditors spend a great portion of their time planning and performing audits to detect
unintentional mistakes made by management and employees. Auditors find a variety of
errors resulting from such things as mistakes in calculations, omissions, misunderstanding
and misapplication of accounting standards, and incorrect summarizations and descriptions.
Throughout the rest of this book, we consider how the auditor plans and performs audits for
detecting both errors and fraud.
Auditors Responsibilities for Detecting Material Fraud
Auditing standards make no distinction between the auditors responsibilities for searching
for errors and fraud. In either case, the auditor must obtain reasonable assurance about
whether the statements are free of material misstatements. The standards also recognize
that fraud is often more difficult to detect because management or the employees
perpetrating the fraud attempt to conceal the fraud, similar to the ZZZZ Best case. Still, the
difficulty of detection does not change the auditors responsibility to properly plan and
perform the audit to detect material misstatements, whether caused by error or fraud.

Auditors Responsibilities for Discovering Illegal Acts
Direct-Effect Illegal Acts Certain violations of laws and regulations have a direct financial
effect on specific account balances in the financial statements.
Indirect-Effect Illegal Acts Most illegal acts affect the financial statements only indirectly.
Evidence Accumulation When There Is No Reason to Believe Indirect-Effect Illegal
Acts Exist Many audit procedures normally performed on audits to search for errors and
fraud may also uncover illegal acts.
Evidence Accumulation and Other Actions When There Is Reason to Believe
Direct- or Indirect-Effect Illegal Acts May Exist The auditor may find indications of
possible illegal acts in a variety of ways.
When the auditor believes that an illegal act may have occurred, several actions are
necessary to determine whether the suspected illegal act actually exists:
1. The auditor should first inquire of management at a level above those likely to be
involved in the potential illegal act.
2. The auditor should consult with the clients legal counsel or other specialist who is
knowledgeable about the potential illegal act.
3. The auditor should consider accumulating additional evidence to determine whether
there actually is an illegal act.
Cycle Approach to Segmenting an Audit
A common way to divide an audit is to keep closely related types (or classes) of
transactions and account balances in the same segment. This is called the cycle
approach. For example, sales, sales returns, cash receipts, and charge-offs of uncollectible
accounts are the four classes of transactions that cause accounts receivable to increase and


For any given class of transactions, several audit objectives must be met before the
auditor can conclude that the transactions are properly recorded. These are called
transaction-related audit objectives in the remainder of this book. For example, there
are specific sales transactionrelated audit objectives and specific sales returns and
allowances transaction-related audit objectives. Similarly, several audit objectives must be
met for each account balance. These are called balance-related audit objectives. For
example, there are specific accounts receivable balance-related audit objectives and specific
accounts payable balance-related audit objectives. We show later in this chapter that the
transaction-related and balance-related audit objectives are somewhat different but closely
related. The third category of audit objectives relates to the presentation and disclosure of
information in the financial statements. These are called presentation and disclosure-
related audit objectives. For example, there are specific presentation and disclosure-
related audit objectives for accounts receivable and notes payable.

Assertions About Classes of Transactions and Events
Management makes several assertions about transactions. These assertions also
apply to other events that are reflected in the accounting records, such as recording
depreciation and recognizing pension obligations.
Occurrence The occurrence assertion concerns whether recorded transactions included in
the financial statements actually occurred during the accounting period. For example,
management asserts that recorded sales transactions represent exchanges of goods or
services that actually took place.
Completeness This assertion addresses whether all transactions that should be included in
the financial statements are in fact included. For example, management asserts that all sales
of goods and services are recorded and included in the financial statements.
Accuracy The accuracy assertion addresses whether transactions have been recorded at
correct amounts. Using the wrong price to record a sales transaction and an error in
calculating the extensions of price times quantity are examples of violations of the accuracy
Classification The classification assertion addresses whether transactions are recorded in
the appropriate accounts. Recording administrative salaries in cost of sales is one example
of a violation of the classification assertion.
Cutoff The cutoff assertion addresses whether transactions are recorded in the proper
accounting period. Recording a sales transaction in December when the goods were not
shipped until January violates the cutoff assertion.

Assertions About Account Balances
Assertions about account balances at year-end address existence, completeness,
valuation and allocation, and rights and obligations.
Existence The existence assertion deals with whether assets, liabilities, and equity interests
included in the balance sheet actually existed on the balance sheet date.
Completeness This assertion addresses whether all accounts and amounts that should be
presented in the financial statements are in fact included.
Valuation and Allocation The valuation and allocation assertion deals with whether
assets, liabilities, and equity interests have been included in the financial statements at
appropriate amounts, including any valuation adjustments to reflect asset amounts at net
realizable value.
Rights and Obligations This assertion addresses whether assets are the rights of the
entity and whether liabilities are the obligations of the entity at a given date.

Assertions About Presentation and Disclosure
Occurrence and Rights and Obligations This assertion addresses whether disclosed
events have occurred and are the rights and obligations of the entity. For example, if the
client discloses that it has acquired another company, it asserts that the transaction has
been completed.
Completeness This assertion deals with whether all required disclosures have been
included in the financial statements.
Accuracy and Valuation The accuracy and valuation assertion deals with whether
financial information is disclosed fairly and at appropriate amounts.
Classification and Understandability This assertion relates to whether amounts are
appropriately classified in the financial statements and footnotes, and whether the balance
descriptions and related disclosures are understandable.

General Transaction-Related Audit Objectives
OccurrenceRecorded Transactions Exist This objective deals with whether recorded
transactions have actually occurred. Inclusion of a sale in the sales journal when no sale
occurred violates the occurrence objective.
CompletenessExisting Transactions Are Recorded This objective deals with
whether all transactions that should be included in the journals have actually been included.
AccuracyRecorded Transactions Are Stated at the Correct Amounts This
objective addresses the accuracy of information for accounting transactions and is one part
of the accuracy assertion for classes of transactions.

General Balance-Related Audit Objectives
ExistenceAmounts Included Exist This objective deals with whether the amounts
included in the financial statements should actually be included. For example, inclusion of an
account receivable from a customer in the accounts receivable trial balance when there is no
receivable from that customer violates the existence objective.
CompletenessExisting Amounts Are Included This objective deals with whether all
amounts that should be included have actually been included. Failure to include an account
receivable from a customer in the accounts receivable trial balance when a receivable exists
violates the completeness objective.

Plan and Design an Audit Approach (Phase I)
For any given audit, there are many ways in which an auditor can accumulate evidence to
meet the overall audit objective of providing an opinion on the financial statements. Two
overriding considerations affect the approach the auditor selects:
1. Sufficient appropriate evidence must be accumulated to meet the auditors
professional responsibility.
2. The cost of accumulating the evidence should be minimized.
Perform Tests of Controls and Substantive Tests of Transactions (Phase II)
Before auditors can justify reducing planned assessed control risk when internal controls are
believed to be effective, they must first test the effectiveness of the controls. The procedures
for this type of testing are commonly referred to as tests of controls.
Perform Analytical Procedures and Tests of Details of Balances (Phase III)
There are two general categories of phase III procedures. Analytical procedures use
comparisons and relationships to assess whether account balances or other data appear
Complete the Audit and Issue an Audit Report (Phase IV)
After the auditor has completed all procedures for each audit objective and for each financial
statement account and related disclosures, it is necessary to combine the information
obtained to reach an overall conclusion as to whether the financial statements are fairly
presented. This highly subjective process relies heavily on the auditors professional
judgment. When the audit is completed, the CPA must issue an audit report to accompany
the clients published financial statements.