Chapter 5

Legal Liability

Raihan Noval Akbar

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 Legal Environment

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.

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 Distinguishing Business Failure,
Audit Failure and Audit Risk

A business failure occurs when a business is unable to repay its

lenders or meet the expecta tions of its investors because of economic
or business conditions, such as a reces sion, poor management
decisions, or unexpected competition in the industry.

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 Distinguishing Business Failure,
Audit Failure and Audit Risk
Audit failure occurs when the auditor issues an
incorrect audit opinion because it failed to comply
with the requirements of auditing standards. An
example is a firm assigning unqualified assistants
to perform certain audit tasks where they failed to
notice material misstatements in the client’s
records that a qualified auditor would have found.
 Distinguishing Business Failure, Audit
Failure and Audit Risk

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 mis stated. 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.

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 Legal Concepts
Affecting Liability

Prudent person concept

Liability for the acts of others

Lacked of privileged
communication

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 Legal Terms Affecting CPAs’ Liability
(Terms related to negligence and fraud)

Ordinary negligence Constructive fraud

Gross negligence Fraud

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 Legal Terms Affecting CPAs’ Liability
(Terms related to contract law)

Breach of Third-party
contract beneficiary

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 Legal Terms Affecting CPAs’ Liability
(Other terms)

Common law

Statutory law

Joint and several liability

Separate and proportionate

liability 9
 Four Major Sources of Auditors’
Legal Liability

Liability to Clients Federal securities laws

Liability to third parties Criminal liability

 Liability to Client

The most common source of lawsuits against CPAs is

from clients. The suits vary widely, including such
claims as failure to complete a nonaudit engagement
on the agreed-upon date, inappropriate withdrawal
from an audit, failure to discover an embezzlement
(theft of assets), and breach of the confidentiality
requirements of CPAs. Typically, the amount of these
lawsuits is relatively small, and they do not receive
the publicity often given to suits involving third parties.

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 Auditor’s Defenses Against Client Suits

Lack of duty to perform Contributory negligence

Absence of casual
Nonnegligent performance
connection

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 Liability to Third Parties Under
Common Law

Ultramares Foreseen
doctrine users

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 Foreseen Users

Credit Restatement
alliance of torts

Foreseeable
user
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 Criminal Liability
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.

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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

o Deal only with clients possessing integrity

o Hire qualified personnel
o Follow the standards of the profession
o Maintain independence
o Understand the client’s business
o Perform quality audits
o Document the work properly

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THANKYOU!

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