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y Arens/Elder/Beasley 5 - 1
Legal Liability Legal Liability
Chapter 5 Chapter 5
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Learning Objective 1 Learning Objective 1
Understand the litigious Understand the litigious
environment in which environment in which
CPAs practice. CPAs practice.
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Changed Legal Environment 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 Changed Legal Environment
o Growing awareness of responsibilities of public accountants by users of financial
statements
o ncreased 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
Major contributors:
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Learning Objective 2 Learning Objective 2
Explain why the failure of financial Explain why the failure of financial
statement users to differentiate statement users to differentiate
among business failure, audit among business failure, audit
failure, and audit risk has failure, and audit risk has
resulted in lawsuits. resulted in lawsuits.
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Business Failure, Audit Failure, Business Failure, Audit Failure,
and Audit Risk and Audit Risk
Business failure
t 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, Business Failure, Audit Failure,
and Audit Risk and Audit Risk
Audit failure
t occurs when the auditor issues an
incorrect audit opinion because it
failed to comply with the requirements
of auditing standards.
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Business Failure, Audit Failure, Business Failure, Audit Failure,
and Audit Risk and Audit Risk
Audit risk
t 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 Learning Objective 3
Use the primary legal concepts Use the primary legal concepts
and terms concerning accountants' and terms concerning accountants'
liability as a basis for studying liability as a basis for studying
legal liability of auditors. legal liability of auditors.
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Lack of privileged communication
Liability for the acts of others
Prudent person concept
Legal Concepts Affecting Legal Concepts Affecting
Liability Liability
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Legal Terms Affecting Legal Terms Affecting
CPAs' Liability CPAs' Liability
Terms related to negligence and fraud:
Ordinary negligence
Constructive fraud
Gross negligence
Fraud
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Legal Terms Affecting Legal Terms Affecting
CPAs' Liability CPAs' Liability
Terms related to contract law:
Breach of contract
Third-party beneficiary
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Legal Terms Affecting Legal Terms Affecting
CPAs' Liability CPAs' Liability
Other terms:
Common law
Joint and several liability
Statutory law
Separate and proportionate liability
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Four Major Sources of Auditors' Four Major Sources of Auditors'
Legal Liability Legal Liability
Liability to third parties
Federal securities laws
Liability to clients
Criminal liability
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Learning Objective 4 Learning Objective 4
Describe accountants' liability to Describe accountants' liability to
clients and related defenses. clients and related defenses.
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Liability to Clients Liability to Clients
The most common source of lawsuits
against CPAs is from clients
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Auditor's Defenses Against Auditor's Defenses Against
Client Suits Client Suits
Lack of duty to perform
Nonnegligent performance
Contributory negligence
Absence of causal connection
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Learning Objective 5 Learning Objective 5
Describe accountants' liability to Describe accountants' liability to
third parties under common law third parties under common law
and related defenses. and related defenses.
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Liability to Third Parties Under Liability to Third Parties Under
Common Law Common Law
Ultramares doctrine
Foreseen users
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Foreseen Users Foreseen Users
Credit alliance
Restatement of torts
Foreseeable user
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Auditor Defenses Against Auditor Defenses Against
Third Third- -Party Suits Party Suits
The preferred defense is
nonnegligent performance.
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Learning Objective 6 Learning Objective 6
Describe accountants' civil liability Describe accountants' civil liability
under the federal securities laws under the federal securities laws
and related defenses. and related defenses.
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Securities Act of 1933 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 Securities Exchange
Act of 1934 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 Rule 10b- -5 of the Securities 5 of the Securities
Exchange Act of 1934 Exchange 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 Auditor Defenses 1934 Act 1934 Act
Nonnegligent performance
Lack of duty
Absence of causal connection
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SEC Sanctions SEC Sanctions
The SEC has the power in certain circumstances
to sanction or suspend practitioners from
doing audits for SEC companies.
n recent years, the SEC has temporarily
suspended a number of individual CPAs
from doing any audits on SEC clients.
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Foreign Corrupt Foreign Corrupt
Practices Act of 1977 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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Sarbanes Sarbanes- -Oxley Act of 2002 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 Learning Objective 7
Specify what constitutes criminal Specify what constitutes criminal
liability for accountants. liability for accountants.
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Criminal Liability Criminal Liability
CPAs can be held liable under
.riminal liability for a..ountants
CPAs can be found guilty for criminal
action under both federal and state laws.
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Sarbanes Sarbanes- -Oxley Act 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 Learning Objective 8
Describe what the profession and Describe what the profession and
the individual CPA can do and the individual CPA can do and
what is being done to reduce what is being done to reduce
the threat of litigation. the threat of litigation.
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The Profession's Response The Profession's Response
to Legal Liability 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 The Profession's Response
to Legal Liability 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 ndividual CPAs Protecting ndividual CPAs
from Legal Liability 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 ndividual CPAs Protecting ndividual CPAs
from Legal Liability 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 ndividual CPAs Protecting ndividual CPAs
from Legal Liability 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 End of Chapter 5