Legal Liability

Chapter 5
5-1

Key Topics in Chapter 5

Legal liability for auditors

Liability to clients, and defenses Liability to third parties, and defenses Liability from Federal securities law: Securities acts of 1933 and 1934 Criminal liability

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.

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).

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.

Business Failure, Audit Failure, and Audit Risk

Audit failure

Business failure

Audit risk

Four Major Sources of Auditors Legal Liability

Client Third party

Federal securities laws

Criminal liability

Liability From Clients

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

Liability Under the Common Law

Liability to Clients:
Under contract law - for breach of contract Under tort law** for:
Ordinary negligence failure to exercise care a reasonable person would under the same circumstances Gross negligence failure to use even slight care in circumstances Fraud - intentional deception
** Tort = wrongful act that injures another persons property, body, or reputation.

Auditors Defenses Against Client Suits

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

Liability to Third Parties Under Common Law

Ultramares doctrine

Foreseen users

Liability Third Parties Under the Common Law

Ultramares: upheld the privity of contract doctrine: third parties cannot sue auditors for ordinary negligence. Foreseen users A limited group of persons for whom the auditor is aware will rely on the financial statements.

Auditor Defenses Against Third-Party Suits

The preferred defense is nonnegligent performance.

Securities Act of 1933

The Securities Act imposes an unusual burden on the auditor see p. 117.

1933 Act : Deals only with new securities. Only original purchasers of securities may recover from auditors.

Securities Exchange Act of 1934

1934 Act requires ongoing filing of quarterly and annual reports, and other information to keep the registration statement current. Certain information, including financial statements must be audited.

The liability of auditors under this act often centers on Rule 10b-5, p. 118.
It may apply to accountants if they intentionally or recklessly misrepresent information intended for 3rd party use.

Auditor Defenses 1934 Act

Nonnegligent performance

Lack of duty

Absence of causal connection

Criminal Liability
CPAs can be found guilty for criminal action under both federal and state laws. Most laws make it a criminal offense to
defraud another person through knowingly being involved with falsifications in financial statements.

The Sarbanes-Oxley Act makes it a felony to destroy or create documents to impede Or obstruct a federal investigation.

Protecting Individual CPAs from Legal Liability

Deal only with clients possessing integrity

Hire qualified personnel

Follow the standards of the profession Maintain independence

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

Protecting Individual CPAs from Legal Liability

Carry adequate insurance

Seek legal counsel

Choose a form of organization with limited liability Exercise professional skepticism