Legal Liability

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Legal Liability

• Chapter 5

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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

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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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Business Failure, Audit Failure, and Audit Risk
Audit failure
Business failure
Audit risk
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Four Major Sources of Auditors Legal Liability
Third party
Client
Federal securities laws
Criminal liability
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Liability From Clients
The most common source of lawsuits against CPAs
is from clients.
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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.

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Auditors Defenses AgainstClient Suits
Lack of duty to perform
Nonnegligent performance
Contributory negligence
Absence of causal connection
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Liability to Third Parties Under Common Law
Ultramares doctrine
Foreseen users
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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.

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Auditor Defenses AgainstThird-Party Suits
The preferred defense is nonnegligent performance.
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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.

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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.

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Auditor Defenses 1934 Act
Nonnegligent performance
Lack of duty
Absence of causal connection
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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.
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Protecting Individual CPAsfrom 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 CPAsfrom Legal Liability
Understand the clients business
Perform quality audits
Document the work properly
Obtain an engagement and a representation letter
Maintain confidential relations
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Protecting Individual CPAsfrom Legal Liability
Carry adequate insurance
Seek legal counsel
Choose a form of organization with limited
liability
Exercise professional skepticism