CHAPTER 4 AUDITOR

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CHAPTER 4AUDITORS LEGAL LIABILITYFall 2007

• Types of CPA Liability
• Liability Under Common vs. Statutory Law
• Defenses
• Liability under SEC Acts of 1933 and 1934, SOX
  and RICO
• Legal Liability for Accounting and Review
  Services
• Best Practices to minimize legal problems

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Auditors Legal Liability

• CPAs should approach every engagement needing to
  defend their work in court.
• Malpractice insurance
• Legal costs astronomical
• Up to 20 of accounting and audit revenues
• Perspective 20,000 audit fee ? 6million
  defense costs
• Damage to reputation
• Criminal liability
• Keep it in perspective though!
• Most CPAs are not careless or incompetent
• An audit provides only reasonable assurance

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Types of Auditor Legal Liability

• Common Law
• Develops through case decisions
• Generally arises due to breach of contract,
  negligence and fraud
• Can also involve torts (harmful act not involving
  breach of contract) in which civil action can be
  brought
• Statutory Law
• Develops when a governmental unit (state or
  Federal government) passes laws and regulations
  that affect CPAs

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Liability Under the Common LawFigure 4-1

• Liability to Clients
• Under contract law for breach of contract
• - Std Report, Non-GAAS audit
• - Report not on time
• - Violate confidentiality
• Under tort law for fraud, constructive
  fraud gross, negligence, and
  ordinary negligence
• Liability to Third Parties
• Under tort law to all third parties for
  fraud, constructive fraud
  and gross negligence
• to designated parties for
  negligence, (Fig4-1)

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Definitions of Liability Levels

• Ordinary Negligence Failure to exercise ordinary
  care
• Gross Negligence Failure to use even the
  slightest care
• Constructive Fraud Such severe gross negligence
  as to effectively be considered fraud (Ultramares
  case)
• Fraud Intentional deception

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Types of Third Parties

• Primary Beneficiaries identified by name to the
  auditor prior to the audit
• Other Beneficiaries unnamed third parties such
  as stockholders, creditors and potential
  investors
• Forseen Class Known (as opposed to all possible)
  class of people who are expected to benefit from
  the auditors report
• Forseeable Class All possible classes of people
  who could benefit from the auditors report.
  This includes all creditors, stockholders, and
  present and future investors.

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Liability for NegligenceUnder Common Law
(Figure 4-1)
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Common Law Defenses

• Due Care Defense
• 1. The auditor attempts to show that the audit
  was made in accordance with GAAS.
• 2. The auditors working papers are critical in
  this defense.
• 3. In addition, the auditor hopes to convince the
  court that there are inherent limitations in
  the audit process.
• 4. Thus, because of selective testing, there is a
  risk that material errors or irregularities, if
  they exist, may not be detected.

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Common Law Defenses

• Contributory Negligence Defense
• 1. If a plaintiff has contributed to his or her
  injury (loss), by his or her own negligence, the
  law considers him or her to be as responsible
  as the defendant for the injury.
• 2. In such a case, there is no basis for recovery
  because the negligence of one party nullifies
  the negligence of the other party.
• 3. Most states rely on comparative negligence
  whereby the plaintiff and defendant allocate
  damages to the extent each is at fault.

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Liability Under Statutory Laws

• Securities Act of 1933 Financial statements
  included in registration statement
• Plaintiff Any person purchasing securities
• Material false or misleading information in
  financial statements
• Does not have to prove reliance
• Does not have to show that the auditor was
  negligent
• Auditor
• Liable for fraud, gross negligence and negligence
• Burden of establishing that he/she was not
  negligent
• Must establish that plaintiffs loss at least in
  part due to other causes

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Liability Under Securities Laws

• Securities Act of 1934 Financial statements
  included in annual report associated with trading
  of securities
• Plaintiff
• False or misleading information in financial
  statements
• Must prove reliance
• Must show that the auditor was grossly negligent
  or willfully and knowingly made a false
  statement. Ordinary negligence not option.

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Liability Under Securities Laws

• Private Securities Litigation Reform Act of 1995
• 1. Proportionate Liability
• 2. Cap on Actual Damages
• 3. Responsibility to Report Illegal Acts
• 4. Other Changes Provided by the Reform Act

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Liability Under Sarbanes-Oxley

• Penalties Increased Substantially
• Failure to maintain workpapers for at least five
  years felony w/penalty up to 10 years
• Document destruction felony w/ penalty of up to
  20 years
• Securities fraud criminal penalties increased to
  25 years
• Fraud discovery statute of limitations extended
  to 2 years from discovery and 5 years from act

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Liability under RICO

• Racketeer Influenced and Corrupt Organization
  Act (RICO)
• Includes such crimes as mail fraud and fraud in
  the sale of secuirites
• Involvement gt 2/10 yrs fraudulent f/s is
  racketeering
• 3x damages and pay plaintiff legal fees
• Still possible if too close to client

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Best Practices

• Minimizing the Risk of Litigation
• Engagement letters
• Investigate clients
• Quality of service rather than growth
• Comply with GAAS and GAAP
• Recognize limitations of standards
• Quality Control
• Take care w/ troubled clients
• Be aware of audit risk alerts

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Liability for Accounting and Review Services

• Write-ups/compilations and reviews
• Do CPAs acting as accountants rather than
  auditors have any legal liability?
• Due professional care to clients
• May be liable for losses to 3rd parties
• To avoid problems
• Use engagement letter (1136 Tenants case)
• Follow due care and appropriate standards
• Be alert to and follow up on any unusual items