Legal Liability

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Legal Liability

• Chapter 5

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Learning Objective 1
Understand the litigious environment in
which CPAs practice.
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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.
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Learning Objective 2
Explain why the failure of financial statement
users to differentiate among business failure,
audit failure, and audit risk has resulted in
lawsuits.
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Business Failure, AuditFailure, and Audit Risk
Audit Failure
Business Failure
Audit Risk
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Business Failure, AuditFailure, 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, AuditFailure, 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, AuditFailure, 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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Learning Objective 3
Use the primary legal concepts and the terms
concerning accountants liability as a basis for
studying legal liability of auditors.
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Legal ConceptsAffecting Liability
Prudent person concept
Liability for the acts of others
Lack of privileged communication
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Major Sources ofAuditors Legal Liability
Federal securities laws
Client
Third party
Criminal liability
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Learning Objective 4
Describe accountants liability to clients and
related defenses.
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Liability to Clients
The most common source of lawsuits against
CPAs is from clients.
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Legal Terms AffectingCPAs Liability
Terms related to negligence and fraud
Ordinary negligence
Constructive fraud
Gross negligence
Fraud
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Legal Terms AffectingCPAs Liability
Terms related to contract law
Breach of contract
Third party beneficiary
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Legal Terms AffectingCPAs Liability
Other terms
Common law
Joint and several liability
Statutory law
Separate and proportionate liability
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Auditors DefensesAgainst Client Suits
Lack of duty
Nonnegligent performance
Contributory negligence
Absence of causal connection
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Learning Objective 5
Describe accountants liability to third parties
under common law and related defenses.
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Liability to Third PartiesUnder Common Law
Ultramares doctrine
Foreseen users
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Foreseen Users
Credit alliance
Restatement of torts
Foreseeable users
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Learning Objective 6
Describe accountants civil liability under the
federal securities laws and related defenses.
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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 ExchangeAct 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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Auditor Defenses 1934 Act
Nonnegligent performance
Lack of duty
Absence of casual connection
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SEC Sanctions
The SEC has the power in certain circumstances to
sanction or suspend practitioners from
doing audits for SEC companies.
Rule 2 (e) of the SECs Rules of Practice says
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SEC Sanctions
The commission may deny, the privilege
of appearing or practicing before it in any way
to any person who is found by the commission (1)
not to possess the requisite qualifications
to represent others, or (2) to be lacking in
character or integrity or to have engaged in
unethical or improper professional conduct.
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Racketeer Influenced andCorrupt Organization Act
This act allows an injured party to seek
treble (triple) damages and recovery of legal
fees in cases where it can be demonstrated that
the defendant was engaged in a pattern of
racketeering activity.
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Foreign CorruptPractices 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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Learning Objective 7
Specify what constitutes criminal liability for
accountants.
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Criminal Liability
CPAs can be held liable under criminal liability
for accountants.
CPAs can be found guilty for criminal action
under both federal and state laws.
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Learning Objective 8
Describe what the profession and the individual
CPA can do and what is being done to reduce the
threat of litigation.
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The Professions Responseto Legal Liability
Research in auditing
Standard and rule setting
Set requirements to protect auditors
Establish peer review requirements
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The Professions Responseto Legal Liability
Oppose law suits
Education of users
Sanction members for improper conduct and
performance
Lobby for changes in laws
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Protecting Individual CPAsfrom Legal Liability
Example
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
Example
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
Example
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