CHAPTER 3 (Continued)

1
CHAPTER 3(Continued)
2
litigation explosion!
- in 1991, the Big 6 accounting firms incurred
costs of 477 million in defense and settlement
of lawsuits - currently, the professions total
liability exposure is an estimated 30 billion
3
Who might sue an auditor and why?
- a client - a third party - a combined group of
stockholders - The federal government may
prosecute an auditor for knowingly issuing an
incorrect audit report (criminal liability)
4
Three legal concepts apply to auditor liability
1. the prudent person concept. 2. liability for
the acts of others. 3. lack of privileged
communication. In general, auditors do not have
the right under common law to withhold
information from the courts on the grounds that
the in- formation is privileged.
5
Several legal terms apply to auditor liability
Related to negligence and fraud - ordinary
negligence - absence of rea- sonable care
6
Several legal terms apply to auditor liability
Related to negligence and fraud - ordinary
negligence - gross negligence - absence of even
slight care, tantamount to reckless be- havior
7
Several legal terms apply to auditor liability
Related to negligence and fraud - ordinary
negligence - gross negligence - constructive
fraud - existence of ex- treme or unusual
negligence even though there was no intent to
deceive or do harm
8
Several legal terms apply to auditor liability
Related to negligence and fraud - ordinary
negligence - gross negligence - constructive
fraud - fraud - a misstatement is made and
there is both the knowledge of its falsi- ty
and the intent to deceive
9
Several legal terms apply to auditor liability
Related to contract law - breach of contract -
failure of one or both parties in a contract
to fulfill the requirements of the contract
Parties who have a relationship that is
established by a contract are said to have
privity of contract.
10
Several legal terms apply to auditor liability
Related to contract law - breach of contract -
third-party beneficiary - a third party who
does not have privity of contract but is known
to the contracting parties and is intended to
have certain rights and benefits under the
contract
11
Several legal terms apply to auditor liability
Related to common and statutory law - common law
- laws that have been de- veloped through court
decisions rather than through government
statutes
common law
12
Several legal terms apply to auditor liability
Related to common and statutory law - common law
- statutory law - laws that have been passed
by the U.S. Congress and other governmental
units
13
Auditors Defenses Against Client Suits
14
Auditors Defenses Against Client Suits
The auditor claims that there was no im- plied or
expressed contract. A common way for an auditor
to demon- strate a lack of duty to perform is by
use of an engagement letter.
15
Auditors Defenses Against Client Suits
The auditor claims that the audit was performed
in accordance with GAAS. Even if there were
undiscovered errors or irregularities, the
auditor is not re- sponsible if the audit was
properly conducted.
16
Auditors Defenses Against Client Suits
The auditor claims that if the client
had performed certain obligations, the loss would
not have occurred.
17
Auditors Defenses Against Client Suits
The auditor claims that there is a lack of a
close causal connection between the auditors
breach of the due care stan- dard and the damages
suffered by the client.
18
Liability to Third Parties under Common Law
An auditor may be liable to third parties if
a loss was incurred by the claimant due to
reliance on misleading financial statements.
Financial Statements
19
Liability to Third Parties under Common Law
An auditor may be liable to third parties if a
loss was incurred by the claimant due to
reliance on misleading financial statements. Thir
d parties include - actual stockholders -
potential stockholders - creditors
- employees - customers - vendors
20
Liability to Third Parties under Common Law
Auditor liability to third parties was
es- tablished, in part, by a 1931 court
deci- sion, Ultramares v. Touche. The key aspect
of the resulting Ultra- mares Doctrine is that
ordinary negli- gence is insufficient for
liability to third parties, because of the lack
of privity of contract between the third party
and the auditor, unless the third party is a
prima- ry beneficiary.
21
Liability to Third Parties under Common Law
The Ultramares Doctrine also specifies that if
there has been fraud or gross negligence, the
auditor could be held liable to more general
third parties. In recent years, the courts have
broadened the Ultramares Doctrine to allow
recovery by third party foreseen users.
22
Liability to Third Parties under Common Law
The Ultramares Doctrine also specifies that if
there has been fraud or gross negligence, the
auditor could be held liable to more general
third parties. In recent years, the courts have
broadened the Ultramares Doctrine to allow
recovery by third party foreseen users.
23
Liability to Third Parties under Common Law
In recent years, the courts have broadened the
Ultramares Doctrine to allow recovery by third
party foreseen users. An even broader
interpretation of the rights of third-party
beneficiaries is to use the concept of
foreseeable users.
?
24
Liability to Third Parties under Common Law
In recent years, the courts have broadened the
Ultramares Doctrine to allow recovery by third
party foreseen users. An even broader
interpretation of the rights of third-party
beneficiaries is to use the concept of
foreseeable users.
users that the auditor should have
reasonably been able to foresee as being likely
users of financial statements
25
x
Three of the four defenses available to auditors
in suits by clients are also available in
third-party suits.
26
x
Three of the four defenses available to auditors
in suits by clients are also available for suits
under the
1934 act.
27
The SEC has the power to sanction or suspend
practitioners from auditing SEC companies.
28
RICO
The Racketeer Influenced and Corrupt
Orga- nization (RICO) Act allows an individual to
seek damages when it can be demonstrated that
the defendant was engaged in a pattern of
racketeering activity. In a 1993 U.S. Supreme
Court decision, the court ruled that outside
professionals such as accountants who do not help
run corrupt businesses can not be sued under the
provi- sions of RICO.
29
Foreign Corrupt Practices Act
The Foreign Corrupt Practices Act - forbids
offering a bribe to an official of a for- eign
country for the purpose of exerting in- fluence
and obtaining or retaining business - requires
SEC companies to maintain rea- sonably complete
and accurate records and an adequate system of
internal control
How does this affect auditors?
30
Foreign Corrupt Practices Act
The Foreign Corrupt Practices Act - forbids
offering a bribe to an official of a for- eign
country for the purpose of exerting in- fluence
and obtaining or retaining business - requires
SEC companies to maintain rea- sonably complete
and accurate records and an adequate system of
internal control
The act may affect auditors through their
responsibility to review and evaluate systems
of internal control as a part of an audit.
31
What can the auditing profession do to reduce
auditors exposure to lawsuits?
- encourage auditing research regarding
litigation and improvements in auditing
practice - establish standards and rules that
meet the changing needs of auditing - establish
standards that protect auditors - establish
peer review requirements - oppose unwarranted
lawsuits - educate financial statement users
about auditing and the auditors opinion -
sanction auditors for improper conduct - lobby
for changes in laws
32
What can individual CPAs do to reduce their
exposure to lawsuits?
- deal only with clients possessing integrity -
hire, train, and supervise qualified personnel -
follow the standards of the profession - maintain
independence - understand the clients business -
perform quality audits - document the work
properly - obtain an engagement letter and a
representation letter - maintain confidential
relations - carry adequate insurance - seek legal
counsel - choose a form of organization with
limited liability