Legal Liability

Chapter 5

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5-1

 Learning Objective 1

Understand the litigious

environment in which
CPAs practice.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5-2

 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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5-3

 Changed Legal Environment

Despite efforts by the profession to

address the legal liability of CPAs…

Both the number of lawsuits and sizes

of awards to plaintiffs remain high.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5-4

 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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5-5

 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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5-6

 Business Failure, Audit
Failure, and Audit Risk
 Audit failure

It occurs when the auditor issues an

incorrect audit opinion because it
failed to comply with the requirements
of auditing standards.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5-7

 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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5-8

 Learning Objective 3

Use the primary legal concepts

and terms concerning accountants’
liability as a basis for studying
legal liability of auditors.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5-9

 Legal Concepts Affecting
Liability
Prudent person concept

Liability for the acts of others

Lack of privileged communication

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 10

 Legal Terms Affecting
CPAs’ Liability
Terms related to negligence and fraud:

 Ordinary negligence

 Gross negligence

 Constructive fraud

 Fraud

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 11

 Legal Terms Affecting
CPAs’ Liability
Terms related to contract law:

 Breach of contract

 Third-party beneficiary

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 12

 Legal Terms Affecting
CPAs’ Liability
Other terms:

 Common law

 Statutory law

 Joint and several liability

 Separate and proportionate liability

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 13

 Four Major Sources of
Auditors’ Legal Liability
 Liability to clients

 Liability to third parties

 Federal securities laws

 Criminal liability

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 14

 Learning Objective 4

Describe accountants’ liability to

clients and related defenses.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 15

 Liability to Clients

The most common source of lawsuits

against CPAs is from clients.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 16

 Auditor’s Defenses Against
Client Suits
 Lack of duty to perform

 Nonnegligent performance

 Contributory negligence

 Absence of causal connection

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 17

 Learning Objective 5

Describe accountants’ liability to

third parties under common law
and related defenses.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 18

 Liability to Third Parties Under
Common Law
 Ultramares doctrine

 Foreseen users

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 19

 Foreseen Users

 Credit alliance

 Restatement of torts

 Foreseeable user

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 20

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

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 21

 Learning Objective 6

Describe accountants’ civil liability

under the federal securities laws
and related defenses.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 22

 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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 23

 Securities Exchange
Act 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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 24

 Rule 10b-5 of the Securities
Exchange Act of 1934
Section 10 and rule 10b-5 are often called
the antifraud provisions of the 1934 act.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 25

 Auditor Defenses – 1934 Act

 Nonnegligent performance

 Lack of duty

 Absence of causal connection

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 26

 SEC Sanctions

The SEC has the power in certain circumstances

to sanction or suspend practitioners from
doing audits for SEC companies.

In recent years, the SEC has temporarily

suspended a number of individual CPAs
from doing any audits on SEC clients.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 27

 Foreign Corrupt
Practices 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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 28

 Sarbanes-Oxley Act of 2002

This act requires the CEO and CFO to

certify the annual and quarterly financial
statements filed with the SEC.

Management must report its assessment

of the effectiveness of internal control
over financial reporting.

The auditor must provide an opinion on

management’s assessment.
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 29
 Learning Objective 7

Specify what constitutes criminal

liability for accountants.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 30

 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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 31

 Sarbanes-Oxley Act

This act makes it a felony to destroy

or create documents to impede or
obstruct a federal investigation.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 32

 Learning Objective 8

Describe what the profession and

the individual CPA can do and
what is being done to reduce
the threat of litigation.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 33

 The Profession’s Response
to Legal Liability
 Research in auditing

 Standard and rule setting

 Set requirements to protect auditors

 Establish peer review requirements

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 34

 The Profession’s Response
to Legal Liability
 Oppose lawsuits

 Education of users

 Sanction members for improper conduct

and performance

 Lobby for changes in laws

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 35

 Protecting Individual CPAs
from Legal Liability
 Deal only with clients possessing integrity

 Hire qualified personnel

 Follow the standards of the profession

 Maintain independence

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 36

 Protecting Individual CPAs
from Legal Liability
 Understand the client’s business

 Perform quality audits

 Document the work properly

 Obtain an engagement and a representation letter

 Maintain confidential relations

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 37
 Protecting Individual CPAs
from Legal Liability
 Carry adequate insurance

 Seek legal counsel

 Choose a form of organization with limited liability

 Exercise professional skepticism

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 38

 End of Chapter 5

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 5 - 39