Chapter 5 — Legal Liability:

Changed Legal Environment:

[LO 1] Major factors that have contributed to the recent increase in the number of lawsuits against auditors & the size of awards to plaintiffs:

1) The growing awareness of the responsibilities of public accountants by users of FS’s.

2) An increased consciousness on the part of the SEC regarding its responsibility for protecting investors' interests.

3) The complexity of auditing & accounting functions caused by the increasing size of businesses, the globalization of business, & the complexities of business operations.

4) Large civil court judgments against CPA firms.

5) Litigious society: People sue auditors because they have an asymmetric law function [if a company does well, no one sues the auditor]. Deep pockets phenomenon: The only one left to sue when the company does poorly, is the auditor.

6) The willingness of CPA firms to settle legal problems out of court to avoid costly legal fees & adverse publicity, rather than pursuing resolution through the judicial process.

7) The difficulty judges & jurors have understanding & interpreting technical accounting & auditing matters.

Business Failure, Audit Failure & Audit Risk [LO 2]

Business Failure: Occurs when a business is unable to repay its lenders or meet expectations of its investors because of economic or business conditions, such as recession, poor management decisions, or unexpected competition in the industry.

Audit Failure: An auditor issues the incorrect opinion b/c they failed to comply with auditing standards—they didn’t do their job. Can be eliminated by doing our jobs correctly.

Audit Risk: The risk that, after conducting an adequate audit in which we have followed auditing standards, & yet we still fail to discover that the client's F/S’s are materially misstated. Here, we come up with the wrong opinion/conclusion. We can’t eliminate audit risk because we don’t look at everything. We look at things on a test basis. Also fraud can keep us from finding things.

Expectation Gap: The gap is the difference between what the public perceives auditors do and what auditors actually do.

Legal Concepts Affecting Liability:

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Prudent person concept: An agreement within the profession & the courts that the auditor is not a guarantor or insurer of FS’s. The auditor is expected only to conduct the audit in due care, & is not expected to be perfect.

Liability for the Acts of Others: CPAs are liable for themselves & everyone under their direct supervision.

Lack of Privileged Communication: CPA’s do NOT have the right to withhold info from the courts on the grounds that the info is privileged. Confidential discussions between the client & auditor cannot be withheld from the courts. Some states have statutes that permit privileged communication between the client & the auditor; however, even then, the intent at the time of the communication must have been for the communication to remain confidential. A CPA can refuse to testify in a state with privileged communication statutes; however that privilege does NOT extend to the federal courts.

Legal Terms Affecting CPAs’ Liability:

Terms Related to Negligence & Fraud:

1) Ordinary Negligence: Ordinary negligence is the absence of reasonable care that can be expected of a person in a set of circumstances. For auditors, it is in terms of what other competent auditors would have done in the same situation.

2) Gross Negligence / Constructive Fraud: Gross negligence is the lack of even slight care that can be expected of a person in a set of circumstances. Gross negligence is also termed reckless behavior. Constructive fraud is the existence of extreme or unusual negligence even though there was no intent to deceive [scienter] or to do harm. Constructive fraud is also termed reckless. Recklessness in the case of an audit is present if the auditor knew an adequate audit was not done but still issued an opinion, even though there was no intention of deceiving statement users.

3) Fraud: Occurs when a misstatement is made & there is both knowledge of its falsity & the intent to deceive.

Terms Related to Contract Law:

1) Breach of Contract: Failure of one or both parties in a contract to fulfill the requirements of the contract. An example is the failure of a CPA firm to deliver a tax return on the agreed-upon date. Parties who have a relationship that is established by a contract are said to have privity of contract.

2) Third Party Beneficiary: A 3rd party who does not have privity of contract but is known to the contracting parties & is intended to have certain rights & benefits under the contract. A common example is a bank that has a large loan outstanding at the B/S date & requires an audit as part of its loan agreement.

Other Terms—Sources of Auditor Liability:

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1) Common Law: Laws that have been developed through court decisions rather than through government statutes. Uses legal precedent to identify fault & responsibility.Can be sued by:

Clients: [Sued for failure to discover fraud.] Non-shareholder third parties : [Someone like a bank or creditor can

sue you for not finding a material mistake or fraud in your audit.]

Under Common Law, you can bring an action under:

Breach of contract: You didn’t fulfill the stuff under the contract. A contract has to exist between the auditor & the client, either verbal or written.

Tort liability: This is more common than breach of contract b/c the amounts you can recover as a plaintiff is larger. Obligation based on failure to exercise appropriate level of professional care, whether it be Ordinary negligence, Gross negligence, or Fraud.

2) Statutory Law: Based on violations of written statutes, like The Securities Acts of 1933 & 1934 & the SOX Act of 2002.Can be sued by: Shareholders

3) Joint & Several Liability: The assessment against a defendant of the full loss suffered by the plaintiff, regardless of the extent to which other parties shared in the wrongdoing. For example, if management intentionally misstates the FS’s, an auditor can be assessed the entire loss to SHer’s if the company is bankrupt & management is unable to pay.

4) Separate & Proportionate Liability: The assessment against a defendant of that portion of the damage caused by the defendant's negligence. For example, if the courts determine that an auditor’s negligence in conducting an audit was the cause of 30% of a loss to a defendant, only 30% of the aggregate damage will be assessed to the CPA firm.

Common Law Negligence & Fraud:

Common Law Negligence: The elements that have to be proven by a plaintiff in order to be brought into action:

1) Duty: Prove that a duty of care existed.2) Breach of that duty.3) There has to be proximate cause—there was some type of breach.4) Injury: You have to have suffered something due to the proximate cause.

Common Law Fraud (Constructive Fraud):

1) There has to be a material misrepresentation or omission of a material fact. They have failed to disclose that a material fact existed.

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2) Reckless disregard for the truth: You just didn’t care.3) There has to be reliance.4) There has to be an injury as a result of relying on them.

Fraud:

1) There has to be a material misrepresentation or omission of a material fact. I failed to disclose that this material fact existed.

2) You INTENTIONALLY deceived people.3) There has to be reliance.4) There has to be an injury as a result of relying on them.

Sources of Legal Liability:

Source of Liability Example of Potential ClaimLiability to Clients Client sues auditor for not discovering a

material fraud during the audit.Liability to 3rd Parties Under Common Law Bank sues auditor for not discovering that a

borrower’s FS’s are materially misstated.Civil Liability Under Federal Law Securities Combined group of SHer’s sues auditor for

not discovering materially misstated FS’s.Criminal Liability Federal Gov’t prosecutes auditor for

knowingly issuing an incorrect audit report.

Common Law Liability—Clients:

The most common source of lawsuits against CPAs is from clients.

Breach of contract: Failure to perform the audit in accordance with engagement letter. An Engagement letter is required under the GAAS standards. It is a document that formalizes the document regarding the services you’re going to perform, fees, etc. This is to protect you from a lawsuit.

What client must prove depends on action brought

Proof & Defenses:

Liable for Ordinary Negligence, Gross Negligence, Constructive Fraud & Fraud

Defenses

Lack of Duty: There’s no express [written] or implied contract. There’s no reason for us to do something that they’re saying we didn’t do.

Non-negligent Performance: You complied with GAAS standards.

Causation: Whatever we did, did not cause the actual injury.

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Contributory negligence (clients were partially responsible for the loss)

Approaches Courts Take to Assign 3 rd Party Liability for Ordinary Negligence Under Common Law:

Interpretation: Approaches by Courts & Example Cases:

Definition of 3 rd Party User:

Example:

Most NARROW

VERY IMPORTANT—Ultramares Corp. vs. Touche: Ordinary negligence is

insufficient for liability because of lack of privity. 3rd parties cannot bring

ordinary negligence suits against an auditor.

Credit Alliance vs. Arthur Andersen: Liable to primary beneficiaries [like

banks] for Ordinary Negligence.

Auditor knows & intends that user will

use audit report.

Auditor is aware of bank loan agreement that requires audited

FS’s.

Somewhere in between

Rusch Factors vs. Levin [Restatement of Torts]: Liable to limited &

identifiable foreseeable third parties [like shareholders] for Ordinary

Negligence

Reasonable limited & identifiable group of

users who have relied on the auditor’s work.

Bank or trade creditors when the auditor is

aware that the client has provided audited

FS’s to such users.

Most BROAD

Rosenblum vs. Adler:Liable to an unlimited class of all

foreseeable third parties for Ordinary Negligence.

An unlimited class of users that the auditor

should have reasonably been able

to foresee as being likely users of the FS’s.

A trade creditor that has NOT previously conducted business with the client. That

client has not provided FS’s to trade creditors

in the past.

Proof & Defenses Against Third Parties:

For Negligence (Fraud) third parties must show: Same as clients

Defenses:

Lack of Duty

Nonnegligent Performance

Causation

Contributory negligence: Not a viable defense against a 3rd party. They aren’t in the position to cause material misstatements in the FS’s.

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Statutory Negligence & Fraud:

Clients—Negligence:DutyBreach of DutyProximate causeInjury

Clients—Gross Negligence or Constructive Fraud [FRAUD]:MaterialRecklessness [Intent]RelianceInjury

3rd Parties: You cannot argue contributory negligence as a defense.

Securities Act of 1933:

Securities Act of 1934:

Sarbanes-Oxley Act of 2002:

Foreign Corrupt Practices Act of 1977: If there’s something that’s illegal in the US, you cannot go to another country & do it.

Securities Act of 1933:

Regulates initial issuance of securities by registrants to investing public

Required to file registration statement with SEC that includes F/S

Under Section 11 of the Securities Act of 1933 plaintiff must prove that:

1. There is a material misrepresentation or omission in the registration statement.

2. That they suffered a loss [purchased securities].

This is the only case where the burden of proof rests on the defendant. The rest rests on the plaintiff. This greatly expands the auditor’s liability.

Liability Under 1933 Act:

Auditors responsible for material misrepresentations or omissions

Defenses Due diligence (auditors performed a GAAS audit) Causation (loss resulted from other factors)

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Escott v. BarChris Construction Corp. Auditors held liable for failure to conduct “reasonable investigation”

(Ordinary Negligence)

Securities Exchange Act of 1934: Regulates daily trading of securities & requires periodic FS’s & information to be filed with the SEC

These provisions prohibit any fraudulent activity associated with the sale or purchase of securities. This includes constructive fraud, as well.

To bring suit, investors must show: [Rule 10-(b) & 10b-5 of the Securities Act of 1934]:

1. Material

2. Recklessness [or intent for fraud]

3. Reliance

4. Injury

Liability Under 1934 Act:

Auditors liable for Gross Negligence, Constructive Fraud, & Fraud

Defenses

Auditors acted in good faith

Auditors were not aware of material misstatements

Ernst & Ernst v. Hochfelder:

Relieved auditors from liability for Ordinary Negligence

Did provide liability for “reckless behavior” in the absence of scienter

Summary of Auditor Liability:

Alleged Auditor Action

Liability to

Client?

3 rd Parties Under Common Law?

Liability to 3 rd

Parties under 1933

Securities Act?

Liability to 3 rd Parties

under 1934 Securities

Act?

Breach of Contract

Yes n/a n/a n/a

Negligence YesPrimary Beneficiary: Yes

Other 3rd Parties: Depends n/a No

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on the Jurisdiction

Gross Negligence / Constructive

Fraud

Yes Yes n/a Yes—Likely

Fraud Yes Yes n/a Yes—Likely

Auditor Defenses Against Suits by Client, 3 rd Parties Under Common Law, & Under the 1933 & 1934 Securities Acts:

Available Defenses Client Suits

3 rd Party Common Law

1933 Securities

Act

1934 Securities

ActLack of Duty to Perform Service

Non-Negligent Performance [Audit in Accordance with

Standards]

Contributory Negligence by Client or 3rd Party

Absence of Causal Connection

[No Reliance on FS’s]

Developments in Auditor Liability:

Sarbanes-Oxley

Extends statute of limitations for bringing suit under the Securities Exchange Act

Increased penalties for mail fraud & wire fraud

Destruction, alteration, & falsification of records

Increased records retention requirements

Higher potential liability in civil cases

If you’re the prepared or the auditor of the FS’s [you’re aware that there are material misstatements, you are criminally liable for your violation.]

Criminal Liability

State Law

Federal Law8

Professions Response to Limiting Liability:

Standards & Rules Fighting Lawsuits Education of Users Sanctions for bad CPAs Lobby

Limiting Liability for Individual CPAs:

Client Acceptance & Retention Policies Independence Knowledge of Entity & Environment Quality Work Document, Document, Document Professional Skepticism

POSSIBLE EXAM QUESTIONS:

KPRV LLP, A CPA firm, provided audit services for AP&P in which they relied on the work of Toiled LLP, another CPA firm, regarding the internal controls of a 3rd party payment processor PayRite. A material fraud was later uncovered which was directly related to PayRite’s internal controls. Which of the following is/are true?

a) KPRV is liable to AP&P for breach of contract for failing to uncover the fraud. WE DON’T KNOW IF THEY ARE LIABLE—THEY MIGHT BE. THIS IS FALSE B/C WE DON’T KNOW.

b) Toiled may be liable for losses caused by their failure to uncover the fraud. c) KPRV is not liable for any loss caused by the fraud because they did not audit

PayRite. THEY ARE LIABLE B/C THEY DIRECTLY SUPERVISED THEM.d) All of the above.

Match the description with the legal term:

Breach of Contract: Failure of one or both parties to fulfill the requirements of a contract.

Gross Negligence or constructive Fraud: Recklessness.

Privity: Parties who share a contractual relationship.

Statutory Law: Laws passed by Congress or governmental units.

Joint Several Liability: The assessment of a full loss suffered by a plaintiff irrespective of shared wrongdoing.

Fraud: Knowledge of a material misstatement with the intent to deceive.

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Terms:

Separate & proportionate liability Common Law Fraud Negligence

Statutory Law Privity Scienter None of the above

The distinction between constructive fraud & fraud is that fraud has a greater degree of recklessness. THE DIFFERENCE IS INTENT.

a) TRUE b) FALSE

At a confidential meeting, an audit client informed a CPA about a client’s illegal insider-trading actions. A year later, the CPA was subpoenaed to appear in a federal court to testify in a criminal trial against the client. The CPA was asked to testify to the meeting between the CPA & the client. After receiving immunity, the CPA should do which of the following? IT’S FEDERAL COURT, SO A STATUTE WOULN’T APPLY.

a) Take the 5th amendment & not discuss the meetingb) Site the privileged communication aspect of being a CPAc) Discuss the entire conversation including the illegal actsd) Discuss only the items that have a direct connection to those items the CPA worked

on for the client in the past

The concept that the auditor is expected to conduct the audit with due care & is not expected to be perfect is referred to as:

a) Promissory Estoppelb) Statute of Fraudsc) Novation Principled) Prudent Person Concepte) None of the above

When CPAs fail in their duty to carry out their contracts for services, liability to clients may be based on: Breach of contract Strict Liability

Yes No[Strict liability generally has to do with statutory contract.]

Which of the following statements best describes whether a CPA has met the required standard of care in conducting the audit of a client’s FS’s?

a) The client’s expectations with regard to the accuracy of the audited FS’sb) The accuracy of the FS’s & whether the statements conform to GAAP. CAN THE FS’S

BE ACCURATE & THE LACK OF CARE NOT BE MET? YES. SO, THIS IS FALSE.c) Whether the CPA conducted the audit with the same skill & care expected of

an ordinarily prudent CPA under the circumstances [prudent person concept]d) Whether the audit was conducted to investigate & discover all acts of fraud. FALSE

BECAUSE AN AUDIT FINDS MATERIAL FRAUD, NOT ALL FRAUD.

A client suing a CPA for negligence must prove each of the following factors except:

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a) Breach of duty of careb) Proximate Causec) Relianced) Injurye) Dutyf) All of the above are required

Which of the following elements, if present, would support a finding of constructive fraud?a) Scienterb) Gross negligence in applying GAASc) Ordinary negligence in applying GAAPd) Identified third partiese) Only a & b

Fill-in-the-blank: Privity is not a viable defense in a suit against the CPA by the client.

If a stockholder sues a CPA for common law fraud based on false statements contained in the FS’s audited by the CPA, which of the following, if present, would be the CPA’s best defense? THE HARDEST THING TO PROVE IN A FRAUD CASE FOR AN AUDITOR, IS THE INTENT TO DECEIVE.

a) The stockholder lacks privity to sue. b) The false statements are immaterial. c) The CPA did not financially benefit from the alleged fraud. Not a considerationd) The contributory negligence of the client. This isn’t a viable defense.e) Only a & b

Hark, CPA, failed to follow GAAS in auditing Long Corp.’s FS’s. Long’s management had told Hark that the audited statements would be submitted to several banks to obtain financing. Relying on the statements, Third bank gave Long a loan. Long defaulted on the loan. In a jurisdiction applying the Ultramares decision, if Third sues Hark, Hark will:

a) Win, because there was no privity of contract between Hark & Thirdb) Lose because Hark knew that banks would be relying on the FS’sc) Win, because Third was contributorily negligent in granting the loand) Lose, because Hark was negligent in performing the audit

Fill-in-the-blank: If a CPA recklessly departs from standards of due care when conducting an audit, the CPA will be liable to 3rd parties who are unknown to the CPA based on Constructive Fraud or Gross Negligence.

Under common law, which of the following statements most accurately reflects the liability of a CPA who fraudulently gives an opinion on an audit client’s FS’s?

a) The CPA is liable only to third parties in privity of contract with the CPA.b) The CPA is liable only to foreseeable users of the FS’s.c) The CPA probably is liable to any person who suffered a loss as a result of the

fraud.d) The CPA probably is liable to the client even if the client was aware of the fraud &

did not rely on the opinion

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Which of the following is the best defense a CPA firm can assert in a suit for common law fraud based on its unqualified opinion on materially false FS’s?

a) Contributory negligence on the part of the clientb) A disclaimer contained in the engagement letterc) Lack of privityd) Lack of scientere) All of the above

Short answer: How does the Securities Act of 1933, which imposes civil liability on auditors for misrepresentations or omissions of material facts in a registration statement, expand auditors’ liability to purchasers of securities beyond that of common law?

1) Privity is not important at all—it’s not an element of proof for the Securities act of 1933.

2) Reliance is NOT neccessary.3) The burden of proof rests on the defendant.

To be successful in a civil action under Section 11 of the Securities Act of 1933 concerning liability for a misleading registration statement, the plaintiff must prove the:

Defendant’s intent to deceive Plaintiff’s reliance on the registration statement

No No

Under the provisions of Section 10(b) & Rule 10b-5 of the Securities exchange Act of 1934, which of these activities must be proven by a stock purchaser in a suit against a CPA?

I. Intentional conduct by the CPA designed to deceive investorsII. Negligence by the CPA

III. Materiality

a) I onlyb) II only

c) III onlyd) Both I & II

e) Both I & IIIf) All of the above

Ocean & Associates, CPAs, audited the FS’s of Drain Corporation. As a result of Ocean’s negligence in conducting the audit, the FS’s included material misstatements. Ocean was unaware of this fact. The FS’s & Ocean’s unqualified opinion were included in a registration statement & prospectus for an original public offering of stock by Drain. Sharp purchased shares in the offering. Sharp received a copy of the prospectus prior to the purchase but did not read it. The shares declined in value as a result of the misstatements in Drain’s FS’s becoming known. Under which of the following Acts is Sharp most likely to prevail in a lawsuit against Ocean?

Securities Act of 1934 Section 10(b) Securities Act of 1933 Section 11No Yes

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Fill-in-the-blank: The most common source of lawsuits against CPAs is from CLIENTS.

Name the four sources of legal liability for auditors:

1.Clients

2.3rd parties under common law

3. Civil Liability under Securities Act

4. Criminal Liability

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