Chapter 17

Professional Liability

What is the public accountant’s responsibility?

The responsibility of public accountants to safeguard the public's interest has increased as the number of investors has increased, as the relationship between corporate managers and stockholders has become more impersonal, and as government increasingly relies on accounting information.

Discuss Auditor Liability

Auditor liability to their clients and third party user groups is derived from the following laws:

Contract law - Liability is based on breach of contract. The contract is usually between the public accounting firm and the client for performance of a professional service, such as an audit performed according to GAAS

Common law - Liability concepts developed through court decisions and based on auditor negligence, gross negligence or fraud

Statutory law - Liability based on state statutes or Federal securities laws. The most important of these to the auditing profession are the Securities Act of 1993 and the Securities and Exchange Act of 1934

Factors leading to increased litigation against auditors:

User awareness of the possibilities and rewards of litigation

Joint and several liability statutes that permit a plaintiff to collect the full amount of the settlement from any defendant, even those only partially responsible for the loss (i.e. deep pockets theory)

Increased audit complexity caused by computerized systems, new types of transactions and operations, more complicated accounting standards, more international business

More demanding audit standards for detection of errors and fraud

Pressures to reduce audit time and improve audit efficiency

Misunderstanding by users that an unqualified opinion is an insurance policy against misstatements (expectations gap)

Contingent-fee-based compensation for law firms, especially in class action lawsuits

Class action lawsuits which allow law firms to combine defendants into one legal action

Punitive damages

Factors leading to increased litigation against auditors:

Discuss Potential Liability

To understand the potential liability, the auditor must understand:

Concepts of breach of contract and tortParties who may bring suitLegal precedence and statutes that

may be as a standard against which auditor performance may be evaluated

Auditor defenses

Discuss Causes of Legal Action

Causes of legal actionBreach of contractNegligence: failure to exercise a reasonable

level of care that causes damage to anotherGross negligence: failure to exercise even a

minimal level of care (reckless disregard) but without intent to harm or damage anyone

Fraud: intentional concealment or misrepresentation of material facts that cause damages to those deceived (scienter)

Comment on Civil Liability

Auditors may be held civilly liable by clients and third parties who use audited financial statements. This civil liability is based

Contract lawCommon lawStatute

Define Breach of Contract

Breach of Contract occurs when auditor fails to perform a contractual duty

Breach actions includefailing to complete the engagement within

the agreed-upon timewithdrawing from the engagement without

sufficient justificationviolating client confidentialityfailing to provide professional quality work

Parties to the contract can file suit

Court remedies to a breach includeorder auditors to fulfill the contract (specific

performance)issue injunction to prohibit the auditor from

continuing the breachorder auditor to pay compensatory (actual)

damages

Auditor defenses includeauditor did not breach the contractclient was contributory negligentclient losses were not caused by the breach

Define Breach of Contract

Review Common Law Liability

To prevail, a plaintiff must generally prove four things:

Existence and amount of damagesFinancial statements were materially

misleadingPlaintiff relied on the statements and as a

result, suffered damages (causality)Auditor misconduct - the level of misconduct

that must be proved depends on who the plaintiff is, and the jurisdiction in which the suit is filed

Who are the plaintiffs under common law?

The courts have ruled auditors can be held liable by clients and third parties reasonably expected to rely on audited statements.

Generally, courts have classified third party users into 3 groups:

Identified users are specific individual users who the auditor knows will use the statements to make a specific decision

Foreseen users while not individually known, belong to a specific group of users whom the auditor knows will use the statements

Foreseeable users belong to a general class of users whose members may or may not use the financial statements

Level of Auditor Misconduct

The level of auditor misconduct a third party plaintiff must prove depends on which group the plaintiff belongs to and the jurisdiction in which the case is tried:

Restatement Citizens State User Credit Alliance of Torts Bank/Rosenblum Identified Negligence Negligence Negligence Foreseen Gross negligence Negligence Negligence Foreseeable Gross negligence Gross negligence Negligence

Auditor Liability Auditor liability under Federal statute was established

by the Securities Act of 1933, and the Securities Exchange Act of 1934, and most recently modified by Sarbanes/Oxley Act of 2002

Auditors found to be unqualified, unethical, or in willful violation can be disciplined by the SEC. Sanctions include

Temporarily or permanently revoking the firm's registration with the Public Company Accounting Oversight Board

Civil penalties of up to $750,000 per violation Require continuing education of firm personnelInvestors in public companies may sue auditors under

common law, statutory law, or both.

Securities Act of 1933Requires companies to file S-1 Registration statement with

SEC before they issue new securities to the publicAudited financial statements are included in the Registration

statement (and prospectus)Because it covers the issue of new securities, the Act requires

a very high standard of care. Plaintiffs need prove only financial statements were materially misleading plaintiff suffered damages plaintiffs do not need to prove reliance on the statements or

auditor misconductAuditor defenses include proving financial statements were not materially misstated proving plaintiff damages were not caused by the

misleading financial statements proving auditor acted with due professional care

Securities Exchange Act of 1934

The Securities Act of 1934 regulates trading of securities after their initial issuance (secondary market) and the filing of periodic reports with the SEC. These reports include annual reports and 10-Ks, quarterly financial reports and 10-Qs, and 8-Ks.

The 1934 Act holds auditors to a much lower standard of care than the 1933 Act. Under the 1934 Act, plaintiffs must prove

Existence and amount of damages Financial statements were materially misleading Plaintiff relied on the statements and as a result,

suffered damages (causality)

Auditor misconduct - the level of misconduct that must be proved is the subject of much debate. In Ernst & Ernst v. Hochfelder, the U.S. Supreme Court held thatCongress had intended that the plaintiff prove the

auditor acted with scienterHowever, the Court reserved judgment as to

whether gross negligence would be sufficient to impose liability

In several cases following Hochfelder, judges and juries have used a standard of "reckless conduct" to hold auditors liable

Securities Exchange Act of 1934

Criminal Liability to Third Parties

Both the 1933 and 1934 Acts provide for criminal actions against auditors - guilty persons can be fined or imprisoned for up to five years.

Key cases regarding auditor criminal liability

Continental Vending (U.S. v Simon)Equity FundingU.S. v Duncan

Policies to Help Assure Auditor Independence

Periodic rotation of audit engagement partner Prohibit certain non-audit services for public

company audit clients Restrict other non-audit services for audit clients Firm policies including training programs that

emphasize auditor independence and requiring each auditor to sign a statement of independence

External quality reviews: Sarbanes/Oxley Act requires the PCAOB perform quality reviews of registered public accounting firms

Internal reviews: concurring partner reviews and interoffice reviews

Approaches to Mitigate Liability Exposure (Defensive Auditing)

Defensive auditing means taking special actions to avoid lawsuits. In addition to establishing good quality controls and quality/peer reviews, firms can take other actions

Use engagement letters for all financial statement and consulting engagements

Client screening Do not accept engagements for which the firm is not

qualified Maintain complete and accurate audit documentation Limited liability partnerships Carry sufficient professional liability insurance Tort reform