Audited Financial Statements: The Accountant's

Pe-::.pon·:, it. iIi t:;.'. L i ·:<.b i 1 ih·.

and P~ecautions Against Li tigation

An Hono~s Thesis (ID 499)

B'Y'

,Jud i th Ann C:u 1/'

Th e·::. i·::. D i r' e e tor'

Ball State Unive~si ty

t"'lune i e. I nd i B.nB.

t·'j.:<.:;.' 1 '7'B4

G~aduation Date: May 19B4

{ 'J c; '{ :'1r,'[ OUTLlr···lE

I . In t r' o:)du c t i on

I I .

A. Bri@f HistorY B. Th@ Past 20 Years - Impact on Auditing

1. I ncr·@.:"·:::.e in neql i gene@ 2. Inc r' 12·:" se i n 1 i .:O.b i 1 i t y'

Gener·.:O.l A. The

1 •

2 B The

1

C. The 1

Pe·:·c.on·:.ibi 1 it:;." of Audi tor-=:. View of the Profession C:l ients .:0.. GAAS t,. eon fide n t i .:0.1 it .... · c. m i -=:·eoncep t ion':. clf eli en t·:. d. management responsibi 1 ty Other users of financial statements Profession's Pespons@ to the View of Others The Cohen Commission .:0 .. eonelu·:.jc)ns b. recommendations View of the Government The Securi ties and Exchange Commission a. concerned wi th disclosure b. promulgates standards and rules

I I I. Le q.:o.1 L i .:O.b i 1 i t /. of Au d i tor":-A. Important Concepts

1. t···le 9 1 i 912 n c e 2. Fr·a.ud 3. Burden of Proof

B. Common L':O.I. ... ,1

1. Cl ient .:0. . .:o.U d i tor' .. ' s 1 i .:o.b i 1 it· ... · b. c i I.} i 1 ·:o.C t i on e. burden of proof d. def@n·:-e·:.

2. Third Parties a. classes of third parties b. .:o.U d i tor' .... :. 1 i .:o.b i 1 i t y'

c . c i I .... i 1 ·:o.C t i on d. burden of proof e . de fen ·:·e .:.

C: . :3 t.:o. t u tor' 'F" L .:0. 1 .... .1

1. :::;12 C!J r' i tie .:. Ac t of 1 -;:-::::3 a. requirements of the act b. a.udi tor·· .. ·:. 1 i .:O.bi 1 i t/· c. burden of proof d. Escott v. BarChris Construction Corp.

2. Securities and Exchange Act of 1934 a. requirements of the act b. section 10(b)

1::' ·:o.u d i tor' .. ' .:. 1 i .:O.b i 1 it>"

2) burden of proof 3) Hochfe1der v. Ernst & Ernst

c . ':;e c t i on 1:3 1::' d.udi tor· .. ·:. 1 i .:'.bi 1 it::, .. 2) burden of proof

3. Other' Feder·.:'.l .3.nd :::;t.3.te Std.tute·:. a. Federal False Statements Act b. Federal Mai 1 Fraud Act c. Federal Conspiracy Statute d. :3 t .:.. t e L.:.,I ..... I·:;

D. Cr' imi n.:'.1 Li .:'.bi 1 it::. 1. De':, c r· i p t ion .~< Com p .:.. r' i son t 0 C i I.} ilL i.:.. b iIi t ~,.,

2. United States v. Simon

IV. Precautions Against Litigation A. Accounting Standards

1. Vn 01..·.11 edge ·3.n d e omp 1 i ·3.n e e 2. Beyond the Standards - Good Judgement

8. Recommendations by the Profession 1. C lie n t d.C C e p t d.n c e d.n d r' e ten t ion 2. Engagement letter

C!u d.1 it/" eon t r' 0 I 4 . 8.:.. I ·3. n e i n ':';1 gr' 01 .... .1 t h d. n d q u .:.. 1 it::" con t r' a 1 5. DefEnsive auditing 6. Legal adVice

I .. ). Cone 1 U·:· ion A. :::;ummd.r· ::,' B. New Areas Presenting New Legal Questions

1. Compi lation and review 2. For·ec.3.·:.ts

C. Thoughts on the Future

Audi tors help to preserve economic freedom. Th i·::.

statement might surprise some people, but it is the truth.

One of the major characteristics of our free economy is our

que .::. t for' per' f eo c t c om pet i t ion . Perfect competition

r' e (1 u ire .::. e f f j c i en t mar' k e t s· su p pI i e d 1) . .1 i t h c mnp 1 E' t e

i nfor·m.::'.t i on . A portion of this information is provided by

. ::'.lJdi toO,d fina.nci.::.l ·::.ta.tements .. ::'.nd other' report·::. ·::.UPI) 1 ied t,>"·

·::,.ccoun t.:<.n t·:: .• As a result, accounting and auditing

functions have become an essential element in maintaining

our free and competi tive society.

American auditing originated from Scottish and Sri tish

accountants who came to the Uni ted States during the late

1800s to check on Sri tish investments in American

i ndu·::.tr i e'::·. The::." .::..udi ted book,::, b>' check i ng in deta.i 1 the

additions and postings in an attempt to detect fraud, but

f r' ·:o.u d i) .. I.:O .. ::. u '::·IJ .::'.1 1}"' not f ou n d be c ·::..u 'se i t 1 ... ·,1·::'.S· ·:o.C c omp 1 i ·::.h e d by'

leaving cash receipts out of the books. S::.·' the e ·::'.r· 1 'T"

1'7':=:0:., the number· of in'.)e·::.tor··::. in cor·por·.:o.te ·::.tock·:: .. ::'.nd

bonds had increased dramatically. Audi tors had to change

their audi ts to accomodate stockholders and investors. The

emphasis changed from the balance sheet to the income

.::. t a. t eme n t . 1..,.1 i t h the e's t a.b I i ·::.hme n t of the f e de r' .:0. i

securi ties laws of 1933 and 1934 came the first audits

required by law.(l) Throughout the 40s and 50s, many

accountants, accounting organizations, and the SEC were

disappointed in the slowness of the accounting profession

in e·::.t.::'.bl i s.h i ng account i n'~ pro i nc i pI es·. A 1 a.c k of

understanding and agreement on the basic postulates and

principles underlying the accounting practice contributed

significantly to the delay. Ever since the principles have

bee n E' .::. t .:;.. b lis h ed, the :: .. , h.:;.. '.} e bee ncr' i tic i zed .:;. .. ::. be i n g too

br·o.:;'.d" They permit the management to influence the

impression conveyed by financial statements by allowing

them to choose between several accounting methods. The

effect of this influence can be misleading to the users of

the f,nancial statements.

Occurences in the past twenty years have had a

significant impact on auditing. Controversies~ such as the

broadness of accounting principles discussed above, along

with criticisms by the SEC, members of the accounting

profession, and other interested parties, nurture an almost

con tin u .:;.. 1 i n t e r' est b}' the fin .:;.. n c i.:;.. 1 P r' e'::· sin .:;.. c c 0 u n tin g

principles and the accounting profession.(2) t···jume r' ou .::.

·::.ca.nd.:;'.l·::. in the 1 a.te .:;.0,::, 1 .... .Ih i ch r'e'su1 ted in cour·t·::. r'ul i ng

t h.:;.. t:;..u d i tor"::, h .::'.d been neg I i ge n t in their' duties, p I u .::. the

gener·:;'.1 di s:.tr·ust of the ·::.:: .. ··::.tem b::.·· the pub1 i c due to

f.,..I.:;..ter·.~a.te C.:;'.u·::.ed a.udi tor"s to I o·::.e the i r' cr'edi bi lit::.', The

pr·ofes:.·::.i on ha.d to con·::.i de,' the adequa.c::.·· of qua.1 it:: .. · contr'ol

.:;'.nd pr·clfe·::.·::.ion.:;'.i di·::.cipl ine. AI'3o, it 1 .... .1.::..s:. time to

r' e c on .::. i de r' the hi·::. tor' i c .:;..1 i .je .:;.. t h a. t a.n ·:;..u d i tor' i·::. not

responsible for searching out fraud. Cou r' t .::. .:;'.n.j

2

go' .... er·nmen t.:;'.1 agencies decided it was time to be tougher on

.:;.. u d ito r' .::. .:;.. n d pI:;.. cern 0 r' e 1 i.:;.. b iIi t :: .. ' CI nth e i r' s h 0 u 1 de r' .::. • A 1 I

of this caused the accounting profession to be greatly

concer·ned. One author stated~ "Today~ wi th fraud cases

becoming more common, and with investigations by

governmental agencies and resul ting 1 i tigation exploding in

al I directions. this disturbing trend is becoming a major

factor in the operation of accounting firms."(3)

Accountants are taking extra precautions because they are

no 1 or'jI~er' ·::·ur·e v!h.:'.t the':,,' 1 .. ' • .Ii 11 be hel d 1 i .:'.bl 02 for'. Th i·::.

p.:'.per· e::q:,] or'es the gener·.:..1 r·es.ponsi bi 1 it::,·, .:'.nd 1 e'~.:..l

I i .~.bi·1 it::,·· of .~.ccountant·::. 1 .• ' . .Ii th r·ega.r·d to a.udi ted f i na.nc i .:'.1

.::. t .~. t erne n t s· • Precautions that accountants should take

.~.g.:.. i n <;:. t 1 i t i ':d':" t i on li·J ill be inc 1 u de d, .:'.1 on g 1 .. ',1 i t h a.u d i tin'~

trends for the future.

There are many different opinions of what an audi tor's

r·e-::.ponsi bi 1 it::, .. : .::. tOl/,lar·,j his c1 i ent-:: .. ;..nd other' user"::. of

financial statements. The profession's view based on the

A I CPA Pro of e ·::.s· i on a. 1 S t .:'.n d2<.r· d·::. i·::. t h.:.. t ~ "A c e r' t i fie oj put, 1 i c

.:..ccc,urlt.:..pt ·::.hould be f.;..ir· .:'.nd c.:'.ndid v . .!i th hi·::. cl ient·:: .. :'.nd

ser·' .... e them to the be·::.t of his 2<.bi 1 i t::,··~ v . .!i th pr·c,fe·::.si on.~.l

con c e r' n for' the i r' be -::. tin t 02 r' 02 s t s l con '::. i ten t I .. ".! i t h h i -::.

r'esponsibi 1 i tie':, to the publ ic."(4) Fir·st. it i-::. impor·t.:'.nt

to look .:'.t 1 .... .Ih.~.t .:..ccount.~.nts h2<.'.)e est.:..bl i -::.hed .~.'::. the i r'

r·e·::.pc,n·::. i b iIi t::, .. to c 1 i en t·:: .. When accepting an audi t

en':;;t2<.':;;tement ~ the .:..udi tor' ha.·::. t.~.ken on the t.:..sk of eX.:'.mi n i ng

financial statements and related supporting information to

form an opinion on whether or not the financial statements

are presented fairly and conform with generally accepted

.~.ccount i n';r pro i rp: i p1 e'::· th.:'.t h2<.'.}e been con·::.i ·:;tentl:;.-· .:..ppl i ed.

4

It is his duty to follow generally accepted audi ting

.:. t ·:'.n dar' d,;, • Un de r' (3AA S ~ h e h .'0<. ';. the r' e s· p 0 n .:. i b iIi t /. t 0

properly plan his examination~ to search for errors or

irregulari ties that would have a material effect on the

f i nanc i a.l ·:.ta.tement·:., a.nd to e:>::er'c i se due ':Y i l'j .;.nd c·;.r·e in

conducting his examination. As long as the audit has been

performed in accordance with GAAS~ the auditor has

f 1J 1 f il 1 e d hi;. prof e':·';· i on .:'.1 r' e ':.p on .:. i b iIi t i e':· • He Ijoes. not

guarantee or insure against errors or irregulari ties.

(; C F'A .;. 1 ':·0 h .;.s. the r' e s· p 0 n s· i b i 1 i t y t 0 k e e p c lie n t

i n f or·m·;. t i on con fide n t i .;.1 . Generally, he cannot disclose

confidenti.:'.l infor·m.;.tion I ..... iithout the cl ient····:. con·:.ent, but

this does not prevent him from complying wi th GAAP and

I~"""""-' ~HH·=' • A,;. .;. r' e s·u 1 t, i t 1 ... ·.I0U 1 d not be .:.. I.) i 01 .;. t i on of

r·e,:.pon·:.i bi 1 it::.' to .;. cl i ent if .;.n ·;.udi tor' qU.;.1 if i ed hi·:.

o~)inion on the cl ient····:. fin.:'.ncia.l st.;.tement·; .. ::'.nd di·:.clo·:.ed

t h.;. t the c 1 i e nth d. oj not c om () 1 i e d 1.' • .1 i t h GAA P •

m.;.int.E!.ining confidenti.:'.l it::.·· doe':, not d.pply in .;.11 cas·e·:·.

Some :.ituations in which accountant may be required to

d i .:. c 1 0 .:. e con f ide n t i.:.. 1 i n for' m .;. t ion inc 1 u oj e c om p 1 ian c e 1.".1 i t h.:..

,,) .:.. 1 i oj .:. u b poe n .;:.. 0 r· .:. u mm 0 n ';" .E!. I.} 0 1 u n t a. r' :: •. , qua. 1 i t ~ •. , re'·) i e 1.,',.1 u n de r'

the authorization of the AICPA. an inquiry made by the

ethics division or Trial Board of the AICPA or a simi lar

state CPA society. or an inauiry made under state

S.td.tute·: .• (5)

There has been a misconception in the past that an

a.ud i tor' .:. m·;. in obj ec t i I.)e in per·fclr·m i ng .9.lJd its is. the

c:-,_I

detection of fraud. As is stated above~ the accounting

profession maintains that the purpose of an audit is to

determine if financial statements are presented fairly.

The margin between the perceived and actual

r'e':,pon':,i bi 1 it i e'=:: .;:'.·:,·:.umed b'," d,n .;:..ccount.;:'.nt in per'for'mi ng a.n

audi t is commonly referred to as the "expectation gap."

Wi th the drastic increase in management fraud that has

occur'r'ed in the p.",,·:.t h',.Ienty· ye.:'.r":., cl ient·=.~ gOI,..'er·nment.;:..1

agencies, and users of financial statements have wanted to

inc r' e·;:' .. :. e t hi,:. g a. p b ::." r' e qui r' i n I;:) m 0 r· e r' e s· p 0 n '::. i b iIi t y for'

de tec t i ng fr'.:..ud duro i ng ,;:'.Ulj it·: .• The Statement on Audi ting

:::; t .:', n d:.. r' d .:. t,··~ 0 • issued by the AICPA sets forth the

d.udi tor·· .. ·:. r·es.pon·:.ibll i t": ... for' the detection of fr·d.ud. It

states that normal audi t examinations are not primari Iy

de·:.igned to di·:.clo·:.e fr·a.ud .;:..nd ':.hould not be r'el ied upon to

Al ':.0. if the di ·:.co'.)er·/' of .:'.11 fr·.;:"ud 1.·'·.Ier·e ·:'.n

objective of the audi tor's examination, the amount of worK

required would increase the cost to a point where no one

could afford an audi t. Even then there would be no

assurance that any existing fraud had been detected because

of the nature of fraudulent acts such as unrecorded

transactions, forgeries and collusion.

I:; u d ito r":· doh d. I.} e r' e':· p 0 n ':. i b iIi tie ':;. tot h e c lie n tin the

con du c t of d.n ,:'.U d it. bu tin f .:',1 1 i b iIi t ::." ,:'.n d c I ,;:.. i r",} o:;,··.;:..n c e ·:'.r' e

not included. It is reasonable for an audi tor to rely upon

the truthfulness of certain documents and the genuineness

of certain documents provided by management. Th i·:. i s, 1 .• "lh .; ...

·:=.ome of the r' e ':=.p on .:=. i b iIi t Y' mu s t be sh i f ted to m.9.n ·~·geme n t .

Management should be held responsible for the

misrepresentation and withholding of material n f or·m.9. t i on

fr'om ,:he ·;:'.udi tor. If an accountant fol lows customary

auditing procedures, those procedures do not disclose any

misrepresentation, and no apparent reason exists to expand

the .~.udi t pr·ocedur·es., the .~.ccount.~.nt ';houl d not be hel d

responsible for the misrepresentation.

f~ 1 on g i} . .! i t h r' e ';p on sib iIi tie s· tot h e c 1 i en t. the

.~.ccount i n'~ pr·ofe·:=.·:=.i on r·e.:'.1 i ze·:=· th.:'.t i t .~.l-=.o h.~.:= .. ~.

r·e·::.!::.on·:=. i b iii t:;.' to pr·omote pub1 i c i}.Je 1 f.9Te . Au d i t c,r' .:=. c ·~.r· r' :: •. ,

ou t t-, i .:=. r·e·;pon·::. i b iIi t·:.·· b::.' e::<pr·e·:=,·:=. i ng op i n i on':· on the

f.~.i r'ness of f i n·~.nc i .;:..1 ·:.t.~.tement·:. of pubi i cl y' t:-·.9.ded f i r·m·: .•

This ~elps to ensure that financial information available

to investors and other users of financial statements is

fair and relevant. The e::·::ch.:..nge of r'e I i .~.bl e f i n·;:'.nc i .:'.1

information is an essential element of our free marKet

.:. ::"':. t em.

The ,~e n e r' .;:.. 1 pub I i c .~. n d·:. om e c 0 u r' t s h.:.. \} e e :>:: p r' e s .:. e ,j .~.

':.1 iqhtl::.' differ'ent \}ie'...,' of tt,e r·e·:.ponsibi 1 i ty of

accountants. This is apparent from the recent criticism of

the accounting profession due to the increase In cases

brought against auditors for failure to detect

misrepresentations in financial statements. Th e Comm i·:.·:. i on

on Audi tor·····:. F.:e·:.ponsi bi 1 it i e':., .9.1':.0 c.~.ll ed the Cohen

Commission, was establ ished by the AICPA in 1974 to respond

t 0 c r' i tic j ·:·m .:.. b 0 u t the .;:.. u d i tin 9 p r' 0 f e':· .:. jon . Th e Comm j ':=.':=. i on

did a studY based on legal cases against audi tors. The

final reoort which was issued in 1978 was considered to be

.~. 1 .~. n dm .~. r' ~:: . The results lead to some very significant

The study found that a significant percentage

of financial statement users consider fraud detection to be

one of the most important objectives of the audit.

fr'equen t c·~.use of .;:..ud it f.;:.. i I ur·e·:· is the i ncorr'O?C t

interpretation or implementation of accounting or auditing

pr'oncluncemen t·: .. The profession is concerned about the

Commissions verification that courts have shown a

1.' • .1 ill i n 9n e':·':· to hoI d .~.U d i tor' .:. r' e ':'p on s i til e f or' m·~. t e r' i .:.. I

7

misreoresentations in financial statements. The ·:.tudy ':'.1 ':·0

found that audi tin9 fal lures were not a resul t of a

deficiency in auditing standards and these failures can

ne'·)er· be tot.;:..] 1':," el imi n.:.ted because hum':'.n er·r·or· I.' . .li 11 .~.ll.' .. I.;:..yS

e::{ i ·:.t. (6) Some of the recommendations by the Commission

include a report by management in the annual report to

.;:.. C ~:: n OI.A.I led I~ ern·;:.. n .:.. gem e n t .' s· r e':::· P 0 n .:::. i b iIi t ::,., for' the fin -2>. n c i.;:.. 1

statements and to describe the status of internal control

and an expanded audi tor's report that wi I focus on the

company's representations contained in the report by

The e>::p.:..nded r·epor·t 1"',loul d r'equ i r'e the .~.udi tor'

to e::-::p.;:..nd hi·:::. 2')·;:'.1 u.~.t i on of i nter·n.~.1 contr·c.l. The

Commission also concluded that it is the audi tor's

r·e·:.pon·:.i bi 1 it>' to .~.ct i • .... el y' ·:.e.;:'.r·ch for' fr·':'.ud r·.~.ther· th.~.n

simply bein9 alert for i t.(7)

The 90'.}er·nmen t a 1':.0 ha.s. a. I.) i el.' . .1 of the r·espon·:. i b iIi t::,·,

of audi tors that differs from the view of the accounting

p r' of e'::·':· i on • The Securities and Exchange Commission

generally the agency that speaks for the government with

reQard to audi ting matters. The SEC can be described as a

regulatorY agency with vast quasi-legislative and

quasi-judicial powers whose rules and regulations have a

direct and significant impact on the accounting profession,

e':· p e c i .:c. 1 1 /. r' e I;:) .:c. r' din I;:) .:c. c c 0 u n t .:c. n t "s. I i .:c. b iIi t ::." • ( :::: ;. The :::; E C

t.:cYe·:, the po·:.i t i on th.:c.t the publ i c a.ccountant····:. dut·: ... i·::. to

·: .. :c.fel;:)u.:c.r·d publ i c in ter·e·:.t .:C.nd th i·:. du t::,·, ta.ke·:; (:Ir'ecedence

0 1.) e r' .:'.n y du t'r" tot h e c lie nt, The accountant"s duty is

carried out by verifying and communicating material

information from financial statements. If fol lowing GAAP

and GAAS does not result in the disclosure of such material

information, the SEC maintains that is has the power to

promulgate addi tional standards and rules.

'···Jov.,1 tha.t the gener·.:c.1 r·e·:.ponsi bi lite':. of a.udi tor':, hal . .!e

bee n e >:: ·:C.m i ned, the n e ::< t t h i n I;:) toe ::< p lor' e the i r' leg .:c. I

I i .:C.b iii t ::,' . First, some important terms that are frequently

encounter'ed 1..·.,1hen di·:.cu·:.·:.in l;:) leg.:..l I i.:C.bi lit:;.' 1,1.,1i II be

c 1 ·:C.r· i fie d .

of pr·oof.

The·E.e ter'm':' .:C.r·e ne l;:)1 i gence, fr·aud •. :C.nd bur'den

t···Je g 1 i ge n c e .:.:c.n be cIa. ·:;s· i fie d a.':· or·d i n ·:C.r· y' or'

I:) r' CI '::. '::; .• Or·d i n ·:C.r ',' n e I~ 1 i ge n c e i,:;, the f .:c. i I u r' e to u s·e

reasonable care when performing services.

is the fai lure to use even minimum care when performing

':·e r· I.} i c €' ': .• N e 1;1 I i g e n c e c .:c. n r' e':· u I t f r' om .:c. .:. p E' C i fie .:c. c tor'

from a fai lure to act. It is often predicated upon a lack

of honesty and loyal ty. In order for an accountant to be

con·::.i der'ed ne';:)l i .;:)ent, he mu'::.t f.:O.i I to per'for'm .:~.ll ·::·er·'.'! ices

in accordance with what a reasonable accountan~ would do

under simi lar circumstances.

Fr·a.ud i·:.

the intentional misrepresentation of a material fact which

deceives and then injures another party. Accor-'din9 to the

cour·t·:., fr·.:O.ud mu·:.t u·::.u.:O.ll::.· include .:O.I .. ' . .Iillful intent to

defr·.:O.ud.':: 9) Four requirements that need to be present for

f r' a,u d to oc cur' ·::r.r· e the i n ten t i on torn i '::.1 e .::r.d 1,<.lh i chi .::.

referred to as scienter, a false representation or the

con c e .::<.1 me n t of .;:.. m·::<. t t e r' of f .:o.c t t h .::<. t i '::. m·;:.. t e r i .::<.1 tot h e

tr·.:O.ns.Ot.ction in que·:.tion, ju-=.tifi.~.b]e r'el i.::<.nce b';.· the

plaintiff on the false statement, and injury as a result of

the r"= I i a.nce . The lack of any of these requirements can be

used as a defense in fraud cases.

Burden of proof means the burden of comin,;:) forward

with evidence to prove or disprove a relevant and material

fact that is beln9 disputed . In 1 i t i g.::<, t i on ·~.9a. in'::. t ·:O.n

. :o,udi tc.r·, ther'e ,:oT'e four' el ement·::. tha.t deter'mi ne the

The burden of proving any or all of

these elements rests on different parties in different

s i tu.:o. t i on'::·. These elements are damage or loss resul ting

f r' om r· eli .:0, n c e u Don fin .:0. n c i .::<. 1 .::. t .:0. tern e n t .::. 0 r' a. d'.'! ice ,

misstated financial statements or erroneous advice,

reI i ·:O.nce upc.n f i n.:<.nc i .:0.1 ·::.t.::<.tement·:. or' .:<.d i .... i ce •. :O.nd .:0.

def i c i enc::.· in the a.ud i tor' .. ' .:. conduc t. In civil cases, which

10

include neq] i qence ca.':· e':· , the pa.r·t::-' li . .Ii th the bur'den of

proof must only provide evidence that welqhs qreater in his

favor to win the case. This is different than in criminal

cases where quilt or innocence must be proven beyond a

reasonable doubt.

c 1 .0<. ':.':. : fie ,j .0< .• :. c Ctfnmon 1 a.I .... .! 1 i ab iIi t Y' or' .:. t a. t u tor' :,., 1 .0<.1 .... .1

1 i.o<.bi 1 i h·'. Common law is derived from leqal precedents

e·:.t.O<.bl i ·:.hed to::.' dec i ·:.i on:· in 1 eqal c·O<.ses. A·:. a. r'esul t.

common law reflects the values of society at the time the

decisions were made. Under' common 1.0<.1.,,1 the 1 i .:<.bi 1 it·,.·· to the

cl ient is for' or·din.O<.r·::-' neg I il::)ence~ l;Jr'o':":' neql il;)ence~ or'

f r' ·3.U d . Th i·:. 1 i .3.b iIi t Y' i S b.3. ·:·e d on the con t r' a.c t u .3.1

re 1 ·3. t i on·:.h i [) be tl..'.Ieen the c 1 i en t a.nd the .3.ud I tor' 0: pro i I .... i t/· of

con t r' 3. c t ::0, ·3. n don the ·3. u d ito r' .' ';:. i n de pen den c e f r' om c 1 i e n t

contr·ol. The contr·.3.ct doe':, not h.3.' .... e to be for·m.:O.l1::.'

I.·-·.Ir itt en. It ma./· be imp1 i ed.

i .• ,Jhen ·3. client t,elie\)e·:. th.:o.t ·:O.n a.uditor· h.:o.s f.:o.iled to

properly carry out the duties of the contract. he may seek

.:0. C i I.) i 1 .0<. C t ion 0:. f b r' e .:;0. c h 0 f con t r' .:;0. c tor' tor' t . Un de r' br' e ·O<.C h

of contract~ the auditor has usually violated qenerally

accepted accounting standards or the confidential

r' e I .0<. t i on ·:.h i p be b.-.Je e n h i m·:·e I f .:;O.n d the c lie n t .O<.n d m.:<.::··· be

subject to monetary damages. One case that set an

important precedent wi th regard to breach of contract was

1136 Tenants' Corp. v. Max Rothenberg & Co. I nth i S· C .0<. ·:·e •

the .:;O.udi tor' 1.·-·.1.3.';:· hi r'ed to per'for'm ser·'..J I ces for' the cl i ent ~

1 1

but no engagemert letter was prepared. 1.,..11""1 en i t 1 ..... 1.:<.·::.

discovered that a former manager had embezzled funds, the

c 1 i en 1: ·::.ue,j the a.ud i tor' bec.;:'.u·::.e ·;:'.n .~.ud it ha.d not been

[)er·for-·med. In defense, the auditor claimed that he had not

been hired to do a complete audit, only a write-up, The

court found in favor of the plaintiff. In it·::. opinion, the

court stated that a wri te-up engagement requires certain

definitive audit procedures, hiring a CPA presumes an

audi t. an audi t may be adequately performed wi thout

indeoendent verification, and accountants have a duty to

detect defalcat~on. The first three of these ~ould have

letter',(10)

Tor·t 1 i .;:'.b iii t /. oc cur' .::. 1 .. ,.11""1 e n ·~.n ·~.c c ou n t ·;:'.n t br' e ·~.c he'::. .~.

nonco~ltr·a.ctu.;:'.1 dut:;.-· r·e·::.ul ting in injur')" to .~.nother· per·=.c,n.

Monetary damages may be awarded. I f the tor' t I .... J.~.·::.

i'ltention.~.I. the '.}ictim i= .. ~.I·::.o entitled to puniti' . .le

In .~.,jdi t i on to the tor·t 1 i .~.bi lit::.· of the

accountant. the firm also is ia.ble if the tor·t i·::.

c omrn itt e d 1 .... .1 i t h i nth e'::· cop e 0 f the .~. c c 0 u n t a. n t ." s ern 1:' i 0 ::"'m e n t .

The burden of proof in cases concerning common law

i .~.t, iIi 1:":." tot h e c lie n t i·::. p I ·~.c e d on the p I .~. i n t iff. F:e c .~.l

that the plaintiff has the burden of proving the four

e 1 em e n t .::. 0 f.;:.. u d ito r' .. ' .:. 1 i.;:.. b iIi t y : damage or loss, the

financial statements were misstated or erroneous advice

gi '·.len. r'el i ·~.nce on f i n·;:'.nc i .::<.1 ·:.t.::<.tement·5 or er·r·oneou·::.

advice, and deficient auditor conduct. Defen':::;'€":::;' ca.n be

bui 1 t on the weakness or nonexistance of any of these

e 1 eme n t ':::; .. The defenses used depend primarily on the

circumstances of the case, but there are a few that are

frequently used. TI ..... lo ·:::;.uch defen':;e':::;' .:'.r·e due d i '1 i gence .:'.nd

con t r' i bu tor' >., n e.; I i ge n c e . The defenda.n t .. ' ':::;. due d iIi gence

defense is that he did not know and in the exercise of

reasonable care would not have discovered the omission or

misrepresentation of information. The defens.e of

contr' i butor'::'" nee)] i .;:)ence c·:'.n t.e used to I imi t .:l.udi tor'

the .:.. ': c 0 u n t .:l. n t .' ':::;. f .:l. i I u r· e top e r' for m the con t r' .:.. ct.:.. n d t 0

r·epor·t tr'ue infor·ma.tion.

Au d i tor' ':::;. h -::'.'.) e a. 1 i .:l.b i ] it::.·· tot h i r' d p ·:l.r· tie ':::;. un de r'

common law as well as cl ients. Third parties are parties

who have an interest in audi ted financial statements. but

don " t ha.'.)e a cc,n tr·.:l.c t 1 .... .1 i th the ·:O.ccoun t.;:'.n t 1 •• • • .Iho a.ud i ted the

':::;. t 21. t eme n t s· • There are three classes of third parties:

primary beneficiaries, foreseen beneficiaries, and

foreseeable third parties. A primary beneficiary is not a

c1 lent but 1 .•••. li 11 r·ecei'.)e a.n .:l.udi t r·epor·t th.;:'.t h.:o.s. been

prepared expressly for his benefit. An e:{ .:O.mp ] e of .;:..

primarY beneficiary is a bank which requires audi ted

financial statements from customers who want to take out a

1 oa.n. Foreseen beneficiaries are not specifica] ly

ide n t i fie d to.;:.. 'J d ito r' ':::;.. but the i r' ,;:) e n e r' .:l. lid e n tit :: .. ' a. n d

specific purpose for relying on the audi ted financial

1 .-:. '-'

statements are known • Foreseeable third parties are not

. :.p e c i ,: i c .:'.1 1 /. cr' c;le n e r' .:'.1 1:." i de n t i fie d, tlU t .:; till m i l;;Ih t be

expected to rely on audited financial statements.

I n'· ... e·=· t or": .. :'.nd potent i .:;'.1 i n '·) e':· t or":· ' .... .Ioul d f.:;..11 i I"ItCI th i .=.

ca. t e I;' CI r' /' •

The c omm 0 n 1 .:;..1 ..•. .1 1 i .::.. b iIi t y' 0 f ·:;..u d ito r' .:. toe .:;.. C h 0 f the

third party classes varies directly with how far each is

removed from a contractual agreement wi th the auditor for

a.udi t ·:·er· I.) ice':·, Since a primary beneficiary is

·:.pec i·f i ca.l1 :: .. , i dent i f i ed to the .:;'.udi tor' by' the 0:1 i ent, the

1 i.:;'.bil it·: .. · to the pr·imaTY· benefici.:;'.r)" .:;..nd the cl ient .:;'.r·e the

fr·.:'.ud.

Foreseen beneficiaries are farther removed from the

contractual agreement than primary beneficiaries. so the

Tr·a.di t i on.:;'.11 /', .audi tor":. h.:;.' .... e been 1 i .:;'.b] e to for·e·:.een

benefici.:;'.r·ie·:, for' I~r'os':' nel;il il~ence .:;..nd fr·.aud, but in a. fel .. ,.!

cases they have been The

decisions in two cases in particular, Rusch Factors, Inc.

I.). LeI.} i n .:;..nd RY.:;..n I.). K.:;..nne. ·:.uppor·t orlji n·:'.r·/· neg] i gence .:'.':.

one of the .:;'.udi tor· .. ··:. Ii .:'.bi lit i e':· to for·e·:.een benef i c i .:;'.r· i e':·,

This is Just one example that supports the current trend to

i ncr·e·:;..se the I i .:;'.b iIi t·y· of .:;'.ccoun t.:'.n t·: ..

Since foreseeable third parties are the furthest

r' em 0 I.) e d f r' om .:;'.: 0 n t r' .:;.. c t u .:;.. 1 1 i.:;.. b iIi t) .. , .:;.. u d i tor":. h.::.. ,.} e the

I e.:;..s.t amoun t of 1 i ab iIi t::.·· to th i·:. gr·oup. Aud i tor·s .. :;..r·e

14

1 i .:'.bl e to for·e·;.ee.:'.bl e th i r·d p.:..r·t i 02-:' for' 9r'0';'-:' ne91 i g ence

·:'.n d f r' ·:..U d.

The ca-:.e of Ultramare-:. Corp. v. Touche ha-:. been the

primary ca-:.e for -:.etting a 1e9al precedent for an auditor's

Ii .:'.bi lit::,.· to IH' im':<.r··:,.· benf i c i .::<.r- i e';· .::<.nd for' e·;·e e.:'.bI 02 th i r'lj

~).:'.r tie';" During an audi t. Touche failed to uncover a

material amount of fictitious account-:. receivable.

c 0 u r' t r' u led t h.:.. t the .:.. u d j tor' 1..<.1 .:.. ';. Ii.:.. b let 0 p r' i ITJ·:'. r' )"'

or' f r·:,. u d m u .:; t 0 c cur' for' the .:.. u d ito r' t 0 bel i .:<. b 1 e t 0

fore-:.eeable third partie-:..

The civil action that can be taken a9ain-:.t audi tor-:..

the bJrden of proof~ and the damage-:. that can be awarded

.:.. r· 02 the ';. ':<.m 02 for' .:.. I I t h i r' d p .:.. r' tie '; .• Tor·t i,;, tht? ci'.}il

action that can be taken. The burden of proof i-:. on the

pl.:.. i n t iff for" the f ou r' e I erne n t .=. of au d i tor' ." s 1 i .:'.b iIi t y' • A

third party can receive both monetary and punitive damage-:..

Be ';. i de ';. the du 02 d iIi I~e n cede fen ';·02 e ::q) 1 .:.. i ned e ·:'.r· lie r' •

audi tor-:. can u-:.e the defen-:.e-:. of lack of privity and

ju·::.t i f i ':'.bl 02 r'el i ·:'.nce In c·::<.·;·e·;· i n' . .!ol',! i ng th i r·d p.::<.r·t i t?:: .•

L.:'.cl< of pro i I.} it::, .. me·:'.n·=· th.:'.t the .:'.udi tor' is. not Ii .:'.bl e to the

third party because there i-:. no contract between them. The

..i us t i f i .:'.b 1 e r' ell .:'.n cede fen ';·02 c ':'.n be u -:.e d ' .... .Ih e nth e de fen d.:'.n t

bel ie· .... e·=. th.:'.t the (:.].:..intiff 1 .. <.1':<.';. not r·e.:..-:.on.:..bl/ ju·;.tified in

rel/ing on the financial -:.tatements.

:=:; t .:'. t u tor' ::.-. 1 .:..1 ... ..1 i';. " i .... .1 r' itt 02 n I .:..' .... .1" t hat i·::. e S. t ':'. b 1 i .:; he db':,"

15

f e de r· ':1.1 .:..n d s· t .:.. tel e,~ i ·::.1 .:.. ti'..' e bod i e s . The primarY federal

statutory laws that have an affect on the accounting

profession are the Securities Act of 1933 and the

Secur ties and Exchange Act of 1934. By passing these acts.

Conl~r·es·:. Ii·.! a.·:. a.ttempt i ng to m.:..Ve a.ccount.:..nts mor·e Ii abl e to

th i r·d p.:..r· tie·: .• The Securities Act of 1933 regulates the

original offering and sale of securities. The s.a.l e of

·::·ecur· it i e·:· .:..f ter· the f i r··:.t i s·::·u·:..nce ·:..r·e not co'..'er·ed under·

thi·::. ~:;ct. The Act r·equ i r·es· th.:..t in or·der· for· ::..n ent it>' to

pub I i c 1 ::,.. ·:·e I lit .::. ·:.e cur· i tie .:., t h.:.. ten tit .:,.. mu s t f i 1 e a.

registration statement (usually an S-I) and a prospectus

This is done in an attempt to promote full

and fair disclosure and prohibi t fraudulent

misrepresentation regarding the original issuance and sale

of ·:·e cur· i tie s .

Accountants come under the 1933 Act when they aid in

the preparation of registration statements and

or·o·:·[)ec tuse·: .. The specific on which most i t i I~.:'. t i on

against accountants is based is Section 11 Under· :::;ec t i on

11. ·:..n .:..ccount.:..nt gener·.:..ll:;.' qu.:..1 if i e·:; .:..-: .. :..n e::-::per·t .:;..nd 1 •• ' • .Ii 11

incur· li.:;..bilit:~·· .:..-:. to a.n omis.·:.ion or· fa.lse ·:.ta.tement of .:;..

material fact unless he had, after a reasoGable

that the statements were true and that no material facts

1 .... .1 e r· e om itt e d . If an accountant violates Section 11, he may

be 1 i .:..bl e to the pur·ch.:..·:;er··::. clf ·:.ecur· it i e·::· for· or·d i n.:..r·::,'

16

The burden of proof under the Securi ties Act of 1933

does not rest solely upon the plaintiff or the defendant.

The plaintiff must prove that he suffered damages and loss~

and that the financial statements were material Ix misstated

or erroneous advice was given. The defendant must prove

t h:<. the ·;<.c ted 1 .. • . .1 i t h du e d iIi ge n c e an d t h .:<. t the pI .:<. i n t iff did

not rely on the financial statements.

The case of Escott v. 8arChris Construction Corp. had

great influence upon the accounting profession with regard

to I i:<.b iIi t .;... un de r· :::;e c t i on 11 of t he 1 '7'33 Ac t . I n the

case, an S-1 review was reauired to examine the events that

had occured between the balance sheet date and the

effective date of the registration statement.

Marwick, Mi tche 1 ] & Co. performed the S-1 review because

they had audi ted the most recent financial statements. The

senior who was in charge of the review was not yet a CPA

and was working on his first engagement as a senior. After

the sale of the securi ties~ 8arChris filed for banKruptcy.

Pe.:<.t. r···l.:<.r·v . .Ii ck c1 <l.imed <l. due di Ii gence defen·::.e. Trle cour· t

ruled that accountants should not be held to a standard

t h <l. t i·::. h i 9h e r· t h <l.n the on e e -;:. t <l.b I i sh e d b:~" the p r· of e .::.-;:. i on ,

but in this case the accountants did not maintain that

standard. The defendant had the burden of proving the due

d iIi ge n cede fen ·'E·e ·3.n d did not e f f e c ti'.} e 1:;.-· do ·::·CI. Th e

court/s opinion prompted the issuance of Statement on

Audi tin9 Procedure No. 47, "Subsequent Events,n. as well as

·::.etting <l. pr·ecedent th.o<.t a.udi tor·· .. s. could be held I i.3.ble for·

or·din'~'.r·::,' ne<:;ll il~ence under· the Secur·i tie-=:. Act o-F 1':;:'3::::.

The Securities and Exchan<:;le Act of 1934 taKes over

1 -=' .l .-

where the 1933 Act leaves off. It re<:;lulates the tradin<:;l of

securi ties that have previously been issued. The pur·po·::.e

of the Act is to promote fair and adequate disclosure of

public1·:.' he11j comp':'.n i e'::· on .:.. continuin';j ba.·::.i·:: .• Entitie'::'

are required to submi t periodic information as well as a

re<:;listration form (commonly form 10) to the SEC •

. :'.1'::.0 r'equ i r'e,j to en1 i ·::.t thE' ser· I.) ice'::. of .:.. C:er·t i f i ed Publ i c

Accclun t.:'.n t. Th eli .:'.b iIi t ::.' of C:PA·::. un de r' t h i'3 Ac t '3 t em'::·

f r' om the i r· i n I.) 0 1 I.) e men tin the Ij i -=:. c los u r' e p r' 0 c e s s • An

.:..ccount.:'.nt i·::. I j .:'.bl e for' er·r·or··::· in f i n·:'.nc i.:.l ·::.t.:'.tement·::.

contained in a prospectus or other filed report even thou<:;lh

it is unaudi ted if there are errors which he knew or

reaso,ably should have Known.

A purchaser or seller of a securi ty usually brings

18 of the 1934 Act.

10(b) . In f.:..c t. th i·::. ·::·ec t i on i -=:. II the most r·.:..p j dl >'

e }:: p a. n din I~ .:.. r· e·:.. 0 f 1 i.:.. b iIi t >' IJ n de r· fed e r· a. I .::. e c IJ r' i tie s 1 .::<.1 .... .1 .::.

for' f i r·m·::· .::< .. ::. I,,·)e I 1 .:...::. d i r' e c tor .::.. of f ice r"::.. .:'Tl'j p IJ b 1 i c

accountants.H(11 Accordin<:;l to Section lOeb) and Rule

lOb - 5. i t i -=:. un I at·,.1 f u Ito u .::. em·:.. i I .::.. .:.. n yin .::. t r'u men t .:.. lit y. 0 f

interstate commerce. or any national securities exchan';je to

defraud any person in connection wi th the purchase or sale

under these provisions is very broad because the provisions

1 c· '-'

cover any false or misleading statement~ regardless of

whether or not it is filed wi th the SEC.

1 i .:'.bl e to ·::.e 11 er .::. or' pur·cha.-::.er"::, for' ';lr·o·::.·::. neg! i ';lence or'

fraud for not complying wi th this section of the 1934 Act.

The burden of proof under section IOCb) rests entirely

on the plaintiff. The plaintiff must prove that he

suffered damage or loss. the statements were materially

false statements or advice. and the auditor's conduct was

deficient.

Hochfe1der v. Ernst & Ernst has been a landmark case

r·eg.;:..r·di n9 a.ccounta.nt .. ··::· 1 i .:'.bi 1 it) .. under' Pul e 101:.-5 of the

Securities and Exchange Act of 1934. The case resulted

from the discovery that the president of First Securi ties

Corporation was using the funds of investors for his own

iJ ":-e • Investors had sent funds directly to him with the

understanding that he would deeosi t the funds in an escrow

·~.CCCIIJ .-J t . He kep t his fr·a.ud a. ·::·ecr·e t by esta.b1 ish i r,,~ the

"m.;:'.i r' u 1 e" ! ..•. .1 h i c h p r' 0 hit. i ted .:;. n ) .. 0 nee] .::. e f r' om 0 pen i n':j rl i·::.

ma.i 1. When the fraud was discovered~ the accountants were

Af ter' r'u 1 i ng'::' in f.:..'''! or' of Er·n·::.t 8.,

Ernst in District Court and against them in the Court of

Appeals~ the case reached the Supreme Court. The Cour' t

and not the "intent to deceive. manipulate. or defraud~"

Er·n·::.t .~< Er·n·::t 1. ••• .1.;:. .. ::. not 1 i a.b] e.';: 12) The Court pointed out

that Congress intended for Pule 10b-5 to apply to something

much ·::.tr·onger· tha.n nel~l I gence a.nd th.3.t lOb-5 cl e.3.r·I;." ·:.ta.te·:.

·:·c i en ter· l .3.nd not mer·e ne91 i qence, 1 ..... 1 ill ·:.utt i ce. The

Ijeci·:.ion in Hochtelder· did limit the .3.ccount.3.nt ... s· lia.bi1it::,··

somewhat, but the Court lett some questions unanswered by

not addressing the question ot whether or not reckless

beh.3. '.}ior· C.3.n r·e·=.ult in li.3.billt::, .. under· :3ection 10(b) .3.nd

Pule lOb-5.

The ·:.coj:1e ot I i a.b IIi t:: .. · under· :::;ec t i on 1:::: o·f the

Securities and Exchange Aet ot 1934 is much narrower than

::::ect i on 10<b) beca.u·:.e it .:,t.pp1 i es· onl y to ·:.t.:..tements. til ed

1 .. • • .1 i t h the SEC . Under this section, persons who maKe talse

. 3.n d m i ·:.1 e .:c.d i n 9 .:;. t .:.. t eme n t .:;. I n til e d dell: ume n t .:. ·:c.r· eli .:c.b 1 e to

j:1ur·ch.:c.s.er··:. a.nd ·:::·e 11 er··:;· ot ·:::·eeur· it i e-=:· v,lho r·e 1 i ed upon the-:.e

statements it the price of the securi ties was attected by

the .:. t .:c. t eme n t .: .. In or·der· for· .:.. CPA to be 1 i a.b1 e l he mu·:::·t

The bur· den ot pr·oof urlljer· th i·:. s·ec t i on is .:.p lit

between the olaintitt and the detendant. Th e pI .:c. i n tit f

must orove that damage or loss was incurred, the statements

I ... ·.le r· e iT! i·:.·:. t .:.. ted or· e r· r· on e (jU .::. .:c.d!.) ice gi' .... en, ·:..n d her· eli e d on

the misstated statements or erroneous advice. The

detend.:..nt c·:..n .:..'}oid 1 i.:..tli 1 j t-;." b::," pr·o!..!inl~ th.:..t he .:..cted in

900d faith and had no Knowledqe of any talse or misleading

-:.t.:c.tement·:. (due di 1 i I~ence).

There are other federal statutes besides the

Secur· it j e·::· Act·:. I/ . .lh j ch mi ght .:..tfect the 1 j .:c.bi lit::, .. ot

a.c c ou n t ·:..n t .: .. These statutes are the Federal False

20

Statements Act, the Federal Mail Fraud Act, and the Federal

Conspiracy Statute. Ape r' '=::·0 n rna::." be c om eli :.. b I €? U n de r' the

Federal False Statements Act if he knowinglY and willfully

makes false statements to any department or agency of the

federal government. Accountants come under the

jurisdiction of this act when their audi ting reports

accompany financial statements in reports filed with the

The Federal Mail Fraud Act prohibits the fraudulent

u·=::.e 0·; the post.;.l ·=::·er·IJ i ce. Th i·=:: .. :..ct a.ppl i e~· to .:,.ccclunt.:'.nt·=::.

i .. ·.Jhen the::,' cer·t if::.,' f! n·:'.nc i .;:'.l=::.t.;:'.tement=::. th.:'.t thE'·:," knol .... .1 or'

should know are false and will be used in violation of the

·=::.t.:'.tute. Li .:'.bi i it::,· under' the Feder·.:'.l Consp i r·a.c::,·· ::::t.:'.tute

arises when two or more individuals agree to commi t a crime

a. 9 .;:.. in=::. t the U nit e d :::: t .;:.. t e·=::· • Accountants may be prosecuted

for conspiracy to violate any of the four federal statutes

previously mentioned.

Since statutes vary from state to state, it would not

be pr·:..ctic.;:..l to di·=::.cu·=::.~. them in ,jepth in thi·=::. p.:'.per·, but

some statutes that are common to many states should be

men t I onelj. Most states have enacted statutes that would

m.:'.ke ·;:'.n .;:..ccount.:'.nt cr·imin.;:'.lly· 1 i.;:'.ble for' obt.;:'.inin ,;:) mone::,' tl:;'"

talse pretenses and for wi 1 lfu1 ly falsifyino reports.

:::: tat e a.c c ou n t ·;:'.n c ::." I .:'.I,..)·=::. rl.:'.I.) e be e n e·=::· t .:'.b 1 i ·=::.h edt 0 r' e I.) ok e or'

suspend an accountant's right to practice if he has engaged

i nun e t h i c .:<.1 c 0"1 du ct. Many states have adopted section 101

of the Uniform Securi ties Act which is very simi lar to SEC

21

rule 10b-5 which is described above.(13) I .. ) .;:0. r' i (I U .::. .::. t .;:.. t e':·

have also enacted laws permitting CPA firms to practice in

the form of a professional corporation. These laws provide

1 i m i +.: E' d I i .:'.b iIi t::., tot h e cor' p or' ·9. t i on • HOI .... .Ie ,.) e r' '. e ·:..c h

p r' of e '=:.'::. i on .:'.1 per' ·::·on rem.::.. j n .::. per' ·::.on a.1 1 :: •. , I i .::'.b 1 e ;: or' 1 ... ·.Ior· k t h ·9. t

he personally performs.(14)

t~· ' i - 1 ,_ . .r' 1m 1 n·:, ... 1 i .9. b iIi t yin I.) 0 I \) j n g a.u d ito r' .::. h a. -=:. not 0 c cur' r' e d

'.)er·::,·· of ten in the p.9.·::.t fet.· .. 1 'y·e·9.r··:: .• There have been very few

c.9ses t",lher'e .9.udi tor'-=:, ha'.)e been hel d cr' imi n.9.11 ::,' Ii .9.bl e,

r-··10·::.t i n' . .!ol' . .!e c i·.} i I i'::'.bi lib·', Cr' i min .9.1 I j .9.b iIi t -:.' i-=:.

d iff e r" e n t f r' om c i I.) i I I i .::'.b j lit ::." i nth ·9. t C rim i n .9.·l 1 i .::'.b i 1 t:: ...

involves a wi Ilful I violation of a statute.

in ten t r'equ i r'emen t·::. 1 .... .1 j I I 1.)·9,r-·:··· a.ccor·d i ng to Clr'eceden ts ·::·e t

for each particular statute. 1 ..... lh i ] e the pI ·9. i n t iff i n ·9.

c i 1.) i I c.9.se U·::.U.9.11 ::.' 1 •• <.Ii n·::· if .::'.11 the e ' . .! j dence 1 e·9.n·:. '::.1 i (~htl :: .. '

in hi =. fa'.)or·, the pl.9.i nt i ff in ·9. cr' imi n.9.1 c·:,.·::·e 1..· • .Ii II not 1 .... .Ii n

unless the defendant's gui 1 t is proven beyond a reasonable

doubt, Most criminal c.::.ses against accountants are

!:,r·o·::.ecuted under' feder·.::'.1 1.::'.1/ . .1.

The case of the United States v. Simon is significant

to the .::..ccount i ng !:Ir·ofe·::.·::.i on bec.:'.u·::.e it est.::..bl i ·::.hed ·::'.n

.::..udi tor· ... ·::. cr' imi n.::.l 1 i .9.bi I it·: .. ,

This case, which is also referred to as the

Continental Vending case, was brought against the

accountants by the government because it was alleged that

they wi Ilful1y orepared false or misleading financial

.::. t .::.. t e"Tle n t ':; .• The audi tors used the defense that they were

f r· e e 0 f c r· i min .:.. IIi .:.. b iIi t::.-· be c a. u .::;. e the ::,. h.:.. d f 0 I I 0'.·'·.1 e d

generally accepted accounting principles. The court

convicted the audi tors of willfully making ~ false and

misleading statement and for using the postal service to

distribute this statement. The auditors received a pardon

from President Nixon. This case imposes a duty upon

accountants to disclose what they Know when they have

r·e·~·::;·on to bel i e'·.!e th.:..t ~. bu·::.i ne·::·s· ent it::,·· to .:.. m.:..ter· i .0..1

22

extent i·". oper·a.t i rjl~ for· the !:Ir· i '.).o..te benef it of its.

management rather than in the interest of its stockholders.

The accounting profession was very concerned about the

decis.icln bec.o..u·::.e it felt th.o..t compl ia.nce ' .... .Iith I3AAP .o..nd I3AA:::;

should be a strong defense.

Within recent Years, the number of cases against

accountants has increased and as a result, more precautions

are being taken. One of the first things an accountant

should do to avoid litigation is make sure he Knows and

c om 1:' 1 i e·::· 1} • .1 i t h .0.. C C 0 u n tin g.::. t .0.. n d a. r· d·::;. .0<. n d p r· 0 n 0 u n c em e n t .:: ..

These ·:..r·e the gu i del i ne·:: of the pr·ofe·=.·=.i on, .o..nd ·:..n

·~., .... .I.o..r·ene·=··=· of them i·::;. e·=··=·en t i .~.I to pr·o',) i de qu.o..1 i t:;.-· ·=·er·'·) i ce

.o..nd r·educe e::q::oo·=.ur·e to 1 it i g.:..t i on. Continuing professional

education is an excellent way to keep current on the

ever-changing standards of the accounting profession.

r·'10·=.t .o..ccounta.nt·= .. o..nd the AICPA bel i e'·)€' tha.t if tr,e

professional standards are followed, an accountant should

not t.e ·=.ubject to 1 i .:..bi 1 i t:: ... bec.o..u:;:.e cour·t·=. c.o..nnot impo·=.e

higher standards than the standards of the profession. To

,jo t hi·:. I.'-IOU 1 d i fT'P o·:·e I i a.b i 1 it::... e I.} e n i f the .3.C c ou n t .:'.n t d i ,j

everything he ought to do. Lawyers of plainti~fs disagree

li . .!i th this bec.:..u·:.e the':," bel iel.}e tha.t the pr·o·fes.sion might

have set standards too low to provide adequate care.

Courts have also ruled, as in Uni ted States v. Simon, that

c om CI I i a. n c e 1 .. ' . .1 i t h i3AA:::: .:.. n d (3AA P m .:<. Y' not CI r' e I) e n t .:.. n .:.. c c 0 u n t .:.. n t

from being liable. The SEC promulgates new rules and

regulations when it feels that accounting standards are not

accountants to comply wi th the standards, but also go

beyond the stan,jards and apply their good judgement.

C clm p Ii.:.. n c e li..\ i t h p r' 0 f e':· ';. ion .:.. I .:.. c c 0 u n tin g';, t .:.. n d.:.. r' d .=. II i,;.

no guarantee that under particular circumstances an auditor

wi I I be held blameless. There is simply no substitute for

vigilance and good judgement when it comes to avoiding

b I .:'.me . II ( 15)

Besides Knowledge of accounting principles and

pronouncements, members of the accounting profession

recommen,j other precautions that should be taKen to avoid

Ii til;J:..tion. One of the·;.e i,;. cl i ent accept.:..nce .:'.nd

r' e ten t i on . Befor'e .:'.ccep t i nl~ .:.. nel .. ,.! c I i en t. it i,;, i mpor' t.:'.n t

to do ·;.uch th i nq·:. ·3.'=· 1001< into the cl i ent···s b.3.cKgr·ound,

find out who the predecessor accountant IS, and learn all

':'.bou t the c I i en t' ';. bu';. i ne·:··=·. ~~et.:..ininq ·3. cl lent decr·e.3se·:::.

::,., 0 u r' pot e n t i.:.. IIi .:.. b iii t Y' be c·:,. u .:::. Eo :;'-' 0 u be c om e m 0 r' e f am iii ·3. r'

with his operations as time goes on.

An engagement letter is a very effective precaution.

24

The letter' i,:;: .. ;:..ctu.;:..I]::,' .;:.. con tr·,;:,.c tu.;:'.l .;:'.';Ireement th.;:'.t can

.;:..c tu.:;'.l I;.' r'educe the E'XPE'C t':'.t i on .:;).;:'.p. I t i,:;:, not r' E' qui r' E' db::.'

thE' professional standards. but most accountants USE' it

anfi~ay to spE'11 out thE' SCOPE' of thE' audit and avoid

misundE'rstandings.

Th r' ou.:;)h q u .:;..1 i t /. con t r' 0 1 ~ ':'.n ·;t.u d i t clr' doE' .:. hi·:; bE' .:. t to

apply thE' samE' hi.:;)h standards durin.:;) E'ach engagE'mE'nt.

C!u.;t.1 i 1:::.-' contr'ol c·;t.n tiE' m':'.int.:'.inE'd b::,.· ·:.ettin9 up ·:.t.:;'.nd':'.r·d

procedures to follow and propE'rly planning en.:;)a9E'mE'nts.

DthE'r' th i ngs ·:'.r·e i n l.}ol '')E'd .;:..l·:.o~ 1 ike qu.;t.1 it::,·, pE'r··:.onnE'l th.:..t

are propE'rly supervisE'd.

AnothE'r way to 9uard a.:;)ainst 1 i tigation :. to b.;t.l.;t.nce

I;;) r' 01.'0.1 t h .:.. n ,j qua lit y' con t r' 0 I • Growth brin.:;)s on things that

c .;t. n d ·:'.m .;:.. 9 E' q U .;:.. 1 ; t >' ·:;u C h.:.. ':;:. lim i t E' d '5U P E' r' I.} i s ion be c ·;:..u .:. E' the

f i r'm i·:. under··:.t.:;..ffed. e:>::ce·:.·:.i I·}e de~.dl i ne pr·es.s.ur·e •. :;..nd

hE'avy overtimE' requirE'ments. Accountants must guard

.;:..,;;)~.in·:;.t thE'sE' thinl;J':' v . .Ihile ·:;:.til1 ~.]loIAling gr·ol.' . .Ith to h~.ppen.

)efen·:.i'.)e .::<.ulji tin,;;) •. ;:.nother· c'r·eca.ution~ in'.)ol '·}e-:.

looking for and evaluating indicators of possible problems.

An .;:'.u,ji tor' ·:;.houldn···t le.;:'.'-.!e him·:.elf open to .;:..ny 1 i.;:'.bi 1 it::,·,

that :ould be prevented. Among other thin95. he should

document all his work careful IY~ be very cautious about

management representations, and consul t wi th a partner or

colle ~ . .:;)u e of ten.

The 1 .;:. .. :. t p r' e c·:.. uti 0 n p r' e':;:· e n ted her' e i·:; leg .;:.. 1 .;:.. d I.} ice •

Even though an auditor should have a good idea of whether

.;:.. n .;:.. c t i·: ill e 9:<. I the .::<.ctu.::<.l deter·min.;:'.tion i·:. usu.;:..II::.-·

.~----.---.. ----------

.-.1:" £0.-_1

beyond his professional competence. This is why he should

consul t a lawyer when questionable acts surface. One

a.uthor ·:.ta.ted,"Pr·ec.::<.ut i ona.r·::.·· I e.;:)a.1 .::<.d\) i ce, 1 ike· pr·el.)ent i 1·.Ie

medicine, may be essential to a CPA firm/s continuing

.. ' I e .;:).::<.1 rl e a.1 t h •. ' Ii ( 1.'5:..)

Th i·:. p.::<.per· h.::<.·:. e::::p 1 or'ed thE' r·es.pons i b iIi ty .::<.nd

potE'nt i a.1 Ii .::..bi 1 i ty th.3.t a.udi tor":, f.::<.ce 1 .... .Ii th r·e~~a.r·d to

·::<.U d i ted fin ·::<.n c i .~.I .:. t .::<. t erne n t .:., .::<.1 on':;I IAI i t h P r' e c ·:<.u t i on s t h .::<. t

c a.n be t .::<Y e n to qu ·3T d ·::<.9,::<, in'::, t 1 i t i q.::<. t i on • The dr' a.':· t i c

increase in management fraud in the past twenty years has

been hard on accountants because it has resulted in an

The i ncr'ease in the i r' nel;)1 i ';tence has ca.u·:.ed audi tor"":. to

publ i c I .. ·.)ho no!/·) th i nk th.::<.t the Ii .::<.bi 1 it::.·· of a.udi tor'':. ,:.houl d

be j ncr·ea.':·ed. Court decisions and regulations by the SEC

tenlj to r'eflect ·::<.n i ncr·e·3.,:·e in Ii ·::<.bi lit::.··. 1 ... ..1 i th mor'e

1 i a.bi lit::.·· pl.::<.ced on them, .::<.ccount·::<.nt·:. need to t.::..ke

precautions to decrease their chances of being sued.

New areas that wi 1 I present new legal questions in the

near future are compilations and reviews. and forecasts.

When performing a compilation and review, the accountant

c om p i 1 e':· fin ·::<T' c 1 .::<. 1 i n for' m .::<. t ion 9 i I.) e n t 0 him b :>" the c 1 i e n t

and then prepares financial statements.

the statements by performing analytical procedures to

discover unusual items and determine whether the financial

statements appear to conform to generally accepted

accounting principles. A compilation and review is not an

qudi t. so the reviewed statements should be marked

Questions almost definitely

-:._r-I-:-e -:._-:- to I/-_d-I€'th€'r- or- not -:..ccount-:..nt·:. ·:..r·€' 1 i .:._bl e for- th€'·:.€'

.:. t a. t erne n t ",.. 1 .. ·.Jh 0 the Y' m i gh t be 1 i ab 1 e to, a.n dun de r' v-Jh a. t

c i r·cum-:.t.:;'.nce-: ..

~-he i i.:'.bi 1 it::,·· of a.ccount.:'.nt·:- for' fin.:;..nci.:;..1 for·ec.:;..·:.t-::;

is uncertain at the present because an accountant's role in

the preparation and release of forecasts is uncertain. It

is not practical for anyone to expect forecasts to have a

high degree of ~ccuracy because th€'Y are basically €'ducated

I;' U e ';. '=. e ':: .. E: uti n e I.) i t d. b 1 ::'_., the r' e 1/ • .1 ill be':, om e p e 01:) let h d. t

1.'.Iill e::·::pect d_ h.,:::)her· de9r'ee of ·:;..ccur·.:;..c::,' th.:;..n the::,' ·:.hould.

The problem wi 11 be determinin9 if the auditor has any

i .:;._ tl iii t ':,' 1/ . .1 hen -:. om eon 12 r- eli e':· 0 n .:;._ for- e c d .. :. t .

What will auditors be able to expect in the future?

F.: i ':::) h t n 0 1 .... ), i t 1 00 k .:::. 1 ike the i r' Ii.:;.. b 1 iii t ;,' 1 .• ' . .1 ill con tin u €' t 0

increase, unless the values of our society change. I t i·:::.

possible that there will be a great decrease in fradulent

d.cts, ,ju-:.t .:;. .. :. ther·e h-:._·:. been .:;.. gr·e.:;..t incr·ea.·:-€' in r'ecent

/-12 ·:;..r- -:.. bu t don .' t t h ink t hi·:::. 1/ . .1 i 1 h.:..ppen in the ne·:;..r·

fu tur·2. Instead, audi tors wi 1 1 have to do somethin,:::) to

i mpr·o'._-'e the i r' cr-ed i b iii t:;.'. Since ther€' has been some

criticism of the broadness of accounting standards, the

profession might have to consider modifying them to improve

r-el d.t i on-::· 1 •• <.li th the publ i c. Th e r- e i·:. .:;..1 ':·0 -:;. .::: I i I:::)h t

I:lo·:::-·:::.i bi 1 it·:" th-:..t the gOI.}er·nment 1,<.Ii 11 t.:._ke contr-ol .:..nd be

.-,--;' L{

the sale regulator of the accounting profession if the

v . .Ih.:'.t h.:'.ppen·:" .:..udi tor":::. I. ... )i 11 h.?' .... e to be '·}er·::,·· ca.r·efu1 in

their auditing procedures and take all possible precautions

to a.'.}oi d 1 i a.bi 1 it:;.', bec.::,.u·:::.e the 1 i .:'.bi 1 i t:;.-· m.?:'·· become mor'e

than they can bear.

.: 1) Denz i 1 ' .. (. C:.:'.u·:::.e::.', Dut i es .:'.nd Li .~.bi lit! e':::· ot PIJbl i c A c c 0 u rL t .:.. n t s (D OI;.J ,J 0 n e':::· - I r·I .. '.J in, 1 9:3 2 .:.. n d 1 ':;' 7:3) ~ P p. 1 2 - 1 4 .

(2) AccolJn t i nq in Tr·.:'.n·:; it i on: Oral Histories ot Recent U.S. Experience~ ed. Thomas :::;t.:'.te Uni' .... er·:::.ib··, 1':;'74), p. 7.

,J. Bur'n':::" (The Ohio

(:3) George R. Carlett, "Relationship ot Auditing :::;t·~.nd.:'<.r·d·:::. to De tec t ion ot Fr·.~.ud," Con tempor:.~.r·::,·· Aud it i nq Pr' Dt;.l~..lfIS , e d. Hov . .Ia.r· d :::; t e t t 1 e r', (Un i ' .... e r' sit ::.' ot f<a.n '::: .. ~.':::. Printing Service, no cODyright proceedings, 1974), P. 47.

,:4) FloY',j V.I. l....Iinda.l .:'.nd Rober·t r···~. Cor·le::.··, It-Ie 8ccount i nq F'r·ote·:::.si on.~.l: .. Eth i c':::·. Re·:::.pon:.i bi 1 i t;:,·, .~.nd

!:-i·:. . ..Q.LUt;:.-·, (Engle l .... Jood C1 itt·:::.: Pr·entice-H.~.ll , Inc •• l'7'E:O) , p. ':;'2.

(5) Il .. linlj.3.1 ~ p. 94

(6) Kent St. Pierre and James Anderson, "An Analysis ot Aud it F.:.. i I ur·e·:::. B.:.sed on Documen ted Leg.:.. 1 C':'.·:::.e·:::,," :J.Qur·n.:..l ot Accountinq. Audi tinq & Finance, Spring 19:32, pp.

( 7) 1 •• <.1 i n da.l, p. 10:;:: •

(:3) I..,jind.:..l, p.

(9) Nancy E. Landahl and L. Lee Re:.pon·:;. i b iIi t;:.-· for' Fr·.~.ud De tec t i on: 1 .... .Iom.:..n CPA. ,Ju 1;:.-' 19:31, p. 22.

(10) La.ndahl~ p. 22.

( 1 1) C:.:a.1J ":-6' ~'r", p. ''7'5.

::;:;ehmi dt, ,Jr'., "Audi tor' D i .:::.p ell i n 9 .~. r·'l;:.·· t h , "

(12) An dr' ev·.1 H. B':'.r·nett ':'.nd F. FultDn Ga.ler·, ":::;cienter' :::; i nee Hochte I der' ," The CPA ,Jour·n·~.h No'h?mbe r' 19:32, p. 42.

( 14) 1 .. ,.1 i n ,j.:.. 1, p. 225.

(15) 1;..Iinda.l, pp. 142-:3.

(16) Charles Chazen, Richard L. Miller, Jr. and Kenneth I. Solomon. "When the Rules Say: 'See Your L.:'.I/ . .I/·er·, .. '" JOldr·n:. . .1 ot Accoun t.:'.ncy, ,J.:'.nu.:'.r·";.-· 1 '7'::::1, p. t.,O.

B I BL I OGPAF'H"'(

Ac ';;'OU.DJ i rfl~ i n Tr' ·:'.n .::. L t i on : Or_· ."":. . ..!.l---.:H..:....:...i ..=-:;-=. tor' i 12 s clf Pe c 12 n t U_. :::; • ~~ ;':: p 12 r'i 12 n c 12 .!.. Ed. Thorn .:.. s· .J. Bur' n .::. • The 0 h i 0 :::; t a. t e Un i '.)er··::. it:;.", 1 -:';'74.

Ba~nett, And~ew H. ~ CPA, DBA and F. Ful ton Gale~.

"Sc i enter' ::::i nce Hochfel der·." The CPEt .Jour·na.l Novembe~ 1982, PP. 40-45.

Biggs, :::;he~idan C •• J~., CPA. "Pe~spectives in Audi ting -I: or' the 19::::0 .::. ·:'.n d Be -:'-'on d. " .J ou r' n .:'.1 gf Ac I; OU.Jl.,t ·:'.n Q~.-\. May 1982, pp. 93-104.

Catlett, Geo~ge R. "Pelationship of Audi ting Standa~ds to Detection of Fraud." Contempo~a~y Audi ti"9 P~oblems. Ed. Howa~d Stettle~. Unive~si ty of Kansas P~inting :;:;er·'.)ice. t"lo cop:,"r·ight. Pr·oceedinl~-:;. clf the 1974 A~thu~ Ande~sen Unive~sity of Kansas SYmposium on ~~u d i t Pro ob 1 em'::· •

c.:'.u '::·12 ::,., De n z i 1 ", .• , .Jr'., DBA, .JD, CPA. Du tie -:;. ·:.,n d 1:- j a. b j 1 j tie '::. 0 f Pub 1 i cAe C 0 u n t a. n t -:;. • D 01 .... .1 .J 0 n e'::· - I r·I .... ,! in, 1 ';:':32 ·:'.n d 1 ':;:'73 •

Ch ·:..Z 12 n. Ch ·:'.r· 1 e'::., F.: i c h ·:'.r· d L. t"1 ill e r·. .Jr·. a.n d ~:::e nne t hI. ':;01 omon. ·'I.·.Jhen the Pu i es :::;a.::.": .. ' :31212 "'(our' La.' .... .I} .. er·. ,'" Jour·n·:.· .. L .. pf Account.;:'.nc';.'·, .J.:..nlj.;:..r·}·· 19:31, pp. 60-70.

Cr',:,. i g ~ R i ch.:'.r·d L. "The I ndependen t Pub1 i c Accclun t·:'.n t "'-:;. ::;::01 e in At te·::.t i ng F i n.;:'.nc i .;:..1 For·ec.:.,·::.t·:: .• " Cur·r·eILl. j='r'clbl em'::· in the Account i n~·ofe·::,·::.i on. ed. t,::." James A. Cashin, MBA. CPA and Do~othea E. Meye~. PhD. Hemp .::. t e .:'.d: Hof -:;. t r··;:. Un i '') .• Se r' i e'::· 1:3. 1'.)01.3.

Dunfee, Thomas W. and Irvin N. Gleim. " Cr' i min .:'.1 L i .:'.b i it·· ... :1 f A c c 0 Ij n t a. n t -:;. : Sou r' c e -:;. .:'. n d Pol i c i e -:;. • " Am e r' i can Bu'::, i ne-:;··::· L.::..I..<,1 .Jour-n.~ 3pr' i ng 1':;:'71. PI:I. 1-20.

Dz i en kO' .. · .. I·::.k: i, .John S. "Accountants ... · Li a.bi 1 i t)-·· for' Compensation and Review Engagements." e.e t.) i e l .... !....!. Ap r' ill 9::::2, p p. 75'7'-:::: 19.

l~):: a'::· L .:..1 .. • .. 1

"Independent Audi tor"::, Ga.i n Cour·t I·.)i ctor' i e'::,," Arne r' i c ·::'.n B.;:'.r· 6,':.-:;.0': i a. t i on .J our' n a.1_1. .Ju n e 19:32, p. .:;.70.

La. n d a. hI. N a. n c :;... E. ·3. n d L. Lee 3 c h mid t, .J r' . " Au d ito r' F.:e·:.pon·::.i bi'j it·: .. · for' Fr·a.ud Detect i on: Di ,:.pe1 i ng a. ("1:: .. ' t h . " 1 .... .IolI!.:..n C:P~..l... .Ju I :;... 1 '?B 1, P p. 22-::::6.

Solomon. Kenneth I~a~ Cha~les Chazen and Richa~d L. Mi 1 1e~ • • ..1 r' • II C c.m 1:1 i 1 .:;. t ion ·3. n d Pe'.) i e 1 .• ',.1 : the::;; .;:.. f e t y. F.:.. c tor' • II

.Jou.c. n ~:.L __ Q .. :L . .£ic c QU n t~r.!.f..iJ .Ju 1 ':." 19::::3. p p. 50 -5::;:.

:::; t. Pie r' r' €'. ~:::e n t ·:'.n d .J ·:..me ':;;. An de r' ·:;;·on • "An An d.l :: •.. :; i,:;, of Au ,j i t F.:..i lur'e':;;' B.:..=.ed on Documente.j Le9d.1 Ca.·::.e·::., II .1.Q!:!.f':'!l:~J :=,f Accounti~8udi tinq, .:..nd Fin.:'.nce-L :::;pr'in9 1':;:'::::2, pp. 22~'-244.

"T' ... ·)o .Jur·/· '·.)er·di ct·::. Limi t Account.:'.nt=.'· Li B.bi 1 i t::.' in Pe·::.pect to t···le91 i gence ." p. 12.

\..· . .li n d.:.. 1 • Flo:;'-'d 1..' .. 1 •. :'.nd Pober·t t···J. Cor· 1 e::.'. The Account i nq E:..c: of e j:.·::.j_on a.l..; __ E t h j c::·. F.:e sp on -:. i b i 1 i t Y..L. d.n d L i .:..to i 1 t :: .. ' • En91 et .. ·.)ood C1 i ffs: Pr'ent i ce-H.:..l1. Inc., 1';;:'::::0. pp. 1-456.

1.. •.. 1 i n t e r' .::.. A 1 .:.. n ,J. " A I.", 0 i din.;j t·l:.. 1 p r' .:.. c tic eLi B. t. i 1 i t;:.-· '=; u it·::. . II

} ou r' n ·~l_ of_.B.C c ou n t ·;:'.n c.:··, Au 9u s· t 1 ':;:':;:: 1. P p. .::.9-74.