chapter 1 – the demand for audit and other assurance … · ©2012 prentice hall business...

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5 - 1

Legal Liability

Chapter 5


Learning Objective 1

Understand the litigious environment in which CPAs practice.


Changed Legal Environment

Audit professionals have a contractual responsibility with clients.

Auditors are liable for negligence. The number of lawsuits and sizes of awards remain high.



Growing awareness by financial statement users

Increased consciousness of the SEC

Complexity in business drives complexity in auditing and accounting functions

Litigious society

Major contributors:



Large civil court judgments against CPA firms

Willingness of CPA firms to settle out of court

Judges’ and jurors’ difficulty in understanding technical accounting and auditing matters

Major contributors (cont.):



Explain why the failure of financial

statement users to differentiate among business failure, audit failure, and audit risk has resulted in lawsuits.


Business Failure, Audit Failure, and Audit Risk

Business failure

A business is unable to meet its obligations or investor expectations due to economic or business conditions.



Audit failure

Auditor issues an incorrect opinion from a failure to follow GAAS.



Audit risk

The risk that the auditor fails to find a material misstatement and issues an unqualified opinion.



Use the primary legal concepts

and terms concerning accountants’

liability as a basis for studying

legal liability of auditors.


Prudent person concept

Liability for the acts of others

Lack of privileged communication

Legal Concepts Affecting Liability


Legal Terms Affecting CPAs’ Liability

Terms related to negligence and fraud: Ordinary negligence

Gross negligence

Constructive fraud

Fraud



Breach of contract

Contract Law

Third party beneficiary



Other terms:

Common law

Joint and several liability

Statutory law

Separate and proportionate liability



Describe accountants’ liability to

clients and related defenses.


Four Major Sources of Auditors’ Legal Liability


Liability to Clients

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


Auditor’s Defenses Against Client Suits

Lack of duty to perform

Nonnegligent performance

Contributory negligence Absence of causal connection



Describe accountants’ liability to

third parties under common law

and related defenses.


Liability to Third Parties Under Common Law

Ultramares doctrine

Foreseen users


Foreseen Users

Credit alliance Restatement of torts

Foreseeable user


Auditor Defenses Against Third-Party Suits



Describe accountants’ civil liability

under the federal securities laws

and related defenses.


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.


Securities Exchange Act of 1934

Auditor liability under this act often centers on the audited financial statements issued in annual reports


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.

“Scienter” states that auditors must have the knowledge and intent to deceive in order to be liable for violation of Rule 10b-5.


SEC Sanctions

SEC can sanction or suspend practitioners.

SEC has temporarily suspended a number of individual CPAs from auditing SEC clients.


Foreign Corrupt Practices Act of 1977

Bribing a foreign official for the purpose of exerting business related influence is illegal.


Sarbanes-Oxley Act of 2002

CEO and CFO are required to certify financial statements filed with the SEC.

Management must report on the effectiveness of internal controls over financial reporting.

Auditors must opine on internal controls over financial reporting.



Specify what constitutes criminal

liability for accountants.


Criminal Liability


Sarbanes-Oxley Act

This act makes it a felony to destroy or create documents to impede or obstruct a federal investigation.


Auditor Defenses – 1933 & 1934 Acts



Describe what the profession and

the individual CPA can do and

what is being done to reduce

the threat of litigation.


The Profession’s Response to Legal Liability

Research in auditing Standard and rule setting

Set requirements to protect auditors Establish peer review requirements


The Profession’s Response to Legal Liability

Oppose lawsuits Education of users

Sanction members for improper conduct and performance Lobby for changes in laws


Protecting Individual CPAs from Legal Liability

Follow Professional

Standards

Honest Clients

Maintain Independence

Qualified Personnel



Understand the client’s business Perform quality audits

Document the work properly

Obtain an engagement and a representation letter Maintain confidential relations



Carry adequate insurance Seek legal counsel

Choose a form of organization with limited liability Exercise professional skepticism


End of Chapter 5

chapter 1 – the demand for audit and other assurance … · ©2012 prentice hall business...

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