Chapter 1

Chapter 20Legal LiabilityMcGraw-Hill/Irwin

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.1Largest CPA firm payouts in recent class actionsCompanyCPA firmSettlementYear filedCendant Corp.Ernst & Young$633,500,0001998AdelphiaDeloitte & Touche$367,500,0002002Tyco InternationalPwC$225,000,0002002Baptist Foundation of ArizonaArthur Andersen$217,000,0001999Parmalat FinanziariaDeloitte & Touche$157,500,0002004HealthSouth Corp.Ernst & Young$142,500,0002002Superior Bank FSBErnst & Young$125,000,0002002Rite Aid Corp.KPMG$125,000,0001999Lernout & Hauspie Speech ProductsKPMG$115,000,0001999Sunbeam Corp.Arthur Andersen$110,000,0001998Enron CorporationArthur Andersen$105,500,0002001One way to classify law is common law vs. statutesTwo Classes of LawCommon LawCase law developed over time by state court judgesStatutory LawStatutes enacted by Congress, interpreted by federal judgesLO# 220-3Common law state in USA by case Statutory law congress 1933 19343Another way to classify law: who the auditor is liable toThe auditor might be liable to who engaged the auditor (usually, but not always, the company that is audited)The auditor might be liable to users (called 3rd parties) of the financial statements.Here is where auditor liability is unique, as we will learn Auditor sue by 3 partiesDo not direct 4OverviewLO# 2

20-5OverviewLO# 2

20-6Common Lawliability to who engaged the auditorSince there is an agreement, there can be contract liability as well as tort liabilityRequires Due CareTypes of Liability to the ClientMay be held liable for breach of contract (contract law)NegligenceGross negligenceFraud These are all genres of tort lawLO# 320-7Bottom line: if auditor performs with due care he is not liable, if not, he is liable.Auditor sue by client. Company engage the auditor for breach of contrace and tort law Tort law is different state will use different nume

7Negligence (liability to company that engaged the auditor)Requires Due CareIf an engagement is performed without due care, the CPA may be held liable for an actionable tort in negligence. Tort law and GAAS - defines what is due care.LO# 320-8Common Law Negligence: liability of auditor to company that engaged the auditor

Company must prove, inter alia, that the behavior of the auditor constitutes a lack of due care. Different courts use different language, but #1 is the easiest for the company to prove, since it is just barely a lack of due care. #2 is harder to prove, and #3 is the hardest to prove. Ordinary negligence or negligenceGross negligence, recklessness or statutory fraud.Actual fraud or knowing fraud.LO# 320-9Ordinary negligence or negligence - against auditor by 3 party, cant successGross negligence, recklessness or statutory fraud.- 3 party can sue the auditor and win it.Actual fraud or knowing fraud auditor will have3 party can sue the auditor and win it. 9Common Law Negligence: ClientAuditors DefenseNo duty was owed to the client.The client was negligent.The auditors work was performed in accordance with professional standards.The client suffered no loss.Any loss was caused by other events.The claim is invalid because the statute of limitations has expired.LO# 320-10Common law liability to 3rd party users of financialsAs noted above theres only tort law liability to 3rd party users of financials (theres no contract so theres no possible breach of contract)We also noted there are 3 severity levels of bad (less than due care) auditor behavior. #1 is easiest for 3rd party users to prove against an auditor, but in a traditional 3rd party privity or Ultramares state, e.g. New York, if that is all that 3rd party users can prove against the auditor, they lose and the auditor wins (not liable).

Ordinary negligence or negligenceGross negligence, recklessness or statutory fraud.Actual fraud or knowing fraud.11Common Law - 3rd party Ordinary Negligence / Negligence Four approaches for 3rd Parties: Privity or Ultramares is arguably the most important , because it is the original approach and it is what New York uses. Know how to apply it. Simply know that the other 3 approaches exist.PrivityNear PrivityForeseen 3rd PartiesReasonably Foreseeable 3rd PartiesLO# 420-12Common Law3rd PartiesNegligenceThird Party Must ProveThe auditor had a duty to the plaintiff to exercise due care. The auditor was worse than negligence or ordinary negligence (i.e. committed gross negligence, recklessness, constructive fraud, actual fraud or knowing fraud). The auditors breach of due care was the direct cause of the 3rd partys injury. The 3rd party suffered an actual loss as a result. LO# 420-1313Common Law3rd PartiesNegligenceAuditors DefenseAuditors behavior was not worse than negligence or ordinary negligence.The 3rd party was negligent.The 3rd party suffered no loss.Any loss was caused by other events.The claim is invalid because the statute of limitations has expired.LO# 420-14Auditor defense 14Fraud 3rd partiesThird Party Must ProveA false representation by the CPA.Knowledge or belief by the CPA that the representation was false.The CPA intended to induce the 3rd party to rely on the false representation.The 3rd party relied on the false representation.The 3rd party suffered damages. LO# 420-15Fraud

15Statutory Liability The Securities Act of 1933The Securities Exchange Act of 1934Two major federal statutes provide sources of statutory liability for auditors:LO# 520-16Easy for the person to sue the auditor And its hare foe auditor to portect them 16Securities Act of 1933Only applies re an offering of securities.LO# 520-17Could be an IPO or could be A secondary or other kind of offeringSecurities Act of 1933 auditors worst liability exposure to 3rd parties because a) very little must be proved, b) no privity defense allowed, and c) auditor has burden of proof that he performed with due care (due diligence defense) 3rd Party Must Merely Prove to win the sueThe 3rd party suffered losses by investing in the registered security.The audited financial statements contained a material omission or misstatement.

LO# 520-1818Securities ExchangeAct of 1934Applies to offerings plus ongoing reporting (e.g. 10K or 10Q) by public companies.Section 10(b) and Rule 10b-5 are the greatest source of liability for auditors under this act.

LO# 620-1919Securities Exchange Act of 19343rd Party Must ProveA material, factual misrepresentation or omission.Reliance on the financial statements.Damages suffered as a result of reliance on the financial statements.Scienter (gross negligence or recklessness is enough). If 3rd party proves auditor committed knowing fraud then auditor faces joint/several liability instead of proportionate liabilityThis means that the auditor could have to pay all the money, if the lawsuit is lost, instead of just his proportionate share

LO# 620-20Scienter : prove auditor was her behavior more just negligencce

Scienter auditor more bad in his or her behavior.

1934 is use 3 party need to prove more 20SEC and PCAOB Sanctions

Suspend Practicing PrivilegeImpose FinesRemedial MeasuresLO# 920-21