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©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 1
Legal Liability
Chapter 5
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 2
Learning Objective 1
Understand the litigiousenvironment in which
CPAs practice.
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 3
Changed Legal Environment
Audit professionals have a responsibility undercommon law to fulfill implied or expressed
contracts with clients.They are liable to their clients for negligenceand/or breach of contract should they fail toprovide the services or not exercise due care
in their performance.
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 4
Learning Objective 2
Explain why the failure of financialstatement users to differentiateamong business failure, audit
failure, and audit risk hasresulted in lawsuits.
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 5
Business Failure, AuditFailure, and Audit Risk
BusinessFailure
AuditFailure
AuditRisk
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 6
Business Failure, AuditFailure, and Audit Risk
Business failure
It occurs when a business is unable torepay its lenders or meet the
expectations of its investors becauseof economic or business conditions.
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 7
Business Failure, AuditFailure, and Audit Risk
Audit failure
It occurs when the auditor issues anerroneous audit opinion as the resultof an underlying failure to complywith the requirements of generally
accepted auditing standards (GAAS).
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 8
Business Failure, AuditFailure, and Audit Risk
Audit riskIt represents the risk that the auditor will
conclude that the financial statementsare fairly stated and an unqualifiedopinion can be issued when, in fact,
they are materially misstated.
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 9
Learning Objective 3
Use the primary legal conceptsand the terms concerningaccountants’ liability as a
basis for studying legalliability of auditors.
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 10
Lack ofprivileged
communication
Liability forthe actsof others
Prudentpersonconcept
Legal ConceptsAffecting Liability
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 11
Federalsecurities laws
Third party
Client
Major Sources ofAuditor’s Legal Liability
Criminalliability
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 12
Learning Objective 4
Describe accountants’ liabilityto clients and related defenses.
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 13
Liability to Clients
The most commonsource of lawsuits
against CPAsis from clients.
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 14
Legal Terms AffectingCPAs’ Liability
Terms related to negligence and fraud
Ordinarynegligence
Grossnegligence
Constructivefraud
Fraud
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 15
Legal Terms AffectingCPAs’ Liability
Terms related to contract law
Breach ofcontract
Third partybeneficiary
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 16
Legal Terms AffectingCPAs’ Liability
Other terms
Commonlaw
Statutorylaw
Joint and severalliability
Separate andproportionate
liability
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 17
Auditor’s DefensesAgainst Client Suits
Lack of dutyNonnegligent performanceContributory negligence
Absence of causal connection
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 18
Learning Objective 5
Describe accountants’ liabilityto third parties under common
law and related defenses.
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 19
Liability to Third PartiesUnder Common Law
Ultramares doctrine
Foreseen users
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 20
Foreseen Users
Credit alliance
Restatement of torts
Foreseeable users
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 21
Learning Objective 6
Describe accountants’ civilliability under the federal
securities laws andrelated defenses.
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 22
Securities Act of 1933
The Securities Act imposes anunusual burden on the auditor.
Section 11 of the 1933 act defines therights of third parties and auditors.
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 23
Securities ExchangeAct of 1934
The liability of auditors under this act oftencenters on the audited financial statements
issued to the public in annual reports orsubmitted to the SEC as a part of annual
Form 10-K reports.
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 24
Auditor Defenses – 1934 Act
Nonnegligent performance
Lack of duty
Absence of casual connection
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 25
SEC Sanctions
The SEC has the power in certain circumstancesto sanction or suspend practitioners from doing
audits for SEC companies. Rule 2 (e) of the SEC’s Rules of Practice says:
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 26
SEC Sanctions
The commission may deny, the privilege ofappearing or practicing before it in any way toany person who is found by the commission…(1) not to possess the requisite qualifications to
represent others, or (2) to be lacking in characteror integrity or to have engaged in unethical or
improper professional conduct.
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 27
Racketeer Influenced andCorrupt Organization Act
This act allows an injured party to seek treble(triple) damages and recovery of legal fees
in cases where it can be demonstratedthat the defendant was engaged in a“pattern of racketeering activity.”
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 28
Foreign CorruptPractices Act of 1977
This act makes it illegal to offer a bribeto an official of a foreign country forthe purpose of exerting influence and
obtaining or retaining business.
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 29
Learning Objective 7
Specify what constitutescriminal liabilityfor accountants.
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 30
Criminal Liability
CPAs can be held liable undercriminal liability for accountants.
CPAs can be found guilty for criminalaction under both federal and state laws.
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 31
Learning Objective 8
Describe what the profession andthe individual CPA can do and
what is being done to reducethe threat of litigation.
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 32
The Profession’s Responseto Legal Liability
Research in auditingStandard and rule setting
Set requirements to protect auditorsEstablish peer review requirements
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 33
The Profession’s Responseto Legal Liability
Oppose law suitsEducation of users
Sanction members for improperconduct and performanceLobby for changes in laws
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 34
Protecting Individual CPAsfrom Legal Liability Example
Deal only with clients possessing integrityHire qualified personnel
Follow the standards of the professionMaintain independence
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 35
Protecting Individual CPAsfrom Legal Liability Example
Understand the client’s businessPerform quality audits
Document the work properlyObtain an engagement and a representation letter
Maintain confidential relations
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 36
Protecting Individual CPAsfrom Legal Liability Example
Carry adequate insuranceSeek legal counsel
Choose a form of organization with limited liabilityExercise professional skepticism
©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 37
End of Chapter 5