©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 1

Legal Liability

Chapter 5

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Learning Objective 1

Understand the litigiousenvironment in which

CPAs practice.

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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.

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Business Failure, AuditFailure, and Audit Risk

BusinessFailure

AuditFailure

AuditRisk

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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.

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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).

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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.

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Learning Objective 3

Use the primary legal conceptsand the terms concerningaccountants’ liability as a

basis for studying legalliability of auditors.

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Lack ofprivileged

communication

Liability forthe actsof others

Prudentpersonconcept

Legal ConceptsAffecting Liability

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Federalsecurities laws

Third party

Client

Major Sources ofAuditor’s Legal Liability

Criminalliability

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Learning Objective 4

Describe accountants’ liabilityto clients and related defenses.

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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

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Legal Terms AffectingCPAs’ Liability

Terms related to contract law

Breach ofcontract

Third partybeneficiary

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Legal Terms AffectingCPAs’ Liability

Other terms

Commonlaw

Statutorylaw

Joint and severalliability

Separate andproportionate

liability

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Auditor’s DefensesAgainst Client Suits

Lack of dutyNonnegligent performanceContributory negligence

Absence of causal connection

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Learning Objective 5

Describe accountants’ liabilityto third parties under common

law and related defenses.

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Liability to Third PartiesUnder Common Law

Ultramares doctrine

Foreseen users

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Foreseen Users

Credit alliance

Restatement of torts

Foreseeable users

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Learning Objective 6

Describe accountants’ civilliability under the federal

securities laws andrelated defenses.

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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.

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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.

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Auditor Defenses – 1934 Act

Nonnegligent performance

Lack of duty

Absence of casual connection

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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:

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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.

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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.”

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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.

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Learning Objective 7

Specify what constitutescriminal liabilityfor accountants.

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Criminal Liability

CPAs can be held liable undercriminal liability for accountants.

CPAs can be found guilty for criminalaction under both federal and state laws.

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Learning Objective 8

Describe what the profession andthe individual CPA can do and

what is being done to reducethe threat of litigation.

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The Profession’s Responseto Legal Liability

Research in auditingStandard and rule setting

Set requirements to protect auditorsEstablish peer review requirements

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The Profession’s Responseto Legal Liability

Oppose law suitsEducation of users

Sanction members for improperconduct and performanceLobby for changes in laws

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Protecting Individual CPAsfrom Legal Liability Example

Deal only with clients possessing integrityHire qualified personnel

Follow the standards of the professionMaintain independence

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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

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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