Professional Liability

1
Chapter 17

• Professional Liability

2
What is the public accountants responsibility?

• The responsibility of public accountants to
  safeguard the public's interest has increased as
  the number of investors has increased, as the
  relationship between corporate managers and
  stockholders has become more impersonal, and as
  government increasingly relies on accounting
  information.

3
Discuss Auditor Liability

• Auditor liability to their clients and third
  party user groups is derived from the following
  laws
• Contract law - Liability is based on breach of
  contract. The contract is usually between the
  public accounting firm and the client for
  performance of a professional service, such as an
  audit performed according to GAAS
• Common law - Liability concepts developed through
  court decisions and based on auditor negligence,
  gross negligence or fraud
• Statutory law - Liability based on state statutes
  or Federal securities laws. The most important of
  these to the auditing profession are the
  Securities Act of 1993 and the Securities and
  Exchange Act of 1934

4
Factors leading to increased litigation against
auditors

• User awareness of the possibilities and rewards
  of litigation
• Joint and several liability statutes that permit
  a plaintiff to collect the full amount of the
  settlement from any defendant, even those only
  partially responsible for the loss (i.e. deep
  pockets theory)
• Increased audit complexity caused by computerized
  systems, new types of transactions and
  operations, more complicated accounting
  standards, more international business
• More demanding audit standards for detection of
  errors and fraud

5
Factors leading to increased litigation against
auditors

• Pressures to reduce audit time and improve audit
  efficiency
• Misunderstanding by users that an unqualified
  opinion is an insurance policy against
  misstatements (expectations gap)
• Contingent-fee-based compensation for law firms,
  especially in class action lawsuits
• Class action lawsuits which allow law firms to
  combine defendants into one legal action
• Punitive damages

6
Discuss Potential Liability

• To understand the potential liability, the
  auditor must understand
• Concepts of breach of contract and tort
• Parties who may bring suit
• Legal precedence and statutes that may be as a
  standard against which auditor performance may be
  evaluated
• Auditor defenses

7
Discuss Causes of Legal Action

• Causes of legal action
• Breach of contract
• Negligence failure to exercise a reasonable
  level of care that causes damage to another
• Gross negligence failure to exercise even a
  minimal level of care (reckless disregard) but
  without intent to harm or damage anyone
• Fraud intentional concealment or
  misrepresentation of material facts that cause
  damages to those deceived (scienter)

8
Comment on Civil Liability

• Auditors may be held civilly liable by clients
  and third parties who use audited financial
  statements. This civil liability is based
• Contract law
• Common law
• Statute

9
Define Breach of Contract

• Breach of Contract occurs when auditor fails to
  perform a contractual duty
• Breach actions include
• failing to complete the engagement within the
  agreed-upon time
• withdrawing from the engagement without
  sufficient justification
• violating client confidentiality
• failing to provide professional quality work
• Parties to the contract can file suit

10
Define Breach of Contract

• Court remedies to a breach include
• order auditors to fulfill the contract (specific
  performance)
• issue injunction to prohibit the auditor from
  continuing the breach
• order auditor to pay compensatory (actual)
  damages
• Auditor defenses include
• auditor did not breach the contract
• client was contributory negligent
• client losses were not caused by the breach

11
Review Common Law Liability

• To prevail, a plaintiff must generally prove four
  things
• Existence and amount of damages
• Financial statements were materially misleading
• Plaintiff relied on the statements and as a
  result, suffered damages (causality)
• Auditor misconduct - the level of misconduct that
  must be proved depends on who the plaintiff is,
  and the jurisdiction in which the suit is filed

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Who are the plaintiffs under common law?

• The courts have ruled auditors can be held liable
  by clients and third parties reasonably expected
  to rely on audited statements.
• Generally, courts have classified third party
  users into 3 groups
• Identified users are specific individual users
  who the auditor knows will use the statements to
  make a specific decision
• Foreseen users while not individually known,
  belong to a specific group of users whom the
  auditor knows will use the statements
• Foreseeable users belong to a general class of
  users whose members may or may not use the
  financial statements

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Level of Auditor Misconduct

• The level of auditor misconduct a third party
  plaintiff must prove depends on which group the
  plaintiff belongs to and the jurisdiction in
  which the case is tried

14
Auditor Liability

• Auditor liability under Federal statute was
  established by the Securities Act of 1933, and
  the Securities Exchange Act of 1934, and most
  recently modified by Sarbanes/Oxley Act of 2002
• Auditors found to be unqualified, unethical, or
  in willful violation can be disciplined by the
  SEC. Sanctions include
• Temporarily or permanently revoking the firm's
  registration with the Public Company Accounting
  Oversight Board
• Civil penalties of up to 750,000 per violation
• Require continuing education of firm personnel
• Investors in public companies may sue auditors
  under common law, statutory law, or both.

15
Securities Act of 1933

• Requires companies to file S-1 Registration
  statement with SEC before they issue new
  securities to the public
• Audited financial statements are included in the
  Registration statement (and prospectus)
• Because it covers the issue of new securities,
  the Act requires a very high standard of care.
  Plaintiffs need prove only
• financial statements were materially misleading
• plaintiff suffered damages
• plaintiffs do not need to prove reliance on the
  statements or auditor misconduct
• Auditor defenses include
• proving financial statements were not materially
  misstated
• proving plaintiff damages were not caused by the
  misleading financial statements
• proving auditor acted with due professional care

16
Securities Exchange Act of 1934

• The Securities Act of 1934 regulates trading of
  securities after their initial issuance
  (secondary market) and the filing of periodic
  reports with the SEC. These reports include
  annual reports and 10-Ks, quarterly financial
  reports and 10-Qs, and 8-Ks.
• The 1934 Act holds auditors to a much lower
  standard of care than the 1933 Act. Under the
  1934 Act, plaintiffs must prove
• Existence and amount of damages
• Financial statements were materially misleading
• Plaintiff relied on the statements and as a
  result, suffered damages (causality)

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Securities Exchange Act of 1934

• Auditor misconduct - the level of misconduct that
  must be proved is the subject of much debate. In
  Ernst Ernst v. Hochfelder, the U.S. Supreme
  Court held that
• Congress had intended that the plaintiff prove
  the auditor acted with scienter
• However, the Court reserved judgment as to
  whether gross negligence would be sufficient to
  impose liability
• In several cases following Hochfelder, judges and
  juries have used a standard of "reckless conduct"
  to hold auditors liable

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Criminal Liability to Third Parties

• Both the 1933 and 1934 Acts provide for criminal
  actions against auditors - guilty persons can be
  fined or imprisoned for up to five years.
• Key cases regarding auditor criminal liability
• Continental Vending (U.S. v Simon)
• Equity Funding
• U.S. v Duncan

19
Policies to Help Assure Auditor Independence

• Periodic rotation of audit engagement partner
• Prohibit certain non-audit services for public
  company audit clients
• Restrict other non-audit services for audit
  clients
• Firm policies including training programs that
  emphasize auditor independence and requiring each
  auditor to sign a statement of independence
• External quality reviews Sarbanes/Oxley Act
  requires the PCAOB perform quality reviews of
  registered public accounting firms
• Internal reviews concurring partner reviews and
  interoffice reviews

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Approaches to Mitigate Liability Exposure
(Defensive Auditing)

• Defensive auditing means taking special actions
  to avoid lawsuits. In addition to establishing
  good quality controls and quality/peer reviews,
  firms can take other actions
• Use engagement letters for all financial
  statement and consulting engagements
• Client screening
• Do not accept engagements for which the firm is
  not qualified
• Maintain complete and accurate audit
  documentation
• Limited liability partnerships
• Carry sufficient professional liability insurance
• Tort reform