Chapter 5 Legal Liability

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Chapter 5Legal Liability
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Presentation Outline

1. Preliminary Legal Concepts
2. Common Law and the Auditor
3. Statutory Law and the Auditor
4. Professions Response to Legal Liability
5. Protecting Individual CPAs from Legal Liability

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I. Preliminary Legal Concepts

1. Distinguishing Between Failures and Audit Risk
2. The Expectations Gap
3. The Prudent Person Concept
4. CPA Liability

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A. Distinguishing Between Failures and Audit Risk

• Business failure occurs when a business is unable
  to repay its lenders or meet the expectations of
  investors because of economic or business
  conditions.
• Audit risk represents the risk that the auditor
  will conclude that the financial statements are
  fairly stated when in fact they are materially
  misstated.
• Audit failure occurs when the auditor issues an
  erroneous audit opinion as a result of failing to
  comply with GAAS.

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B. The Expectations Gap

• Many financial statement users believe that
  auditors guarantee the accuracy of financial
  statements, and some even believe that an auditor
  guarantees the financial viability of the
  clients business.
• Most auditors believe that the conduct of an
  audit in accordance with GAAS is all that can be
  expected of auditors.
• In most cases, courts continue to support the
  auditors view.

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C. The Prudent Person Concept

• A person offering service is understood as
  holding themselves out to the public as
  possessing the degree of skill commonly possessed
  by others in the same employment, and if the
  pretentions are unfounded, commits a species of
  fraud upon every person who employs them.
• A person is liable for negligence, bad faith, or
  dishonesty, but not for losses resulting from
  pure errors of judgment.

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D. CPA Liability

• Joint and Several Liability
• The assessment against a defendant for the full
  loss suffered by the plaintiff, regardless to
  which other parties shared in the wrongdoing.

• Separate and Proportionate Liability
• The assessment against a defendant caused by the
  defendants negligence. For example, if 30 of
  plaintiff loss is due to misstated financials an
  accountant would only be held liable for the 30.

For lawsuits in state courts, state law
determines which approach to damages applies.
When lawsuits are brought under federal
securities laws, the separate and proportionate
approach will apply except in cases where it can
be shown that the CPA knew or participated in the
fraud.
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II. Common Law and the Auditor
A. Common Law Defined

1. Sources of Auditor Liability to Clients Under
   Common Law

C. Common Law Burden of Proof
D. Auditor Liabilities to Third Parties
E. Auditor Defenses Under Common Law
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A. Common Law Defined
Common law refers to unwritten or case-made law
that evolves from prior or precedent cases. It
is state dependent meaning that different laws
can be applied under common law in different
states.
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B. Sources of Auditor Liability To Clients Under
Common Law
Suit in Contract is based on privity and the
auditors alleged breach of the agreement (usually
the engagement letter). This source does not
apply to third parties (nonclients).
Suit in tort is based on negligence, gross
negligence, or fraud.
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B1. The Meaning of Negligence
Negligence is a failure of a CPA to use due
professional care. It is also known by the names
simple negligence and ordinary negligence.
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B2. The Meaning of Gross Negligence

• The CPA made a representation about a material
• fact with lack of reasonable support.

2. The purpose of the representation was to
induce reliance by another.
3. The representation was relied on by the client
or third party.
4. The reliance caused damages to the client or
third party.
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B3. The Meaning of Fraud
Fraud contains the following items
1. False representation

1. Knowledge of a wrong and acting with the intent
   to deceive

3. The intent to induce reliance
4. Justifiable reliance
5. Resulting damages
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B4. A Comparison of Terms

• Negligence v. Gross Negligence
• Difference is a matter of degree. Negligence is
  failure to exercise due care. Gross negligence
  is a reckless departure from the standard of due
  care.

• Gross Negligence v. Fraud
• Fraud is different from gross negligence in that
  there is an intent to deceive.

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C. Common Law Burden of Proof
In order to hold the auditor liable for
substandard auditing, the client must prove

1. The CPA has a duty of care to the client.

1. The CPA has breached the duty of care.

3. The client suffered damages.

1. The damages were caused by the CPAs breach of
   the duty of care.

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D1. Auditor Liability to Third Parties
(Nonclients) Traditional Rulings
Ultramares Corporation v. Touche decided in
1931 in New York.
The Ultramares doctrine holds that ordinary
negligence is insufficient for liability to third
parties because of lack of privity of contract
between the third party and the auditor, unless
the third party is a primary beneficiary.
However, liability to more general third parties
will exist if the the third plaintiff can
establish gross negligence or fraud. Many courts
have broadened the Ultramares doctrine by
introducing the concept of a forseen user. Three
views have emerged regarding the concept of
forseen users.
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D2. Views on Auditor Liability to Third Parties
Credit Alliance (1) Auditor must know and intend
that the work product be used by the plaintiff
third party for a specific purpose. (2) The
knowledge and intent must be evidenced by the
auditors conduct.
Restatement of Torts Rule Forseen users must be
members of a reasonably limited and identifiable
group of users that have relied on the CPAs
work, such as creditors, even though those
persons were not specifically known to the CPA at
the time the work was done.
Forseeable Users Any users that the auditor
should have reasonably been able to forsee as
being likely users of financial statements have
the same rights as those with privity of contract.
Current movement is away from the forseeable
users approach. There may be some movement toward
the Credit Alliance ruling.
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E. Auditor Defenses Under Common Law
CPA may use the following defenses under common
law
1. There was a lack of duty to perform the
service.
2. The engagement was performed using reasonable
care and skill, and in accordance with GAAS.
3. There is no connection between the clients
loss and the CPAs actions.
4. The client was contributively negligent.
Note that is defense is not viable against third
party plaintiffs since they are not in a position
to misstate the financial statements.
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III. Statutory Law and the Auditor
A. Statutory Law Defined
B. The Sarbanes-Oxley Act
C. Liability to Third Parties (Nonclients) Under
the Securities Acts
D. Criminal Procedures and Defenses
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A. Statutory Law Defined
Statutory law refers to written law as
established by federal or state legislative
bodies.
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B. The Sarbanes-Oxley Act

• The Sarbanes-Oxley Act provides for fines and
  imprisonment of up to 20 years for altering or
  destroying documents to impede an official
  investigation. (See Figure 5-9 on page 122)

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C. Liability to Third Parties (Nonclients) Under
the Securities Acts
The Securities Acts signficantly extended the
CPAs liability to third parties beyond the
bounds of common law.
Securities Act of 1933 (1933 Act) regulates the
initial offering and sale of securities through
the mails and other forms of interstate commerce.
Only protects original purchaser of securities.
Securities Exchange Act of 1934 (1934 Act) deals
primarily with trading in previously issued
securities.
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C1. Plaintiffs Burden of Proof Under the 1933
Act - Section 11

1. The security was part of the offering of shares
   covered by the registration statement.

1. The registration statement was false or
   misleading or omitted material information that
   should have been included.

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C2. Auditor Defenses under the 1933 Act - Section
11

• Third-party users do not have the burden of proof
  that they relied on the financial statements or
  that the auditor was negligent or fraudulent in
  doing the audit. The auditor has the burden of
  demonstrating as a defense that
• An adequate audit was conducted in the
  circumstances or
• all or a portion of the plaintiffs loss was
  caused by factors other than the misleading
  financial statements.

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C3. Plaintiffs Burden of Proof Under the 1934
Act Rule 10b-5

1. The materiality of the alleged false, misleading,
   or omitted statement.

1. The CPAs knowledge of the statement. Although
   not the current trend, earlier cases considered
   poor judgment to be equivalent to knowledge.

1. The plaintiffs reliance on the statements.

1. Actual damages sustained as a result of such
   reliance.

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C4. Auditor Defenses under the 1934 Act Rule
10b-5

1. CPAs conduct does not include scienter.
   Scienter is a mental state embracing intent to
   deceive, manipulate or defraud.

2. The engagement was performed using reasonable
care and skill, and in accordance with GAAS.
3. There was a lack of duty to perform the
service.
4. There is no connection between the clients
loss and the CPAs actions.
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D. Criminal Procedures and Defenses

1. In a criminal action, the U.S. Justice Department
   or the state attorney general files suit as the
   plaintiff.

1. Plaintiff does not need to establish damages,
   only that a statute has been violated.

1. Plaintiff must establish beyond a reasonable
   doubt that the auditor knew they were acting
   criminally.

1. Primary defense is good faith meaning that the
   audit complied with GAAP and GAAS, and there was
   no willful knowledge of criminal acts.

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IV. Professions Response to Legal Liability

• Auditing research in regard to errors, fraud, and
  auditor independence.
• Standard setting to meet changing needs.
• Peer review to identify deficiencies in meeting
  standards.
• Oppose unwarranted lawsuits.
• Lobby for changes in laws to protect accountants.

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V. Protecting Individual CPAs from Legal Liability

• Deal only with clients possessing integrity.
• Understand the clients business.
• Document the work properly.
• Exercise professional skepticism.

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The Legal Environment of the Auditor
Illegal Client Acts
Common law
Negligence Gross negligence Fraud
Statutory law
Securities laws Criminal liability