Arens Chapter 5

Legal Liability Chapter 5

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

5-1

Learning Objective 1 Understand the litigious environment in which CPAs practice.

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

5-2

Changed Legal Environment Audit professionals have a responsibility under common law to fulfill implied or expressed contracts with clients. They are liable to their clients for negligence and/or breach of contract should they fail to provide the services or not exercise due care in their performance. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley

5-3

Learning Objective 2 Explain why the failure of financial statement users to differentiate among business failure, audit failure, and audit risk has resulted in lawsuits. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley

5-4

Business Failure, Audit Failure, and Audit Risk Audit Failure

Business Failure

Audit Risk

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

5-5

Business Failure, Audit Failure, and Audit Risk Business failure It occurs when a business is unable to repay its lenders or meet the expectations of its investors because of economic or business conditions.

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

5-6

Business Failure, Audit Failure, and Audit Risk Audit failure It occurs when the auditor issues an erroneous audit opinion as the result of an underlying failure to comply with the requirements of generally accepted auditing standards (GAAS).

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

5-7

Business Failure, Audit Failure, and Audit Risk Audit risk It represents the risk that the auditor will conclude that the financial statements are fairly stated and an unqualified opinion can be issued when, in fact, they are materially misstated.

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

5-8

Learning Objective 3 Use the primary legal concepts and the terms concerning accountants’ liability as a basis for studying legal liability of auditors. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley

5-9

Legal Concepts Affecting Liability Prudent person concept

Liability for the acts of others

Lack of privileged communication

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

5 - 10

Major Sources of Auditor’s Legal Liability

Client

Federal securities laws

Third party

Criminal liability

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

5 - 11

Learning Objective 4 Describe accountants’ liability to clients and related defenses.

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

5 - 12

Liability to Clients

The most common source of lawsuits against CPAs is from clients.

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

5 - 13

Legal Terms Affecting CPAs’ Liability Terms related to negligence and fraud Ordinary negligence

Constructive fraud

Gross negligence

Fraud

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

5 - 14

Legal Terms Affecting CPAs’ Liability Terms related to contract law

Breach of contract

Third party beneficiary

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

5 - 15

Legal Terms Affecting CPAs’ Liability Other terms Common law

Joint and several liability

Statutory law

Separate and proportionate liability

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

5 - 16

Auditor’s Defenses Against Client Suits Lack of duty Nonnegligent performance Contributory negligence Absence of causal connection

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

5 - 17

Learning Objective 5 Describe accountants’ liability to third parties under common law and related defenses.

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

5 - 18

Liability to Third Parties Under Common Law

Ultramares doctrine Foreseen users

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

5 - 19

Foreseen Users Credit alliance

Restatement of torts Foreseeable users ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley

5 - 20

Learning Objective 6 Describe accountants’ civil liability under the federal securities laws and related defenses. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley

5 - 21

Securities Act of 1933 The Securities Act imposes an unusual burden on the auditor. Section 11 of the 1933 act defines the rights of third parties and auditors.

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

5 - 22

Securities Exchange Act of 1934

The liability of auditors under this act often centers on the audited financial statements issued to the public in annual reports or submitted 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 - 23

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 - 24

SEC Sanctions The SEC has the power in certain circumstances to 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 - 25

SEC Sanctions The commission may deny, the privilege of appearing or practicing before it in any way to any person who is found by the commission… (1) not to possess the requisite qualifications to represent others, or (2) to be lacking in character or 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 - 26

Racketeer Influenced and Corrupt Organization Act

This act allows an injured party to seek treble (triple) damages and recovery of legal fees in cases where it can be demonstrated that 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 - 27

Foreign Corrupt Practices Act of 1977

This act makes it illegal to offer a bribe to an official of a foreign country for the purpose of exerting influence and obtaining or retaining business.

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

5 - 28

Learning Objective 7 Specify what constitutes criminal liability for accountants.

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

5 - 29

Criminal Liability CPAs can be held liable under criminal liability for accountants. CPAs can be found guilty for criminal action under both federal and state laws.

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

5 - 30

Learning Objective 8 Describe what the profession and the individual CPA can do and what is being done to reduce the threat of litigation. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley

5 - 31

The Profession’s Response to Legal Liability Research in auditing Standard and rule setting Set requirements to protect auditors Establish peer review requirements

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

5 - 32

The Profession’s Response to Legal Liability Oppose law suits Education of users Sanction members for improper conduct and performance Lobby for changes in laws

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

5 - 33

Protecting Individual CPAs from Legal Liability Example Deal only with clients possessing integrity Hire qualified personnel Follow the standards of the profession Maintain independence

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

5 - 34

Protecting Individual CPAs from Legal Liability Example Understand the client’s business Perform quality audits Document the work properly Obtain an engagement and a representation letter Maintain confidential relations

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

5 - 35

Protecting Individual CPAs from Legal Liability Example Carry adequate insurance Seek legal counsel Choose a form of organization with limited liability Exercise professional skepticism

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

5 - 36

End of Chapter 5

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

5 - 37