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Professional Liability, Auditor Judgment Frameworks, and Professional Responsibilities

Auditing A Risk-Based Approach To Conducting A Quality Audit 10 th edition. Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg. Chapter 4. Professional Liability, Auditor Judgment Frameworks, and Professional Responsibilities. Learning Objectives.

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Professional Liability, Auditor Judgment Frameworks, and Professional Responsibilities

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  1. AuditingA Risk-Based Approach To Conducting A Quality Audit 10th edition Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg Chapter 4 Professional Liability, Auditor Judgment Frameworks, and Professional Responsibilities

  2. Learning Objectives • Discuss the liability environment in which auditors operate and explore the effects of lawsuits on audit firms • List laws from which auditor liability is derived and describe the causes of legal action against auditors • Describe auditor liability under contract law, common law, and statutory law

  3. Learning Objectives • Articulate a framework for making quality professional decisions and apply this framework in selected audit settings • Articulate a framework for making quality ethical decisions and apply this framework in selected settings • Identify guidance on auditors’ professional responsibilities and make audit decisions informed by the appropriate professional guidance.

  4. THE AUDIT OPINION FORMULATION PROCESS

  5. Learning Objective 1 Discuss the Liability Environment in Which Auditors Operate and Explore the Effects of Lawsuits on Audit Firms

  6. Effects of Lawsuits on Audit Firms • Litigation cases are expensive for audit firms • Result in monetary losses • Consume time of audit firm members • Hurt their reputation • Practice protection costs are second-highest costs for audit firms after employee compensation costs

  7. Reasons for Litigation against Audit Firms • Liability doctrines permit a recovery of full amount of settlement from an external audit firm even though that firm is found to be only partially responsible for the loss • Deep-pocket theory: Suing another party based on perceived ability of that party to pay damages

  8. Liability Doctrines • Joint and several liability: Apportions losses among all defendants who have an ability to pay for damages, regardless of level of fault • Designed to protect users suffering losses because of misplaced reliance on materially misstated financial statements • Proportionate liability: Payment by an individual defendant based on degree of fault

  9. Reasons for Litigation against Audit Firms • Class action suits and associated user awareness of possibilities and rewards of litigation • Contingent-fee-based compensation for law firms • Misunderstanding by some users of financial statements that an unqualified audit opinion represents an insurance policy against investment losses • Results in an expectations gap

  10. Learning Objective 2 List Laws from Which Auditor Liability is Derived and Describe the Causes of Legal Action against Auditors

  11. Laws from Which Auditor Liability is Derived • Common law: Liability concepts developed through court decisions based on negligence, gross negligence, or fraud • Contract law: Liability occurred where there is a breach of contract • Contract is between external auditor and client for performance of financial statement audit • Statutory law: Developed through legislation • Securities Act of 1933 • Securities Exchange Act of 1934 • Sarbanes-Oxley Act of 2002

  12. Causes of Legal Action • Breach of contract • Failure to perform a contractual duty that has not been excused • For audit firms, parties to a contract include clients and designated third-party beneficiaries

  13. Causes of Legal Action • Negligence: Failure to exercise reasonable care, thereby causing harm to another or to property • Gross negligence • Failure to use minimal care or evidence of activities that show a recklessness or careless disregard for truth • Evidence may not be present, but inferred by jury because of carelessness of defendant’s conduct

  14. Causes of Legal Action • Fraud: Intentional concealment or misrepresentation of a material fact • Intending to deceive another person • Causing damage to deceived person • Scienter: Knowledge on part of person making representations, at the time they are made, that they are false

  15. Parties that May Bring Suit against Auditors • Client and third-party users - Anyone who can support a claim that damages were incurred based on misleading audited financial statements can bring a claim against an auditor • Can accuse auditor of: • Breach of contract • Tort: A civil wrong, other than breach of contract, based on negligence, constructive fraud, or fraud

  16. Exhibit 4.1 - Overview of Auditor Liability

  17. Learning Objective 3 Describe auditor liability under contract law, common law, and statutory law

  18. Common-Law Liability to Clients - Breach of Contract • Can be held liable to clients under contract law and/or under common law for breach of contract • Can be sued under concepts of negligence, gross negligence, and fraud • Causes for action • Violating client confidentiality • Failing to provide audit report on time • Failing to discover a material error or employee fraud • Withdrawing from an audit engagement without justification

  19. Common-Law Liability to Clients - Breach of Contract • Remedies for breach of contract • Requires specific performance of contract agreement • Grant an injunction prohibiting auditor from certain acts • Provide for the recovery of amounts lost • Auditor’s arguments as defenses against a breach of contract • Auditor exercised due professional care • Client was contributory negligent • Client’s losses not caused by breach

  20. Common-Law Liability to Third Parties • To win a claim against the auditor, third parties suing under common law must prove that: • They suffered a loss • The loss was due to reliance on misleading financial statements • The auditor knew, or should have known, that financial statements were misleading

  21. Differing Requirements for Auditor Liability to Third Parties • Foreseeability and negligence • The Ultramares case: Third-party beneficiary test • Expansion of Ultramares: Identified user test • Foreseen user test • Foreseeable user test

  22. Foreseeability and Negligence • Critical point in determining the type of claim is the likelihood that an auditor could foresee the user relying upon audited financial statements • Less foreseeable plaintiffs need to establish a gross negligence claim • Foreseeable users, in some jurisdictions, have to establish only a negligence claim

  23. The Third-Party Beneficiary Test • Ultramares Corporation v. Touche case • Court held auditors liable to third parties for fraud and gross negligence, but not for negligence • Third-party beneficiary: A person who was not a party to a contract, but is named in contract as one to whom contracting parties intended that benefits be given • For liability to be established, a third-party beneficiary must be specifically identified as a user

  24. The Identified User Test • Credit Alliance Corp. v. Arthur Andersen & Co. extended auditor liability for ordinary negligence to identified users • Identified user: The auditor has specific knowledge that known users will be utilizing financial statements in making specific economic decisions

  25. Foreseen User Test • Restatement (Second) of Torts expanded auditor liability for negligence to: • Identified users • Foreseen users: Individually unknown third parties who are members of a known or intended class of third-party users who the auditor can foresee will use the statements • Client must inform auditor that third parties intend to use financial statements • Auditor does not have to know identity of third party

  26. Foreseeable User Test • Some courts have extended auditor liability to foreseeable users of audited financial statements • Foreseeable users: • Not known by auditors to be using financial statements • Recognized by general knowledge as current and potential creditors and investors who will use them

  27. EXHIBIT 4.2 - FORESEEABILITY CONCEPTS FOR AUDITOR’S COMMON-LAW LIABILITY TO THIRD PARTIES

  28. Auditor Liability under Statutory Law • Primary federal statutes affecting auditor liability for public clients • Securities Act of 1933 - imposes liability for misstatements in a prospectus (Section 11) • Securities Exchange Act of 1934 • Sarbanes-Oxley Act of 2002 • Enacted to assure that investors in public companies have access to full and adequate disclosure of relevant information

  29. Securities Act of 1933 • An auditor may be held liable to purchasers of securities for negligence, gross negligence, fraud • Purchasers need to prove that: • They incurred a loss • Financial statements were materially misleading • In their defense, auditors must prove that: • Due professional care was used • Statements were not materially misstated • The purchaser did not incur a loss caused by the misleading financial statements

  30. Securities Exchange Act of 1934 • Regulated companies are required to file periodic reports with the SEC and stockholders Annual reports to shareholders and 10-Ks • Annual reports filed with the SEC • Both contain audited financial statements • 10-Ks must be filed within 60 to 90 days of the end of the fiscal year Quarterly financial reports to shareholders and 10-Qs • Quarterly reports filed with the SEC • 10-Qs must be filed within 40 to 45 days of end of each of first three quarters • 10-Qs must be reviewed by auditors 8-Ks • Reports filed with the SEC describing occurrence of important events

  31. Securities Exchange Act of 1934 • Act makes it unlawful to: • Make any untrue statement of a material fact • Omit to state a material fact necessary for understanding financial statements • Prohibits material misrepresentations or omissions and fraudulent conduct • Provides a general antifraud remedy for purchasers and sellers of securities • Auditor may be held liable for fraud when a plaintiff alleges being misled by misstatements in financial statements

  32. Securities Exchange Act of 1934 • Elements for a successful case for securities fraud • Material misrepresentation or omission • Fraudulent conduct in connection with purchase or sale of a security • Scienter, when making the misrepresentation or omission • Reliance upon fraudulent conduct • Measurable monetary damages • A causal connection between misrepresentation or omission and economic loss • Showing compliance with GAAP is generally an acceptable defense by an auditor

  33. Auditor Liability under Statutory Law • Auditors found unqualified, unethical, or in willful violation of any provision of federal securities laws can be sanctioned by SEC • Temporarily or permanently revoking the firm’s registration with the PCAOB, meaning that the SEC will not accept its audit reports • Imposing civil monetary penalties • Requiring special continuing education of firm personnel • Suspending individuals from serving as officers or directors of securities issuers or participating in the securities industry

  34. Learning Objective 4 Articulate a Framework for Making Quality Professional Decisions and Apply This Framework in Selected Audit Settings

  35. A Framework for Professional Decision Making • Quality decisions of auditors • Add value to financial markets • Unbiased • Meet expectations of users • Comply with professional standards • Based on sufficient factual information to justify the decision that is rendered

  36. Exhibit 4.3 - A Framework for Professional Decision Making

  37. Importance of Skepticism in Making Professional Judgments • A professionally skeptical auditor will: • Critically question contradictory audit evidence • Carefully evaluate reliability of audit evidence • Reasonably question authenticity of documentation • Reasonably question honesty and integrity of: • Management • Individuals charged with governance • Third party providers of audit evidence

  38. Importance of Skepticism in Making Professional Judgments • Tips to encourage skeptical mindset • Be sure to collect sufficient evidence • When evidence is contradictory, be diligent in evaluating reliability of individuals or processes • Generate independent ideas about reasons for unexpected trends or financial ratios • Question trends that appear too good • Wait to make professional judgments until facts known • Have confidence in your knowledge to understand complex situations

  39. Learning Objective 5 Articulate a Framework for Making Quality Ethical Decisions and Apply This Framework in Selected Settings

  40. Resolving Ethical Dilemmas • Ethical dilemma: • A situation in which moral duties or obligations conflict • An ethically correct action may conflict with an individual’s immediate self-interest • Ethical theories help in dealing with ethical dilemmas • Utilitarian theory • Rights theory

  41. Utilitarian Theory • Suggests that ethical is the action that achieves the greatest good for the greatest number of people • Requirements • An identification of the potential problem and possible courses of action • An identification of the potential direct or indirect impact of actions on each affected party • An assessment of the desirability of each action • An overall assessment of the greatest good for the greatest number

  42. Rights Theory • Identifies a hierarchy of rights that should be considered in solving ethical dilemmas • Based on fundamental rights of parties involved • Higher order rights take precedence over lower order rights • Most effective in identifying outcomes that ought to be automatically eliminated

  43. Exhibit 4.4 - A Framework for Ethical Decision Making

  44. Learning Objective 6 IDENTIFY GUIDANCE ON AUDITORS’ PROFESSIONAL RESPONSIBILITIES AND MAKE AUDIT DECISIONS INFORMED BY THE APPROPRIATE PROFESSIONAL GUIDANCE.

  45. International Ethics Standards Board for Accountants (IESBA) Code of Ethics for professional accountants • The Code requires auditors to adhere to fundamental principles • Integrity • Objectivity • Professional competence and due care • Confidentiality • Professional Behavior • The Code also contains specific standards addressing many of the topics contained in the AICPA Code of Professional Conduct

  46. AICPA Code of Professional Conduct • Principles of professional conduct • Broad principles that articulate auditors’ responsibilities and their requirements to: • Act in the public interest • Act with integrity and objectivity • Be independent • Exercise due care • Perform an appropriate scope of services

  47. AICPA Rules of Conduct • Rules of conduct • Detailed guidance to assist an auditor in applying broad principles contained in AICPA’s Code of Professional Conduct • Rules evolved over time as members of profession encountered specific ethical dilemmas in complying with principles of the Code • See Exhibit 4.6

  48. Emerging issue • AICPA Revises Code of Professional Conduct • The AICPA’s Professional Ethics Executive Committee (PEEC) adopted a revised Code in January 2014, with an effective date of December 15, 2014. Additionally, the Code includes two conceptual frameworks with a delayed effective date of December 15, 2015. • More user-friendly, which resulted in a number of improvements and some substantive revisions

  49. Enforcement of the Code of Professional Conduct • Compliance with Code depends on: • Voluntary cooperation of AICPA members • Public opinion and reinforcement by peers • Disciplinary proceedings by the Joint Ethics Enforcement Program • Sponsored by the AICPA and state CPA societies

  50. Other guidance • The Sarbanes-Oxley Act, the PCAOB, and the SEC also have requirements for professional responsibilities for audits of public companies. Many of these requirements are similar to those of the AICPA. • Additional requirements address: • Preapproval of services • Fee disclosures • Rotation • Additional prohibited nonaudit services

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