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Legal Liability. Chapter 5. Learning Objective 1. Understand the litigious environment in which CPAs practice. Changed Legal Environment. Audit professionals have a contractual responsibility with clients. Auditors are liable for negligence.

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learning objective 1
Learning Objective 1

Understand the litigious environment in which CPAs practice.

changed legal environment
Changed Legal Environment
  • Audit professionals have a contractual responsibility with clients.
  • Auditors are liable for negligence.
  • The number of lawsuits and sizes of awards remain high.
changed legal environment4
Changed Legal Environment

Major contributors:

  • Growing awareness by financial statement users
  • Increased consciousness of the SEC
  • Complexity in business drives complexity in auditing and accounting functions
  • Litigious society
changed legal environment5
Changed Legal Environment

Major contributors (cont.):

  • Large civil court judgments against CPA firms
  • Willingness of CPA firms to settle out of court
  • Judges’ and jurors’ difficulty in understanding technical accounting and auditing matters
learning objective 2
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.

business failure audit failure and audit risk
Business Failure, Audit Failure, and Audit Risk
  • Business failure

A business is unable to meet its

obligations or investor expectations due

to economic or business conditions.

business failure audit failure and audit risk8
Business Failure, Audit Failure, and Audit Risk
  • Audit failure

Auditor issues an incorrect opinion from

a failure to follow GAAS.

business failure audit failure and audit risk9
Business Failure, Audit Failure, and Audit Risk
  • Audit risk

The risk that the auditor fails to find a

material misstatement and issues an

unqualified opinion.

learning objective 3
Learning Objective 3

Use the primary legal concepts

and terms concerning accountants’

liability as a basis for studying

legal liability of auditors.

legal concepts affecting liability
Legal Concepts Affecting Liability
  • Prudent person concept
        • Liability for the acts of others
        • Lack of privileged communication
legal terms affecting cpas liability
Legal Terms AffectingCPAs’ Liability
  • Terms related to negligence and fraud:
    • Ordinary negligence
    • Gross negligence
    • Constructive fraud
    • Fraud
legal terms affecting cpas liability13
Legal Terms AffectingCPAs’ Liability

Contract Law

Breach of

contract

Third party

beneficiary

legal terms affecting cpas liability14
Legal Terms AffectingCPAs’ Liability

Other terms:

  • Common law
  • Statutory law
  • Joint and several liability
  • Separate and proportionate liability
learning objective 4
Learning Objective 4

Describe accountants’ liability to

clients and related defenses.

liability to clients
Liability to Clients

The most common source of lawsuits

against CPAs is from clients.

auditor s defenses against client suits
Auditor’s Defenses AgainstClient Suits
  • Lack of duty to perform
  • Nonnegligent performance
  • Contributory negligence
  • Absence of causal connection
learning objective 5
Learning Objective 5

Describe accountants’ liability to

third parties under common law

and related defenses.

liability to third parties under common law
Liability to Third Parties Under Common Law

Ultramares

doctrine

Foreseen

users

foreseen users
Foreseen Users
  • Credit alliance
  • Restatement of torts
  • Foreseeable user
learning objective 6
Learning Objective 6

Describe accountants’ civil liability

under the federal securities laws

and related defenses.

securities act of 1933
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.

securities exchange act of 1934
Securities ExchangeAct of 1934

Auditor liability under this act often

centers on the audited financial statements

issued in annual reports

rule 10b 5 of the securities exchange act of 1934
Rule 10b-5 of the Securities Exchange Act of 1934
  • Section 10 and rule 10b-5 are often called
  • the antifraud provisions of the 1934 act.
  • “Scienter” states that auditors must have
  • the knowledge and intent to deceive in
  • order to be liable for violation of
  • Rule 10b-5.
sec sanctions
SEC Sanctions

SEC can sanction or suspend practitioners.

SEC has temporarily suspended a number of

individual CPAs from auditing SEC clients.

foreign corrupt practices act of 1977
Foreign CorruptPractices Act of 1977

Bribing a foreign official for the purpose

of exerting business related influence

is illegal.

sarbanes oxley act of 2002
Sarbanes-Oxley Act of 2002

CEO and CFO are required to certify

financial statements filed with the SEC.

Management must report on the

effectiveness of internal controls over

financial reporting.

Auditors must opine on internal controls over financial reporting.

learning objective 7
Learning Objective 7

Specify what constitutes criminal

liability for accountants.

sarbanes oxley act
Sarbanes-Oxley Act

This act makes it a felony to destroy

or create documents to impede or

obstruct a federal investigation.

learning objective 8
Learning Objective 8

Describe what the profession and

the individual CPA can do and

what is being done to reduce

the threat of litigation.

the profession s response to legal liability
The Profession’s Responseto Legal Liability
  • Research in auditing
  • Standard and rule setting
  • Set requirements to protect auditors
  • Establish peer review requirements
the profession s response to legal liability36
The Profession’s Responseto Legal Liability
  • Oppose lawsuits
  • Education of users
  • Sanction members for improper conduct

and performance

  • Lobby for changes in laws
protecting individual cpas from legal liability
Protecting Individual CPAsfrom Legal Liability

Honest Clients

Qualified

Personnel

Maintain

Independence

Follow

Professional

Standards

protecting individual cpas from legal liability38
Protecting Individual CPAsfrom Legal Liability
  • Understand the client’s business
  • Perform quality audits
  • Document the work properly
  • Obtain an engagement and a representation letter
  • Maintain confidential relations
protecting individual cpas from legal liability39
Protecting Individual CPAsfrom Legal Liability
  • Carry adequate insurance
  • Seek legal counsel
  • Choose a form of organization with limited liability
  • Exercise professional skepticism
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