Legal Liability Chapter 5
Key Topics in Chapter 5 • Legal liability for auditors • Liability to clients, and defenses • Liability to third parties, and defenses • Liability from Federal securities law: Securities acts of 1933 and 1934 • Criminal liability
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.
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).
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.
Business Failure, Audit Failure, and Audit Risk Audit failure Business failure Audit risk
Four Major Sources of Auditors’ Legal Liability Client Third party Federal securities laws Criminal liability
Liability From Clients The most common source of lawsuits against CPAs is from clients.
Liability Under the Common Law • Liability to Clients: • Under contract law - for breach of contract • Under tort law** for: • Ordinary negligence – failure to exercise care a reasonable person would under the same circumstances • Gross negligence – failure to use even slight care in circumstances • Fraud- intentional deception • ** Tort = wrongful act that injures another person’s property, body, or reputation.
Auditor’s Defenses AgainstClient Suits Lack of duty to perform Nonnegligent performance Contributory negligence Absence of causal connection
Liability to Third Parties Under Common Law Ultramares doctrine Foreseen users
Liability Third Parties Under the Common Law • Ultramares:upheld the privity of contract doctrine: third parties cannot sue auditors for ordinary negligence. • Foreseen users – A limited group of persons for whom the auditor is aware will rely on the financial statements.
Auditor Defenses AgainstThird-Party Suits The preferred defense is nonnegligent performance.
Securities Act of 1933 The Securities Act imposes an unusual burden on the auditor – see p. 117. • 1933 Act : • Deals only with new securities. • Only original purchasers of securities • may recover from auditors.
Securities Exchange Act of 1934 1934 Act – requires ongoing filing of quarterly and annual reports, and other information to keep the registration statement current. Certain information, including financial statements must be audited. • The liability of auditors under this act often • centers on Rule 10b-5, p. 118. • It may apply to accountants if they intentionally • or recklessly misrepresent information intended for • 3rd party use.
Auditor Defenses – 1934 Act Nonnegligent performance Lack of duty Absence of causal connection
Criminal Liability • CPAs can be found guilty for criminal • action under both federal and state laws. • Most laws make it a criminal offense to • defraud another person through knowingly • being involved with falsifications in financial • statements. The Sarbanes-Oxley Act makes it a felony to destroy or create documents to impede Or obstruct a federal investigation.
Protecting Individual CPAsfrom Legal Liability Deal only with clients possessing integrity Hire qualified personnel Follow the standards of the profession Maintain independence
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 CPAsfrom Legal Liability Carry adequate insurance Seek legal counsel Choose a form of organization with limited liability Exercise professional skepticism