Legal Liability

Chapter 5

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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

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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.
Despite efforts by the profession to address the legal
liability of CPAs, both the number of lawsuits and sizes
of awards to plaintiffs remain high.
2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Changed Legal Environment

Major contributors:
o Growing awareness of responsibilities of public accountants by users of financial
statements
o Increased consciousness of the Securities and Exchange Commission (SEC) for its
responsibility for protecting investors interests
o Complexity of auditing and accounting functions caused by increasing size of
businesses, globalization of business, and complexities of business operations
oTendency of society to accept lawsuits by injured parties against anyone who might
be able to provide compensation, regardless of fault (deep-pocket concept of
liability)
o Large civil court judgments against CPA firms awarded in a few cases encourage
attorneys to provide legal services on a contingent-fee basis offers the injured party
a potential gain when the suit is successful, but minimal losses when it is not
o Willingness of many CPA firms to settle legal problems out of court in an attempt to
avoid costly legal fees and adverse publicity, rather than resolution through judicial
process
o Judges and jurors difficulty in understanding and interpreting technical accounting
and
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5-4

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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Business Failure, Audit Failure,

and Audit Risk
Audit failure
It occurs when the auditor issues an
incorrect audit opinion because it
failed to comply with the requirements
of auditing standards.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Learning Objective 3
Use the primary legal concepts
and terms concerning accountants
liability as a basis for studying
legal liability of auditors.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Legal Concepts Affecting

Liability
Prudent person concept
Liability for the acts of others
Lack of privileged communication

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Legal Terms Affecting

CPAs Liability
Terms related to negligence and fraud:
Ordinary negligence
Gross negligence
Constructive fraud
Fraud

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Legal Terms Affecting

CPAs Liability
Terms related to contract law:
Breach of contract
Third-party beneficiary

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Legal Terms Affecting

CPAs Liability
Other terms:
Common law
Statutory law
Joint and several liability
Separate and proportionate liability

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Four Major Sources of Auditors

Legal Liability
Liability to clients
Liability to third parties
Federal securities laws
Criminal liability

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

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

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Auditors Defenses Against

Client Suits
Lack of duty to perform
Nonnegligent performance
Contributory negligence
Absence of causal connection

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

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Liability to Third Parties Under

Common Law
Ultramares doctrine
Foreseen users

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Foreseen Users
Credit alliance
Restatement of torts
Foreseeable user

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Auditor Defenses Against

Third-Party Suits
The preferred defense is
nonnegligent performance.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Learning Objective 6
Describe accountants civil liability
under the federal securities laws
and related defenses.

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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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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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.

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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.

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Auditor Defenses 1934 Act

Nonnegligent performance
Lack of duty
Absence of causal connection

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SEC Sanctions
The SEC has the power in certain circumstances
to sanction or suspend practitioners from
doing audits for SEC companies.
In recent years, the SEC has temporarily
suspended a number of individual CPAs
from doing any audits on SEC clients.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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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.

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Sarbanes-Oxley Act of 2002

This act requires the CEO and CFO to
certify the annual and quarterly financial
statements filed with the SEC.
Management must report its assessment
of the effectiveness of internal control
over financial reporting.
The auditor must issue an opinion on the
effectiveness of internal control over
financial reporting .
2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Learning Objective 7
Specify what constitutes criminal
liability for accountants.

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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.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Sarbanes-Oxley Act
This act makes it a felony to destroy
or create documents to impede or
obstruct a federal investigation.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Learning Objective 8
Describe what the profession and
the individual CPA can do and
what is being done to reduce
the threat of litigation.

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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The Professions Response

to Legal Liability
Research in auditing
Standard and rule setting
Set requirements to protect auditors
Establish peer review requirements

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The Professions Response

to Legal Liability
Oppose lawsuits
Education of users
Sanction members for improper conduct
and performance
Lobby for changes in laws

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Protecting Individual CPAs

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

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Protecting Individual CPAs

from Legal Liability
Understand the clients business
Perform quality audits
Document the work properly
Obtain an engagement and a representation letter
Maintain confidential relations
2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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Protecting Individual CPAs

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

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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End of Chapter 5

2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley

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