Auditing Theory ▪ Unable to decide whether

Chapter 4 noncompliance is due to circumstances

CPA’s Legal Liability or entity – consider effect on auditor’s
report
- To regulatory and enforcement authority
NOCLAR – Noncompliance of Laws and Regulations ▪ Auditor’s duty of confidentiality
precludes reporting to 3rd party
Potential litigation is a major concern arising from ▪ In some circumstances, this is
responsibility to fulfill contracts with client’s with overridden by:
reasonable care ▪ Statute
▪ Law
Tax evasion ▪ Courts of law
Environmental issues ▪ Auditor may seek LEGAL advice w/
Insider trading consideration of duty to public interest
- Withdrawal from engagement
Bank and financing industry – heavily regulated ▪ May be done if client does not take
remedial action
Approaches ▪ Seek legal advice
1. Inquiry of management
2. Inspecting documents
LEGAL CONCEPTS
Lawsuits arise from:
- Improper/inadequate disclosure 1. Due professional care
- Inappropriate valuation ▪ Standard of care to which audit is
expected to be held
Typical lawsuits: ▪ Prudent person concept
- Failure to discover employee defalcation ▪ Agreement bet. The profession and
- Failure to complete audit on time courts that THE AUDITOR IS NOT A
- Inappropriate withdrawal GUARANTOR OF FS’ ACCURACY, but are
EXPECTED TO EXERCISE THE SAME
REASONABLE CARE
Noncompliance
- Responsibility of MANAGEMENT 2. Source of Responsibility
- Deterred by the fact that annual audit is carried a. Common laws – developed thru court
out decisions
b. Statutory laws – passed by legislative
bodies
Reporting Non-compliance
3. Degree of wrongdoing
- To Management. a. Appropriate audit – none
▪ Consequential matters – BOD/ senior b. Fraud – issue report w/ intent to
management deceive
▪ Suspected BOD – report to higher
authority 2 degrees of wrongdoing:
▪ No higher authority – seek LEGAL advice ▪ Ordinary negligence – absence of
- To the users of the auditor’s report reasonable care
▪ Noncompliance – request revision; if ▪ Gross negligence – consistent failure to
not revised, qualified or adverse follow standards of profession;
opinion CONSTRUCTIVE FRAUD, RECKLESSNESS
▪ Auditor precluded from obtaining
sufficient evidence – qualified or 4. Lack of Privileged Communication
disclaimer of opinion
 ▪ Privileged information – could not be 1. Payment for damages
required by legal proceedings even 2. Public censure
though there is a subpoena 3. Injunction
▪ Information obtained by CPA from 4. Suspension/prohibition from practice before
client is NOT privileged information SEC
5. Temporary/permanent loss of license to
5. Liability for Acts of Others practice
▪ Partners of a CPA are JOINTLY liable for
civil actions
Grounds for Suspension from BOA
1. Neglect of duty/ incompetence
Legal Liability of the Independent Auditor 2. Violation/ tolerance of violation
- To clients: due professional care// negligence 3. Final judgment of crimes involving moral
- To third parties: liable for losses caused by turpitude
auditor’s report// gross negligence 4. Manipulation of CPALE results

Liability in Tax Practices

- Primary responsibility: client pays proper tax
- Secondary responsibility: public interest as
represented by the BIR

PSA 240 Limitation on Auditor’s Responsibility

- Auditor should communicate findings to
management if:
▪ Suspected fraud exists EVEN IF
IMMATERIAL
▪ Significant fraud is found
- Selective testing is sufficient to fulfill auditor’s
responsibility

Defenses Against Lawsuits

By Client By Third Party

- Lack of duty to - Nonnegligent

perform the service
(no
IMPLIED/EXPRESSED
contract
- No damages caused
(WITH OR WITHOUT
reasonable care)
- Absence of causal
connection – reliance
on FS did not cause
the loss
- Contributory
negligence – client’s
actions contributed to
the loss
- Expiry of the statute
of limitations on the
action
performance –
preferred defense;
performance based on
standards
- Lack of privity of
contract – no liability
to 3rd party for
ordinary negligence
- Absence of causal
connection
- Expiry of statute of
limitations on the
action

Penalties