CHAPTER 5: Legal Liability
(Arens)
Deep-pocket Concept of Liability
- Joint and several liability Doctrine
Major causes of Litigation to CPAs
1. Business failure vs Audit Failure
2. Audit Failure vs Audit Risk
BUSINESS FAILURE
- Unable to repay lenders or meet
expectations of investors because of
economic or business conditions.
AUDIT FAILURE
- Incorrect opinion issued because of
noncompliance to Auditing standards.
- Law often allows parties to recover some
or all of the losses caused by this failure.
AUDIT RISK
- Risk of issuing an unmodified opinion
when in fact, it is materially misstated.
EXPECTATION GAP
- Courts support the Auditor’s view.
- Often results to unwarranted lawsuits
PRUDENT PERSON CONCEPTS
- Auditor is not a guarantor or insurer of FS
- Undertakes for good faith and integrity,
but not for infallibility
AUDITORS OFTEN RELY ON:
1. Employees of the CPA Firm
2. Other CPA firms engaged to do part of the
work
3. Specialists / Experts
NOTE:
A CPA can refuse to testify in a state with
privileged communications statutes, however it
does not extend to federal courts.
Privity of Contract
- Parties who have a relationship that is
established by a contract.
Ordinary Negligence
- Absence of reasonable care that
expected of a normal person
Gross Negligence
- Lack of even slight care.
Constructive Fraud
- Extreme or unusual negligence without
intent to deceive
- Aka recklessness
NOTE:
Tort actions are preferable because
amount recoverable are more than those under
breach of contract. The can be based on ordinary
and gross negligence, as well as fraud.
Failure to meet auditing standards is
conclusive evidence of negligence.
Principal Issue in Alleged Negligence is the
level of care required
Questions of Level of Care required gets
difficult during reviews or compilation of FS.
1136 Tenants Case caused the initiation
of Engagement Letters!
Privity of contract can exist WITHOUT a
written agreement
Engagement Letters defines the contract
more clearly; setting responsibilities, etc.
SOURCES OF LEGAL LIABILITY OF AUDITOR
1. Liability to Clients
2. Liability to 3rd Parties under common law
3. Civil liability under the federal securities
laws
4. Criminal Liability
FOUR DEFENSES DURING CLIENTS’ LEGAL
CLAIMS
1. Lack of Duty
o No expressed or implied contract
2. Non-negligent Performance
o Auditor claims that the audit was
performed in accordance with the
standards
o Hence, auditor has no liability
since it is properly conducted.
3. Contributory Negligence
is o It is client’s fault that resulted to
the loss or prevented auditor to
detect the cause of the loss.
4. Absence of Causal Connection
o Not valid if audit was late to be
completed

Ultramares Corporation vs Touche
- Leading precedent-setting auditing case in
3rd party Liability
Ultramares Doctrine
- Ordinary negligence is insufficient for
liability to 3rd parties because of the lack
of privity of contract between the 3rd
part and the auditor.
Parties because they are not able to contribute to
misstated financial statements.
NOTE:
Non-negligent Performance is the
preferred defense for 3rd Parties, but difficult.
CRITICAL TIP!
Foreseeable Users – unlimited
Foresee Users – limited

XCP: if the 3rd party is a primary Scieter

beneficiary!
XCP: if fraud or gross negligence on the
auditor, the latter is liable to 3rd parties that
are NOT primary beneficiaries.
Foreseen Users
- Members of a limited class of users that
the auditor knows will rely on the FS.
- Treated as a KNOWN THIRD PARTY
LEADING APPROACHES TAKEN BY COURTS
1. Credit Alliance
o To be liable:
 Auditor must know and
intend the work to be used
by the 3rd Party
 Knowledge and Intent
must be evidenced by
auditor’s conduct.
2. Restatement of Torts
o Approach followed by most states
o An authoritative set of legal
principles
o Foreseen users must be a member
of a REASONABLE limited and
IDENTIFIABLE group of users
that have relied on the CPA’s work
o i.e. Rusch Factors v. Latin
- Commission of an act with knowledge or
intent to deceive.
Securities Act of 1933
- Deals with register and sell securities to
the public
- Original purchasers of securities may
recover damages if FS are misstated
XCP: Auditor proves that the audit was adequate
or that 3rd Party’s loss was caused by factors
other than the FS.
Securities Act of 1934
- Deals with companies that trade securities
on national and OTC exchanges
- Auditors do annual report with AFS
Private Securities Litigation Reform Act of
1995
- Significantly reduced potential damages in
securities-related litigations.

3. Foreseeable User
o Broadest interpretation
o ANY user that the auditor should
have reasonably been able to
foresee as LIKELY users shall
have the SAME RIGHTS as those
with PRIVITY OF CONTRACTS
o Under UNLIMITED class

NOTE:
Contributory Negligence (1/4 of the
Defenses) is ordinarily not applicable to 3rd