Addthis Arens Chapter05

Legal Liability
Chapter 5

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

5-1

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

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

5-2

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

5-3

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
©2010 Prentice
Hallauditing
Businessmatters
Publishing, Auditing 13/e, Arens/Elder/Beasley

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

5-5

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

5-6

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

5-7

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

5-8

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

5-9

Legal Concepts Affecting
Liability
Prudent person concept
Liability for the acts of others
Lack of privileged communication

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

5 - 10

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

5 - 11

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

5 - 12

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

5 - 13

Four Major Sources of Auditors’
Legal Liability
 Liability to clients

 Liability to third parties
 Federal securities laws
 Criminal liability

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

5 - 14

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

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

5 - 15

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

5 - 16

Auditor’s Defenses Against
Client Suits
 Lack of duty to perform
 Nonnegligent performance
 Contributory negligence
 Absence of causal connection

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

5 - 17

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

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

5 - 18

Liability to Third Parties Under
Common Law
 Ultramares doctrine
 Foreseen users

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

5 - 19

Foreseen Users
 Credit alliance
 Restatement of torts
 Foreseeable user

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

5 - 20

Auditor Defenses Against
Third-Party Suits
The preferred defense is
non negligent performance.

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

5 - 21

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

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

5 - 22

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

5 - 23

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.

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

5 - 24

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.

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

5 - 25

Auditor Defenses – 1934 Act
 Non negligent performance
 Lack of duty
 Absence of causal connection

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

5 - 26

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

5 - 27

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.

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

5 - 28

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

5 - 29

Learning Objective 7
Specify what constitutes criminal
liability for accountants.

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

5 - 30

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

5 - 31

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

5 - 32

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

5 - 33

The Profession’s Response
to Legal Liability
 Research in auditing
 Standard and rule setting
 Set requirements to protect auditors
 Establish peer review requirements

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

5 - 34

The Profession’s Response
to Legal Liability
 Oppose lawsuits
 Education of users
 Sanction members for improper conduct
and performance
 Lobby for changes in laws

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

5 - 35

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

5 - 36

Protecting Individual CPAs
from Legal Liability
 Understand the client’s 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

5 - 37

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

5 - 38

End of Chapter 5

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

5 - 39