©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder - Legal Liability

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
5 - 1
Legal Liability
Chapter 5

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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Learning Objective 1
Understand the litigious
environment in which
CPAs practice.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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Changed Legal Environment
Both the number of lawsuits and sizes
of awards to plaintiffs remain high.
Despite efforts by the profession to
address the legal liability of CPAs…

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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· Lack of privileged communication

· Liability for the acts of others

· Prudent person concept

Legal Concepts Affecting Liability

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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Legal Terms Affecting
CPAs’ Liability
Terms related to negligence and fraud:
· Ordinary negligence

· Constructive fraud

· Gross negligence

· Fraud

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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Legal Terms Affecting
CPAs’ Liability
Terms related to contract law:
· Breach of contract

· Third-party beneficiary

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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Legal Terms Affecting
CPAs’ Liability
Other terms:
· Common law

· Joint and several liability

· Statutory law

· Separate and proportionate liability

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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Four Major Sources of Auditors’ Legal Liability
· Liability to third parties

· Federal securities laws

· Liability to clients

· Criminal liability

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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Learning Objective 4
Describe accountants’ liability to
clients and related defenses.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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Liability to Clients
The most common source of lawsuits
against CPAs is from clients.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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Auditor’s Defenses Against
Client Suits
· Lack of duty to perform

· Nonnegligent performance

· Contributory negligence

· Absence of causal connection

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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Learning Objective 5
Describe accountants’ liability to
third parties under common law
and related defenses.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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Liability to Third Parties Under Common Law
· Ultramares doctrine

· Foreseen users

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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Foreseen Users
· Credit alliance

· Restatement of torts

· Foreseeable user

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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Auditor Defenses Against
Third-Party Suits
The preferred defense is
nonnegligent performance.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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Learning Objective 6
Describe accountants’ civil liability
under the federal securities laws
and related defenses.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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Auditor Defenses – 1934 Act
· Nonnegligent performance

· Lack of duty

· Absence of causal connection

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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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 provide an opinion on
management’s assessment.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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Learning Objective 7
Specify what constitutes criminal
liability for accountants.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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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.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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The Profession’s Response
to Legal Liability
· Research in auditing

· Standard and rule setting

· Set requirements to protect auditors

· Establish peer review requirements

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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The Profession’s Response
to Legal Liability
· Oppose lawsuits

· Education of users

· Sanction members for improper conduct
and performance
· Lobby for changes in laws

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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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

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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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

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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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

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder
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End of Chapter 5



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