Legal Liability

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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
contractual responsibility with clients.
Auditors are liable for negligence.
The number of lawsuits and sizes of
awards remain high.

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Changed Legal Environment

Major contributors:

Growing awareness by financial statement

users
Increased consciousness of the SEC
Complexity in business drives complexity in
auditing and accounting functions

Litigious society
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Changed Legal Environment

Major contributors (cont.):
Large civil court judgments against CPA firms
Willingness of CPA firms to settle out of court
Judges and jurors difficulty in understanding
technical accounting and auditing matters

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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.

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Business Failure, Audit Failure,

and Audit Risk
Business failure
A business is unable to meet its
obligations or investor expectations due
to economic or business conditions.

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Business Failure, Audit Failure,

and Audit Risk
Audit failure

Auditor issues an incorrect opinion from

a failure to follow GAAS.

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Business Failure, Audit Failure,

and Audit Risk
Audit risk

The risk that the auditor fails to find a

material misstatement and issues an
unqualified opinion.

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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.

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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

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Legal Terms Affecting

CPAs Liability
Contract Law

Breach of
contract

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Third party
beneficiary

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Legal Terms Affecting

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

Separate and proportionate liability

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

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Four Major Sources of Auditors

Legal Liability

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

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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

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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

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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.
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Securities Exchange
Act of 1934
Auditor liability under this act often
centers on the audited financial statements
issued in annual 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.
Scienter states that auditors must have
the knowledge and intent to deceive in
order to be liable for violation of
Rule 10b-5.

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SEC Sanctions
SEC can sanction or suspend practitioners.

SEC has temporarily suspended a number of

individual CPAs from auditing SEC clients.

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Foreign Corrupt
Practices Act of 1977
Bribing a foreign official for the purpose
of exerting business related influence
is illegal.

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Sarbanes-Oxley Act of 2002

CEO and CFO are required to certify
financial statements filed with the SEC.

Management must report on the

effectiveness of internal controls over
financial reporting.
Auditors must opine on internal controls
over financial reporting.
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Learning Objective 7
Specify what constitutes criminal
liability for accountants.

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Criminal Liability

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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.

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Auditor Defenses
1933 & 1934 Acts

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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.

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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

Honest Clients

Follow
Professional
Standards
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Qualified
Personnel

Maintain
Independence
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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
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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

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End of Chapter

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