Auditing

8e

Chapter 17

Gramling
Rittenberg
Johnstone

Professional
Liability

Copyright 2012 South-Western/Cengage Learning

Audit Opinion Formulation Process

LO: 1 The Legal Environment

The responsibility of public accountants to
safeguard the publics interest has increased as
the number of investors has increased, as the
relationship between corporate managers and
stockholders has become more impersonal, and
as government increasingly relies on
accounting information

The Legal Environment (continued)

Factors that lead to increased litigation against the
auditor include:
Joint and several liability statutes that permit a plaintiff to
collect the full amount of the settlement from any
defendant, even those only partially responsible for the loss
(i.e. deep pockets theory)
Increased audit complexity caused by computerized
systems, new types of transactions and operations, more
complicated accounting standards, more international
business
Pressures to reduce audit time and improve audit efficiency

The Legal Environment (continued)

Misunderstanding by users that an unqualified
opinion is an insurance policy against
misstatements (expectations gap)
Contingent-fee-based compensation for law firms,
especially in class action lawsuits
Class-action lawsuits which allow law firms to
combine defendants into one legal action

LO 2: Laws from Which Auditor

Liability Is Derived
Liability that affects public accounting firms is
derived from the following laws:
Common law
Liability concepts are developed through court decisions based on
negligence, gross negligence, or fraud

Statutory law.
Liability is based on federal securities laws or state statutes.
The most important of these statutes to the auditing profession are
the Securities Act of 1933 (1933 Act) and the Securities Exchange
Act of 1934 (1934 Act)

Causes of Legal Action

Causes of legal action
Breach of contract
Negligence: failure to exercise a reasonable level
of care that causes damage to another
Gross negligence: failure to exercise even a
minimal level of care (reckless disregard) but
without intent to harm or damage anyone
Fraud: intentional concealment or
misrepresentation of material facts that cause
damages to those deceived (scienter)

LO 3 & 4: Key Cases, Causes of

Action, Remedies or Sanctions,
Auditors may be held civilly liable by clients
and third parties who use audited financial
statements. This civil liability is based
Contract law
Common law
Statutory law

Legal Precedence
Auditors may be held civilly liable by clients
and third parties who use audited financial
statements
This civil liability is based
Contract law
Common law
Statutory law

Breach of Contract
Breach of contract occurs when auditor fails
to perform a contractual duty
Breach actions include

Violating client confidentiality

Failing to provide the audit report on time
Failing to discover a material error or employee fraud
Withdrawing from an audit engagement without
justification

Parties to the contract can file suit

Breach of Contract (continued)

Court remedies to a breach include
Requiring specific performance of the contract
agreement
Granting an injunction to prohibit the auditor from
doing certain acts, such as disclosing confidential
information
Providing for recovery of amounts lost as a result
of the breach

Breach of Contract (continued)

Auditor defenses include
The auditor exercised due professional care in
accordance with the contract
The client was contributory negligent
The clients losses were not caused by the breach

Common Law Liability

To prevail, a plaintiff must generally prove
They suffered a loss
The loss was due to reliance on misleading
financial statements
The auditor knew, or should have known, that the
financial statements were misleading

Third-Party Beneficiary Test

The courts have ruled auditors can be held
liable by clients and third parties reasonably
expected to rely on audited statements.
Generally, courts have classified third-party
users into 3 groups:
Identified users are specific individual users who
the auditor knows will use the statements to make
a specific decision

Third-Party Beneficiary Test

(continued)

Foreseen users while not individually known,

belong to a specific group of users whom the
auditor knows will use the statements
Foreseeable users belong to a general class of users
whose members may or may not use the financial
statements

Statutory Liability to Third

Parties
Auditor liability under Federal statute was
established by the Securities Act of 1933, and
the Securities Exchange Act of 1934, and most
recently modified by Sarbanes/Oxley Act of
2002
Auditors found to be unqualified, unethical, or
in willful violation can be disciplined by the
SEC. Sanctions include

Statutory Liability to Third

Parties (continued)
Temporarily or permanently revoking the firms
registration with the Public Company Accounting
Oversight Board
Civil penalties of up to $750,000 per violation
Require continuing education of firm personnel

Investors in public companies may sue

auditors under common law, statutory law, or
both

Securities Act of 1933

Requires companies to file S-1 Registration
statement with SEC before they issue new
securities to the public
Audited financial statements are included in
the Registration statement (and prospectus)
Because it covers the issue of new securities,
the Act requires a very high standard of care.
Plaintiffs need prove only
financial statements were materially misleading

Securities Act of 1933 (continued)

plaintiff suffered damages
plaintiffs do not need to prove reliance on the
statements or auditor misconduct

Auditor defenses include

proving financial statements were not materially
misstated
proving plaintiff damages were not caused by the
misleading financial statements
proving auditor acted with due professional care

Securities Exchange Act of 1934

The Securities Exchange Act of 1934
regulates trading of securities after their initial
issuance (secondary market) and the filing of
periodic reports with the SEC. These reports
include annual reports and 10-Ks, quarterly
financial reports and 10-Qs, and 8-Ks.
The 1934 Act holds auditors to a much lower
standard of care than the 1933 Act. Under the
1934 Act, plaintiffs must prove

Securities Exchange Act of 1934

(continued)

Existence and amount of damages

Financial statements were materially misleading
Plaintiff relied on the statements and as a result,
suffered damages (causality)

Auditor misconductthe level of misconduct

that must be proved is the subject of much
debate. In Ernst & Ernst v. Hochfelder, the
U.S. Supreme Court held that

Securities Exchange Act of 1934

(continued)

Congress had intended that the plaintiff prove the

auditor acted with scienter

However, the Court reserved judgment as to

whether gross negligence would be sufficient
to impose liability
In several cases following Hochfelder, judges
and juries have used a standard of reckless
conduct to hold auditors liable

Criminal Liability to Third

Parties
Both the 1933 and 1934 Acts provide for
criminal actions against auditorsguilty
persons can be fined or imprisoned for up to
five years.
Key cases regarding auditor criminal liability
Continental Vending (U.S. v Simon)
Equity Funding

LO 5: Emerging Liability Issues

Liability Issues of Multinational CPA Firms
Most large U.S. CPA firms are affiliates of
international organizations.
Such organizational structures have important
implications for legal liability, although the legal
liability outcomes are not always predictable.

Emerging Liability Issues

Liability Impact of Internet Dissemination of
Audited Financial Information.
An unsettled issue of liability concerns audited
financial information disseminated on the Internet.
Everyone who owns a computer with access to the
Internet has access to such information.
The liability implications, if not carefully
delineated, are staggering.

LO 6: Enhancing Audit Quality and

Minimizing Liability Exposure
Periodic rotation of audit engagement partner
Partner Rotation
Prohibit certain non-audit services for public
company audit clients
Restrict other non-audit services for audit clients
Firm policies including training programs that
emphasize auditor independence and requiring
each auditor to sign a statement of independence

Enhancing Audit Quality and

Minimizing Liability Exposure
Other-control programs: Sarbanes/Oxley Act
requires the PCAOB perform quality reviews of
registered public accounting firms
Internal reviews: concurring partner reviews and
interoffice reviews

LO 7: Other Actions to Assure Audit Quality

and Minimize Liability Exposure
There are other actions firms can take to
ensure quality and minimize liability exposure
including
Issuing engagement letters
Making appropriate client acceptance/continuance
decisions
Evaluating the audit firms limitations
Maintaining high-quality audit documentation