Chapter 04

Legal Liability of
CPAs

McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
 Scope of CPA Liability

 Potential
liability may exceed that of other
professions (such as physicians) because:
 Number of parties suffering significant losses.
 Possibly millions of investors as well as firm
creditors.
 Amounts can be excessive in some cases
exceeding the limits of professional liability
insurance

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 Scope of CPA Liability

 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.

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 Auditor liability increased due to…
 Highly-publicized failures (WorldCom, Enron, Tyco)
 “Privity” no longer applied in traditional context
 Parties with no contracts with auditors can sue auditors
 Investor awareness of ability to recover monetary losses
from auditors (deep pockets)
 Complex accounting standards (e.g., FAS 123R)
 Joint and several liability (plaintiff can recover all
damages from any defendant)
 Class action suits (e.g., Overtime lawsuit)
 Auditors are an attractive target for plaintiff attorneys

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 CPA Liability
 Common Law
 Develops through case decisions
 Generally arising due to
• Breach of contract,
• Negligence
• Fraud
 Plaintiffs: Clients and third parties
 Statutory liability
 Develops when governmental unit passes laws and
regulations imposing liability on CPAs (e.g., Securities
Act of 1933 and Securities Exchange Act of 1934)
 Plaintiffs: Shareholders
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 Types of Third Parties
 Primary beneficiaries: Known by
name to the auditor (large SH,
lenders) More
Known
 Foreseen: Parties who could to Auditor
reasonably be expected to rely on
the auditors’ work (smaller SH,
lenders)
 Foreseeable: Parties whose
decisions normally rely on
audited F/S and opinions on Less Known
those F/S (suppliers, vendors, to Auditor
other external users)

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Primary Sources of CPA Liability
 Liability to clients
 Client sues auditor for not discovering material
fraud during audit
 Liability to third parties under common law
 Bank sues auditor for not discovering a borrower’s
financial statements are materially misstated
 Civil liability under federal securities laws
 Combined group of shareholders sues auditor for
not discovering F/S were materially misstated
 Criminal liability
 Federal government prosecutes auditor for issuing
an incorrect audit report
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 Other Sources of CPA Liability

 Criminal statutes
 Most lawsuits allege violations of federal
securities acts
 Usually class action lawsuits by investors
 RICO Act
 Racketeer Influenced Corruption
Organizations Act
• Deals with organized crime

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 Elements of Proof by Client Under
Common Law

 Duty—CPAs accepted a duty of due

professional care
 Breach of duty—CPAs breached that
duty
 Losses—Suffered by plaintiff
 Causation (proximate cause)—Losses
were caused by CPAs’ performance

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 Third Parties
 Must establish that losses resulted from
CPAs’ performance
 CPA breached a duty of due professional
care
 Typical case:
 Third party seeks to establish that it sustained a loss
caused by relying on misleading financial statements
which included an audit report that was inadequate
 Gross negligence will establish liability
 Ordinary negligence depends on jurisdiction

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Auditor’s Defenses Against Client Suits

 Lack of duty to perform

 Non-negligent performance
 Auditors acted in good faith
• Due diligence (auditors performed a GAAS audit)
 Auditors were not aware of material misstatement
 Contributory negligence
 Clients were partially responsible for loss (e.g., weak
controls, poor client culture)
 Absence of causal connection
 Loss caused by factors other than the F/S and auditor’s
examination (causation defense)

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Liability to Third Parties under Statutory
Laws

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 Proportionate Liability under 1934 Act

 Private Securities Litigation Reform Act of

1995
 Placed limits on amount of auditors’ liability by
establishing proportionate liability
• If one of more defendants are not able to pay their
share of losses,
 to certain small investors only, auditors have unlimited
joint and several liability
 To other investors, auditors liability limited to an amount
not to exceed 50% of the auditors’ proportionate share of
the losses

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 Criminal Liability
 United States v. Arthur Andersen (2002)—Arthur
Andersen was accused of the wholesale destruction of
documents relating to the Enron Corporation collapse.
The jury found, based primarily on an email message
that an Arthur Andersen attorney advised a partner to
revise a memo to omit certain information, including a
comment that an Enron press release that included an
earnings announcement was misleading. Loss of this
case effectively put Arthur Andersen out of business.
The conviction was overturned by the U.S. Supreme
Court

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 SEC
 Has power to prohibit CPAs from reporting
on SEC registrants’ financial statements.
 Can take punitive action against public
accounting firms
 Consent decrees which can enforce certain
penalties or restrictions
 Auditors are forced to report illegal acts by
clients to SEC if the client fails to report
them

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 PCAOB

 May conduct investigations and

disciplinary proceedings on registered
CPA firm and professional employee
 Sanctions can include:
 Monetary damages
 Suspension of firms and accountants from
engagements for publicly traded companies
 Referral of criminal cases to the Justice
Department

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Unaudited Financial Statements of Nonpublic
Companies: What are they?
 Compilation of financial statements
 Preparation of financial statements based
upon information provided to CPAs by client
 Not intended to lend any assurance as to
statements’ reliability
 Review of financial statements
 Consists of limited verification procedures,
substantially less in scope than an audit
 Provides limited assurance as to statements’
reliability
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 Liability for “Unaudited” Financial
Statements
Selected Case
1136 Tenants Corporation v. Max Rothenberg and
Company (1971)--A landmark case for accountants’
liability when they are associated with unaudited financial
statements. The case demonstrated the importance of
engagement letters to clearly establish an understanding
with the client regarding the nature of the services to be
provided. It also illustrated the need to follow up on
unusual findings even when the CPAs are not performing
audits.

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Lessons from 1136 Tenants’ Corp. Case

 CPAs who prepare unaudited financial

statements should
 adhere closely to Rules of Conduct 102 and 202 of
AICPA Code of Professional Conduct
 Engagements letters are essential
 Should still be alert for and follow up on unusual items
such as missing invoices
 Report clearly and concisely using standardized
language in SAS and SSARS

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 Preventing Litigation
 Place emphasis within the firm on complying
with GAAS and professional ethics
 Retain legal counsel that is familiar with CPA’s
legal liability
 Maintain adequate professional liability
insurance
 Investigate prospective clients thoroughly
 Obtain a thorough knowledge of the client’s
business

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Protecting Individual CPAs from Legal Liability

 Exercise professional skepticism

 Deal only with clients possessing integrity
 Hire qualified personnel
 Follow standards
 Maintain independence
 Understand client’s business
 Perform quality audits
 Document work properly
 Obtain engagement letter and representation letter
 Maintain confidential relations

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 Sarbanes-Oxley
 Extends statute of limitations for bringing suit
under the Securities Exchange Act
 Increased penalties for mail fraud and wire fraud
 Increased penalties for destruction, alteration,
and falsification of records
 Increased records retention requirements
 Higher potential liability in civil cases

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The Profession’s Response to Legal Liability

 Research in auditing (center for audit quality

indicators)
 Standard and rule setting
 Set requirements to protect auditors
 Establish peer review requirements
 Oppose lawsuits
 Education of users
 Sanction members for improper conduct and
performance
 Lobby for changes in laws
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