McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Chapter 20 Legal Liability

20-2 Historical Perspective 1970 Claims against auditors were relatively uncommon before the 1970’s Due to a slump in the economy in the early 1970’s and the recession of the 1980’s, it became more common for auditors to be sued. The recession of led to another upsurge in litigation against auditors. The profession pushed for litigation reform, and in the 1990’s Congress passed litigation reform acts that provided some limits to auditor liability and made it more difficult to sue auditors successfully.

20-3 Historical Perspective 1970 Claims against auditors were relatively uncommon before the 1970’s Due to a slump in the economy in the early 1970’s and the recession of the 1980’s, it became more common for auditors to be sued. The recession of led to another upsurge in litigation against auditors Due to several high-profile frauds, Congress refocused attention on auditors in the Sarbanes-Oxley Act of 2002.

20-4 Overview There are four general stages in the initiation and disposition of audit-related disputes: (1) the occurrence of events that result in losses for users of the financial statements, (2) the investigation by plaintiff attorneys before filing suit to link the user losses with allegations of material omissions or misstatements of financial statements, (3) the legal process that commences with the filing of the suit, and (4) the final resolution of the dispute. LO# 1

20-5 Overview Two Classes of Law Common Law Case law developed by judges Statutory Law Written law enacted by the legislative branch of government LO# 2

20-6 Overview LO# 2

20-7 Overview LO# 2

20-8 Common Law—Clients Requires Due Care Degree of Liability to the Client May be held liable for breach of contract or negligence Is liable for gross negligence and fraud ( acting with knowledge and intent to deceive) LO# 3

20-9 Breach of Contract Breach-of-contract liability is based on the auditor’s failing to complete the services agreed to in the contract with the client. LO# 3

20-10 Negligence Requires Due Care If an engagement is performed without due care, the CPA may be held liable for an actionable tort in negligence. LO# 3

20-11 Negligence Client Must Prove 1.A duty was owed to the client. 2.Failure to act in accordance with that duty. 3.A causal connection between the auditor’s negligence and the client’s damage. 4.Actual loss or damage to the client. LO# 3

20-12 Negligence Auditor’s Defense 1.No duty was owed to the client. 2.The client was negligent. 3.The auditor’s work was performed in accordance with professional standards. 4.The client suffered no loss. 5.Any loss was caused by other events. 6.The claim is invalid because the statute of limitations has expired. LO# 3

20-13 Common Law—Third Parties Four Legal Standards for Third Parties Privity Near Privity Foreseen 3 rd Parties Reasonably Foreseeable 3 rd Parties LO# 4

20-14 Common Law—Third Parties Near Privity 3 rd parties whose relationship with the CPA approaches privity. Foreseen 3 rd Parties 3 rd parties whose reliance should be foreseen, even if the specific person is unknown to the auditor. Reasonably Foreseeable 3 rd Parties 3 rd parties whose reliance should be reasonably foreseeable, even if the specific person is unknown to the auditor. LO# 4

20-15 Common Law—Third Parties Negligence Third Party Must Prove 1.The auditor had a duty to the plaintiff to exercise due care. 2.The auditor breached that duty and was negligent in not following the professional standards. 3.The auditor’s breach of due care was the direct cause of the 3 rd party’s injury. 4.The 3 rd party suffered an actual loss as a result. LO# 4

20-16 Common Law—Third Parties Negligence Auditor’s Defense 1.No duty was owed to the 3 rd party (level of duty required depends on the case law followed by the courts). 2.The 3 rd party was negligent. 3.The auditor’s work was performed in accordance with professional standards. 4.The 3 rd party suffered no loss. 5.Any loss was caused by other events. 6.The claim is invalid because the statute of limitations has expired. LO# 4

20-17 Fraud If an auditor has acted with knowledge and intent to deceive a third party, he or she can be held liable for fraud. LO# 4

20-18 Fraud Third Party Must Prove 1.A false representation by the CPA. 2.Knowledge or belief by the CPA that the representation was false. 3.The CPA intended to induce the 3 rd party to rely on the false representation. 4.The 3 rd party relied on the false representation. 5.The 3 rd party suffered damages. LO# 4

20-19 Statutory Liability The Securities Act of 1933 The Securities Exchange Act of 1934 Three major statutes that provide sources of liability for auditors: Sarbanes-Oxley Act of 2002 LO# 5

20-20 Securities Act of 1933 Generally regulates the disclosure of information in a registration statement for a new public offering of securities. Section 11 imposes a liability on issuers and others, including auditors, for losses suffered by 3 rd parties when false or misleading information is included in a registration statement. LO# 5

20-21 Securities Act of 1933 Third Party Must Prove 1.The 3 rd party suffered losses by investing in the registered security. 2.The audited financial statements contained a material omission or misstatement. LO# 5

20-22 Securities Exchange Act of 1934 Concerned primarily with ongoing reporting by companies whose securities are listed and traded on a stock exchange. Section 18 imposes liability on any person who makes a material false or misleading statement in documents filed with the SEC. Section 10(b) and Rule 10b-5 are the greatest source of liability for auditors under this act. LO# 6

20-23 Securities Exchange Act of 1934 Third Party Must Prove 1.A material, factual misrepresentation or omission. 2.Reliance on the financial statements. 3.Damages suffered as a result of reliance on the financial statements. 4.Scienter. LO# 6

20-24 Private Securities Litigation Reform Act of 1995 and the Securities Litigation Uniform Standards Act of 1998 Private Securities Litigation Reform Act of 1995 Provides for proportionate liability for defendants based on percentage of responsibility and a specific statement of fraud at the beginning of the case Securities Litigation Uniform Standards Act of 1998 Prevents plaintiffs from seeking to evade the protections that Federal law provides against abusive litigation by filing suit in State, rather than Federal Court LO# 7

20-25 Sarbanes-Oxley Act of 2002 Most sweeping securities law since 1934 Creation of PCAOB Stricter independence rules Audits of internal controls Increased reporting responsibilities LO# 8

20-26 SEC and PCAOB Sanctions Suspend Practicing Privilege Impose Fines Remedial Measures LO# 9

20-27 Foreign Corrupt Practices Act (FCPA) An auditor may be subject to administrative proceedings, civil liability, and civil penalties. Passed in 1977 in response to the discovery of bribery and other misconduct on the part of more than 300 American companies. LO# 10

20-28 Racketeer Influenced and Corrupt Organizations Act (RICO) RICO provides for civil and criminal sanctions for certain illegal acts. Passed in 1970 to combat the infiltration of legitimate businesses by organized crime. LO# 11

20-29 Criminal Liability Gross Negligence Fraud Auditors can be held criminally liable under the laws discussed in the previous section. Criminal prosecutions require that some form of criminal intent be present, such as gross negligence or fraud. LO# 8 & 12

20-30 Approaches to Minimizing Legal Liability Professional Level 1.Establish stronger auditing and attestation standards. 2.Update Code of Professional Conduct and sanction members who do not comply. 3.Educate users. Firm Level 1.Institute sound quality control and review procedures. 2.Ensure independence. 3.Follow sound client acceptance and retention procedures. 4.Be alert to risk factors. 5.Perform and document work diligently. LO# 8 & 12

20-31 End of Chapter 20