Multiple Choice to Get Started Which of the following are control mechanisms that can improve the quality of audit work? a. firm-wide policies to review stock ownership of auditors to avoid independence violations. b. staffing procedures to assign more experienced auditors to riskier audits. c. laws that allow victims of fraudulent financial reporting to sue auditors for deficiency in the audit d. all of the above. e. a. and b. above.

Legal Liability of Auditors Private Securities Litigation Reform Act of 1995 Sarbanes-Oxley Act of 2002 Background Information Fundamental Legal Issues Significant Cases Impacting Auditor Liability

Background Information Types of law Standard of due care Privity Types of deficient conduct Beneficiaries

Types of Law Common Law Statutory Law –Securities Act of 1933 –Securities Exchange Act of 1934 –Sarbanes-Oxley Act of 2002

Standard of due care Assurance versus insurance Professionalism

Privity Common Law Doctrine Only a person in privity … Privity  Questions: –How do we define a contractual relationship as it applies to audits? –What do we mean by negligence?

Types of Deficiency Nonnegligent behavior (not really a deficiency) Ordinary Negligence Gross Negligence (constructive fraud) Fraud Other terminology--Scienter

Beneficiaries of the Auditor’s Work Type of beneficiaryGot Privity? Client Primary beneficiary Foreseen beneficiary Foreseeable beneficiary

Grounds for Liability So under common law, the auditor would be liable if: Material misstatement Reliance Damages Auditor deficiency –Level of deficiency needed depends on whether or not the plaintiff can demonstrate privity.

Statutory Law: Securities Exchange Act of 1934 Key section: 10(b)5 Key question: What level of deficiency is targeted? –It shall be unlawful for any person directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) to employ any device, scheme, or artifice to defraud, (b) to make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or c) to engage in an act, practice or course of business which operates or would operate as a fraud or deceit upon any person in connection with the purchase or sale of any security.

Fundamental Legal Issues The two key questions upon which the courts have ruled –To whom is the auditor liable for ordinary negligence? (Question # 1) –Is gross negligence a form of intentional deception (scienter)? (Question # 2)

Legal IssueCommon Law Statement of the Issue Statutory Law Statement of the Issue To whom is the auditor liable for ordinary negligence? Is gross negligence a form of intentional deception

Significant Cases Ultramares v. Touche (Common Law) Restatement of Torts (Common Law) Rosenblum v. Adler (Common Law) Hochfelder v. Ernst & Ernst (1934 act) Sirota v. Solitron (1934 Act) Escott v. Bar Chris (1933 Act)

Ultramares v. Touche Key Points of Judge Cordozo’s Ruling –Q#1 –Q#2

Restatement of Torts Extends liability for ordinary negligence to a limited class of foreseen third parties. –Q#1 –Q#2

Rosenblum v. Adler Broad definition of privity –Q#1

Hochfelder v. Ernst & Ernst A separate trial to rule on the issue of whether ordinary negligence was grounds for liability under 10(b)-5. –Q#1 –Q#2

Sirota v. Solitron Q#2

Escott v. Bar Chris Securities Act of 1933 Auditor failed to prove due diligence

Auditor Defenses Third Party Suits –Nonnegligent performance –Lack of duty –Absence of causal connection Client Suits –Same as above –Contributory negligence

Prevention Quality control (Chapter 2) –Client screening –Personnel management –Adherence to professional standards –Independence in fact and appearance –Documentation –Engagement letter –Skepticism