MODERN AUDITING 7th Edition William C. Boynton California Polytechnic State University at San Luis Obispo Raymond N. Johnson Portland State University Walter G. Kell University of Michigan Developed by: Dr. Raymond N. Johnson, CPA Gregory K. Lowry, MBA, CPA John Wiley & Sons, Inc.

CHAPTER 4 AUDITOR’S LEGAL LIABILITY u The Legal Environment u Liability Under Common Law u Liability Under Securities Laws u Other Considerations u Appendix 4A: Chronological Summary of Additional Selected Legal Cases

The Legal Environment Trends in Litigation in the United States End of 1992 The accounting profession faced more than 4,000 liability suits with unsettled claims estimated to exceed $30 billion. During 1992 The U.S.’s 7th largest accounting firm, Laventhol and Horwath, declared bankruptcy, largely as a result of its liability burden — 1995 Liability costs for accounting firms skyrocketed. 1995: Private Securities Litigation Reform Act Improved liability environment for CPA Firms Tip of Earnings Management Iceberg 2002 Sarbanes-Oxley Act of 2002

Liability Under the Common Law Figure 4-1 Liability to Clients: Under contract law — for breach of contract Under tort law — for fraud, gross negligence, and ordinary negligence Liability to Third Parties: Under tort law — to all third parties for fraud and gross negligence — to designated parties for ordinary negligence, as follows:

Liability Under the Common Law Figure 4-1

1136 Tenants’ Corp CPA performed the equivalent to compilation services Client thought they were receiving an audit No engagement letter Evidence of fraud (not followed up on) in CPAs working papers

Common Law Defenses Due Care Defense 1.The auditor attempts to show that the audit was made in accordance with GAAS. 2.The auditor’s working papers are critical in this defense. 3.The auditor hopes to convince the court (jury) that there are inherent limitations in the audit process.

Common Law Defenses Contributory Negligence Defense 1. If a plaintiff has contributed to his or her injury (loss), by his or her own negligence, the law considers him or her to be as responsible as the defendant for the injury. 2. In such a case, there is no basis for recovery because the negligence of one party nullifies the negligence of the other party. 3. In most states, contributory negligence is a defense for the auditor only when the negligence directly contributes to the auditor’s failure to perform.

Liability Under Securities Laws Securities Act of 1933 – Financial statements included in registration statement Plaintiff: 1.False or misleading information in financial statements – Does not have to prove reliance – Does not have to show that the auditor was negligent Auditor: 1.Due care defense: Burden of establishing freedom from negligence

Liability Under Securities Laws Securities Act of 1934 – Financial statements included in annual report associated with trading of securities Plaintiff: 1.False or misleading information in financial statements 2.Must prove reliance 3.Must show that the auditor was grossly negligent or willfully and knowingly made a false statement

Securities Law Cases SEC Act of 1933 Escott v. BarChris Construction Corp (SEC 33 Act). – Due Diligence Defense U.S. v. Simon – 1969 (Continental Vending) – Jury Decision: Financial Statements were so materially misstated and auditors helped draft a note that was misleading

Securities Law Cases SEC Act of 1934 Ernst and Ernst v. Hochfelder (SEC 34 Act) – The auditor was perhaps negligent in not following up on a “mail rule,” but this did not meet the test of willful conduct required by rule 10b-5 of the 34 act. Fund of Funds Limited v. Arthur Anderson – Two clients, doing business with each other, and audited with the same audit team. – The auditors inappropriately issued an unqualified opinion on King Resources Corp. – Jury found AA liable for aiding and abetting violations of securities law (Rule 10b-5) U.S. v. Natelli (1975) – Criminal Liability – Failure to disclose write-off of uncollectible accounts – Reliance on oral evidence (phone conversations) – Treatment of retroactive adjustment was done intentionally to conceal errors in 1968 accounts (NI overstated by 46%) – Auditors shut eyes to what could plainly be seen

Liability Under Securities Laws Private Securities Litigation Reform Act of Proportionate Liability 2. Cap on Actual Damages 3. Responsibility to Report Illegal Acts 4. Other Changes Provided by the Reform Act

Securities Laws Sarbanes - Oxley Act of 2002 Auditors 1.Prohibited Non-Attest Services 2.Increased Internal Control Responsibility 3.PCAOB sets auditing standards for auditors of public companies and carries out quality control inspections.

Securities Laws Sarbanes - Oxley Act of 2002 Management 1.CEO and CFO Certifications of the financial statements 2.Unlawful for any officer or director to take any action to fraudulently influence, coerce, manipulate, or mislead any auditor 3.Reimbursement of bonus based on restated earnings

CHAPTER 4 AUDITOR’S LEGAL LIABILITY

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