1 CHAPTER 3 (Continued)

2 litigation explosion! - in 1991, the “Big 6” accounting firms incurred costs of $477 million in defense and settlement of lawsuits - currently, the profession’s total liability exposure is an estimated $30 billion

3 Who might sue an auditor and why? - a client - a third party - a combined group of stockholders - The federal government may prosecute an auditor for knowingly issuing an incorrect audit report (criminal liability)

4 1. the prudent person concept. 2. liability for the acts of others. 3. lack of privileged communication. In general, auditors do not have the right under common law to withhold information from the courts on the grounds that the in- formation is privileged. Three legal concepts apply to auditor liability: COURT

5 Several legal terms apply to auditor liability: Related to negligence and fraud: - ordinary negligence - absence of rea- sonable care reasonable care

6 Several legal terms apply to auditor liability: Related to negligence and fraud: - ordinary negligence - gross negligence - absence of even slight care, tantamount to reckless be- havior slight care

7 Several legal terms apply to auditor liability: Related to negligence and fraud: - ordinary negligence - gross negligence - constructive fraud - existence of ex- treme or unusual negligence even though there was no intent to deceive or do harm

8 Several legal terms apply to auditor liability: Related to negligence and fraud: - ordinary negligence - gross negligence - constructive fraud - fraud - a misstatement is made and there is both the knowledge of its falsi- ty and the intent to deceive

9 Several legal terms apply to auditor liability: Related to contract law: - breach of contract - failure of one or both parties in a contract to fulfill the requirements of the contract Parties who have a relationship that is established by a contract are said to have privity of contract.

10 Several legal terms apply to auditor liability: Related to contract law: - breach of contract - third-party beneficiary - a third party who does not have privity of contract but is known to the contracting parties and is intended to have certain rights and benefits under the contract

11 Several legal terms apply to auditor liability: Related to common and statutory law: - common law - laws that have been de- veloped through court decisions rather than through government statutes COURT common law

12 Several legal terms apply to auditor liability: Related to common and statutory law: - common law - statutory law - laws that have been passed by the U.S. Congress and other governmental units statutory law

13 Auditor’s Defenses Against Client Suits lack of duty nonnegligent performance contributory negligence absence of causal connection

14 Auditor’s Defenses Against Client Suits The auditor claims that there was no im- plied or expressed contract. A common way for an auditor to demon- strate a lack of duty to perform is by use of an engagement letter. lack of duty

15 Auditor’s Defenses Against Client Suits The auditor claims that the audit was performed in accordance with GAAS. Even if there were undiscovered errors or irregularities, the auditor is not re- sponsible if the audit was properly conducted. nonnegligent performance

16 Auditor’s Defenses Against Client Suits The auditor claims that if the client had performed certain obligations, the loss would not have occurred. contributory negligence

17 Auditor’s Defenses Against Client Suits The auditor claims that there is a lack of a close causal connection between the auditor’s breach of the due care stan- dard and the damages suffered by the client. absence of causal connection

18 Liability to Third Parties under Common Law An auditor may be liable to third parties if a loss was incurred by the claimant due to reliance on misleading financial statements. Financial Statements Ace Company 19x4 Financial Statements

19 An auditor may be liable to third parties if a loss was incurred by the claimant due to reliance on misleading financial statements. Third parties include: - actual stockholders - potential stockholders - creditors - employees - customers - vendors Liability to Third Parties under Common Law

20 Liability to Third Parties under Common Law Auditor liability to third parties was es- tablished, in part, by a 1931 court deci- sion, Ultramares v. Touche. The key aspect of the resulting Ultra- mares Doctrine is that ordinary negli- gence is insufficient for liability to third parties, because of the lack of privity of contract between the third party and the auditor, unless the third party is a prima- ry beneficiary.

21 Liability to Third Parties under Common Law The Ultramares Doctrine also specifies that if there has been fraud or gross negligence, the auditor could be held liable to more general third parties. In recent years, the courts have broadened the Ultramares Doctrine to allow recovery by third party foreseen users. ?

22 Liability to Third Parties under Common Law The Ultramares Doctrine also specifies that if there has been fraud or gross negligence, the auditor could be held liable to more general third parties. In recent years, the courts have broadened the Ultramares Doctrine to allow recovery by third party foreseen users. members of a limited class of users who the auditor is aware will rely on the financial statements

23 Liability to Third Parties under Common Law In recent years, the courts have broadened the Ultramares Doctrine to allow recovery by third party foreseen users. An even broader interpretation of the rights of third-party beneficiaries is to use the concept of foreseeable users. ?

24 Liability to Third Parties under Common Law In recent years, the courts have broadened the Ultramares Doctrine to allow recovery by third party foreseen users. An even broader interpretation of the rights of third-party beneficiaries is to use the concept of foreseeable users. users that the auditor should have reasonably been able to foresee as being likely users of financial statements

25 lack of duty nonnegligent performance contributory negligence absence of causal connection Three of the four defenses available to auditors in suits by clients are also available in third-party suits. x

26 lack of duty nonnegligent performance contributory negligence absence of causal connection x Three of the four defenses available to auditors in suits by clients are also available for suits under the 1934 act.

27 The SEC has the power to sanction or suspend practitioners from auditing SEC companies. SEC

28 RICO The Racketeer Influenced and Corrupt Orga- nization (RICO) Act allows an individual to seek damages when it can be demonstrated that the defendant was engaged in a pattern of racketeering activity. In a 1993 U.S. Supreme Court decision, the court ruled that outside professionals such as accountants who do not help run corrupt businesses can not be sued under the provi- sions of RICO.

29 Foreign Corrupt Practices Act The Foreign Corrupt Practices Act: - forbids offering a bribe to an official of a for- eign country for the purpose of exerting in- fluence and obtaining or retaining business - requires SEC companies to maintain rea- sonably complete and accurate records and an adequate system of internal control How does this affect auditors?

30 Foreign Corrupt Practices Act The Foreign Corrupt Practices Act: - forbids offering a bribe to an official of a for- eign country for the purpose of exerting in- fluence and obtaining or retaining business - requires SEC companies to maintain rea- sonably complete and accurate records and an adequate system of internal control The act may affect auditors through their responsibility to review and evaluate systems of internal control as a part of an audit.

31 What can the auditing profession do to reduce auditors’ exposure to lawsuits? - encourage auditing research regarding litigation and improvements in auditing practice - establish standards and rules that meet the changing needs of auditing - establish standards that protect auditors - establish peer review requirements - oppose unwarranted lawsuits - educate financial statement users about auditing and the auditor’s opinion - sanction auditors for improper conduct - lobby for changes in laws COURT

32 What can individual CPAs do to reduce their exposure to lawsuits? - deal only with clients possessing integrity - hire, train, and supervise qualified personnel - follow the standards of the profession - maintain independence - understand the client’s business - perform quality audits - document the work properly - obtain an engagement letter and a representation letter - maintain confidential relations - carry adequate insurance - seek legal counsel - choose a form of organization with limited liability COURT