1. AUDITING CHAPTER 5 Legal Liability By David N. Ricchiute

2. GBW 8th ed. Ch. 5 2 TOPICS Issues of liability to clients, 3 rd parties Common law liability to foreseen 3 rd parties & Restatement of Torts Auditors & the Securities Acts Statutory liability to securities purchasers, sellers & securities litigation reform Liability for criminal offenses Responsibility to detect, report illegal acts Minimizing risk of legal liability

3. GBW 8th ed. Ch. 5 3 ISSUES CONTRIBUTING TO LEGAL LIABILITY Joint-and-several liability Allowed plaintiffs to recover against auditor alone Revised by Private Securities Litigation Reform Act of 1995  Changed to proportionate liability, i.e., auditor’s share Privity doctrine limits liability to parties to contract Expanded to include certain 3 rd parties

4. GBW 8th ed. Ch. 5 4 ISSUES IN CIVILITY LIABILITY Source of law for suit Who is plaintiff? What is auditor’s potential liability Who has the burden of proof, plaintiff or defendant? Penalty is monetary damages

5. GBW 8th ed. Ch. 5 5 SUMMARY OF ISSUES: Sources of Law Common law Written opinions of prior courts Statutory law Written statutes established by Congress, state legislatures Securities Act of 1933 Securities Exchange Act of 1934

6. GBW 8th ed. Ch. 5 6 SUMMARY OF ISSUES: Plaintiff Under common law Breach of contract  Client  3 rd party primary beneficiaries Tort (wrongful act)  Foreseen 3 rd parties  Foreseeable 3 rd parties Under Securities Act 1933 Initial purchasers Under Securities Exchange Act of 1934 Subsequent purchasers, sellers

7. GBW 8th ed. Ch. 5 7 SUMMARY OF ISSUES: Auditor’s Potential Liability Ordinary negligence Lack of reasonable care in performing services  Departure from GAAS Gross negligence Lack of minimum care in performing services  Reckless departure from GAAS Fraud Intentional misstatement or omission of material fact Constructive fraud lacks intent

8. GBW 8th ed. Ch. 5 8 SUMMARY OF ISSUES: Burden of Proof Plaintiff had damage, loss Materially misstated financial statements Reliance on financial statements, advice Deficient auditor conduct

9. GBW 8th ed. Ch. 5 9 COMMON LAW: Legal Action Breach of contract Allege violations of GAAS or confidentiality Tort (wrongful act) Allege injury due to negligence, gross negligence, fraud

10. GBW 8th ed. Ch. 5 10 COMMON LAW Primary Beneficiaries Specifically identified to auditors Beneficiaries of services Privity of contract Breach of contract Threshold for primary beneficiaries ordinary negligence

11. GBW 8th ed. Ch. 5 11 COMMON LAW: 3 rd Parties General identity, reliance on statements known Foreseen 3 rd parties Not specifically identified though known Creditors Foreseeable 3 rd parties Bondholders, shareholders Uses tort law Threshold for 3 rd parties gross negligence or fraud

12. GBW 8th ed. Ch. 5 12 RESTATEMENT OF TORTS Accepted in majority of states Establishes auditor’s liability to foreseen 3 rd parties Treats as primary beneficiaries Report used to influence plaintiff who provided funding

13. GBW 8th ed. Ch. 5 13 PRIVITY DOCTRINE Used in states that don’t accept Restatement of Torts Established in Ultramares Corp v. Touche (1931) Auditors liable to 3 rd parties for fraud Reaffirmed in Credit Alliance  Established linkage test to link auditor to plaintiff

14. GBW 8th ed. Ch. 5 14 LIABILITY TO FORESEEABLE 3 RD PARTIES Most liberal interpretation of culpability Used only in Mississippi & Wisconsin

15. GBW 8th ed. Ch. 5 15 STATUTORY LAW Securities Act of 1933 New issues of securities (IPO) Registration statement (S-1) filed with SEC Auditor’s involvement Auditor of annual reports Reviews statements Reviews S-1 for consistency with statements Issues “comfort letter’ to underwriters (SAS 72)

16. GBW 8th ed. Ch. 5 16 STATUTORY LAW: Securities Exchange of 1934 Regulates trading of securities Requires registration with SEC & periodic reporting (10-k, 10-q) Antifraud provisions of Section 10(b) & Rule 10b-5 Protect purchasers, sellers from manipulation, deception by auditor

17. GBW 8th ed. Ch. 5 17 AUDITOR’S LIABILITY UNDER ’33, ’34 ACTS ’33 Act Derives from association with registration statement ’34 Act Derives from association with 10-k, 10-q Liable for untrue statements or omissions of material fact

18. GBW 8th ed. Ch. 5 18 STATUTORY LAW: Private Securities Litigation Reform Act 1995 Sanctions lawyers who sue auditors for frivolous or factually impertinent arguments Retains joint-and-several liability for knowingly perpetrating fraud Applies proportional liability for less culpable defendants

19. GBW 8th ed. Ch. 5 19 MAJOR CASES Securities Act 1933 Escott v. BarChris Construction Corp. (1961) Material, Misleading statements with registration Securities Exchange Act 1934 Ernst & Ernst v. Hochfelder (1976) Auditors not liable in absence of scienter (intent to deceive)

20. GBW 8th ed. Ch. 5 20 CRIMINAL LIABILITY: 1930s Securities Act 1933 & Securities Exchange Act 1934 Willfully making a false statement or omitting a material fact Federal Mail Fraud Statute Mailing, conspiracy to mail false statements Major case United States v. Simon (Continental Vending) 1969

21. GBW 8th ed. Ch. 5 21 CRIMINAL LIABILITY: 1990s Racketeer Influenced & Corrupt Organizations Act (RICO) Intended to curtail movement of organized crime into legitimate business Applies to auditors who are engaged in the management of a business

22. GBW 8th ed. Ch. 5 22 FOREIGN CORRUPT PRACTICES ACT Illegal acts by US multinational companies overseas Influencing foreign governments, officials, etc. by payments, gifts Multinationals must implement sufficient internal controls to  Comply with authorization  Record as necessary  Restrict access to assets

23. GBW 8th ed. Ch. 5 23 COPING WITH LIABILITY Arbitration, mediation Practice development Client acceptance, retention Engagement letters GAAS & Quality control Professional liability insurance Countersuits Limited liability partnerships (LLPs)