1. 4 - 1 Copyright  2003 Pearson Education Canada Inc. CHAPTER 4 Legal Liability

2. 4 - 2 Copyright  2003 Pearson Education Canada Inc. In recent years, the accounting profession has faced increasing litigation

3. 4 - 3 Copyright  2003 Pearson Education Canada Inc. U.S. litigation explosion! - in 1991, the “Big 6” accounting firms in the U.S. incurred costs of $447 million in defense and settlement of lawsuits

4. 4 - 4 Copyright  2003 Pearson Education Canada Inc. U.S. litigation explosion! - in 1991, the “Big 6” accounting firms in the U.S. incurred costs of $477 million in defense and settlement of lawsuits - currently, the U.S. profession’s total liability exposure is $30 billion

5. 4 - 5 Copyright  2003 Pearson Education Canada Inc. Who might sue an auditor and why?

6. 4 - 6 Copyright  2003 Pearson Education Canada Inc. Will Canadian Auditors be Subjected to the U.S. Liability Crisis?

7. 4 - 7 Copyright  2003 Pearson Education Canada Inc. -few jury trials for civil suits involving auditors -- judges knowledgeable -small punitive damages -more effective cost sanctions -class action suits less common -less aggressive regulatory environment Will Canadian Auditors be Subjected to the U.S. Liability Crisis? Likely Not!

8. 4 - 8 Copyright  2003 Pearson Education Canada Inc. Who might sue an auditor and why? - A client may sue an auditor for failing to discover a defalcation (common law liability to client)

9. 4 - 9 Copyright  2003 Pearson Education Canada Inc. Who might sue an auditor and why? - a client - A third party may sue an auditor; e.g., a bank may sue an auditor for failing to discover that a borrower’s financial statements are partially misstated (common law liability to third parties)

10. 4 - 10 Copyright  2003 Pearson Education Canada Inc. Who might sue an auditor and why? - a client - a third party - A combined group of shareholders may sue an auditor for not discovering materially misstated financial statements (liability under provincial securities acts)

11. 4 - 11 Copyright  2003 Pearson Education Canada Inc. Who might sue an auditor and why? - a client - a third party - a combined group of shareholders - The federal government may prosecute an auditor for knowingly issuing an incorrect audit report (criminal liability)

12. 4 - 12 Copyright  2003 Pearson Education Canada Inc. One reason for lawsuits against auditors is a lack of understanding on the part of financial statement users regarding: business failure audit failure audit risk

13. 4 - 13 Copyright  2003 Pearson Education Canada Inc. One reason for lawsuits against auditors is a lack of understanding on the part of financial statement users regarding: business failure audit failure audit risk What do these terms mean?

14. 4 - 14 Copyright  2003 Pearson Education Canada Inc. business failure Business failure occurs when a busi- ness is unable to repay its lenders or meet investor expectations.

15. 4 - 15 Copyright  2003 Pearson Education Canada Inc. business failure Business failure occurs when a busi- ness is unable to repay its lenders or meet investor expectations. Business failure is the result of unfavour- able economic or business conditions such as a recession, poor management decisions, or unexpected competition.

16. 4 - 16 Copyright  2003 Pearson Education Canada Inc. Audit failure occurs when an auditor issues an erroneous audit opinion as a result of an underlying failure to comply with GAAS. audit failure

17. 4 - 17 Copyright  2003 Pearson Education Canada Inc. Audit risk is the risk that the auditor, while appropriately following GAAS, will conclude that the financial statements fairly stated when, in fact, they are not. audit risk

18. 4 - 18 Copyright  2003 Pearson Education Canada Inc. business failure audit failure audit risk Under which of these concepts should an auditor be held responsible for financial damage suffered by a client or other parties?

19. 4 - 19 Copyright  2003 Pearson Education Canada Inc. business failure audit failure audit risk Under which of these concepts should an auditor be held responsible for financial damage suffered by a client orother parties? no yes no, but difficult to determine

20. 4 - 20 Copyright  2003 Pearson Education Canada Inc. Three legal concepts apply to auditor liability: 1. the prudent person concept. An auditor is expected to con- duct the audit with due care but the auditor is not ex- pected to be perfect. I’m a prudent practitioner!!

21. 4 - 21 Copyright  2003 Pearson Education Canada Inc. 1. the prudent person concept. 2. liability for the acts of others. The partners of a partnership are jointly liable for civil actions of a partner. Three legal concepts apply to auditor liability:

22. 4 - 22 Copyright  2003 Pearson Education Canada Inc. 1. the prudent person concept. 2. liability for the acts of others. The partners of a partnership are jointly liable for civil actions of a partner. Partners may also be liable for work of others such as employees, other public accounting firms, and specialists. Three legal concepts apply to auditor liability:

23. 4 - 23 Copyright  2003 Pearson Education Canada Inc. 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

24. 4 - 24 Copyright  2003 Pearson Education Canada Inc. Several legal terms apply to auditor liability: Related to negligence and fraud: - negligence - absence of reasonable care reasonable care

25. 4 - 25 Copyright  2003 Pearson Education Canada Inc. Several legal terms apply to auditor liability: Related to negligence and fraud: - negligence - absence of reasonable care Plaintiff must prove: 1. defendant owed duty of care 2. defendant was negligent 3. plaintiff suffered a loss 4. connection exists between defendant’s negligence and plaintiff’s loss

26. 4 - 26 Copyright  2003 Pearson Education Canada Inc. Several legal terms apply to auditor liability: Related to negligence and fraud: - negligence - tort action for negligence - failure to meet social or professional obligations which caused an injury to another party

27. 4 - 27 Copyright  2003 Pearson Education Canada Inc. Several legal terms apply to auditor liability: Related to negligence and fraud: - negligence - tort action for negligence - constructive fraud - existence of such recklessness that even though there was no intent to deceive or do harm, court will impute fraud

28. 4 - 28 Copyright  2003 Pearson Education Canada Inc. Several legal terms apply to auditor liability: Related to negligence and fraud: - negligence - tort action for negligence - constructive fraud - fraud - a false assertion made know- ingly or recklessly

29. 4 - 29 Copyright  2003 Pearson Education Canada Inc. Several legal terms apply to auditor liability: Related to negligence and fraud: - negligence - tort action for negligence - constructive fraud - fraud - a false assertion made know- ingly or recklessly - plaintiff must prove: - defendant intended plaintiff to act on the assertion - plaintiff did act on the assertion - plaintiff suffered a loss

30. 4 - 30 Copyright  2003 Pearson Education Canada Inc. 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 CONTRACT

31. 4 - 31 Copyright  2003 Pearson Education Canada Inc. 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.

32. 4 - 32 Copyright  2003 Pearson Education Canada Inc. 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

33. 4 - 33 Copyright  2003 Pearson Education Canada Inc. 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

34. 4 - 34 Copyright  2003 Pearson Education Canada Inc. Several legal terms apply to auditor liability: Related to common and statutory law: - common law - statutory law - laws that have been passed by the Canadian government statutory law

35. 4 - 35 Copyright  2003 Pearson Education Canada Inc. Several legal terms apply to auditor liability: Related to assessed proportion of liability: - joint and several liability - the assess- ment against a defendant of the full loss suffered by a plaintiff regardless of the extent to which other parties shared in the wrongdoing

36. 4 - 36 Copyright  2003 Pearson Education Canada Inc. Several legal terms apply to auditor liability: Related to assessed proportion of liability: - joint and several liability - separate and proportionate liability - the assessment against a defendant of that portion of the damage caused by the defendant’s negligence

37. 4 - 37 Copyright  2003 Pearson Education Canada Inc. Several legal terms apply to auditor liability: Contributory negligence

38. 4 - 38 Copyright  2003 Pearson Education Canada Inc. Several legal terms apply to auditor liability: Contributory negligence - when plaintiff also partly caused his or her loss or injuries

39. 4 - 39 Copyright  2003 Pearson Education Canada Inc. Auditor’s Defenses Against Client Suits lack of duty absence of negligence contributory negligence absence of causal connection

40. 4 - 40 Copyright  2003 Pearson Education Canada Inc. 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

41. 4 - 41 Copyright  2003 Pearson Education Canada Inc. 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. absence of negligence

42. 4 - 42 Copyright  2003 Pearson Education Canada Inc. 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

43. 4 - 43 Copyright  2003 Pearson Education Canada Inc. 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

44. 4 - 44 Copyright  2003 Pearson Education Canada Inc. 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. Ace Company 2004 Financial Statements

45. 4 - 45 Copyright  2003 Pearson Education Canada Inc. 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 shareholders - potential shareholders - creditors (bankers) - employees - customers - vendors Liability to Third Parties under Common Law

46. 4 - 46 Copyright  2003 Pearson Education Canada Inc. 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.

47. 4 - 47 Copyright  2003 Pearson Education Canada Inc. Liability to Third Parties under Common Law The Ultramares Doctrine also specifies that if there has been fraud or constructive fraud, 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. ?

48. 4 - 48 Copyright  2003 Pearson Education Canada Inc. Liability to Third Parties under Common Law The Ultramares Doctrine also specifies that if there has been fraud or constructive fraud, 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 -Hedley Byrne v. Heller & Partners -Haig v. Bamford -Toromont v. Thorne

49. 4 - 49 Copyright  2003 Pearson Education Canada Inc. What’s the Current Status of Duty of Care of Auditors?

50. 4 - 50 Copyright  2003 Pearson Education Canada Inc. Contraction of foreseeability concept? Caparo Industries v. Dickmans What’s the Current Status of Duty of Care of Auditors? Unclear!

51. 4 - 51 Copyright  2003 Pearson Education Canada Inc. 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. ?

52. 4 - 52 Copyright  2003 Pearson Education Canada Inc. 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

53. 4 - 53 Copyright  2003 Pearson Education Canada Inc. The four defenses available to auditors in suits by clients are also available in third-party suits. However, contributory negligence would be less commonly used. lack of duty absence of negligence contributory negligence absence of causal connection

54. 4 - 54 Copyright  2003 Pearson Education Canada Inc. Criminal Liability Auditors may be found guilty for crimi- nal action under federal laws. It is illegal to defraud another person through knowingly being involved with false financial statements.

55. 4 - 55 Copyright  2003 Pearson Education Canada Inc. Criminal Liability Auditors may be found guilty for crimi- nal action under federal laws. It is illegal to defraud another person through knowingly being involved with false financial statements. Few Canadian Cases -U.S. v. Simon -U.S. v. Natelli -U.S. v. Weiner -ESM Government Securities v. Alexander Grant

56. 4 - 56 Copyright  2003 Pearson Education Canada Inc. What can the auditing profession do to reduce auditors’ exposure to lawsuits?

57. 4 - 57 Copyright  2003 Pearson Education Canada Inc. 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 requirements that protect auditors - establish practice inspection 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

58. 4 - 58 Copyright  2003 Pearson Education Canada Inc. What can individual public accountants do to reduce their exposure to lawsuits?

59. 4 - 59 Copyright  2003 Pearson Education Canada Inc. What can individual public accountants 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 COURT

60. 4 - 60 Copyright  2003 Pearson Education Canada Inc. Confidentiality vs. Association with False and Misleading Information Which responsibility is higher?

61. 4 - 61 Copyright  2003 Pearson Education Canada Inc. Confidentiality vs. Association with False and Misleading Information Which responsibility is higher? No Canadian cases exist In U.S. - Consolidata - Funds of Funds

62. 4 - 62 Copyright  2003 Pearson Education Canada Inc. Civil Liability Under U.S. Federal Securities Laws The Securities Act of 1933 deals with informa- tion in registration statements and prospec- tuses and concerns only reporting require- ments related to new securities. Ace Company 1 share of common stock Ace Company 1 share of common stock Ace Company 1 share of common stock Ace Company 1 share of common stock

63. 4 - 63 Copyright  2003 Pearson Education Canada Inc. Civil Liability Under U.S. Federal Securities Laws Section 11 of the 1933 act defines rights: - Any third party who purchased securities described in the registration statement may sue the auditor for material misrepresenta- tions or ommissions in audited statements... - Third party users do not have the burden of proof that they relied on the financial state- ments or that the auditor was negligent or fraudulent. The user must only prove that the audited statements contained a material mis- representation or omission.

64. 4 - 64 Copyright  2003 Pearson Education Canada Inc. Civil Liability Under U.S. Federal Securities Laws Section 11 of the 1933 act defines rights: As defenses, the auditor must demonstrate (1) an adequate audit was conducted, or (2) all or part of the plaintiff’s loss was caused by factors other than the misleading statements.

65. 4 - 65 Copyright  2003 Pearson Education Canada Inc. Civil Liability Under U.S. Federal Securities Laws The Securities Exchange Act of 1934 also results in auditor liability related to audited financial statements and information issued to the public and the SEC in monthly (8-K), quarterly (10-Q), and annual (10-K) reports. Ace Company 2004 Financial Statements 8-K vgffcg hgyvyyv iygu 10-Q vgffcg hgyvyyv iygu 10-K vgffcg hgyvyyv iygu

66. 4 - 66 Copyright  2003 Pearson Education Canada Inc. Civil Liability Under U.S. Federal Securities Laws The principal focus on auditor liability under the 1934 act has been Rule 10b-5. This rule prohibits, by interstate commerce, mail, or a national securities exchange: - any device, scheme, or artifice to defraud - untrue statements of material fact or omis- sion of material facts necessary to make the statements not misleading - fraud or deceit in connection with the pur- chase or sale of any security

67. 4 - 67 Copyright  2003 Pearson Education Canada Inc. 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.

68. 4 - 68 Copyright  2003 Pearson Education Canada Inc. The U.S. SEC has the power to sanction or suspend practitioners from auditing SEC companies. SEC

69. 4 - 69 Copyright  2003 Pearson Education Canada Inc. RICO The U.S. Racketeer Influenced and Corrupt Organization (RICO) Act allows an individual to seek damages when it can be demonstrated that the defendant was engaged in a pattern of racketeering activity.

70. 4 - 70 Copyright  2003 Pearson Education Canada Inc. RICO The U.S. Racketeer Influenced and Corrupt Organization (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.

71. 4 - 71 Copyright  2003 Pearson Education Canada Inc. U.S. Foreign Corrupt Practices Act The U.S. 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

72. 4 - 72 Copyright  2003 Pearson Education Canada Inc. U.S. Foreign Corrupt Practices Act The U.S. 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?

73. 4 - 73 Copyright  2003 Pearson Education Canada Inc. U.S. Foreign Corrupt Practices Act The U.S. 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.