1. CHAPTER 4 AUDITOR’S LEGAL LIABILITY Fall 2007 u Types of CPA Liability u Liability Under Common vs. Statutory Law u Defenses u Liability under SEC Acts of 1933 and 1934, SOX and RICO u Legal Liability for Accounting and Review Services u “Best Practices” to minimize legal problems

2. Auditor’s Legal Liability CPAs should approach every engagement needing to defend their work in court. –Malpractice insurance –Legal costs astronomical Up to 20% of accounting and audit revenues Perspective: $20,000 audit fee  $6million defense costs –Damage to reputation –Criminal liability Keep it in perspective though! –Most CPAs are not careless or incompetent –An audit provides only reasonable assurance

3. Types of Auditor Legal Liability Common Law –Develops through case decisions –Generally arises due to breach of contract, negligence and fraud –Can also involve torts (harmful act not involving breach of contract) in which civil action can be brought Statutory Law –Develops when a governmental unit (state or Federal government) passes laws and regulations that affect CPAs

4. Liability Under the Common Law Figure 4-1 Liability to Clients: Under contract law — for breach of contract -Std Report, Non-GAAS audit -Report not on time -Violate confidentiality Under tort law — for fraud, constructive fraud gross, negligence, and ordinary negligence Liability to Third Parties: Under tort law — to all third parties for fraud, constructive fraud and gross negligence — to designated parties for negligence, (Fig4-1)

5. Definitions of Liability Levels Ordinary Negligence : Failure to exercise ordinary care Gross Negligence : Failure to use even the slightest care Constructive Fraud : Such severe gross negligence as to effectively be considered fraud (Ultramares case) Fraud : Intentional deception

6. Types of Third Parties Primary Beneficiaries : identified by name to the auditor prior to the audit Other Beneficiaries : unnamed third parties such as stockholders, creditors and potential investors – Forseen Class : Known (as opposed to all possible) class of people who are expected to benefit from the auditors’ report – Forseeable Class : All possible classes of people who could benefit from the auditors’ report. This includes all creditors, stockholders, and present and future investors.

7. Liability for Negligence Under Common Law (Figure 4-1)

8. 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. In addition, the auditor hopes to convince the court that there are inherent limitations in the audit process. 4. Thus, because of selective testing, there is a risk that material errors or irregularities, if they exist, may not be detected.

9. 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. Most states rely on “comparative negligence whereby the plaintiff and defendant allocate damages to the extent each is at fault.

10. Liability Under Statutory Laws Securities Act of 1933 – Financial statements included in registration statement Plaintiff: “Any person” purchasing securities Material false or misleading information in financial statements Does not have to prove reliance Does not have to show that the auditor was negligent Auditor: Liable for fraud, gross negligence and negligence Burden of establishing that he/she was not negligent Must establish that plaintiff’s loss at least in part due to other causes

11. Liability Under Securities Laws Securities Act of 1934 – Financial statements included in annual report associated with trading of securities Plaintiff: False or misleading information in financial statements Must prove reliance Must show that the auditor was grossly negligent or willfully and knowingly made a false statement. Ordinary negligence not option.

12. Liability Under Securities Laws Private Securities Litigation Reform Act of 1995 1. Proportionate Liability 2. Cap on Actual Damages 3. Responsibility to Report Illegal Acts 4. Other Changes Provided by the Reform Act

13. Liability Under Sarbanes-Oxley Penalties Increased Substantially Failure to maintain workpapers for at least five years: felony w/penalty up to 10 years Document destruction: felony w/ penalty of up to 20 years Securities fraud: criminal penalties increased to 25 years Fraud discovery statute of limitations extended to 2 years from discovery and 5 years from act

14. Liability under RICO Racketeer Influenced and Corrupt Organization Act (RICO) – Includes such crimes as mail fraud and fraud in the sale of secuirites – Involvement > 2/10 yrs fraudulent f/s is racketeering – 3x damages and pay plaintiff legal fees – Still possible if “too close” to client

15. “Best Practices” Minimizing the Risk of Litigation – Engagement letters – Investigate clients – Quality of service rather than growth – Comply with GAAS and GAAP – Recognize limitations of standards – Quality Control – Take care w/ troubled clients – Be aware of audit risk alerts

16. Liability for Accounting and Review Services Write-ups/compilations and reviews Do CPAs acting as accountants rather than auditors have any legal liability? –Due professional care to clients –May be liable for losses to 3 rd parties To avoid problems –Use engagement letter (1136 Tenants case) –Follow due care and appropriate standards –Be alert to and follow up on any unusual items