1. Audit Legal Environment
Kathleen Sage Huffman, Esq.

2. Legal liability of the auditor
varies from country to country, district to district.
based on one or more of the following:
common law,
civil liability under statutory law,
criminal liability under statutory law, and
liability for members of professional accounting organizations.
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Liability for auditors under common law generally falls in two categories: liabilities to clients and third party liability

3. Common Law Ultramares - Touche case (Ultramares Corporation v Touche et al.)
the accountants were negligent for not finding that a material amount of accounts receivable had been falsified when careful investigation would have shown it to be fraudulent,
not liable to a third party bank because the creditors were not a primary beneficiary, or known party,
called the Ultramares doctrine, that ordinary negligence is not sufficient for a liability to a third party because of lack of privity of contract between the third party and the auditor.
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1931

4. Civil Liability Under Statutory Law
The Securities Act of 1933 established the first U.S. statutory civil recovery rules for third parties against auditors.
Original purchasers have recourse against the auditor for up to the original purchase price if the financial statements are false or misleading.
The auditor has the burden of demonstrating that reasonable investigation was conducted or that all the loss of the purchaser of securities (plaintiff) was caused by factors other than the misleading financial statements.
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In the United States, the Securities Act of 1933 not only created the Securities and Exchange Commission (SEC); it established the first statutory civil recovery rules for third parties against auditors. Original purchasers of securities of a firm newly registered to make a public offering have recourse against the auditor for up to the original purchase price if the financial statements are false or misleading. Anyone who purchased securities described in the registration statement (S1) may sue the auditor for material misrepresentations or omissions in financial statements published in the S1. The auditor has the burden of demonstrating that reasonable investigation was conducted or all that the loss of the purchaser of securities (plaintiff) was caused by factors other than the misleading financial statements. If the auditor cannot prove this, the plaintiff wins the case.

5. Sarbanes Oxley Act of 2002 Civil Penalties for CEOs and CFOs
If there is a material restatement of a company’s reported financial results due to the material noncompliance of the company, as a result of misconduct, the CEO and CFO shall reimburse the company for any bonus or incentive or equity-based compensation received within the 12 months following the filing with the financial statements subsequently required to be restated (Section 304)
Financial statements filed with the SEC by any public company must be certified by CEOs and CFOs. If all financials do not fairly present the true condition of the company CEOs and CFOs may receive fines of up to $1 million. If certifications are made knowing the statements are incorrect, the fine can be up to $5 million.
SOX
Sec 30
Sec. 906 Corporate Responsibility for Financial Reports – 1350 Failure of Corporate officers to certify financial reports

6. Criminal Liability Under Statutory Law
The Securities Exchange Act of 1934 in the United States sets out (Rule 10b-5) criminal liability for the auditor to employ any device, scheme or artifice to defraud or intentionally or recklessly misrepresent information for third party use.
Cases: In United States v. Natelli (1975)* United States v. Weiner (1975) * ESM Government Securities v. Alexander Grant & Co. (1986).
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The SEC also has authority to sanction or suspend an auditor from doing audits for SEC registered companies.  

7. United States v. Natelli (1975)
auditors convicted of criminal liability under 1934 SEC Art for certifying National Student Marketing Corporation financial statements with material account receivable disclosure omissions
United States v. Natelli (1975) auditors convicted of criminal liability under 1934 SEC Art for certifying National Student Marketing Corporation financial statements with material account receivable disclosure omissions.;

8. United States v. Weiner (1975)
auditors convicted of securities fraud in auditing Equity Funding Corporation of America which overstated financial statements by fraud.
The audit work was so poor that the court concluded that the auditors must have known about the fraud.
United States v. Weiner (1975) auditors convicted of securities fraud in auditing Equity Funding Corporation of America which overstated financial statements by fraud. The audit work was so poor that the court concluded that the auditors must have known about the fraud.

9. ESM Government Securities v. Alexander Grant & Co. (1986).
The company told AG partner about a fraud the prior year and the partner agreed to say nothing.
The partner was sentenced to 12 years in prison.
ESM Government Securities v. Alexander Grant & Co. (1986). The company told AG partner about a fraud the prior year and the partner agreed to say nothing. The partner was sentenced to 12 years in prison.

10. Sarbanes Oxley Act of 2002 Criminal Penalties for CEOs, CFOs and Auditors
To knowingly destroy, create, manipulate documents and/or impede or obstruct federal investigations is considered felony, and violators will be subject to fines or up to 20 years imprisonment, or both
All audit reports or related workpapers must be kept by the auditor for 7 years. Failure to do this may result in 10 years imprisonment.
CFOs and CEOs who falsely certify financial statements or internal controls are subject to 10 years imprisonment. Willful false certification may result in a maximum of 20 years imprisonment
SOX Sec 801
1519 Destruction, alteration or falsification of records in Federal investigations and bankruptcy
1520 “Destruction of corporate audit records”
Sec 906
1350 “Failure of corporate officers to certify financial reports”

11. Liabilities as Members of Professional Organizations
Nearly all national audit professions have some sort of disciplinary court.
The disciplinary court makes its judgment and determines the sanction. It may be:
a fine;
a reprimand (either oral or written);
a suspension for a limited period of time (e.g. 6 months); or
a lifetime ban from the profession.
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12. The plaintiff must quantify her losses (quantum issue).
In order to hold the auditor successfully legally liable in a civil suit, the following conditions have to be met:
An audit failure/neglect has to be proven (negligence issue).
The auditor should owe a duty of care to the plaintiff (due professional care).
The plaintiff has to prove a causal relationship between her losses and the alleged audit failure (causation issue)
The plaintiff must quantify her losses (quantum issue).
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13. Suggested Solutions to Auditor Liability
A system of proportionate liability - an audit firm is not liable for the entire loss incurred by plaintiffs but only to the extent to which the loss is attributable to the auditor.
Some countries (e.g. Germany) have put a legally determined cap on the liability of auditors (to the client in the case of Germany).
In order to protect the personal wealth of audit partners, some audit firms are structured as a limited liability partnership (e.g. in the UK).
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14. The Occurrence of Fraud
ISA 240- the responsibility for the prevention and detection of fraud and error rests with both those charged with the governance and the management.
ISA 210 states that when planning and performing audit procedures and in evaluating and reporting the results, auditors should consider the risk of misstatements in financial statements resulting in fraud.
In planning the audit, the auditor must assess the risk that material fraud or error has occurred.
Page 60 – 64;
International Federation of Accountants Handbook Of International Quality Control, Auditing, Review, Other Assurance, And Related Services Pronouncements 2010 Edition Part I

15. US Fraud Standard Auditing Standard Number 99 (SAS 99)
The standard requires that as part of the planning process the audit team must consider how and where the client’s financial statements may be susceptible to fraud.
Gather information by inquiring of management and consider ing fraud risk factors
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16. Cenco Inc. v. Seidman & Seidman (1982)
Cenco management in massive fraud to inflate the value of company inventory
After the fraud was discovered shareholders sued the auditors who settled out of court for $3.5 million
Replacement management sued the CPAs a second time, who claimed that wrongdoings of management was at fault
CPA firm judged not responsible

17. The Occurrence of Illegal Acts
Both ISA 250 and most national regulators state that the tauditor is not responsible for preventing non-compliance and cannot be expected to detect noncompliance with all laws and regulations. In conducting an audit of financial statements, the auditor takes into account the applicable legal and regulatory framework when planning the audit.
 The professional regulations in some countries require the auditor to inform members of the audit committee or board of directors
Page 64; ISA 250 Laws and Regulations, International Federation of Accountants Handbook Of International Quality Control, Auditing, Review, Other Assurance, And Related Services Pronouncements 2010 Edition Part I
Exercise 2-20 Opinion on the Occurrence of Illegal Acts.
However, the auditor is not responsible for preventing non-compliance and cannot be expected to detect noncompliance with all laws and regulations.
5. The auditor is responsible for obtaining reasonable assurance that the financial statements, taken as a whole, are free from material misstatement, whether caused by fraud or error.1 In conducting an audit of financial statements, the auditor takes into account the applicable legal and regulatory
framework. Owing to the inherent limitations of an audit, there is anunavoidable risk that some material misstatements in the financial statementsmay not be detected, even though the audit is properly planned and performed in accordance with the ISAs.2 In the context of laws and regulations, the potential effects of inherent limitations on the auditor’s ability to detect
material misstatements are greater for such reasons as the following:
• There are many laws and regulations, relating principally to the
operating aspects of an entity, that typically do not affect the
financial statements and are not captured by the entity’s information
systems relevant to financial reporting.
• Non-compliance may involve conduct designed to conceal it, such as
collusion, forgery, deliberate failure to record transactions,
management override of controls or intentional misrepresentations
being made to the auditor.
• Whether an act constitutes non-compliance is ultimately a matter for
legal determination by a court of law.
Ordinarily, the further removed non-compliance is from the events and
transactions reflected in the financial statements, the less likely the auditor
is to become aware of it or to recognize the non-compliance.
6. This ISA distinguishes the auditor’s responsibilities in relation to
compliance with two different categories of laws and regulations as follows:
(a) The provisions of those laws and regulations generally recognized to
have a direct effect on the determination of material amounts and
disclosures in the financial statements such as tax and pension laws
and regulations (see paragraph 13); and
(b) Other laws and regulations that do not have a direct effect on the
determination of the amounts and disclosures in the financial
statements, but compliance with which may be fundamental to the
operating aspects of the business, to an entity’s ability to continue its
business, or to avoid material penalties (for example, compliance with
the terms of an operating license, compliance with regulatory solvency
requirements, or compliance with environmental regulations); noncompliance
with such laws and regulations may therefore have a
material effect on the financial statements (see paragraph 14).