1. Copyright © 2007 Pearson Education Canada 1 Chapter 4: Legal Liability

2. Copyright © 2007 Pearson Education Canada 4-2 Chapter 4 objectives  Identify sources of legal liability  Distinguish between a business failure and an audit failure  Explain the concept of privileged communication  List who can sue the auditor, and discuss the auditor’s potential defences  Discuss what individual accountants and the accounting profession are doing to respond to legal liability

3. Copyright © 2007 Pearson Education Canada 4-3 Sources of legal liability  Why do you believe that an auditor might be sued or liable?  Check your answers on Table 4-1 (p. 82)

4. Copyright © 2007 Pearson Education Canada 4-4 Confusing business and audit failure  Business failure: when a business cannot repay its debts, perhaps due to poor management, a shift in demand, or economic factors  Audit failure: when the auditor issues an incorrect audit opinion (e.g. an unqualified opinion when it should be qualified)

5. Copyright © 2007 Pearson Education Canada 4-5 Think of an example …  Think of a recent business failure that was publicized in your area  Were the auditors sued?  If so, do you think that it was a business failure, or an audit failure, or both?  Was fraud involved?

6. Copyright © 2007 Pearson Education Canada 4-6 Role of audit risk  The auditor uses audit risk to help decide how much evidence to collect  Audit risk is the risk that the auditor will conclude that the financial statements are fairly stated, when they are not (For example, if the auditor chooses audit risk of 3%, there is a 3% risk of material error in the financial statements)

7. Copyright © 2007 Pearson Education Canada 4-7 Practice problem 4-20 (p. 106)  How does management integrity affect the audit process?  Is the auditor responsible to consider organized criminal activity?

8. Copyright © 2007 Pearson Education Canada 4-8 Expectation gap  There is an expectation gap when two different groups expect different outcomes in a particular situation  Here, we use the term ‘expectation gap’ to refer to the difference between what users actually expect and what the audit report actually provides

9. Copyright © 2007 Pearson Education Canada 4-9 What do users expect?  Think about the different users of financial statements  What might the difference in expectations be among these users with respect to the auditor’s report?

10. Copyright © 2007 Pearson Education Canada 4-10 Terminology and context  Before moving on, take a look at some of the legal terms covered on pages 84 to 87  We will focus on three of these: – Prudent person – Joint and several liability – Lack of privileged communication

11. Copyright © 2007 Pearson Education Canada 4-11 Practice problem 4-14 (p. 105)  Clarifying terminology  Use this question with a series of true and false questions to test your understanding of key legal terms

12. Copyright © 2007 Pearson Education Canada 4-12 Prudent person  The auditor is not expected to be perfect  How is the standard of performance set?  According to the courts it is based upon “reasonable care and diligence in the performance of obligations” – this means that the auditor does his/her best given the training and experience required

13. Copyright © 2007 Pearson Education Canada 4-13 Joint and several liability  The partner in charge of an audit engagement is responsible for his/her employees, other partners on the engagement, as well as work performed by other audit firms, internal auditors or specialists  Limited liability could be present if the firm formed a limited liability partnership

14. Copyright © 2007 Pearson Education Canada 4-14 Lack of privileged communication  Lawyers may refuse to provide information to the courts that was given to them by their clients (called privileged communication)  Accountants do not have this right  They must provide information to the courts when subpoenaed

15. Copyright © 2007 Pearson Education Canada 4-15 Practice problem 4-4 (p. 103)  Think about the typical accounting firm  Think of as many specific examples as you can – who would the partner in the public accounting firm be held liable for?

16. Copyright © 2007 Pearson Education Canada 4-16 Who can sue the auditor?  Clients (the business entity or organization that hired the auditor)  Third parties: – Owners or shareholders (existing or potential) – Vendors – Bankers, Canada Revenue Agency or other creditors – Customers – Employees, etc.

17. Copyright © 2007 Pearson Education Canada 4-17 Practice problem 4-19 (p. 106)  Fiduciary duty?  What is it?  When is an auditor responsible?

18. Copyright © 2007 Pearson Education Canada 4-18 Five possible defences against third-party suits (p. 94)  Lack of duty of care  Absence of misstatement  Non-negligent performance  Absence of causal connection  Contributory negligence Preferably used in the above order during a suit.

19. Copyright © 2007 Pearson Education Canada 4-19 Lack of duty of care (also called “lack of privity”)  The auditor claims that there was no duty to the party that is suing  There is a duty of reasonable care to the client  An engagement letter helps identify that there is no duty of care to find fraud

20. Copyright © 2007 Pearson Education Canada 4-20 Practice problem 4-13 (pp. 104-5)  The bank lent some more money  After relying upon the financial statements  Lo, and behold, the company went bankrupt  And the bank sued the auditors (of course?)  So are the auditors liable?

21. Copyright © 2007 Pearson Education Canada 4-21 Absence of misstatement  The statements were in accordance with GAAP  There were no material errors in the financial statements  The financial statements accurately portray the financial statements of the organization

22. Copyright © 2007 Pearson Education Canada 4-22 Non-negligent performance  The audit was done in accordance with generally accepted auditing standards  The auditors are not responsible for undiscovered errors or fraud because their audit was done appropriately  CICA Assurance Handbook or expert witness used to support this defence

23. Copyright © 2007 Pearson Education Canada 4-23 Absence of causal connection  This defence claims that there is no connection between the auditor’s breach (i.e. an audit failure) and the client’s loss  For example, the client relied upon others (such as a banker) or upon their own expertise when deciding to invest or lend money

24. Copyright © 2007 Pearson Education Canada 4-24 Contributory negligence  The auditor accepts partial blame, i.e. accepts that the audit was not conducted in accordance with GAAS  However, the auditor also places blame on the party that is suing the auditor, e.g. management did not correct internal control weaknesses

25. Copyright © 2007 Pearson Education Canada 4-25 No damages  There is one additional defence that arises from the definition of a tort action for negligence (p. 86), and it is simply:  “No damages”  This defence is simply the fact that the plaintiff did not lose any money by relying upon the financial statements

26. Copyright © 2007 Pearson Education Canada 4-26 Practice problem 4-18 (p. 106)  Deliberate fraud on the part of the client  Overstatement of accounts receivable and inventory  Is the auditor liable?  Why or why not?  What defence would be used?

27. Copyright © 2007 Pearson Education Canada 4-27 Preventing excess legal costs  Both the accounting profession and the individual practitioner need to respond to the potential of legal liability

28. Copyright © 2007 Pearson Education Canada 4-28 The profession’s response to legal liability  Conduct research in auditing  Set standards and rules  Set requirements to protect auditors  Establish practice inspection requirements  Defend unjustified lawsuits  Educate users  Sanction members for improper conduct or performance  Lobby for changes in laws

29. Copyright © 2007 Pearson Education Canada 4-29 The individual practitioner’s response to legal liability  Deal only with clients possessing integrity  Hire qualified personnel and train and supervise them properly  Follow the standards of the profession  Maintain independence  Understand the client’s business  Perform quality audits

30. Copyright © 2007 Pearson Education Canada 4-30 The individual practitioner’s response to legal liability (cont’d)  Document the work properly  Obtain an engagement letter and a management representation letter  Maintain confidential relations  Carry adequate insurance  Seek legal counsel (when warranted)

31. Copyright © 2007 Pearson Education Canada 4-31 Practice problem 4-16 (p. 105)  It is important to follow up all errors  This practice problem looks at a firm’s internal quality control and supervision processes