LEGAL

LIABILITY
CHAPTER 5

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 CHAPTER 5 LEARNING OBJECTIVES

5-1 Understand the litigious environment in which CPAs practice.

5-2 Explain why the failure of financial statement users to
differentiate among business failure, audit failure, and audit
risk
has resulted in lawsuits.
5-3 Use the primary legal concepts and terms concerning
accountants liability as a basis for studying legal liability of
auditors.
5-4 Describe accountants liability to clients and related
defenses.

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 CHAPTER 5 LEARNING OBJECTIVES

5-5 Describe accountants liability to third parties under common

law and related defenses.
5-6 Describe accountants civil liability under the federal securities
laws and related defenses.
5-7 Specify what constitutes criminal liability for accountants.
5-8 Describe how the profession and individual CPAs can reduce
the
threat of litigation.

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 OBJECTIVE 5-1
Understand the litigious
environment in which
CPAs practice.

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CHANGED LEGAL ENVIRONMENT

Professionals, including CPAs, are held to a high

level of performance.
Under common law, auditors must fulfill
contracts with clients and may also be held
liable to third parties.
Auditors may also be held liable to third parties
based on statute, including the Securities Act
of 1933, the Securities Exchange Act of 1934,
and the Sarbanes-Oxley Act.

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 CHANGED LEGAL ENVIRONMENT (CONT.)
Increase in the number of lawsuits and the sizes of the
awards to plaintiffs
Reasons for this trend include:
Growing awareness of the responsibilities of CPAs
Increased effort by the SEC to protect investors
interests
Increased complexity of auditing and accounting
Litigious society

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 CHANGED LEGAL ENVIRONMENT (CONT.)
Reasons for increased litigation against CPAs (cont):
Recession and tough economic times resulting in
business failures
Attorneys often provide legal services on a contingent-
fee basis
CPA firms willing to settle legal cases out of court
Difficulties of judges and juries understanding
technical accounting and auditing matters

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 OBJECTIVE 5-2
Explain why the failure of financial
statement users to differentiate
among business failure, audit
failure, and audit risk has resulted
in lawsuits.

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 DISTINGUISHING BUSINESS FAILURE,
AUDIT FAILURE, AND AUDIT RISK

Important distinctions:
1. The difference between a business failure and an
audit failure
2. The difference between an audit failure and audit
risk

A business failure occurs when a business is

unable to repay its lenders or meet the
expectations of investors

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 DISTINGUISHING BUSINESS FAILURE,
AUDIT FAILURE, AND AUDIT RISK
Audit failure occurs when the auditor issues an incorrect audit
opinion because the auditor did not comply with auditing
standards
Audit risk represents the possibility that the auditor concludes,
after conducting an adequate audit, that the financial statements
were fairly stated when, in fact, they were materially misstated
In cases when an audit failed to uncover material misstatements
and the wrong type of opinion was issued, it is appropriate to
question whether the auditor exercised due care in performing the
audit.
If the auditor did not exercise due care, the auditor can be held
liable for the incorrect opinion.

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 DISTINGUISHING BUSINESS FAILURE,
AUDIT FAILURE, AND AUDIT RISK
The expectation gap contributes to the
amount of litigation against auditors.
The expectation gap refers to the difference
between what an auditors responsibilities are and
what the user expects from the auditor.
Auditors responsibility: to perform the audit in
accordance with auditing standards
User expectation: is often that the auditor
guarantees the accuracy of the financial statements,
and even guarantees the viability of the business

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 OBJECTIVE 5-3
Use the primary legal concepts
and terms concerning
accountants liability as a basis for
studying legal liability of auditors.

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 LEGAL CONCEPTS AFFECTING LIABILITY

Some basic legal concepts involved in determining liability :

Prudent person concept
Liability for the acts of others
Lack of privileged communication
Legal terms affecting CPAs liability
Sources of legal liability:
1. Liability to clients
2. Liability to third parties under common law
3. Civil liability under federal securities laws
4. Criminal liability

Some examples of these classifications of liability are included in Figure 5-

1.

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 OBJECTIVE 5-4
Describe accountants liability to
clients and related defenses.

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 LIABILITY TO CLIENTS

The most common source of lawsuits against

CPAs is from clients regarding negligent acts,
which are detailed in Table 5-1.
For example, see summary of Cenco
Incorporated v. Seidman & Seidman, in Figure 5-
2.

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 LIABILITY TO CLIENTS

Auditors normally use one, or a combination of, the

following four defenses with claims filed by clients:
Lack of duty to perform service
Nonnegligent performance
Contributory negligence
Absence of causal connection
Figure 5-3 discusses a case in which the auditor was
not engaged to perform an audit. As a result of this
case, auditors and clients typically sign engagement
letters detailing the expectations of the engagement.

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 OBJECTIVE 5-5
Describe accountants liability to
third parties under common law
and related defenses.

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 LIABILITY TO THIRD PARTIES UNDER COMMON LAW

The Ultramares Doctrine resulted from a precedent-

setting auditing case from 1931.
Even though the auditors were negligent, they were not
liable to the creditors because the creditors were not
the primary beneficiary.

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 LIABILITY TO THIRD PARTIES UNDER COMMON
LAW (CONT.)

Courts have since broadened the Ultramares Doctrine to include

third parties who are considered foreseen users.
Foreseen users are a class of users that the auditor knows will rely
on the financial statement. The Rusch Factors case in Figure 5-5
involves foreseen users.

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 LIABILITY TO THIRD PARTIES UNDER COMMON
LAW (CONT.)
The broadest interpretation of third-party beneficiaries is the
concept of foreseeable users. This includes any user that the auditor
should have reasonably been able to foresee as a likely user of the
clients financial statements. Table 5-2 summarizes the different
approaches to third-party liability under common law.

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LIABILITY TO THIRD PARTIES UNDER COMMON
LAW (CONT.)

Auditor Defenses Against Third-Party Suits

Of the four defenses that are available to
auditors in suits against them by clients,
three are also available in suits against
them by third parties:
Lack of duty to perform service
Nonnegligent performance
Absence of causal connection

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 OBJECTIVE 5-6
Describe accountants civil liability
under the federal securities laws
and related defenses.

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 CIVIL LIABILITY UNDER THE FEDERAL
SECURITIES LAWS

The Securities Act of 1933Deals with

reporting requirements for the issuance of
new securities.
The only parties who can recover from
auditors under the 1933 Act are the original
purchasers of the securities.
Figure 5-6 details a case filed under the
Securities Act of 1933.

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 CIVIL LIABILITY UNDER THE FEDERAL
SECURITIES LAWS (CONT.)
The Securities Exchange Act of 1934Deals with
subsequent reporting by the public company. Suits filed
under this Act usually involve the audited financial
statements.
Rule 10b-5 of the Securities Exchange Act of 1934
the antifraud provision of the law.
In Hochfelder v. Ernst & Ernst, the court ruled that
scienter, which is the knowledge and intent to deceive,
is required for a CPA to be held liable under Rule 10b-5.
Figure 5-7 details this case.

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 CIVIL LIABILITY UNDER THE FEDERAL
SECURITIES LAWS (CONT.)
Rule 10b-5 of the Securities Exchange Act of 1934 (cont.)
In Howard Sirota v. Solitron Devices, Inc., the court ruled
that the auditor knew all of the relevant facts of the
fraud, but made poor judgments. Figure 5-8 details this
case.
In subsequent suits under Rule 10b-5, courts have ruled
that poor judgment is not proof of fraud.
Auditor defenses under the 1934 Act are the same as
under common law: lack of duty, nonnegligent
performance, and absence of causal connection.

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 CIVIL LIABILITY UNDER THE FEDERAL
SECURITIES LAWS (CONT.)
SEC and PCAOB SanctionsThe SEC Rules of Practice
and the PCAOB Rules of the Board permit them to deny a
CPA from being associated with financial statements for
lack of qualifications or having engaged in unethical
behavior.
Foreign Corrupt Practices Act of 1977This Act
makes it illegal to offer a bribe to a foreign official for the
purpose of exerting influence or retaining business.
FCPA also requires SEC companies to have reasonably
complete and accurate records, as well as an adequate
system of internal control.

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 CIVIL LIABILITY UNDER THE FEDERAL
SECURITIES LAWS (CONT.)
Sarbanes-Oxley Act of 2002increases the
responsibilities of public companies and their auditors
Requires that auditors express an opinion on the
effectiveness of internal control, which could expose
auditors to legal liability based on their opinion.
The PCAOB may also sanction registered CPA firms for
violations of the Act.
Table 5-3 summarizes the sources of liability for auditors.
Table 5-4 summarizes the defenses available to auditors.

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 OBJECTIVE 5-7
Specify what constitutes criminal
liability for accountants.

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 CRIMINAL LIABILITY
Criminal Liability for Accountants
Federal laws make it a criminal offense to defraud another
person through knowingly being involved with false
financial statements.
The Sarbanes-Oxley Act of 2002 made it a felony to destroy
documents to impede or obstruct a federal investigation.
These provisions were enacted in response to United States
v. Andersen, in which the auditor, Andersen, was held
responsible for shredding documents in the Enron case.
This case is detailed in Figure 5-9.

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 OBJECTIVE 5-8
Describe how the profession and
individual CPAs can reduce the
threat of litigation.

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 THE PROFESSIONS RESPONSE TO LEGAL LIABILITY

The AICPA and the profession as a whole can do the

following to reduce practitioners exposure to legal
liability:
1. Seek protection from nonmeritorious litigation.
2. Improve auditing to better meet users needs.
3. Educate users about the limits of auditing.
One law change that has helped in this area is the
Private Securities Litigation Reform Act of 1995,
which limits the liability of auditors by providing for
proportionate liability.

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THE PROFESSIONS RESPONSE TO LEGAL
LIABILITY
Protecting Individual CPAs from Legal Liability
Practicing auditors may take the following actions to minimize
their liability:
Deal only with clients possessing integrity.
Maintain independence.
Understand the clients business.
Perform quality audits.
Document the work properly.
Exercise professional skepticism.
It is also important for CPAs to carry adequate insurance and
choose a form of organization that provides some form of legal
liability protection to owners.

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