CHAPTER 4CHAPTER 4AUDITOR’S LEGAL LIABILITYAUDITOR’S LEGAL LIABILITY

Fall 2007Fall 2007

CHAPTER 4CHAPTER 4AUDITOR’S LEGAL LIABILITYAUDITOR’S LEGAL LIABILITY

Fall 2007Fall 2007

Types of CPA Liability Liability Under Common vs. Statutory

Law Defenses Liability under SEC Acts of 1933 and

1934, SOX and RICO Legal Liability for Accounting and

Review Services “Best Practices” to minimize legal

problems

Auditor’s Legal LiabilityAuditor’s Legal LiabilityAuditor’s Legal LiabilityAuditor’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

Types of Auditor Legal LiabilityTypes of Auditor Legal LiabilityTypes of Auditor Legal LiabilityTypes 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

Liability Under the Common LawLiability Under the Common LawFigure 4-1Figure 4-1

Liability Under the Common LawLiability Under the Common LawFigure 4-1Figure 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)

Definitions of Liability LevelsDefinitions 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

Types of Third PartiesTypes 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.

Liability for Liability for NegligenceNegligenceUnder Common Law Under Common Law (Figure 4-1)(Figure 4-1)

Liability for Liability for NegligenceNegligenceUnder Common Law Under Common Law (Figure 4-1)(Figure 4-1)

Common Law DefensesCommon Law DefensesCommon Law DefensesCommon Law Defenses

Due Care Defense1. 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.

Common Law DefensesCommon Law DefensesCommon Law DefensesCommon Law Defenses

Contributory Negligence Defense1. 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.

Liability Under Statutory Liability Under Statutory LawsLaws

Liability Under Statutory Liability Under Statutory LawsLaws

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

negligentAuditor:• 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

Liability Under Securities Liability Under Securities LawsLaws

Liability Under Securities Liability Under Securities LawsLaws

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.

Liability Under Securities Liability Under Securities LawsLaws

Liability Under Securities Liability Under Securities LawsLaws

Private Securities Litigation Reform Act of 19951. Proportionate Liability2. Cap on Actual Damages3. Responsibility to Report Illegal

Acts4. Other Changes Provided by the

Reform Act

Liability Under Sarbanes-Liability Under Sarbanes-OxleyOxley

Liability Under Sarbanes-Liability Under Sarbanes-OxleyOxley

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

Liability under RICOLiability under RICOLiability under RICOLiability 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

““Best Practices”Best Practices”““Best Practices”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

Liability for Accounting and Liability for Accounting and Review ServicesReview Services

Liability for Accounting and Liability for Accounting and Review ServicesReview 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 3rd 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