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Legal Liability
Chapter 5
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Learning Objective 1
Understand the litigious
environment in which
CPAs practice.
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Changed Legal Environment
Audit professionals have a responsibility under
common law to fulfill implied or expressedcontracts with clients.
They are liable to their clients for negligence
and/or breach of contract should they fail toprovide the services or not exercise due care
in their performance.
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Learning Objective 2
Explain why the failure of financial
statement users to differentiateamong business failure, audit
failure, and audit risk hasresulted in lawsuits.
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Business Failure, Audit
Failure, and Audit Risk
BusinessFailure
Audit
Failure
AuditRisk
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Business Failure, Audit
Failure, and Audit Risk
Business failure
It occurs when a business is unable torepay its lenders or meet the
expectations of its investors because
of economic or business conditions.
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Business Failure, Audit
Failure, and Audit Risk
Audit failure
It occurs when the auditor issues anerroneous audit opinion as the result
of an underlying failure to comply
with the requirements of generallyaccepted auditing standards (GAAS).
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Business Failure, Audit
Failure, and Audit Risk
Audit risk
It represents the risk that the auditor willconclude that the financial statements
are fairly stated and an unqualified
opinion can be issued when, in fact,they are materially misstated.
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Learning Objective 3
Use the primary legal concepts
and the terms concerningaccountants liability as a
basis for studying legalliability of auditors.
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Lack ofprivileged
communication
Liability for
the acts
of others
Prudent
person
concept
Legal Concepts
Affecting Liability
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Federal
securities laws
Third party
Client
Major Sources of
Auditors Legal Liability
Criminal
liability
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Learning Objective 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.
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Legal Terms Affecting
CPAs Liability
Terms related to negligence and fraud
Ordinary
negligence
Gross
negligence
Constructive
fraud
Fraud
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Legal Terms Affecting
CPAs Liability
Terms related to contract law
Breach of
contract
Third party
beneficiary
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Legal Terms Affecting
CPAs Liability
Other terms
Common
law
Statutory
law
Joint andseveral
liability
Separate and
proportionate
liability
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Auditors Defenses
Against Client Suits
Lack of duty
Nonnegligent performance
Contributory negligence
Absence of causal connection
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Learning Objective 5
Describe accountants liability
to third parties under common
law and related defenses.
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Liability to Third Parties
Under Common Law
Ultramares doctrine
Foreseen users
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Foreseen Users
Credit alliance
Restatement of torts
Foreseeable users
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Learning Objective 6
Describe accountants civil
liability under the federal
securities laws and
related defenses.
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Securities Act of 1933
The Securities Act imposes an
unusual burden on the auditor.Section 11 of the 1933 act defines the
rights of third parties and auditors.
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Securities Exchange
Act of 1934
The liability of auditors under this act oftencenters on the audited financial statements
issued to the public in annual reports or
submitted to the SEC as a part of annual
Form 10-K reports.
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Auditor Defenses1934 Act
Nonnegligent performance
Lack of duty
Absence of casual connection
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SEC Sanctions
The SEC has the power in certain circumstances
to sanction or suspend practitioners from doingaudits for SEC companies.
Rule 2 (e) of the SECsRules of Practice says:
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SEC Sanctions
The commission may deny, the privilege of
appearing or practicing before it in any way toany person who is found by the commission
(1) not to possess the requisite qualifications to
represent others, or (2) to be lacking in character
or integrity or to have engaged in unethical or
improper professional conduct.
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Racketeer Influenced and
Corrupt Organization Act
This act allows an injured party to seek treble(triple) damages and recovery of legal fees
in cases where it can be demonstrated
that the defendant was engaged in a
pattern of racketeering activity.
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Foreign Corrupt
Practices Act of 1977
This act makes it illegal to offer a bribeto an official of a foreign country for
the purpose of exerting influence and
obtaining or retaining business.
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Learning Objective 7
Specify what constitutes
criminal liability
for accountants.
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Criminal Liability
CPAs can be held liable under
criminal liability for accountants.CPAs can be found guilty for criminal
action under both federal and state laws.
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Learning Objective 8
Describe what the profession and
the individual CPA can do and
what is being done to reduce
the threat of litigation.
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The Professions Response
to Legal Liability
Research in auditing
Standard and rule settingSet requirements to protect auditors
Establish peer review requirements
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The Professions Response
to Legal Liability
Oppose law suits
Education of usersSanction members for improper
conduct and performance
Lobby for changes in laws
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Protecting Individual CPAs
from Legal Liability Example
Deal only with clients possessing integrity
Hire qualified personnelFollow the standards of the profession
Maintain independence
i di id l
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Protecting Individual CPAs
from Legal Liability Example
Understand the clients business
Perform quality auditsDocument the work properly
Obtain an engagement and a representation letter
Maintain confidential relations
i di id l C A
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Protecting Individual CPAs
from Legal Liability Example
Carry adequate insurance
Seek legal counselChoose a form of organization with limited liability
Exercise professional skepticism
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End of Chapter 5