Ch 4 Legal Liability of Auditors

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Ch 4 Legal Liability of Auditors
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Background

• US--litigation oriented society
• Previously lawsuits against CPAs escalated
• Now dropping off-CPAs are doing better work
• CPAs uniquely vulnerable to litigation
• Not only potentially liable to client
• But also potentially to third party users of F/S
• Negligence--lack of due prof care
• Gross negligence--reckless absence of due care
• Common law--unwritten law court decisions
• Statutory law--based on legislation/laws

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Approaches to Auditor Common Law Liability

• Ultramares (Torts) Approach1931 (Known user
  Approach)
• Liable to clients third-party beneficiaries
  for ordinary negligence
• Liable to other third parties only for gross
  negligence
• Restatement of Torts Approach (Rusch)1968
  (Forseen user Approach)
• Liable to clients and foreseen third parties for
  ordinary negligence
• Liable to other third parties only for gross
  negligence
• Rosenblum Approach1983 (Foreseeable user
  approach)
• Liable to clients and all foreseeable third
  parties for ordinary negligence

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Approaches to AuditorStatutory
LawLiability--1933 SEC Act

• Registration Act--New Securities
• Liability to purchasers of new securities
• Must prove loss
• Must prove that registration was misleading
• CPAs must prove audit conducted with due
  diligence not negligent
• BarChris Case--CPAs lose case--did not follow
  GAAS (or exert due prof care)

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Approaches to Auditor Statutory Law
Liability--1934 SEC Act

• Annual SEC Filings Audited F/S
• Liability to purchasers/sellers of
  securities--they must prove
• Loss, that F/S were misleading that they relied
  on F/S
• CPAs must prove
• Audit not conducted with fraud, etc.(sec 10)
• Auditor exercises good faith (sec 18)
• Hochfelder Case--CPAs win case--negligent, but
  no fraud or deception involved

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Summary--Civil Liability Under Securities Acts

• What must be proved by the third party?
• Misleading Standard of
• Act Loss F/S Reliance Liability
• 33 Act Yes Yes No
  Auditor must prove due
  diligence
• 34 Act, Yes Yes Yes
  Third party must
• sec. 10 prove gross
• negligence or fraud
• 34 Act, Yes Yes Yes
  Auditor must prove
• sec, 18
  good faith

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Criminal Liability Under the Securities Acts

• Continental Vending Case--1969
• Auditors were held criminally liable for gross
  negligence
• Knew of lack of significant related party
  disclosure
• However, no intent of CPAs to defraud
• But convicted of criminal fraud based on gross
  negligence

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Criminal Liability Under the Securities Acts

• Enron ltArthur Andersengt Case - 2002/2005
• SEC charged Andersen with obstruction of justice
  for destroying documents prior to SEC Securities
  investigation.
• Andersen stated firm was applying its record
  retention policy.
• Jury trial verdictAndersen guilty
• SEC Andersen prohibited from auditing public
  companies.
• Andersen files bankruptcy- 28,000 employees
  discharged
• Appeal by Andersen heard by Supreme Court April
  2005 conviction overturned
• But Andersen is bankrupt and out of business

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SECs PCAOBs Regulation of Accountants

• The Commission / PCAOB may suspend privilege of
  CPA in SEC / Public Company practice because
• CPA not qualified
• CPA lacking in character, integrity or engaged in
  unethical or improper prof conduct
• CPA has filed deficient work with Commission
• Previously limited PWC practice on
  non-independent audits suspended Arthur Andersen
  from all Public Company audits after Enron.

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Liability for Unaudited Financial Statements

• 1136 Tenants Corp Case
• CPA compiled F/S for 600
• Sued for undiscovered defalcations under
  contention engagement was an audit
• CPA made audit-like comments in W/Ps billing
  said audit services
• CPA held responsible for loss
• Lessons to CPAs performing non-audit services
• Follow Code Rules 102 202, get engagement
  letters, exercise due prof care follow SSARS
  language

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CPAs Actions to Prevent Litigation

• Emphasis on complying with GAAS and Code of
  Ethics
• Retain legal counsel that is familiar with CPAs
  legal liability
• Maintain adequate professional liability
  insurance
• Investigate prospective clients thoroughly
• Obtain a thorough knowledge of the clients
  business
• Use engagement letters--for all services
• Assess risk of errors irregularities in
  clients F/S
• Exercise extreme care in audits of clients that
  have a high degree of business risk, clients in
  financial difficulties
• Carefully prepare and review exercise due care
  in working papers
• AND MOST IMPORTANT BE CAREFUL OF WHOM YOU
  ACCEPT AS A CLIENT!

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GOOD LUCK!