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CHAPTER 3(Continued)
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litigationexplosion!
- in 1991, the “Big 6” accounting firmsincurred costs of $477 million in defenseand settlement of lawsuits- currently, the profession’s total liabilityexposure is an estimated $30 billion
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Who might sue an auditor and Who might sue an auditor and whywhy??
- a client- a third party- a combined group of stockholders- The federal government may prosecute an auditor for knowingly issuing an incorrect audit report (criminal liability)
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1. the prudent person concept.2. liability for the acts of others.3. lack of privileged communication. Ingeneral, auditors do not have the rightunder common law towithhold informationfrom the courts on thegrounds that the in-formation is privileged.
Three legal Three legal conceptsconcepts apply to auditor liability:apply to auditor liability:
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Several legal Several legal termsterms apply to auditor liability:apply to auditor liability:Related to negligence and fraud:- ordinary negligence - absence of rea- sonable care
reasonablecare
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Several legal Several legal termsterms apply to auditor liability:apply to auditor liability:Related to negligence and fraud:- ordinary negligence- gross negligence - absence of even slight care, tantamount to reckless be- havior
slightcare
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Several legal Several legal termsterms apply to auditor liability:apply to auditor liability:Related to negligence and fraud:- ordinary negligence- gross negligence - constructive fraud - existence of ex- treme or unusual negligence even though there was no intent to deceive or do harm
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Several legal Several legal termsterms apply to auditor liability:apply to auditor liability:Related to negligence and fraud:- ordinary negligence- gross negligence - constructive fraud - fraud - a misstatement is made and there is both the knowledge of its falsi- ty and the intent to deceive
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Several legal Several legal termsterms apply to auditor liability:apply to auditor liability:Related to contract law:- breach of contract - failure of one or both parties in a contract to fulfill the requirements of the contract
Parties who have a relationship that is established by a contract are said to have privity of contract.
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Several legal Several legal termsterms apply to auditor liability:apply to auditor liability:Related to contract law:- breach of contract - third-party beneficiary - a third party who does not have privity of contract but is known to the contracting parties and is intended to have certain rights and benefits under the contract
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Several legal Several legal termsterms apply to auditor liability:apply to auditor liability:Related to common and statutory law:- common law - laws that have been de- veloped through court decisions rather than through government statutes
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Several legal Several legal termsterms apply to auditor liability:apply to auditor liability:Related to common and statutory law:- common law - statutory law - laws that have been passed by the U.S. Congress and other governmental units
statutorylaw
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Auditor’s Defenses Against Client SuitsAuditor’s Defenses Against Client Suits
lack of duty
nonnegligentperformance
contributorynegligence
absenceof causal connection
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Auditor’s Defenses Against Client SuitsAuditor’s Defenses Against Client Suits
The auditor claims that there was no im-plied or expressed contract.A common way for an auditor to demon-strate a lack of duty to perform is by useof an engagement letter.
lack of duty
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Auditor’s Defenses Against Client SuitsAuditor’s Defenses Against Client Suits
The auditor claims that the audit was performed in accordance with GAAS.Even if there were undiscovered errorsor irregularities, the auditor is not re-sponsible if the audit was properly conducted.
nonnegligentperformance
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Auditor’s Defenses Against Client SuitsAuditor’s Defenses Against Client Suits
The auditor claims that if the client hadperformed certain obligations, the losswould not have occurred.
contributorynegligence
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Auditor’s Defenses Against Client SuitsAuditor’s Defenses Against Client Suits
The auditor claims that there is a lack ofa close causal connection between theauditor’s breach of the due care stan-dard and the damages suffered by theclient.
absenceof causal connection
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Liability to Third Parties Liability to Third Parties under Common Lawunder Common Law
An auditor may be liable to third parties if aloss was incurred by theclaimant due to reliance onmisleading financialstatements.
Financial
StatementsAceCompany
19x4Financial
Statements
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An auditor may be liable to third partiesif a loss was incurred by the claimant due to reliance on misleading financialstatements.
Third parties include:- actual stockholders- potential stockholders - creditors
- employees- customers - vendors
Liability to Third Parties Liability to Third Parties under Common Lawunder Common Law
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Liability to Third Parties Liability to Third Parties under Common Lawunder Common Law
Auditor liability to third parties was es-tablished, in part, by a 1931 court deci-sion, Ultramares v. Touche.The key aspect of the resulting Ultra-mares Doctrine is that ordinary negli-gence is insufficient for liability to thirdparties, because of the lack of privity ofcontract between the third party and theauditor, unless the third party is a prima-ry beneficiary.
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Liability to Third Parties Liability to Third Parties under Common Lawunder Common Law
The Ultramares Doctrine also specifies thatif there has been fraud or gross negligence,the auditor could be held liable to more general third parties.In recent years, the courts have broadened the Ultramares Doctrine to allow recovery bythird party foreseen users.
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Liability to Third Parties Liability to Third Parties under Common Lawunder Common Law
The Ultramares Doctrine also specifies thatif there has been fraud or gross negligence,the auditor could be held liable to more general third parties.In recent years, the courts have broadened the Ultramares Doctrine to allow recovery bythird party foreseen users.
membersof a limited class of users
who the auditor is aware will rely on the financial statements
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Liability to Third Parties Liability to Third Parties under Common Lawunder Common Law
In recent years, the courts have broadened the Ultramares Doctrine to allow recovery bythird party foreseen users.An even broader interpretation of the rights ofthird-party beneficiaries is to use the conceptof foreseeable users.
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Liability to Third Parties Liability to Third Parties under Common Lawunder Common Law
In recent years, the courts have broadened the Ultramares Doctrine to allow recovery bythird party foreseen users.An even broader interpretation of the rights ofthird-party beneficiaries is to use the conceptof foreseeable users.
users that the auditor
should have reasonablybeen able to foresee as
being likely users offinancial statements
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lack of duty
nonnegligentperformance
contributorynegligence
absenceof causal connection
Three of the four defenses available to auditors insuits by clients are also available in third-party suits.
x
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lack of duty
nonnegligentperformance
contributorynegligence
absenceof causal connection
xThree of the four defenses available to auditors in
suits by clients are also available for suits under the1934 act.
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The SEC has the power to The SEC has the power to sanctionsanction or or suspendsuspend practitioners from practitioners from
auditing SEC companies.auditing SEC companies.
SEC
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RICORICOThe Racketeer Influenced and Corrupt Orga-nization (RICO) Act allows an individual to seek damages when it can be demonstratedthat the defendant was engaged in a patternof racketeering activity.In a 1993 U.S. Supreme Court decision, thecourt ruled that outside professionals suchas accountants who do not help run corruptbusinesses can not be sued under the provi-sions of RICO.
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Foreign Corrupt Practices ActForeign Corrupt Practices ActThe Foreign Corrupt Practices Act:- forbids offering a bribe to an official of a for-eign country for the purpose of exerting in-fluence and obtaining or retaining business- requires SEC companies to maintain rea-sonably complete and accurate records andan adequate system of internal control
How does thisaffect auditors?
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Foreign Corrupt Practices ActForeign Corrupt Practices ActThe Foreign Corrupt Practices Act:- forbids offering a bribe to an official of a for-eign country for the purpose of exerting in-fluence and obtaining or retaining business- requires SEC companies to maintain rea-sonably complete and accurate records andan adequate system of internal control
The act may affectauditors through their responsibilityto review and evaluate systems of
internal control as a part of an audit.
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What can the auditing profession do to What can the auditing profession do to reduce auditors’ exposure to lawsuits?reduce auditors’ exposure to lawsuits?
- encourage auditing research regarding litigation and improvements in auditing practice- establish standards and rules that meet the changing needs of auditing- establish standards that protect auditors- establish peer review requirements- oppose unwarranted lawsuits- educate financial statement users about auditing and the auditor’s opinion- sanction auditors for improper conduct- lobby for changes in laws
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What can What can individual CPAsindividual CPAs do to do to reduce their exposure to lawsuits?reduce their exposure to lawsuits?
- deal only with clients possessing integrity- hire, train, and supervise qualified personnel- follow the standards of the profession- maintain independence- understand the client’s business- perform quality audits- document the work properly- obtain an engagement letter and a representation letter- maintain confidential relations- carry adequate insurance- seek legal counsel- choose a form of organization with limited liability
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