Chapter 5
Legal Liabillities
Changed Legal Environment
Under common law, audit professionals have a responsibility to fulfll implied
or expressed contracts with clients. Should auditors fail to provide the
services or not exercise due care in their performance, they are liable to their
clients for negligence and/or breach of contract, and in certain
circumstances, to parties other than clients.
The following factors are major contributors to address legal liability:
- Growing awarenes of the responsibilities of public accountants by users of
fnancial statements
- An increased consciousness on the part of Securities and Exchange
Comission (SEC) for its responsibility for protecting investor’s interest.
- The complexity of auditing and accounting functions caused by the
increasing size of business, the globalization of business, and the
complexities of business operations and fnancing transactions.
- The tendency of society to accept the lawsuit by injured parties against
anyone who might be able to provide compensation, regardless of who
was at fault,coupled with the joint and several liability doctrine (often
called the deep pocket concept of liability).
- Global recession and tough economic times resulting in business failures,
which prompt stakeholders to seek restitution from others, including
external auditors.
- Large civil court judgements against CPA frms awarded in a few cases,
encouraging attorneys to provide legal services on a contingent-fee basis,
which ofers the injured party a potential gain when the suit is successful,
but minimal losses when it is not.
- Many CPA frms being willing to settle legal problems out of court in an
attempt to avoid costly legal fees and adverse publicity, rather than
pursuing resolution through the judicial process.
- The difculty judges and jurors have understanding and interpreting
technicalll accounting and auditing matters.
Distinguishing Business Failure, Audit Failure, and Audit
Risk
A business failure occurs when a business is unable to repay its lenders or
meet the expectations of its investors because of economic or business
conditions, such as a recession, poor management decisions, or unexpected
competition in the industry.
, Audit failure occurs when the auditor issues an incorrect audit opinion
because it failed to comply with the requirements of auditing standards.
Audit risk represents the possibility that the auditor concludes after
conducting an adequate audit that the fnancial statements were fairly stated
when, in fact, they were materially misstated.
Legal Concepts Afecting Liaaility
Prudent person concept the legal concept that a person has a duty to
exercise reasonable care and diligence in the performance of obligations to
another.
Liability for the acts of others the partners may also be liable for the work
of others whom they rely under the laws of agency (employees, other CPA
frm engaged to do part of the work, specialist called upon to provide
technical information).
Lack of privileged communication under common law, CPAs do not have
the right to withhold informationn from the courts on the grounds that the
information is privileged.
Legal terms afecting CPAs’ liability when the auditor has failed to conduct
an adequate audit, liability may depend on the level of negligence.
Sources of legal liability:
1. Liability to clients
2. Liability to thir parties under common law
3. Civil liability under federal securities law
4. Criminal liability
Liaaility to Clients
For example: client sues auditor for not discovering a material fraud during the
audit.
Auditor’s Defenses Against Client Suits
Lack of duty the CPA frm claims that there was no implied or expressed
contract.
Nonnegligent performance the CPA frm claims that the audit was
performed in accordance with auditing standards. Even if there were
undiscovered misstatements, the auditor is not responsible if the audit was
conducted properly.
Contributory negligent the auditor claims the client’s own actions either
resulted in the loss that is the basis for damages or interfered with the
conduct of the audit in such a way that prevented the auditor from
discovering the cause of the loss.
Legal Liabillities
Changed Legal Environment
Under common law, audit professionals have a responsibility to fulfll implied
or expressed contracts with clients. Should auditors fail to provide the
services or not exercise due care in their performance, they are liable to their
clients for negligence and/or breach of contract, and in certain
circumstances, to parties other than clients.
The following factors are major contributors to address legal liability:
- Growing awarenes of the responsibilities of public accountants by users of
fnancial statements
- An increased consciousness on the part of Securities and Exchange
Comission (SEC) for its responsibility for protecting investor’s interest.
- The complexity of auditing and accounting functions caused by the
increasing size of business, the globalization of business, and the
complexities of business operations and fnancing transactions.
- The tendency of society to accept the lawsuit by injured parties against
anyone who might be able to provide compensation, regardless of who
was at fault,coupled with the joint and several liability doctrine (often
called the deep pocket concept of liability).
- Global recession and tough economic times resulting in business failures,
which prompt stakeholders to seek restitution from others, including
external auditors.
- Large civil court judgements against CPA frms awarded in a few cases,
encouraging attorneys to provide legal services on a contingent-fee basis,
which ofers the injured party a potential gain when the suit is successful,
but minimal losses when it is not.
- Many CPA frms being willing to settle legal problems out of court in an
attempt to avoid costly legal fees and adverse publicity, rather than
pursuing resolution through the judicial process.
- The difculty judges and jurors have understanding and interpreting
technicalll accounting and auditing matters.
Distinguishing Business Failure, Audit Failure, and Audit
Risk
A business failure occurs when a business is unable to repay its lenders or
meet the expectations of its investors because of economic or business
conditions, such as a recession, poor management decisions, or unexpected
competition in the industry.
, Audit failure occurs when the auditor issues an incorrect audit opinion
because it failed to comply with the requirements of auditing standards.
Audit risk represents the possibility that the auditor concludes after
conducting an adequate audit that the fnancial statements were fairly stated
when, in fact, they were materially misstated.
Legal Concepts Afecting Liaaility
Prudent person concept the legal concept that a person has a duty to
exercise reasonable care and diligence in the performance of obligations to
another.
Liability for the acts of others the partners may also be liable for the work
of others whom they rely under the laws of agency (employees, other CPA
frm engaged to do part of the work, specialist called upon to provide
technical information).
Lack of privileged communication under common law, CPAs do not have
the right to withhold informationn from the courts on the grounds that the
information is privileged.
Legal terms afecting CPAs’ liability when the auditor has failed to conduct
an adequate audit, liability may depend on the level of negligence.
Sources of legal liability:
1. Liability to clients
2. Liability to thir parties under common law
3. Civil liability under federal securities law
4. Criminal liability
Liaaility to Clients
For example: client sues auditor for not discovering a material fraud during the
audit.
Auditor’s Defenses Against Client Suits
Lack of duty the CPA frm claims that there was no implied or expressed
contract.
Nonnegligent performance the CPA frm claims that the audit was
performed in accordance with auditing standards. Even if there were
undiscovered misstatements, the auditor is not responsible if the audit was
conducted properly.
Contributory negligent the auditor claims the client’s own actions either
resulted in the loss that is the basis for damages or interfered with the
conduct of the audit in such a way that prevented the auditor from
discovering the cause of the loss.
