1. Professional Liability
Chapter 17
Professional Liability

2. What is the public accountant’s responsibility?
The responsibility of public accountants to safeguard the public's interest has increased as the number of investors has increased, as the relationship between corporate managers and stockholders has become more impersonal, and as government increasingly relies on accounting information.

3. Discuss Auditor Liability
Auditor liability to their clients and third party user groups is derived from the following laws:
Contract law - Liability is based on breach of contract. The contract is usually between the public accounting firm and the client for performance of a professional service, such as an audit performed according to GAAS
Common law - Liability concepts developed through court decisions and based on auditor negligence, gross negligence or fraud
Statutory law - Liability based on state statutes or Federal securities laws. The most important of these to the auditing profession are the Securities Act of 1993 and the Securities and Exchange Act of 1934

4. Factors leading to increased litigation against auditors:
User awareness of the possibilities and rewards of litigation
Joint and several liability statutes that permit a plaintiff to collect the full amount of the settlement from any defendant, even those only partially responsible for the loss (i.e. deep pockets theory)
Increased audit complexity caused by computerized systems, new types of transactions and operations, more complicated accounting standards, more international business
More demanding audit standards for detection of errors and fraud

5. Factors leading to increased litigation against auditors:
Pressures to reduce audit time and improve audit efficiency
Misunderstanding by users that an unqualified opinion is an insurance policy against misstatements (expectations gap)
Contingent-fee-based compensation for law firms, especially in class action lawsuits
Class action lawsuits which allow law firms to combine defendants into one legal action
Punitive damages

6. Discuss Potential Liability
To understand the potential liability, the auditor must understand:
Concepts of breach of contract and tort
Parties who may bring suit
Legal precedence and statutes that may be as a standard against which auditor performance may be evaluated
Auditor defenses

7. Discuss Causes of Legal Action
Breach of contract
Negligence: failure to exercise a reasonable level of care that causes damage to another
Gross negligence: failure to exercise even a minimal level of care (reckless disregard) but without intent to harm or damage anyone
Fraud: intentional concealment or misrepresentation of material facts that cause damages to those deceived (scienter)

8. Comment on Civil Liability
Auditors may be held civilly liable by clients and third parties who use audited financial statements. This civil liability is based
Contract law
Common law
Statute

9. Define Breach of Contract
Breach of Contract occurs when auditor fails to perform a contractual duty
Breach actions include
failing to complete the engagement within the agreed-upon time
withdrawing from the engagement without sufficient justification
violating client confidentiality
failing to provide professional quality work
Parties to the contract can file suit

10. Define Breach of Contract
Court remedies to a breach include
order auditors to fulfill the contract (specific performance)
issue injunction to prohibit the auditor from continuing the breach
order auditor to pay compensatory (actual) damages
Auditor defenses include
auditor did not breach the contract
client was contributory negligent
client losses were not caused by the breach

11. Review Common Law Liability
To prevail, a plaintiff must generally prove four things:
Existence and amount of damages
Financial statements were materially misleading
Plaintiff relied on the statements and as a result, suffered damages (causality)
Auditor misconduct - the level of misconduct that must be proved depends on who the plaintiff is, and the jurisdiction in which the suit is filed

12. Who are the plaintiffs under common law?
The courts have ruled auditors can be held liable by clients and third parties reasonably expected to rely on audited statements.
Generally, courts have classified third party users into 3 groups:
Identified users are specific individual users who the auditor knows will use the statements to make a specific decision
Foreseen users while not individually known, belong to a specific group of users whom the auditor knows will use the statements
Foreseeable users belong to a general class of users whose members may or may not use the financial statements

13. Level of Auditor Misconduct
The level of auditor misconduct a third party plaintiff must prove depends on which group the plaintiff belongs to and the jurisdiction in which the case is tried:

14. Auditor Liability
Auditor liability under Federal statute was established by the Securities Act of 1933, and the Securities Exchange Act of 1934, and most recently modified by Sarbanes/Oxley Act of 2002
Auditors found to be unqualified, unethical, or in willful violation can be disciplined by the SEC. Sanctions include
Temporarily or permanently revoking the firm's registration with the Public Company Accounting Oversight Board
Civil penalties of up to $750,000 per violation
Require continuing education of firm personnel
Investors in public companies may sue auditors under common law, statutory law, or both.

15. Securities Act of 1933
Requires companies to file S-1 Registration statement with SEC before they issue new securities to the public
Audited financial statements are included in the Registration statement (and prospectus)
Because it covers the issue of new securities, the Act requires a very high standard of care. Plaintiffs need prove only
financial statements were materially misleading
plaintiff suffered damages
plaintiffs do not need to prove reliance on the statements or auditor misconduct
Auditor defenses include
proving financial statements were not materially misstated
proving plaintiff damages were not caused by the misleading financial statements
proving auditor acted with due professional care

16. Securities Exchange Act of 1934
The Securities Act of 1934 regulates trading of securities after their initial issuance (secondary market) and the filing of periodic reports with the SEC. These reports include annual reports and 10-Ks, quarterly financial reports and 10-Qs, and 8-Ks.
The 1934 Act holds auditors to a much lower standard of care than the 1933 Act. Under the 1934 Act, plaintiffs must prove
Existence and amount of damages
Financial statements were materially misleading
Plaintiff relied on the statements and as a result, suffered damages (causality)

17. Securities Exchange Act of 1934
Auditor misconduct - the level of misconduct that must be proved is the subject of much debate. In Ernst & Ernst v. Hochfelder, the U.S. Supreme Court held that
Congress had intended that the plaintiff prove the auditor acted with scienter
However, the Court reserved judgment as to whether gross negligence would be sufficient to impose liability
In several cases following Hochfelder, judges and juries have used a standard of "reckless conduct" to hold auditors liable

18. Criminal Liability to Third Parties
Both the 1933 and 1934 Acts provide for criminal actions against auditors - guilty persons can be fined or imprisoned for up to five years.
Key cases regarding auditor criminal liability
Continental Vending (U.S. v Simon)
Equity Funding
U.S. v Duncan

19. Policies to Help Assure Auditor Independence
Periodic rotation of audit engagement partner
Prohibit certain non-audit services for public company audit clients
Restrict other non-audit services for audit clients
Firm policies including training programs that emphasize auditor independence and requiring each auditor to sign a statement of independence
External quality reviews: Sarbanes/Oxley Act requires the PCAOB perform quality reviews of registered public accounting firms
Internal reviews: concurring partner reviews and interoffice reviews

20. Approaches to Mitigate Liability Exposure (Defensive Auditing)
Defensive auditing means taking special actions to avoid lawsuits. In addition to establishing good quality controls and quality/peer reviews, firms can take other actions
Use engagement letters for all financial statement and consulting engagements
Client screening
Do not accept engagements for which the firm is not qualified
Maintain complete and accurate audit documentation
Limited liability partnerships
Carry sufficient professional liability insurance
Tort reform