It Takes the Net Profit From Many Audits to Offset the 5 It Takes the Net Profit From Many Audits to Offset the Cost of One Lawsuit

CHANGED LEGAL ENVIRONMENT Understand the litigious environment in which CPAs practice. Audit professionals have a responsibility under common law to fulfill implied or expressed contracts with clients. They are liable to their clients for negligence and/or breach of contract should they fail to provide the services or not exercise due care in their performance.

DISTINCTION AMONG BUSINESS FAILURE, AUDIT FAILURE, AUDIT RISK Explain why the failure of financial statement users to differentiate among business failure, audit failure, and audit risk has resulted in lawsuits. 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. Audit Failure - occurs when the auditor issues an erroneous audit opinion as the result of an underlying failure to comply with the requirements of generally accepted auditing standards (GAAS). Audit Risk - represents the risk that the auditor will conclude that the financial statements are fairly stated and an unqualified opinion can be issued when, in fact, they are materially misstated. EVEN THOUGH IT WAS A WELL-CONDUCTED GAAS AUDIT!

Audit Risk Business Failures Audit Failure

LEGAL CONCEPTS AFFECTING LIABILITY Prudent Person Concept (not perfection) Liability for the Acts of Others (LLP) Lack of Privileged Communication (w/p’s) Use the primary legal concepts and the terms concerning accountants’ liability as a basis for studying legal liability of auditors. Four Major Sources of Auditors’ Legal Liability 1. Client - liability to client under common law 2. Third party - liability to third parties under common law 3. Liability under federal securities laws – SH suit 4. Criminal liability – Intent to deceive

LIABILITY TO CLIENTS Legal Terms Affecting CPAs’ Liability The most common source of lawsuits against CPAs is from clients. Describe accountants’ liability to clients and related defenses. Legal Terms Affecting CPAs’ Liability Terms Related to Negligence and Fraud Ordinary Negligence Gross Negligence Constructive Fraud Fraud Terms Related to Contract Law Breach of Contract Third-Party Beneficiary Common Law Statutory Law Joint and Several Liability Separate and Proportionate Liability Other Terms

Lack of Duty - means that the CPA claims that there was no implied or expressed contract to perform. Nonnegligent Performance - in an audit, the CPA firm claims that the audit was performed in accordance with GAAS. Contributory Negligence - exists when the client’s own action prevents the auditor from discovering the cause of the loss. Absence of Causal Connection - to succeed in an action against the auditor, the client must be able to show that there is a close causal connection between the auditor’s breach of the standard of due care and the damages suffered by the client.

LIABILITY TO THIRD PARTIES UNDER COMMON LAW Describe accountants’ liability to third parties under common law and related defenses. LIABILITY TO THIRD PARTIES UNDER COMMON LAW Ultramares Doctrine - A case that summarized the Liability to Third Parties. Foreseen Users - The broadest interpretation of the rights of third-party beneficiaries is to use the concept of foreseeable users. Credit Alliance - Was a case in New York in which a lender brought suit against the auditor of one of its borrowers, alleging that it relied on the financial statements of the borrower, who was in default, in granting the loan. TO BE LIABLE, THE AUDITOR MUST KNOW WHO WILL RELY ON HIS REPORT AND WHY. Restatement of Torts - foreseen users may be members of a Reasonably limited and identifiable group of users (eg, creditors)

CIVIL LIABILITY UNDER THE FEDERAL SECURITIES LAWS Describe accountants’ civil liability under the federal securities laws and related defenses. 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. Involves new security issues - Securities Exchange Act of 1934 - The liability of auditors under this act often centers 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. Fraud=Rule 10b-5

The SEC has the power in certain circumstances to sanction or suspend practitioners from doing audits for SEC companies. Rule 2 (e) of the SEC’s Rules of Practice states. The commission may deny, temporarily or permanently, the privilege of appearing or practicing before it in any way to any 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.

Racketeer Influenced and Corrupt Organization Act (RICO) 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.”

THE PROFESSION’S RESPONSE TO LEGAL LIABILITY Research in auditing Describe what the profession and the individual CPA can do and what is being done to reduce the threat of litigation. Research in auditing Standard and rule setting Set requirements to protect auditors Establish peer review requirements Oppose lawsuits Education of users Sanction members for improper conduct and performance Lobby for changes in laws