Learning Objectives LO5 Explain the importance of an independence framework for auditors. LO6 Outline auditor legal responsibilities. LO7 Outline the various types of common law liability for PAs, citing specific case precedents. LO8 Apply and integrate the chapter topics to analyze a practical auditing situation/case/scenario. 1

Common Law and Statutory Law Common law is based on precedents and past decisions in the courts.  Common law is not enacted by legislation.  Statutory law is all of the laws enacted by a legislature.  Prior to Enron, the major source of liability for accountants was common law. In the post- Enron world this appears to be changing. LO7 2

Liability Under Common Law Legal liabilities of PAs may arise from the law of contracts or as tort actions for negligence.  Breach of contract is a claim that services were not performed in the manner agreed.  The rule of the law of torts is to compensate victims for harm suffered from the activities of others. LO7 3

Characteristics of Common Law Actions Burden of proof on the plaintiff. Plaintiff must prove the following:  That there was damage or loss.  That there was a privity or beneficiary relationship.  That financial statements were materially misleading.  That the statements were relied on.  That the statements were the direct cause of the loss.  That the accountant was negligent in performance of duties. LO7 4

Characteristics of Common Law Actions Clients may bring a lawsuit for breach of contract.  The relationship of direct involvement between parties to a contract is known as privity.  When privity exists, the plaintiff usually need only show that the defendant was negligent.  See Smith v. London Assurance Corp. LO7 5

Characteristics of Common Law Actions Third parties may file a lawsuit under the tort law of negligence.  Negligence is failure to perform a duty with requisite standard care.  Plaintiff must demonstrate:  There is a duty of care owed the plaintiff.  There must be a breach in that duty.  There must be proof that damage resulted.  There must be a reasonably proximate connection between the breach of duty and the resulting damages. LO7 6

Due Care to Whom? To whom do auditors owe a duty of care?  To the contractual party (client).  To the financial stakeholders (owners).  Owners cannot sue on behalf of the corporation.  Stakeholders can only take action as third parties. LO7 7

Due Care to Whom? Third Parties: Reasonably foreseeable third parties can sue in the case of negligence.  Hedley Byrne v. Heller and Partners (1964).  Includes shareholders, lenders, some prospective shareholders and lenders.  This decision has been upheld in a number of subsequent cases. Auditor liability is much broader if there has been Gross negligence or Fraud. LO7 8

Due Care: Its Meaning Due care implies the careful application of all the standards of the profession.  Due care is that of a reasonably prudent practitioner. Neither the highest nor minimum standards would be considered due care. LO7 9

Auditors’ Liability Under Statutory Law The SEC laws give the SEC the legal right to decide what is GAAP.  Increasingly the OSC (Ontario Securities Commissions) and the Quebec regulators are seeking more enforcement power over professionals such as accountants operating in the capital markets.  Canadian statutory law is the Canadian Business Corporations Act and the related provincial corporation acts. LO7 10

Auditors’ Liability Under Statutory Law Canada Business Corporations Act:  S 161 Conditions under which the auditor is not considered independent.  S 162 and 163 Conditions of appointing and retiring the auditor.  S 168 Auditors rights and responsibilities:  attend shareholders meetings  provide written statement of reasons for resignation  to make an audit examination unimpeded and gain access to data the auditor considers necessary  S44-47 Identify the financial statements subject to audit and specify that the financial statements must be in conformity with the CICA Handbook. LO7 11

Some Developments Concerning the Liability Crisis Private Securities Litigation Reform Act Objectives:  Discourages abusive claims of investors losses due to fraudulent financial statements.  Provides more protection against securities fraud.  Increases the flow of forward-looking financial statements. LO7 12

Some Developments Concerning the Liability Crisis How the Act meets its Objectives:  Establishes specific pleading requirements.  Reduces the effectiveness of discovery in coercing settlements.  Mandates sanctions for frivolous claims.  Provides for proportionate liability.  Codifies the auditors’ responsibility to search for and disclose fraud. LO7 13

Auditor’s Liability in Foreign Corrupt Practices Auditors are responsible for detecting foreign bribes where they have a material effect on financial statements. LO7 14

Other Issues Fiduciary duty of accountants:  An accountant may be a fiduciary in many different situations.  Allegations of breach of fiduciary responsibility are increasing. LO7 15

Other Issues Legal liability implications for auditor practice:  Be wary of the type of clients being accepted.  Know thoroughly the client’s business.  Perform quality audits. LO7 16