1. Legal Liability
Chapter 5

2. Learning Objective 1 Understand the litigious environment in which
CPAs practice.

3. Changed Legal Environment
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.

4. Changed Legal Environment
Despite efforts by the profession to
address the legal liability of CPAs…
Both the number of lawsuits and sizes
of awards to plaintiffs remain high.

5. Learning Objective 2 Explain why the failure of financial
statement users to differentiate
among business failure, audit
failure, and audit risk has
resulted in lawsuits.

6. Business Failure, Audit Failure, and Audit Risk
It occurs when a business is unable to
repay its lenders or meet the
expectations of its investors because
of economic or business conditions.

7. Business Failure, Audit Failure, and Audit Risk
It occurs when the auditor issues an
incorrect audit opinion because it
failed to comply with the requirements
of auditing standards.

8. Business Failure, Audit Failure, and Audit Risk
It 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.

9. Learning Objective 3 Use the primary legal concepts
and terms concerning accountants’
liability as a basis for studying
legal liability of auditors.

10. Legal Concepts Affecting Liability
Prudent person concept
Liability for the acts of others
Lack of privileged communication

11. Legal Terms Affecting CPAs’ Liability
Terms related to negligence and fraud:
Ordinary negligence
Gross negligence
Constructive fraud
Fraud

12. Legal Terms Affecting CPAs’ Liability
Terms related to contract law:
Breach of contract
Third-party beneficiary

13. Legal Terms Affecting CPAs’ Liability
Other terms:
Common law
Statutory law
Joint and several liability
Separate and proportionate liability

14. Four Major Sources of Auditors’ Legal Liability
Liability to clients
Liability to third parties
Federal securities laws
Criminal liability

15. Learning Objective 4 Describe accountants’ liability to
clients and related defenses.

16. Liability to Clients The most common source of lawsuits
against CPAs is from clients.

17. Auditor’s Defenses Against Client Suits
Lack of duty to perform
Nonnegligent performance
Contributory negligence
Absence of causal connection

18. Learning Objective 5 Describe accountants’ liability to
third parties under common law
and related defenses.

19. Liability to Third Parties Under Common Law
Ultramares doctrine
Foreseen users

20. Foreseen Users
Credit alliance
Restatement of torts
Foreseeable user

21. Auditor Defenses Against Third-Party Suits
The preferred defense is
nonnegligent performance.

22. Learning Objective 6 Describe accountants’ civil liability
under the federal securities laws
and related defenses.

23. 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.

24. 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.

25. Rule 10b-5 of the Securities Exchange Act of 1934
Section 10 and rule 10b-5 are often called
the antifraud provisions of the 1934 act.

26. Auditor Defenses – 1934 Act Nonnegligent performance Lack of duty
Absence of causal connection

27. SEC Sanctions The SEC has the power in certain circumstances
to sanction or suspend practitioners from
doing audits for SEC companies.
In recent years, the SEC has temporarily
suspended a number of individual CPAs
from doing any audits on SEC clients.

28. Foreign Corrupt Practices Act of 1977
This act makes it illegal to offer a bribe
to an official of a foreign country for
the purpose of exerting influence and
obtaining or retaining business.

29. Sarbanes-Oxley Act of 2002 This act requires the CEO and CFO to
certify the annual and quarterly financial
statements filed with the SEC.
Management must report its assessment
of the effectiveness of internal control
over financial reporting.
The auditor must provide an opinion on
management’s assessment.

30. Learning Objective 7 Specify what constitutes criminal
liability for accountants.

31. Criminal Liability CPAs can be held liable under
criminal liability for accountants.
CPAs can be found guilty for criminal
action under both federal and state laws.

32. Sarbanes-Oxley Act This act makes it a felony to destroy
or create documents to impede or
obstruct a federal investigation.

33. Learning Objective 8 Describe what the profession and
the individual CPA can do and
what is being done to reduce
the threat of litigation.

34. The Profession’s Response to Legal Liability
Research in auditing
Standard and rule setting
Set requirements to protect auditors
Establish peer review requirements

35. The Profession’s Response to Legal Liability
Oppose lawsuits
Education of users
Sanction members for improper conduct
and performance
Lobby for changes in laws

36. Protecting Individual CPAs from Legal Liability
Deal only with clients possessing integrity
Hire qualified personnel
Follow the standards of the profession
Maintain independence

37. Protecting Individual CPAs from Legal Liability
Understand the client’s business
Perform quality audits
Document the work properly
Obtain an engagement and a representation letter
Maintain confidential relations

38. Protecting Individual CPAs from Legal Liability
Carry adequate insurance
Seek legal counsel
Choose a form of organization with limited liability
Exercise professional skepticism

39. End of Chapter 5