1. It Takes the Net Profit From Many Audits to Offset the5
It Takes the Net Profit From
Many Audits to Offset the
Cost of One Lawsuit

2. 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.

3. 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!

4. Audit
Risk
Business
Failures
Audit
Failure

5. 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

6. 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

7. 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.

8. 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)

9. 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 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

10. 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.

11. 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.”

12. 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