1. Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter Six Legal and Regulatory Obligations in an Ethical Framework

2. 6-2 Duties and Liabilities of Directors and Officers Duty of Care – Fiduciaries – Ethical and Legal duties – Due care – Liable for negligence Duty of Loyalty – Faithfulness to one’s obligations and duties – Subordinate personal interests to welfare of organization – Refrain from self-serving Liability of Directors and Officers – Crimes – Torts

3. 6-3 Duties and Liabilities of Directors and Officers Business Judgment Rule – Used to avoid liability for poor business judgments Chancery Court – Court of equity – Resolution of commercial business litigation – Can issue temporary injunctions & declaratory judgments

4. 6-4 Legal Liability: An Overview 1.Events that result in losses for users of financial statements 2.Investigate by plaintiff attorneys to link the user losses with allegations of material omissions or misstatements 3.Filing of lawsuit 4.Final resolution of the dispute

5. 6-5 Legal Liability: An Overview Auditors can be sued by clients, investors, creditors, and the government Auditors can be held liable under two classes of law 1.Common law Breach of contract Torts 2.Statutory law Legislation passed at state or federal level that establishes certain courses of conduct that must be adhered to by parties

6. 6-6 Liability to Clients A contractual obligation to the client that creates a privity relationship A client can bring a lawsuit against an accountant for failing to live up to terms of the contract Ultramares v. Touche, 1933 – Third party not in contractual privity cannot sue based on negligence – Left open possibility for gross negligence and fraud

7. 6-7 Liabilities to Third Parties Foreseen Third Parties – Rusch Factors, Inc. v. Levin, 1968 – Restatement (Second) of Torts – Blue Bell, Inc. v. Peat, Marwick, Mitchell & Co., 1986 Foreseeable Third Parties – H. Rosenblum v. Adler, 1983 – Citizens State Bank v. Timm, Schmidt & Company – Bily v. Arthur Young, 1992 – Murphy v. BDO Seidman, LLP

8. 6-8 Common Law What Plaintiffs Must Prove Plaintiff must prove – False representation by auditor – Knowledge by auditor representation was false – Auditor intended 3 rd party to rely on false statements – 3 rd relied on false representations – 3 rd party suffered damages

9. 6-9 Statutory Liability Securities Act of 1933 – Regulates the initial offering of securities through the mails or interstate commerce Securities and Exchange Act of 1934 – Regulates subsequent trading of securities sold on national stock exchanges Sarbanes-Oxley (SOX) Act of 2002 Civil liabilities Criminal liabilities SOX makes it a felony to destroy or create documents to impede or obstruct a federal investigation

10. 6-10 Potential Criminal Liability Securities Act of 1933 – Imprisonment up to 10 years, OR – Fine up to $10,000, OR both Securities Act of 1934 – Imprisonment up to 10 years, OR – Fine up to $100,000, OR both SOX – Imprisonment of 20 years for obstruction of justice – Imprisonment of 25 years for securities fraud

11. 6-11 Insider Reporting and Trading Owners of 10% or more of stock of a company must report ownership and trading of the stock Legal insider trading when corporate insider trade company stock and report trades to SEC Illegal insider trading when owner bases trade of stocks on information the public does not know – Also illegal to give a tip of the information to someone else so that he could trade his stock

12. 6-12 Financial Fraud Detection and Disclosure Private Securities Litigation Reform Act (PSLRA), 1995 Auditors must report illegal acts (including financial statement fraud) to – Management – Audit Committee or BOD – OR the SEC Illegal act with material effect on financial statements Proportionate Liability – A party is liable only for that proportion of damages for which he is responsible

13. 6-13 Sarbanes-Oxley Act (SOX) Relevant provisions for management and auditors that affect legal liability Section 302. Corporate Responsibility for Financial Reports Certification by CEO and CFO that financial reports do contain untrue material fact or omission of such Section 308. Fair Funds for Investors Section 401. Disclosures in Periodic Reports Section 801. Corporate Criminal Fraud Accountability Section 806. Protection for Employees of Publicly Traded Companies who Provide Evidence in Fraud Cases Section 906. Corporate Responsibility for Financial Reports

14. 6-14 Whistle blowing Internal – Auditor brings matter to the supervisor – Supervisor informs the partner – Partner discusses the matter with top management and audit committee – Audit committee should support the auditors External – Auditor violates the confidentiality obligation to client – Auditor may lose license to practice as CPA

15. 6-15 Other Laws Affecting Accountants and Auditors Foreign Corrupt Practices Act of 1977 (FCPA) – Establishes standards of acceptability of payments (bribes) made by U. S. multinational entities to foreign government officials U. S. Federal Sentencing Guidelines – Caremark International, 1991 – Provides scheduled fines Racketeer Influenced and Corrupt Organizations Act (RICO) – Civil and criminal sanctions for illegal acts – Treble damages

16. 6-16 Omnibus Trade and Competitiveness Act of 1988 Amends FCPR Clarifies when a payment is prohibited – Intended to influence a foreign official to act incompatible with legal duty Clarifies grease payments and may include – Permits, licenses, documents to qualify for work – Processing papers, such as visas – Providing police protection – Providing utilities