1. Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Auditing & Assurance Services, 6e

2. Module C Legal Liability “When men are pure, laws are useless; when men are corrupt, laws are broken.” Benjamin Disreali, Former British Prime Minister Mod C-2

3. Module Objectives 1.Identify and describe auditors’ exposure to lawsuits and loss judgments. 2.Specify the characteristics of auditors’ liability under common law and cite some specific case precedents. 3.Identify auditors’ liability to third parties under statutory law. 4.Specify the civil and criminal liability provisions of the Securities Act of 1933. 5.Specify the civil and criminal liability provisions of the Securities Exchange Act of 1934. 6.Understand recent developments that affect auditors’ liability to clients and third parties. Mod C-3

4. The Legal Environment Auditors Client Third-party user of F/S Performs services in accordance with contract Conduct a GAAS audit Rely on audited F/S in making economic decisions Issue auditors’ report Mod C-4

5. Sources of Auditor Liability Common law: Uses legal precedent to identify responsibility. –Clients –Nonshareholder third parties Statutory liability: Based on violations of written statutes. –Shareholders Mod C-5

6. Major Topics I.Common Law Liability –Clients –Third Parties II.Statutory Liability –Securities Act of 1933 –Securities Exchange Act of 1934 III.Developments in Auditor Liability Mod C-6

7. Common Law Breach of contract: Services not performed by auditors in manner described in contract Tort liability: Obligation based on failure of auditors to exercise appropriate level of professional care –Ordinary negligence is lack of reasonable care –Gross negligence is lack of minimal care (similar to constructive fraud) –Fraud is a misrepresentation of fact an individual knows to be false Mod C-7

8. Common Law Liability: Clients Breach of contract –Contractual relationship with client (through engagement letter) creates potential liability Tort liability –Liable for ordinary negligence, gross negligence, and fraud Mod C-8

9. Proof and Defenses: Clients Clients must show –Economic loss –Auditors breached contract or failed to exercise appropriate care –The loss was caused by the breach of contract or failure of auditors to exercise the appropriate level of care Defenses –Auditors did not breach contract or performed with appropriate level of care –Causation (something else caused client loss) –Contributory negligence (clients were partially responsible for loss) Mod C-9

10. Major Topics I.Common Law Liability –Clients –Third Parties II.Statutory Liability –Securities Act of 1933 –Securities Exchange Act of 1934 III.Developments in Auditor Liability Mod C-10

11. Types of Third Parties Primary beneficiaries: Known by name to the auditor Foreseen: Parties who could reasonably be expected to rely on the auditors’ work Foreseeable: Parties whose decisions normally rely on audited F/S and opinions on those F/S More Known to Auditor Less Known to Auditor Mod C-11

12. Common Law Liability: Third Parties Generally liable to all third parties for gross negligence and fraud Liability for ordinary negligence –Ultramares: No liability for ordinary negligence –Credit Alliance v. Arthur Andersen: Liable to primary beneficiaries for ordinary negligence –Fleet National Bank (restatement of torts): Liable to foreseen third parties for ordinary negligence –Rosenblum v. Adler: Liable to foreseeable third parties for ordinary negligence Mod C-12

13. Proof and Defenses: Third Parties Third parties must show –Economic loss –Auditors failed to exercise appropriate level of care –F/S contained a material misstatement –Loss caused by reliance on misstated F/S Defenses –Lack of appropriate standing (relationship with auditor) to bring suit –Third party’s loss caused by factors other than the F/S and auditors examination (causation defense) –Audit conducted per GAAS Mod C-13

14. Summary of Liability for Ordinary Negligence Ultramares: Liable for GN and F Credit Alliance v. Arthur Andersen: ON to primary beneficiaries Fleet National Bank v. Gloucester Co: ON to foreseen (restatement of torts) Rosenblum v. Adler: ON to foreseeable Less Exposure More Exposure Mod C-14

15. Summary of Common Law Liability Liability to clients –Breach of contract –Tort liability for ON, GN, F Liability to third parties –Only tort liability, unless they contract with auditors –Liable to all for GN and F –Liability for ON depends upon relationship and jurisdiction Mod C-15

16. Major Topics I.Common Law Liability –Clients –Third Parties II.Statutory Liability –Securities Act of 1933 –Securities Exchange Act of 1934 III.Developments in Auditor Liability Mod C-16

17. Statutory Liability Violations of specific laws or statutes Securities Acts –Regulate securities trading in the U.S. –Require disclosure of important financial and nonfinancial information using GAAP –Require audited F/S Mod C-17

18. Securities Act of 1933 (Securities Act) Regulates initial issuance of securities by registrants to investing public Required to file registration statement with SEC that includes F/S To bring suit, investors must show: –Loss –F/S contained a material misstatement –No need to show reliance on F/S or that loss was caused by misstatement Mod C-18

19. Liability Under Securities Act Auditors responsible for ordinary negligence, gross negligence, and fraud Defenses –Due diligence (auditors performed a GAAS audit) –Causation (loss resulted from other factors) Escott v. BarChris Construction Corp. –Auditors held liable for failure to conduct “reasonable investigation” (ordinary negligence) Mod C-19

20. Civil and Criminal Liability Civil Liability (Section 11) –Because auditors are “experts” and must perform a “reasonable investigation”, they have liability under Section 11 –Burden of proof has shifted to the auditors Criminal Liability (Section 24) –Auditors must have “willfully” violated provisions of the Securities Act (fraud or GN) –United States vs. Benjamin addressed criminal liability Mod C-20

21. Major Topics I.Common Law Liability –Clients –Third Parties II.Statutory Liability –Securities Act of 1933 –Securities Exchange Act of 1934 III.Developments in Auditor Liability Mod C-21

22. Securities Exchange Act of 1934 (Securities Exchange Act) Regulates daily trading of securities and requires periodic financial statements and information to be filed with the SEC Reports filed with SEC –Form 10-K: Annual F/S (audited) –Form 10-Q: Quarterly F/S (reviewed) –Form 8-K: “Current events” report filed as appropriate Mod C-22

23. Liability under the Securities Exchange Act of 1934 To bring suit, investors must show: –Economic loss –F/S contained a material misstatement –Loss caused by reliance on F/S (burden of proof shifted to investor) –Auditors were aware that the F/S contained a material misstatement (has been interpreted as gross negligence) Mod C-23

24. Auditors liable for gross negligence and fraud –Scienter is a mental state embracing the intent to deceive, manipulate, or defraud Defenses –Auditors acted in good faith –Auditors were not aware of material misstatements Ernst & Ernst v. Hochfelder –Relieved auditors from liability for ordinary negligence –Did provide liability for “reckless behavior” in the absence of scienter Mod C-24 Liability under the Securities Exchange Act of 1934

25. Civil and Criminal Liability Civil Liability (Rule 10b-5 and Section 18) –Plaintiffs have burden of proof –Auditors cannot be held liable for ON Criminal Liability (Section 32) –Did auditors act “willfully and knowingly”? –Fines of up to $5 million and imprisonment for up to 20 years –United States vs. Natelli (“National Student Marketing”) Mod C-25

26. Summary of Auditor Liability SourceBurden of Proof OffenseAuditors’ Defenses Common Law/ClientsClientBreach of contract ON, GN, F No breach or inappropriate performance (GAAS audit) Causation Contributory negligence Common Law/Third Parties Third PartiesON depends upon party and jurisdiction GN, F Lack of appropriate third party standing Causation No inappropriate performance (GAAS audit) Securities Act of 1933AuditorsON, GN, FDue diligence (GAAS audit) Causation Securities Act of 1934InvestorsGN, FGood faith No knowledge of material misstatements (“scienter”) ON = Ordinary negligence GN = Gross negligence F = Fraud Mod C-26

27. Major Topics I.Common Law Liability –Clients –Third Parties II.Statutory Liability –Securities Act of 1933 –Securities Exchange Act of 1934 III.Developments in Auditor Liability Mod C-27

28. Why Has Auditor Liability Increased? Highly-publicized failures (WorldCom, Enron) Investor awareness of ability to recover monetary losses from auditors Complex accounting standards Joint and several liability Class action suits Auditors (“deep pockets”) are an attractive target for plaintiff attorneys Mod C-28

29. Sarbanes-Oxley Extends statute of limitations for brining suit under the Securities Exchange Act Increased penalties for mail fraud and wire fraud Increased penalties for destruction, alteration, and falsification of records Increased records retention requirements Higher potential liability in civil cases Mod C-29

30. Other Developments in Auditor Liability Auditors not subject to RICO (and treble damages) Limitations on aiding and abetting Organization of firms as limited liability partnerships Private Securities Litigation Reform Act (1995) –Proportionate liability, instead of joint and several liability Mod C-30

31. Other Developments in Auditor Liability Class Action Fairness Act (2005) –Moves class action cases from state courts to federal courts Securities Litigation Uniform Standards Act (1998) –Requires class action lawsuits with > 50 parties to be filed in federal courts Auditor liability caps Mod C-31