2. Chapter 4
Legal Environment Affecting Audits

3. Learning Objectives
1. Learn the meaning of legal standing and the characteristics of various legal standing classifications of plaintiffs. 2. Describe the processes that occur in a legal action resulting in a trial. 3. Understand different causes of action typically used in cases against auditors along with likely defenses and damages. 4. Recognize various statutory laws that may affect auditors in civil and criminal actions.

4. Auditors and Risk Audit Risk
The possibility that the auditors issue opinions that ICFR is effective and financial statements are fair when that is not true
Audit failure occurs when an auditor issues an inappropriate audit report
Audit failures are exposed when fraud is discovered or a company goes bankrupt

5. Who Can Sue the Auditor?
A plaintiff who has standing can bring a legal cause of action against an auditor
Four descriptions of standing apply:
1. Privity
2. Near privity
3. Foreseen third parties
4. Foreseeable third parties

6. Cause of Action Negligence – absence of due professional care Fraud
Breach of Contract
Statutory violations
Only those in close proximity will be granted standing for negligence

7. Privity
Defined as “the connection or relationship between two parties each having a legally recognized interest in the same subject matter”
Ultramares case – a person or entity must have privity with an auditor in order to collect damages if an auditor is negligent

8. Near Privity 1. did the auditor know the financial statements were to
Near privity – Three part test
1. did the auditor know the financial statements were to
be used for a specific purpose?
2. did the auditor know the third party?
3. some action by the auditor showing an understanding that the third party was going to rely on the financial statements

9. Foreseen Third Parties
A majority of the states and the federal government use this standard when determining standing of a potential plaintiff.
From Restatement of Torts, 2d. Section 552
Accountant can be liable for failure to use reasonable care or skill
Liability is limited to the loss suffered
Liability is owed only to those to whom the accountant intended to provide the information or knew the recipient intended it for
Accountant knows the recipient intended to rely on the information
Foreseeable third parties are a far broader class, and the foreseeable third party standard is only used by Mississippi and Wisconsin.

10. Civil Legal Action
Majority of cases against accountants are civil cases covered by tort law
Tort law addresses a situation where a party suffers a loss and wants damages

11. Arbitration, Negotiation and Settlement
Arbitration is a process in which negotiation occurs conducted by an independent arbitrator
Arbitration may be mandated by contract or voluntarily entered into by both parties
Many times disputes are settled before going to trial

12. A Legal Action
Step 1: - A complaint is a document stating the facts as stated by the plaintiff.
Proposed course of action
Remedies being sought
Dollar amount of damages sought by the auditor
Step 2: The Answer – defendant’s response.
Step 3: Discovery – fact-finding using documents and depositions
Step 4: Trial
Step 5: After the proceedings, if a judgment is made, damages are awarded; appeal is possible

13. Depositions, Purposes and Possible Outcomes
Discovering facts sufficient to establish or defend against the allegations
Establishing a defendant’s testimony under oath
Obtaining an admission of the alleged negligence
Narrowing the contested factual aspects of the case; both parties may “stipulate” or state that they agree about certain facts
Establishing testimony that can be used to impeach or discredit a witness at a later point during the trial

14. Causes of Action, Defenses and Potential Damages
The cause of action is the legal theory used to allege wrongdoing by the defendant
Attempts of proof and defenses are tailored for the cause of action
Legal cases can be civil or criminal
Requirements to prove the guilt in a criminal case are stricter and potential damages more severe
In a criminal case, the plaintiff is the government
Prison time is possible in criminal cases

15. Negligence and Gross Negligence
Negligence: “conduct which falls below the standard established by law for the protection of others against unreasonable risk of harm”
To prove negligence on the part of an auditor
1. The financial statements were materially misleading
2. The auditor was negligent in the performance of the audit engagement
a. The auditors did not meet professional standards of a “reasonable man” or “prudent person”
b. The auditors did not perform to their own professional standards
3. The plaintiff relied on the financial statements
4. The auditor was known or responsible to the plaintiff
5. The plaintiff was damaged by relying on the statements

16. Defenses to Negligence
Due professional care was used
No duty of care existed
The plaintiff did not rely on the financial information
The negligent behavior did not cause the damages
The plaintiff was culpable of contributory negligence

17. Damages Compensatory damages
Limited to the loss the plaintiff suffered
Punitive damages
Gross negligence is “reckless disregard”
A finding of gross negligence can result in punitive damages
Ultramares is most often cited case re negligence
Liability may be
Joint and severally
Separate and proportionate

18. Fraud Proofs required for a finding of fraud
The financial statements were materially misleading
The auditor knowingly misrepresented or intentionally omitted items within the financial statements
The plaintiff relied on the financial statements
The auditor was responsible to the plaintiff; standing
The plaintiff was damaged by relying on the financial statements
Defense: That the auditor did not knowingly or intentionally perform the act or omit the information

19. Relevant Fraud Cases State Street Trust Co. v. Alwin C. Ernst
Houbigant v. Deloitte & Touche
Reisman v. KPMG Peat Marwick

20. Breach of Contract Breach of contract claim is valid only if:
The plaintiff had a contract with the auditor and the auditor did not comply with the requirements of the contract.
Third-party beneficiary plaintiffs are usually not successful because they do not have privity with the auditor
Defenses
The contract was not breached
The plaintiff did not have privity of contract
Damages, typically compensatory
Relevant case
National Medical Transportation Network v. Deloitte and Touche

21. Statutory Civil Law First main cause of action: Securities Act of 1933
Any third party who purchases securities described in a registration statement may sue the auditor for any material misrepresentation or omission in the financial statements
No requirement to prove anything except that there was a material misrepresentation or omission in the financial statements
Section 11(b) defense – due diligence
Section 11(e) defense – lack of causal connection
Damages, compensatory with proportionate liability
Relevant cases
Escott v. Barchris Construction.
Bernstein v. Crazy Eddie.

22. Statutory Civil Law continued
Second main cause of action: Securities Exchange Act of 1934
Section 10b-5 targets fraud
Defense: prove that intent to deceive does not exist; plaintiff can then still allege negligence but that is not sufficient to bring a case under the 1934 Act
Damages, compensatory and punitive with proportionate liability
Relevant cases
Ernst & Ernst v. Hochfelder (1976)
Nappier v. Price Waterhouse (2002)

23. Possible Government Actions
Following can be used to bring civil actions against auditors:
SEC Rules of Practice – sanctions and penalties imposed by the SEC can effectively put a CPA firm out of business
RICO – Racketeer Influenced and Corrupt Organization Act
Used for civil and criminal actions
Typically used for federal mail or wire violations; fraud
Foreign Corrupt Practices Act
Makes bribing foreign officials illegal
Requires companies to maintain reasonable records and have an adequate system of internal control
Sarbanes-Oxley Act of 2002
PCAOB is mandated to inspect public accounting firms that do audits of public companies and can assess fines

24. Criminal Actions Fraud Fraud under the SEC Acts of 1933 and 1934
Obstruction of Justice
Sarbanes – Oxley Act, misleading an auditor

25. Appendix A – United States Court Systems
Federal and State courts
Stare Decisis
Subject matter Jurisdiction
PSLRA 1995, SLUSA 1998

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