CHAPTER 2

2.3 Legal Liability

 Legal Environment for CPAs
• Legal liability of Auditors
– It refers to the possibility of court action that auditors
expect if they do not adhere to auditing standards and
to the code of ethics
• Auditor generally owes a duty of care to third parties who
are part of a limited group of persons whose reliance is
"foreseen" by the auditor.
• The legal environment is changing, audit professionals
have a responsibility under common law to fulfill implied or
expressed contracts with clients
• In addition to common law liability, auditors may be held
liable to third parties under statutory law
• In rare cases, auditors have even been held liable for
criminal acts
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 Legal Environment for CPAs
• …Legal liability of Auditors
 When CPAs take any engagement, they are obliged to
render the service with due professional care, this
obligation exists whether it is written in the contract or
not.
 Auditors are liable to their clients for negligence and/or
breach of contract if they fail to provide the services or
fail to exercise due care in their performance.
 Based on precedents in common law, clients and third
parties have the right to recover damages caused by
auditors for ordinary negligence

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 Legal Environment for CPAs
• Reasons for increase in the number of lawsuits and
the sizes of the awards to plaintiffs:
– The growing awareness of the responsibilities of public
accountants by users of financial statements
– An increased consciousness on the part of the Securities
and Exchange Commission regarding its responsibility
for protecting investors' interests
– The complexity of auditing and accounting functions
caused by the increasing size of businesses, the
globalization of business, and the complexities of
business operations and financing transactions
– The tendency of society to accept lawsuits by
injured parties against anyone who might be able to
provide compensation, regardless of who was at fault,
coupled with joint and several liability doctrine

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 Legal Environment for CPAs
• ….Reasons for increase in the number of lawsuits and
the sizes of the awards to plaintiffs:
– The global recession and tough economic times result
in business failures, which prompt stakeholders to
seek compensation from others, including external
auditors
– Large civil court judgments against CPA firms
awarded in a few cases (Contingent-fee-based
compensation for law firms)
– The willingness of CPA firms to settle legal problems
out of court to avoid costly legal fees and adverse
publicity, rather than pursuing resolution through the
judicial process
– Courts’ difficulties in understanding and interpreting
accounting and auditing matters
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Distinguishing Business Failure,
Audit Failure, and Audit Risk
• A major cause of lawsuits against CPA firms is
financial statement users’ lack of understanding of
two concepts:
– The difference between a business and an audit
failure
– The difference between an audit failure and audit risk
Distinguishing Business Failure,
Audit Failure, and Audit Risk
• Business failure occurs when a business is unable to
repay its lenders or meet the expectations of its investors
• Audit failure occurs when the auditor issues an incorrect
audit opinion because it failed to comply with the
requirements of auditing standards
• Audit risk represents the possibility that the auditor
concludes after conducting an adequate audit that the
financial statements were fairly stated when, in fact, they
were materially misstated
 Distinguishing Business Failure,
Audit Failure, and Audit Risk
• Which one (Business failure, Audit failure, or Audit risk is
a good reason to take complaints to court?
– Audit failure is a good reason for taking complaints to
courts
– The law often allows parties who suffered losses to
recover some or all of the losses caused by the audit
failure
– But, the complexity of the auditing process makes it
difficult to easily decide on the existence of failure to
comply with auditing standards

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•
 Distinguishing Business Failure,
Audit Failure, and Audit Risk
….Which one (Business failure, Audit failure, or Audit
risk is a good reason to take complaints to court?
– Audit risk is unavoidable, since audits are performed on
test basis (sample);
– So, it may occur even if an audit is conducted as per the
auditing standards
– Auditors can not give guarantee that financial statements
are accurate, they can give only a reasonable assurance, but
some users expect auditors to give guarantee about the
accuracy of financial statements (expectation gap)-another
cause for increased litigation
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Expectation Gap

• The existence of an “expectation gap” between users

and auditors:
– Most auditors believe that the conduct of the audit in
accordance with auditing standards is all that can be
expected of auditors
– Many users believe that auditors guarantee the
accuracy of financial statements and some even
believe that the auditor guarantees the financial
viability of the business
 Implication of Increased Lawsuits
Implications of increased law suits:
 The need to be aware of the legal liability inherent in the practice before
deciding to enter in the auditing profession
 Auditors must approach every engagement with the expectation that they
may appear in court to defend their work
 The cost of professional liability insurance will continue to increase. Not
only the cost issue, but reputations of audit firms will also be damaged
 Performing tasks with due care is essential to reduce the costs and keep the
image of the profession
 It is obvious that, no matter how careful a CPA firm is, it may occasionally
find it self as defendant in litigation, however:
 CPAs are never liable to any party, if they perform their services with
due professional care
 Having exercised due professional care (due diligence) is a complete
defense against any charge of improper conduct

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 Legal Concepts Affecting Auditors Liability

• Legal concepts pertinent to lawsuits involving CPAs:

1. Prudent person concept
2. Liability for the acts of others
3. Lack of privileged communication

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 Legal Concepts Affecting Auditors Liability
1. Prudent person concept
It is considered as a standard of due care, the auditor is
expected to conduct the audit with due care
It requires CPA firms:
 To exercise due diligence- Those who provide services
should have the required skills and competence, if this is
not the case, it is considered as fraud (deceiving others)
 To provide service in good faith and highest level of
integrity It is understood that auditors can provide only
reasonable assurance, not a guarantee about the
accuracy of financial statements (It means, errors may
occur in the process since no one is perfect (infallibility is
not assumed). Negligence and dishonesty makes
auditors liable to others, but not an error occurred in
providing services in good faith.
 Legal Concepts Affecting Auditors Liability
2. Liability for the acts of others
 CPA firms provide service to others through their employees, or may
involve other CPA firms to do part of the work, and may also invite
specialists to provide technical information
 If an employee performs improperly in doing an audit, the partners can
be held liable for the employee’s performance.
 In general, partners of the CPA firms are liable for the work of others
on whom they relay
3. Lack of privileged communication
 Information obtained by a CPA from a client are confidential but not
privileged.
 They are confidential (are not revealed without the consent of the
client), but exceptionally they are communicated eg. by court orders
(cannot be withheld from the court)

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Sources of Legal Liability
• Auditors face four sources of legal liability
– Liability to clients
– Liability to third parties under common law
– Civil liability under statutory law
– Criminal liability
 Liability to Clients
• Most common source of lawsuits against CPAs is from
clients
• Lawsuits can be for breach of contract, a tort action for
negligence, or both
• Tort actions can be based on:
– Ordinary negligence
– Gross negligence
– Fraud

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 Auditor’s Defenses Against Client Suits
• The CPA firm normally uses one or a combination of
four defenses when there are legal claims by clients:
1. CPA firm did not breach the contract
2. CPA firm was not negligent in performing its duties,
3. Existence of contributory negligence
– Eg by demonstrating client's negligence that contributes to the
loss. Eg. a loss resulted from failure to implement auditor’s
recommendation)
– Contributory negligence may eliminate auditor’s liability or
the concept of comparative negligence may be applied to
allocate the damage between the auditor and the client
4. Client losses were not caused by the breach

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Liability to Third Parties Under
Common Law
• CPAs may be liable to third parties under common law if
a loss was incurred by the claimant due to reliance on
misleading financial statements
• The Ultramares doctrine
– Ordinary negligence is insufficient for liability to third
parties because of the lack of privity of contract
between the third party and the auditor, unless the
third party is a primary beneficiary
Liability to Third Parties Under
Common Law
• Foreseen users
– Members of a limited class of users that the auditor
knows will rely on the financial statements
• Foreseeable users
– Any users who the auditor should have reasonably
been able to foresee as likely users of the client’s
financial statements
 Burdon of Proof Under Common Law
• The Burden of Proof Under Common Law
– Legal actions under common law require the plaintiff to bear most of
the burden of proof.
– Plaintiffs seeking damages from CPAs must prove that they sustained
losses, due to their reliance on audited financial statements that were
misleading, and auditors were guilty of a certain degree of negligence
The following proofs are required from Clients:
 CPA Accepted Duty to Exercise Due Professional Care (Level of care
should be included in the engagement letter - based on level of
service.)
 Existence of Breach of Duty (through negligence)
 Existence of Loss Suffered by Client
 Proof that the Loss is Resulted due to CPA’s Negligence

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Auditor Defenses Against Third-
Party Suits
• Three of the four defenses available to auditors in
suits by clients are also available in third-party
lawsuits:
1. Lack of duty to perform the service (CPA did not
perform the breach)
2. Nonnegligent performance (CPA was not negligent in
performing duties)
3. Absence of causal connection (the breach was not
the cause for clien’ts loss)
– Contributory negligence is not available because a
third party is not in a position to contribute to
misstated financial statements
 Approaches Courts Take to Assign Third-Party
Liability Under Common Law
Civil Liability Under the Federal
Securities Laws
• The greatest growth in CPA liability litigation has been
under the federal securities laws
• Litigants commonly seek federal remedies because of
the availability of class-action litigation and the ability to
obtain significant damages from defendants
• Several sections of the securities laws impose strict
liability standards on CPAs
 Civil Liability Under the Federal
Securities Laws
• The greatest growth in CPA liability litigation has been
under the federal securities laws
• Litigants commonly seek federal remedies because of
the availability of class-action litigation and the ability to
obtain significant damages from defendants
• Several sections of the securities laws impose strict
liability standards on CPAs

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Civil Liability Under the Federal
Securities Laws
• The Securities Act of 1933
– Deals only with the reporting requirements for
companies issuing new securities
– The only parties who can recover from auditors under
the Securities Act of 1933 are original purchasers of
securities.
• Auditor’s defenses
– An adequate audit was conducted (due diligence) or all
or a portion of the plaintiff’s loss was caused by
factors other than the misleading financial statements
Courts action when Auditor are found to
breach
• When the auditor is found to breach the contract, court
remedies to a breach include
– order auditors to fulfill the contract (specific
performance)
– issue injunction to prohibit the auditor from continuing
the breach
– order auditor to pay compensatory (actual) damages
If the case falls under the criminal act- the auditors, can
be fined or imprisoned
Civil Liability Under the Federal
Securities Laws
• The SEC and the PCAOB have the power to sanction or
suspend practitioners from doing audits for SEC
companies
• The Foreign Corrupt Practices Act of 1977 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
• The Sarbanes–Oxley Act greatly increased the
responsibilities of public companies and their auditors
Criminal Liability
• Under criminal liability for accountants, CPAs can be
found guilty for criminal action under both federal and
state laws
• It is a criminal offense to:
– Defraud another person through knowingly being
involved with false financial statements (A CPA is
subject to criminal liability if knowingly involved with
false financial statements)
– Destroy or create documents to impede or obstruct a
federal investigation (Sarbanes Oxley act of 2002
makes a felony/crime to destroy or create documents
to impede or obstruct a federal investigation)
The Profession’s Response to Legal
Liability
• The AICPA and the profession can do a number of
things to reduce practitioners’ exposure to lawsuits:
– Set standards and revise them to meet the changing
needs of auditing.
– Oppose lawsuits.
– Educate investors and other users of financial statements
as to the meaning of an auditor's opinion and the extent
and nature of the auditor's work.
– Sanction members for improper conduct and performance
– Lobby for changes in laws.
...The Profession’s Response to Legal Liability
• Practicing auditors may also take specific action to
minimize their liability:
– Deal only with clients possessing integrity
– Maintain independence
– Understand the client's business
– Perform quality audits
– Document the work properly
– Obtain an engagement letter and a representation letter
– Exercise professional skepticism
– Carry adequate insurance
– Choose a form of organization that provides some form of
legal liability protection to owners
– Consult with experienced legal counsel in the event of
actual or threatened litigation
 End of Chapter 2:

Questions

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