It Takes the Net Profit From
Many Audits to Offset the
Cost of One Lawsuit
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
DISTINCTION AMONG BUSINESS
FAILURE, AUDIT FAILURE,
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!
LEGAL CONCEPTS AFFECTING LIABILITY
Use the primary legal concepts and Prudent Person Concept (not perfection)
the terms concerning accountants’
liability as a basis for studying legal
Liability for the Acts of Others (LLP)
liability of auditors. Lack of Privileged Communication (w/p’s)
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
LIABILITY TO CLIENTS The most
Describe accountants’ liability to of lawsuits
clients and related defenses. against CPAs
Legal Terms Affecting CPAs’ Liability clients.
Terms Related Ordinary Negligence
to Negligence Gross Negligence
and Fraud Fraud
Terms Related Breach of Contract
to Contract Law Third-Party Beneficiary
Other Terms Statutory Law
Joint and Several Liability
Separate and Proportionate Liability
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.
Describe accountants’ liability to
third parties under common law LIABILITY TO THIRD PARTIES
and related defenses.
UNDER COMMON LAW
Ultramares Doctrine - A case that summarized the Liability to
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)
CIVIL LIABILITY UNDER Describe accountants’ civil liability
under the federal securities laws and
THE FEDERAL SECURITIES LAWS 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 1934 - 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
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
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.
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
THE PROFESSION’S Describe what the profession and the
RESPONSE TO 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