EXTERNAL AUDITING 555EXTERNAL AUDITING 555 TCO # D TCO # D

LITIGIOUS ENVIRONMENTLITIGIOUS ENVIRONMENT

ISSUES, LAWS, LEGAL SITUATIONS.ISSUES, LAWS, LEGAL SITUATIONS.

Business Failure, Audit Failure, Business Failure, Audit Failure, and Audit Riskand Audit Risk

Business failureBusiness failure

It occurs when a business is unable toIt occurs when a business is unable torepay its lenders or meet therepay its lenders or meet theexpectations of its investors becauseexpectations of its investors becauseof economic or business conditions.of economic or business conditions.

Business Failure, Audit Failure, Business Failure, Audit Failure, and Audit Riskand Audit Risk

Audit failureAudit failure

It occurs when the auditor issues anIt occurs when the auditor issues anerroneous audit opinion as the resulterroneous audit opinion as the resultof an underlying failure to complyof an underlying failure to complywith the requirements of generallywith the requirements of generallyaccepted auditing standards (GAAS).accepted auditing standards (GAAS).

Business Failure, Audit Failure, Business Failure, Audit Failure, and Audit Riskand Audit Risk

Audit riskAudit risk

It represents the risk that the auditor willIt represents the risk that the auditor willconclude that the financial statementsconclude that the financial statementsare fairly stated and an unqualifiedare fairly stated and an unqualifiedopinion can be issued when, in fact,opinion can be issued when, in fact,they are materially misstated.they are materially misstated.

Business Failure, Audit Failure, Business Failure, Audit Failure, and Audit Riskand Audit Risk

BusinessBusinessfailurefailure

AuditAuditfailurefailure

AuditAuditriskrisk

Four Major Sources of Auditors’ Four Major Sources of Auditors’ Legal LiabilityLegal Liability

Third partyThird party

FederalFederalsecurities lawssecurities laws

ClientClient

CriminalCriminalliabilityliability

Liability From ClientsLiability From Clients

The most common source of lawsuitsThe most common source of lawsuitsagainst CPAs is from clientsagainst CPAs is from clients..

Liability to Clients:Liability to Clients:Under contract law - for breach of contractUnder contract law - for breach of contractUnder tort law** for:Under tort law** for:

Ordinary negligenceOrdinary negligence – failure to exercise care – failure to exercise care a a reasonable person would under the same reasonable person would under the same circumstancescircumstances

Gross negligenceGross negligence – failure to use even slight – failure to use even slight care in circumstancescare in circumstances

FraudFraud - - intentional deceptionintentional deception

** Tort = wrongful act that injures another person’s property, body, or ** Tort = wrongful act that injures another person’s property, body, or reputation.reputation.

Liability Under the Common LawLiability Under the Common Law

Auditor’s Defenses AgainstAuditor’s Defenses AgainstClient SuitsClient Suits

Lack of duty to performLack of duty to perform

Nonnegligent performanceNonnegligent performance

Contributory negligenceContributory negligence

Absence of causal connectionAbsence of causal connection

Liability Third Parties Under the Liability Third Parties Under the Common LawCommon Law

Ultramares:Ultramares: upheld the privity of contract upheld the privity of contract doctrine: third parties cannot sue auditors for doctrine: third parties cannot sue auditors for ordinary negligence.ordinary negligence.

Foreseen users – A limited group of persons for Foreseen users – A limited group of persons for whom the auditor is aware will rely on the whom the auditor is aware will rely on the financial statements.financial statements.

Securities Exchange Act of 1934Securities Exchange Act of 1934

1934 Act – requires ongoing filing of quarterly and

annual reports, and other information to keep the

registration statement current. Certain information,

including financial statements must be audited.

The liability of auditors under this act oftenThe liability of auditors under this act oftencenters on Rule 10b-5, p. 118.centers on Rule 10b-5, p. 118.

• It may apply to accountants if they intentionally It may apply to accountants if they intentionally or recklessly misrepresent information intended foror recklessly misrepresent information intended for33rdrd party use. party use.

Auditor Defenses – 1934 ActAuditor Defenses – 1934 Act

Nonnegligent performanceNonnegligent performance

Lack of dutyLack of duty

Absence of causal connectionAbsence of causal connection

Criminal LiabilityCriminal Liability

CPAs can be found guilty for criminalCPAs can be found guilty for criminalaction under both federal and state laws.action under both federal and state laws.

• Most laws make it a criminal offense to Most laws make it a criminal offense to defraud another person through defraud another person through knowinglyknowinglybeing involved with falsifications in financialbeing involved with falsifications in financialstatements.statements.

The Sarbanes-Oxley Act makes it a felonyThe Sarbanes-Oxley Act makes it a felonyto destroy or create documents to impede to destroy or create documents to impede Or obstruct a federal investigation.Or obstruct a federal investigation.

Protecting Individual CPAsProtecting Individual CPAsfrom Legal Liabilityfrom Legal Liability

Deal only with clients possessing integrityDeal only with clients possessing integrity

Hire qualified personnelHire qualified personnel

Follow the standards of the professionFollow the standards of the profession

Maintain independenceMaintain independence

Protecting Individual CPAsProtecting Individual CPAsfrom Legal Liabilityfrom Legal Liability

Understand the client’s businessUnderstand the client’s business

Perform quality auditsPerform quality audits

Document the work properlyDocument the work properly

Obtain an engagement and a representation letterObtain an engagement and a representation letter

Maintain confidential relationsMaintain confidential relations