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1Chapter 5

Legal Liability

Review Questions

5-1 Several factors that have affected the increased number of lawsuits againstCPAs are:

1. The growing awareness of the responsibilities of public accountants onthe part of users of financial statements.

2. An increased consciousness on the part of the SEC regarding itsresponsibilit for protecting investors! interests.

". The greater comple#ities of auditing and accounting due to theincreasing si$e of businesses% the globali$ation of business% and

the intricacies of business operations.&. Societ!s increasing acceptance of lawsuits.'. (arge civil court )udgments against CPA firms% which have encouraged

attornes to provide legal services on a contingent fee basis.*. The willingness of man CPA firms to settle their legal problems out of

court.+. The difficult courts have in understanding and interpreting technical

accounting and auditing matters.

5-2 The most important positive effects are the increased ,ualit control bCPA firms that is li-el to result from actual and potential lawsuits and the abilit

of in)ured parties to receive remuneration for their damages. egative effects arethe energ re,uired to defend groundless cases and the harmful impact on thepublic!s image of the profession. (egal liabilit ma also increase the cost ofaudits to societ% b causing CPA firms to increase the evidence accumulated.

5-3 /usiness failure is the ris- that a business will fail financiall and% as a result%will be unable to pa its financial obligations. Audit ris- is the ris- that the auditorwill conclude that the financial statements are fairl stated and an un,ualifiedopinion can therefore be issued when% in fact% the are materiall misstated.

0hen there has been a business failure% but not an audit failure% it iscommon for statement users to claim there was an audit failure% even if the mostrecentl issued audited financial statements were fairl stated. an auditorsevaluate the potential for business failure in an engagement in determining theappropriate audit ris-.

5-4 The prudent person concept states that a person is responsible forconducting a )ob in good faith and with integrit% but is not infallible. Therefore%the auditor is e#pected to conduct an audit using due care% but does not claim tobe a guarantor or insurer of financial statements.

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5-5 The difference between fraud and constructive fraud is that in fraud thewrongdoer intends to deceive another part whereas in constructive fraud thereis a lac- of intent to deceive or defraud. Constructive fraud is highl negligentperformance.

5-6 an CPA firms willingl settle lawsuits out of court in an attempt to minimi$e

legal costs and avoid adverse publicit. This has a negative effect on theprofession when a CPA firm agrees to settlements even though it believes thatthe firm is not liable to the plaintiffs. This encourages others to sue CPA firmswhere the probabl would not to such an e#tent if the firms had the reputation ofcontesting the litigation. Therefore% outofcourt settlements encourage morelawsuits and% in essence% increase the auditor!s liabilit because man firms willpa even though the do not believe the are liable.

5-7 An auditor!s best defense for failure to detect a fraud is an audit properlconducted in accordance with auditing standards. SAS 33 4A5 "1*6 states thatthe auditor should assess the ris- of material misstatements of the financial

statements due to fraud. /ased on this assessment% the auditor should designthe audit to provide reasonable assuranceof detecting material misstatementsdue to fraud. SAS 33 also states that because of the nature of fraud 4includingdefalcations6% a properl designed and e#ecuted audit ma not detect a materialmisstatement due to fraud.

5-8 Contributor negligence used in legal liabilit of auditors is a defense usedb the auditor when he or she claims the client or user also had a responsibilit inthe legal case. An e#ample is the claim b the auditor that management -new ofthe potential for fraud because of deficiencies in internal control% but refused tocorrect them. The auditor thereb claims that the client contributed to the fraud

b not correcting material wea-nesses in internal control.

5- An engagement letter from the auditor to the client specifies theresponsibilities of both parties and states such matters as fee arrangements anddeadlines for completion. The auditor ma also use this as an opportunit to informthe client that the responsibilit for the prevention of fraud is that of the client. A wellwritten engagement letter can be useful evidence in the case of a lawsuit% giventhat the letter spells out the terms of the engagement agreed to b both parties.0ithout an engagement letter% the terms of the engagement are easil disputed.

5-1! (iabilit to clients under common law has remained relativel unchanged

for man ears. 7f a CPA firm breaches an implied or e#pressed contract with aclient% there is a legal responsibilit to pa damages. Traditionall the distinctionbetween privit of contract with clients and lac- of privit of contract with thirdparties was essential in common law. The lac- of privit of contract with thirdparties meant that third parties would have no rights with respect to auditorse#cept in the case of gross negligence.

That precedent was established b the 5ltramares case. 7n recent earssome courts have interpreted 5ltramares more broadl to allow recover b third

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parties if those third parties were -nown and recogni$ed to be reling upon thewor- of the professional at the time the professional performed the services4foreseen users6. Still others have re)ected the 5ltramares doctrine entirel andhave held the CPA liable to anone who relies on the CPA8s wor-% if that wor- is

performed negligentl. The liabilit to third parties under common law continuesin a state of uncertaint. 7n some )urisdictions the precedence of 5ltramares isstill recogni$ed whereas in others there is no significant distinction betweenliabilit to third parties and to clients for negligence.

5-11 7n recent ears the auditor!s liabilit to a third part has become affectedb whether the part is -nown or un-nown. ow a -nown third part% undercommon law% usuall has the same rights as the part that is priv to thecontract. An un-nown third part usuall has fewer rights. The approach followedin most states is the Restatement of Torts approach to the foreseen usersconcept. 5nder the Restatement of Torts approach% foreseen users must be

members of a reasonabl limited and identifiable group of users that have reliedon the CPA8s wor-% even though those persons were not specificall -nown tothe CPA at the time the wor- was done.

5-12 The differences between the auditor!s liabilit under the securities acts of13"" and 13"& are because the 13"" act imposes a heavier burden on theauditor. Third part rights as presented in the 13"" act are:

1. An third part who purchases securities described in the registrationstatement ma sue the auditor.

2. Third part users do not have the burden of proof that the relied on

the financial statements or that the auditor was negligent orfraudulent in doing the audit. The must onl prove that thefinancial statements were misleading or not fairl stated.

7n con)unction with these third part rights% the auditor has a greaterburden in that he or she must demonstrate that:

1. The statements are not materiall misstated.2. An ade,uate audit was conducted.". The user did not incur the loss because of misleading financial

statements.

The liabilit of auditors under the 13"& act is not as harsh as under the 13""act. 7n this instance% the burden of proof is on third parties to show that the relied onthe statements and that the misleading statements were the cause of the loss.

The principal focus of accountants8 liabilit under the 13"& act is on 9ule1b'. 5nder 9ule 1b'% accountants generallycan onl be held liable if theintentionall or rec-lessl misrepresent information intended for thirdpart use.an lawsuits involving accountants8 liabilit under 9ule 1b' have resulted in

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accountants being liable when the -new all of the relevant facts% but merelmade poor )udgments. 7n recent ears% however% courts have decided that poor

)udgment doesn8t necessaril prove fraud on the part of the accountant.

5-13 The auditor!s legal liability to the clientcan result from the auditor!s failureto properl fulfill his or her contract for services. The lawsuit can be for breach ofcontract% which is a claim that the contract was not performed in the manneragreed upon% or it can be a tort action for negligence. An e#ample would be theclient!s detection of a misstatement in the financial statements% which would havebeen discovered if the auditor had performed all audit procedures re,uired in thecircumstances 4e.g.% misstatement of inventor resulting from an inaccuratephsical inventor not properl observed b the auditor6.

The auditor!s liability to third parties under common lawresults from anloss incurred b the claimant due to reliance upon misleading financial statements.

An e#ample would be a ban- that has loans outstanding to an audited compan.

7f the audit report did not disclose that the compan had contingent liabilities thatsubse,uentl became real liabilities and forced the compan into ban-ruptc% theban- could proceed with legal action against the auditors for the material omission.

Civil liability under the Securities Act of 1933provides the right of thirdparties to sue the auditor for damages if a registration statement or a prospectuscontains an untrue statement of a material fact or omits to state a material factthat results in misleading financial statements. The third part does not have toprove reliance upon the statements or even show his or her loss resulted fromthe misstatement. An e#ample would be stoc- purchased b an investor in whatappears% based upon audited financial statements% to be a sound compan. 7f thefinancial statements are later found to be inaccurate or misleading% and the

investment loses value as a result of a situation e#isting but not disclosed at thedate of the financial statements% the investor could file legal proceedings againstthe auditor for negligence.

Civil liability under the Securities Act of 1934 relates to audited financialstatements issued to the public in annual reports or 1; reports. 9ule 1b' ofthe Act prohibits fraudulent activit b direct sellers of securities. Several federalcourt decisions have e#tended the application of 9ule 1b' to accountants%underwriters and others. An e#ample would be an auditor -nowingl permittingthe issuance of fraudulent financial statements of a publicl held client.

Criminal liabilityof the auditor ma result from federal or state laws if theauditor defrauds another person through -nowingl being involved with false

financial statements. An e#ample of an act that could result in criminal liabilitwould be an auditor!s certifing financial statements that he or she -nowsoverstate income for the ear and the financial position of the compan at theaudit date.

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5-14 The SEC can impose the following sanctions against a CPA firm:

1. Suspend the right to conduct audits of SEC clients.2. Prohibit a firm from accepting an new clients for a period.". 9e,uire a review of the firm!s practice b another CPA firm.&. 9e,uire the firm to participate in continuing education programs.

5-15 Some of the was in which the profession can positivel respond andreduce liabilit in auditing are:

1. Continued research in auditing.2. Standards and rules must be revised to meet the changing needs of

auditing.". The A7CPA can establish re,uirements that the better practitioners

alwas follow in an effort to increase the overall ,ualit of auditing.&. Establish new peer review re,uirements.'. CPA firms should oppose all unfounded lawsuits rather than settling

out of court.*. 5sers of financial statements need to be better educated regarding the

attest function.+. 7mproper conduct and performance b members must be sanctioned.

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defense is unli-el to be successful in most )urisdictions toda. Thesecond defense which =ost is more li-el to be successful with isthat the firm followed auditing standards in the audit of inventor%including the emploment of due care. ?rdinaril it is unreasonable

to e#pect a CPA firm to find such an unusual problem in the courseof an ordinar audit. /ecause the CPA firm did not uncover thefraud does not mean it has responsibilit for it.

c. She is li-el to be successful in her defense against the client because ofthe contributor negligence. The compan has responsibilit forinstituting ade,uate internal controls. The president!s statement thatit was impractical to count all inventor on the same da because ofpersonnel shortages and customer preferences puts considerableburden on the compan for its own loss.

7t is also unli-el that >irst Cit ational /an- will besuccessful in a suit. The court is li-el to conclude that =ost followed

due care in the performance of her wor-. The fact that there wasnot a count of all inventor on the same date is unli-el to besufficient for a successful suit. The success of =ost!s defenses isalso heavil dependent upon the )urisdiction!s attitude about privitof contract. 7n this case there is unli-el to be a claim of e#tremenegligence. Therefore it would be re,uired for the court to bothignore the privit of contract precedence and find =ost negligent forthe suit to be successful.

d. The issues and outcomes should be essentiall the same under thesuit brought under the Securities E#change Act of 13"&. 7f the suitwere brought under 9ule 1b'% it is certainl unli-el that the

plaintiff would be successful% inasmuch as there was no intent todeceive. The plaintiff would li-el be unsuccessful in such a suit.

5-1 =es. ormall a CPA firm will not be liable to third parties with whom it hasneither dealt nor for whose benefit its wor- was performed. ?ne notablee#ception to this rule is fraud. 0hen the financial statements were fraudulentlprepared% liabilit runs to all third parties who relied upon the false informationcontained in them. >raud can be either actual or constructive. @ere% there was noactual fraud on the part of Small or the firm in that there was no deliberatefalsehood made with the re,uisite intent to deceive. @owever% it would appearthat constructive fraud might be present. Constructive fraud is found where the

auditor!s performance is found to be grossl negligent. That is% the auditor reallhad either no basis or so flims a basis for his or her opinion that he or she hasmanifested a rec-less disregard for the truth. Small!s disregard for standardauditing procedures would seem to indicate such gross negligence and%therefore% the firm is liable to third parties who relied on the financial statementsand suffered a loss as a result.

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5-2! The answers provided in this section are based on the assumption that thetraditional legal relationship e#ists between the CPA firm and the third part user.That is% there is no privit of contract% the -nown versus un-nown third part useris not a significant issue% and high levels of negligence are re,uired before thereis liabilit.

a. >alse. There was no privit of contract between artinson and 0attsand 0illiams% therefore% ordinar negligence will usuall not besufficient for a recover.

b. True. 7f gross negligence is proven% the CPA firm can and probabl willbe held liable for losses to third parties.

c. True. See a.d. >alse. ross negligence 4constructive fraud6 is treated as actual fraud

in determining who ma recover from the CPA.e. >alse. artinson is an un-nown third part and will probabl be able to

recover damages onl in the case of gross negligence or fraud.

Assuming a liberal interpretation of the legal relationship between auditorsand third parties% the answers to a. and e. would probabl both be true. The otheranswers would remain the same.

5-21 a. @anover will li-el not be found liable to the purchasers of thecommon stoc- if the suit is brought under 9ule 1b' of theSecurities E#change Act of 13"& because there was no -nowledgeor intent to deceive b the auditor. @owever% if the purchasers areoriginal purchasers and are able to bring suit under the Securities

Act of 13""% the plaintiffs will li-el succeed because the must onlprove the e#istence of a material error or omission.

b. @anover was aware that the financial statements were to be usedto obtain financing from >irst ational /an-. @anover is li-el to beheld responsible for negligence to the ban- as a -nown third partthat relied on the financial statements.

5-22 a. The legal issues involved in this case revolve around the auditor!scompliance with auditing standards and contributor negligence.

Auditing standards re,uire that accounts receivable be confirmedb the auditor in most circumstances. This procedure wasemploed in the case% and the legal issue is whether or not theauditor used due care in following up on the confirmation replies

received.As a defense in the lawsuit% the auditor would claim to have

followed auditing standards b properl confirming accountsreceivable. 7n addition% the auditor ma defend him or herself btestifing that the compan controller was responsible for investigatingthe reason for the differences reported on the confirmation replies.The auditor ma state that he or she had a right to conclude that

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the controller had reviewed the e#planations provided b theboo--eeper% and concluded the were correct. The auditor mightalso use the defense that there was contributor negligence. Thecontroller should not have delegated the wor- to the boo--eeper

and should have recogni$ed the potential for intentional wrongdoingb the boo--eeper.

b. The CPA!s deficienc in conducting the audit of accounts receivable washis or her failure to investigate and obtain evidence to substantiatethe e#planations provided b the boo--eeper. The auditor shouldhave investigated each of the timing differences% through which he orshe ma have discovered that no sales allowance had been granted tothe customer% but in fact% the customer had mailed pament for themerchandise which the boo--eeper had stolen.

5-23 a. =es. Smith was a part to the issuance of false financial

statements. The elements necessar to establish an action forcommon law fraud are present. There was a material misstatement offact% -nowledge of falsit 4scienter6% intent that the plaintiff ban- rel onthe false statement% actual reliance% and damage to the ban- as aresult thereof. 7f the action is based upon fraud there is no re,uirementthat the ban- establish privit of contract with the CPA. oreover% ifthe action b the ban- is based upon ordinar negligence% which doesnot re,uire a showing of scienter% the ban- ma recover as a thirdpart beneficiar because it is a primar beneficiar. Thus% the ban-will be able to recover its loss from Smith under either theor.

b. o. The lessor was a part to the secret agreement. As such% the lessorcannot claim reliance on the financial statements and cannot recover

uncollected rents. Even if the lessor was damaged indirectl% his or herown fraudulent actions led to the loss% and the e,uitable principle ofBunclean handsB precludes the lessor from obtaining relief.

c. =es. Smith had -nowledge that the financial statements did not followgenerall accepted accounting principles and willingl prepared anun,ualified opinion. That is a criminal act because there was an intentto deceive.

5-24 0ard East!s strongest defense would be that the e#ercised due care inperforming the audit and that the adhered to auditing standards. The fact thatDasper Co. later found fraud should not significantl affect the case in as much as

the were specificall engaged to determine the e#istence of fraud% not to do anordinar audit.0ard East are li-el to have to demonstrate that the audit was ade,uatel

planned and sufficient appropriate evidence was accumulated and properlevaluated. >or e#ample% the case states that the managers who were defrauding thecompan negotiated lower than normal rents in return for the -ic-bac-s. 7t is possiblethat analtical procedures or other audit tests might have revealed that some rents

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were abnormall low. The auditor ma have to prove that such procedures were notnecessar in the circumstances or would not have uncovered the fraud. Similarl% thedecentrali$ation of lease negotiations ma also be cited b the plaintiff as evidencethat internal control was inade,uate and that additional testing was necessar that

could have uncovered the fraud. 0ard East ma have to prove that theunderstanding of internal control the obtained was ade,uate and the audit evidencethe accumulated was appropriate% given the decentrali$ed lease negotiations.

5-251. c /oth. aterial misstatements must be shown under both acts.2. c /oth. onetar loss must be demonstrated under both acts.". d either. Plaintiff dues not have to prove lac- of diligence under

the 13"" Act% but the accountant can use due diligence as adefense. Scienter must be demonstrated under the 13"& Act.

&. d either. Privit applies to common law and not the 13"" and

13"& acts.'. b 13"& Act onl. 9eliance is not re,uired under the 13""Act.

*. b Scienter is re,uired under the 13"& Act% but not the 13""Act.

5-26 a. The case should be dismissed. A suit under Section 14b6 and 9ule1b' of the Securities E#change Act of 13"& must establish fraud.>raud is an intentional tort and as such re,uires more than ashowing of negligent manner the CPAs neither participated in thefraudulent scheme nor did the -now of its e#istence. The elementof scienter or guilt -nowledge must be present in order to state acause of action for fraud under Section 14b6 of the SecuritiesE#change Act of 13"&.

b. The plaintiffs might have stated a common law action for negligence.@owever% the ma not be able to prevail due to the privitre,uirement. There was no contractual relationship between thedefrauded parties and the CPA firm. Although the e#act status of theprivit rule is unclear% it is doubtful that the simple negligence in thiscase would e#tend ordon roton!s liabilit to the customers whotransacted business with the bro-erage firm. @owever% the facts ofthe case as presented in court would determine this.

Another possible theor which has been attempted recentlin the courts is liabilit under Section 1+ of the Securities E#change

Act of 13"&% which re,uires registered bro-ers to submit auditedfinancial statements to the SEC. 7n one such case% the plaintiffclaimed that the accountant failed to perform a proper audit andthereb created liabilit to the customers of the bro-erage firm whosuffered losses as a result of the financial collapse of the bro-eragefirm.

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5-27 The ban- is li-el to succeed. 9obertson apparentl -new that a)estic wasBtechnicall ban-ruptB at Fecember "1% 2

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b. The customers and shareholders of 0hitlow Compan would attemptto recover on a negligence theor based on itchell oss! failure tocompl with auditing standards. Even if itchell oss werenegligent% 0hitlow Compan!s customers and shareholders must

also establish either that:

1. The were third part beneficiaries of itchell oss! contractto audit 0hitlow Compan% or

2. itchell oss owed the customers and shareholders a legaldut to act without negligence.

Although man cases have e#panded a CPA!s legal responsibilitiesto a third part for negligence% the facts of this case ma fall withinthe traditional rationale limiting a CPA!s liabilit for negligence thatis% the unfairness of imputing an indeterminate amount of liabilit to

un-nown or unforeseen parties as a result of mere negligence onthe auditor!s part. Accordingl% 0hitlow Compan!s customersand shareholders will prevail onl if 416 the courts rule that the areeither thirdpart beneficiaries or are owed a legal dut and 426 theestablish that itchell oss was negligent in failing to complwith auditing standards.

5-28 )*R. 2

a. The basis of Dac-son!s claim will be that she sustained a loss basedupon misleading financial statements. Specificall% she will rel

upon section 114a6 of the Securities Act of 13""% which provides thefollowing:

7n case an part of the registration statement% when suchpart became effective% contained an untrue statementof a material fact or omitted to state a material factre,uirement to be stated therein or necessar to ma-ethe statements therein not misleading% an personac,uiring such securit 4unless it is proved that at thetime of such ac,uisition he -new of such untruth oromission6 ma% either at law or in e,uit% in an court of

competent )urisdiction% sue ever accountant who haswith his consent been named as having prepared orcertified an part of the registration statement.

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To the e#tent that the relativel minor misstatements resultedin the certification of materiall false or misleading financialstatements% there is potential liabilit. Dac-son!s case is based onthe assertion of such an untrue statement or omission coupled with

an allegation of damages. Dac-son does not have to prove relianceon the statements nor the compan!s or auditor!s negligence inorder to recover the damages. The burden is placed on thedefendant to provide defenses that will enable it to avoid liabilit.

b. The first defense that could be asserted is that Dac-son -new of theuntruth or omission in audited financial statements included in theregistration statement. The act provides that the plaintiff ma notrecover if it can be proved that at the time of such ac,uisition she-new of such Buntruth or omission.B

Since Dac-son was a member of the private placement

group and presumabl priv to the tpe of information that would becontained in a registration statement% plus an other informationre,uested b the group% she ma have had sufficient -nowledge ofthe facts claimed to be untrue or omitted. 7f this were the case% thenshe would not be reling on the certified financial statements butupon her own -nowledge.

The ne#t defense available would be that the untruestatement or omission was not material. The SEC has defined theterm as meaning matters about which an average prudent investorought to be reasonabl informed before purchasing the registeredsecurit. >or section 11 purposes% this has been construed as

meaning a fact that% had it been correctl stated or disclosed% wouldhave deterred or tended to deter the average prudent investor frompurchasing the securit in ,uestion.

Allen% Funn% and 9ose would also assert that the loss in,uestion was not due to the false statement or omission this is%that the false statement was not the cause of the price drop. 7twould appear that the general decline in the stoc- mar-et wouldaccount for at least a part of the loss. Additionall% if the decline inearnings was not factuall connected with the false statement oromission% the defendants have another basis for refuting the causalconnection between their wrongdoing and the resultant drop in the

stoc-!s price.>inall% the accountants will claim that their departure from

auditing standards was too minor to be considered a violation of thestandard of due diligence re,uired b the act.

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/nternet )roble( 0olution 0+C +nor#e(ent

5-1 The SEC!s Enforcement Fivision Gwww.sec.govHdivisionsHenforce.shtmlIinvestigates possible violations of securities laws% recommends SEC action whenappropriate% either in a federal court or before an administrative law )udge% andnegotiates settlements. (itigation 9eleases% which are descriptions of SEC civil

and selected criminal suits in the federal court proceedings% are posted on theSEC8s 0eb site.

>ind (itigation 9elease o. 1

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