Chapter 4

Legal Environment Affecting Audits

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.

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

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

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

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

Near Privity

Near privity – Three part test1. 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

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.

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

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

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

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

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

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

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

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

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

Relevant Fraud Cases

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

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

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.

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)

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

Criminal Actions

Fraud Fraud under the SEC Acts of 1933

and 1934 Obstruction of Justice Sarbanes – Oxley Act, misleading an

auditor

Appendix A – United States Court Systems

Federal and State courts Stare Decisis Subject matter Jurisdiction PSLRA 1995, SLUSA 1998

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