Chapter 5 Legal Liability
Review Questions
Several factors that have affected the increased number of lawsuits against CPAs are: 5-1
1. The growing growing awareness awareness of the responsibi responsibilitie lities s of public public accountant accountants s on the part of users of financial statements. 2. An increas increased ed conscio consciousn usness ess on the part of the SEC regard regarding ing its responsibilit for protecting investors! interests. ". The greater greater comple#it comple#ities ies of auditin auditing g and accountin accounting g due to the the increasing si$e of businesses% the globali$ation of business% and the intricacies of business operations. &. Societ! Societ!s s increasi increasing ng acceptan acceptance ce of lawsuits. lawsuits. '. (arge (arge civil civil court court )udgme )udgments nts against against CPA firm firms% s% which which have have encouraged attornes to provide legal services on a contingent fee basis. *. The willingn willingness ess of man CPA firms firms to settle settle their legal legal problems problems out of court. +. The difficu difficult lt courts courts have in understa understandin nding g and interpre interpretin ting g technical technical accounting and auditing matters. The most important positive effects are the increased ,ualit control b CPA 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 are the energ re,uired to defend groundless cases and the harmful impact on the public!s image of the profession. (egal liabilit ma also increase the cost of audits to societ% b causing CPA firms to increase the evidence accumulated. 5-2
/usiness failure is the ris- that a business will fail financiall and% as a result% will be unable to pa its financial obligations. Audit Audit ris- is the ris- that the auditor will conclude that the financial statements are fairl stated and an un,ualified opinion can therefore be issued when% in fact% the are materiall misstated. 0hen there has been a business failure% but not an audit failure% it is common for statement users to claim there was an audit failure% even if the most recentl issued audited financial statements were fairl stated. an auditors evaluate the potential for business failure in an engagement in determining the appropriate audit ris-. 5-3
The prudent person concept states that a person is responsible for conducting a )ob in good faith and with integrit% but is not infallible. Therefore% the auditor auditor is e#pected e#pected to conduct conduct an audit using using due care% but does not claim to be a guarantor or insurer of financial statements. statements. 5-4
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The difference between fraud and constructive fraud is that in fraud the wrongdoer intends to deceive another part whereas in constructive fraud there is a lac- of intent to deceive or defraud. Constructive fraud is highl negligent performance. 5-5
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 the profession when a CPA firm agrees to settlements even though it believes that the firm is not liable to the plaintiffs. This encourages others to sue CPA firms where the probabl would not to such an e#tent if the firms had the reputation of contesting the litigation. Therefore% outofcourt settlements encourage more lawsuits and% in essence% increase the auditor!s liabilit because man firms will pa even though the do not believe the are liable. 5-6
An auditor!s best defense for failure to detect a fraud is an audit properl conducted in accordance with auditing standards. The Principles in auditing standards 3see Chapter 24 note that the ob)ective of an audit is to obtain reasonable assurance that the financial statements are free of material misstatement% whether due to fraud or error. Thus% auditors design audit procedures to provide reasonable assurance that material misstatements due to fraud are detected. 5owever% because reasonable assurance is not absolute assurance% a properl designed and e#ecuted audit ma not detect a material misstatement due to fraud. 5-7
Contributor negligence used in legal liabilit of auditors is a defense used b the auditor when he or she claims the client or user also had a responsibilit in the legal case. An e#ample is the claim b the auditor that management -new of the potential for fraud because of deficiencies in internal control% but refused to correct them. The auditor thereb claims that the client contributed to the fraud b not correcting material wea-nesses in internal control. 5-8
An engagement letter from the auditor to the client specifies the responsibilities of both parties and states such matters as fee arrangements and deadlines for completion. The auditor ma also use this as an opportunit to inform the 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% given that 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-
(iabilit to clients under common law has remained relativel unchanged for man ears. 6f a CPA firm breaches an implied or e#pressed contract with a client% there is a legal responsibilit to pa damages. Traditionall the distinction between privit of contract with clients and lac- of privit of contract with third parties was essential in common law. The lac- of privit of contract with third parties meant that third parties would have no rights with respect to auditors e#cept in the case of gross negligence. 5-1!
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%$That precedent was established b the Ultramares case. 6n recent ears some courts have interpreted Ultramares more broadl to allow recover b third parties if those third parties were -nown and recogni$ed to be reling upon the wor- of the professional at the time the professional performed the services 3foreseen users4. Still others have re)ected the Ultramares doctrine entirel and have held the CPA liable to anone who relies on the CPA!s wor-% if that wor- is performed negligentl. The liabilit to third parties under common law continues in a state of uncertaint. 6n some )urisdictions% the precedence of Ultramares is still recogni$ed% whereas in others there is no significant distinction between liabilit to third parties and to clients for negligence. 6n recent ears% the auditor!s liabilit to a third part has become affected b whether the part is -nown or un-nown. ow a -nown third part% under common law% usuall has the same rights as the part that is priv to the contract. An un-nown third part usuall has fewer rights. The approach followed in most states is the Restatement of Torts approach to the foreseen users concept. 7nder the Restatement of Torts approach% foreseen users must be members of a reasonabl limited and identifiable group of users that have relied on the CPA!s wor-% even though those persons were not specificall -nown to the CPA at the time the wor- was done. 5-11
The differences between the auditor!s liabilit under the securities acts of 18"" and 18"& are because the 18"" act imposes a heavier burden on the auditor. Third part rights as presented in the 18"" act are: 5-12
1. An third part who purchases securities described in the registration statement 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 or fraudulent in doing the audit. The must onl prove that the financial statements were misleading or not fairl stated. 6n con)unction with these thirdpart rights% the auditor has a greater burden in that he or she must demonstrate that: 1. The statements were 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 18"& act is not as harsh as under the 18"" act. 6n this instance% the burden of proof is on third parties to show that the relied on the statements and that the misleading statements were the cause of the loss. The principal focus of accountants! liabilit under the 18"& act is on 9ule 1b'. 7nder 9ule 1b'% accountants generally can onl be held liable if the intentionall or rec-lessl misrepresent information intended for thirdpart use. '"
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%$an lawsuits involving accountants! liabilit under 9ule 1b' have resulted in accountants being liable when the -new all of the relevant facts% but merel made poor )udgments. 6n recent ears% however% courts have decided that poor )udgment doesn!t necessaril prove fraud on the part of the accountant. The auditor!s legal liability to the client can result from the auditor!s failure to properl fulfill his or her contract for services. The lawsuit can be for breach of contract% which is a claim that the contract was not performed in the manner agreed upon% or it can be a tort action for negligence. An e#ample would be the client!s detection of a misstatement in the financial statements% which would have been discovered if the auditor had performed all audit procedures re,uired in the circumstances 3e.g.% misstatement of inventor resulting from an inaccurate phsical inventor not properl observed b the auditor4. The auditor!s liability to third parties under common law results from an loss 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. 6f the audit report did not disclose that the compan had contingent liabilities that subse,uentl became real liabilities and forced the compan into ban-ruptc% the ban- could proceed with legal action against the auditors for the material omission. Civil liability under the Securities Act of 1933 provides the right of third parties to sue the auditor for damages if a registration statement or a prospectus contains an untrue statement of a material fact or omits to state a material fact that results in misleading financial statements. The third part does not have to prove reliance upon the statements or even show his or her loss resulted from the misstatement. An e#ample would be stoc- purchased b an investor in what appears% based upon audited financial statements% to be a sound compan. 6f the financial 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 the date of the financial statements% the investor could file legal proceedings against the auditor for negligence. Civil liability under the Securities Act of 193 relates to audited financial statements issued to the public in annual reports or 1; reports. 9ule 1b' of the act prohibits fraudulent activit b direct sellers of securities. Several federal court decisions have e#tended the application of 9ule 1b' to accountants% underwriters% and others. An e#ample would be an auditor -nowingl permitting the issuance of fraudulent financial statements of a publicl held client. Criminal liability of the auditor ma result from federal or state laws if the auditor defrauds another person through -nowingl being involved with false financial statements. An e#ample of an act that could result in criminal liabilit would be an auditor!s certifing financial statements that he or she -nows overstate income for the ear and the financial position of the compan at the audit date. 5-13
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The SEC can impose the following sanctions against a CPA firm: 1. 2. ". &.
Suspend the right to conduct audits of SEC clients. 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.
Some of the was in which the profession can positivel respond and reduce liabilit in auditing are: 5-15
1. Continued research in auditing. 2. Standards and rules must be revised to meet the changing needs of auditing. ". The A6CPA 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. *. 7sers of financial statements need to be better educated regarding the attest function. +. 6mproper conduct and performance b members must be sanctioned. <. (obb for changes in state and federal laws concerning accountants! liabilit.
&ultiple Choi#e Questions 'ro( C)* +,a(inations
5-16
a.
324
b.
314
c.
3&4
5-17
a.
3"4
b.
3&4
c.
324
d.
324
is#ussion Questions an$ )roble(s
5-18
1.
7nder common law% CPAs do not have the right to withhold information from the courts on the grounds that the information is privileged. Confidential discussions between the client and the auditor cannot be withheld from the courts. Some states do have statutes that permit privileged communication between the client and auditor= however% the privilege would not e#tend to federal courts. Thus% 0eaver and >ones will most li-el need to provide the documentation re,uested b the subpoena. 2. Spencer Cullen will most li-el be liable for gross negligence for failure to obtain sufficient appropriate evidence to e#amine the valuation of securities. Accepting the client!s valuation without corroborating evidence will most li-el be viewed as displaing a lac- of even slight care or as rec-less behavior.
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%$". The plaintiff will most li-el not be able to see- restitution from /rogan!s personal assets given the firm operates as a limited liabilit partnership 3((P4% /rogan was not involved in the engagement in ,uestion% and she did not rel on the wor- of the other partner. &. 5oc-ada!s primar defense tactic should demonstrate that there was no negligence on his part and that there was no intent on his part to deceive. ?iven he is confident that he full complied with auditing standards% he should be able to demonstrate a lac- of rec-lessness. '. ;oda-!s ban-ruptc is an e#ample of a business failure that does not necessaril impl the presence of audit failure. Audit failure occurs when the auditor issues an incorrect audit opinion because it failed to compl with the re,uirements of auditing standards. There is no indication that the ;oda- financial statements are materiall misstated. Thus% there is no evidence of audit failure% despite the compan!s subse,uent ban-ruptc. 5-1
1. 2. ". &. '. *. +. <.
5-2!
a.
c i d h a b e ) g f
3fraud4 3gross negligence4 3ordinar negligence4 3privit of contract4 3due diligence4 3reliance on the financial statements4 3material error or omission4 3separate and proportionate4 3foreseen users4 3intent to deceive4 3contributor negligence4
@ost and Co. should use the defenses of meeting auditing standards and contributor negligence. The fraud perpetuated b Stuart Suppl Compan was a reasonabl comple# one and difficult to uncover e#cept b the procedures suggested b @ost. 6n most circumstances it would not be necessar to phsicall count all inventor at different locations on the same da. urthermore% the president of the compan contributed to the failure of finding the fraud b refusing to follow @ost!s suggestion. There is evidence of that through his signed statement. b. There are two defenses @ost and Compan should use in a suit b irst Cit ational /an-. irst% there is a lac- of privit of contract. Even though the ban- was a -nown third part% it does not necessaril mean that there is an dut to that part in this situation. That defense is unli-el to be successful in most )urisdictions toda. The second defense which @ost is more li-el to be successful with is that the firm followed auditing standards in the audit of
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%$inventor% including the emploment of due care. Brdinaril it is unreasonable to e#pect a CPA firm to find such an unusual problem in the course of an ordinar audit. /ecause the CPA firm did not uncover the fraud does not mean it has responsibilit for it. c. She is li-el to be successful in her defense against the client because of the contributor negligence. The compan has responsibilit for instituting ade,uate internal controls. The president!s statement that it was impractical to count all inventor on the same da because of personnel shortages and customer preferences puts considerable burden on the compan for its own loss. 6t is also unli-el that irst Cit ational /an- will be successful 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 was not a count of all inventor on the same date is unli-el to be sufficient for a successful suit. The success of @ost!s defenses is also heavil dependent upon the )urisdiction!s attitude about privit of contract. 6n this case% there is unli-el to be a claim of e#treme negligence. Therefore% it would be re,uired for the court to both ignore the privit of contract precedence and find @ost negligent for the suit to be successful. d. The issues and outcomes should be essentiall the same under the suit brought under the Securities E#change Act of 18"&. 6f the suit were brought under 9ule 1b'% it is certainl unli-el that the plaintiff would be successful% inasmuch as there was no intent to deceive. The plaintiff would li-el be unsuccessful in such a suit. @es. ormall a CPA firm will not be liable to third parties with whom it has neither dealt nor for whose benefit its wor- was performed. Bne notable e#ception to this rule is fraud. 0hen the financial statements were fraudulentl prepared% liabilit runs to all third parties who relied upon the false information contained in them. raud can be either actual or constructive. 5ere% there was no actual fraud on the part of Small or the firm in that there was no deliberate falsehood made with the re,uisite intent to deceive. 5owever% it would appear that constructive fraud might be present. Constructive fraud is found where the auditor!s performance is found to be grossl negligent. That is% the auditor reall had either no basis or so flims a basis for his or her opinion that he or she has manifested a rec-less disregard for the truth. Small!s disregard for standard auditing procedures would seem to indicate such gross negligence and% therefore% the firm is liable to third parties who relied on the financial statements and suffered a loss as a result. 5-21
'+
The answers provided in this section are based on the assumption that the traditional legal relationship e#ists between the CPA firm and the thirdpart user. That is% there is no privit of contract% the -nown versus un-nown third part user is not a significant issue% and high levels of negligence are re,uired before there is liabilit. 5-22
a. alse. There was no privit of contract between Thompson and ole and >ensen% therefore% ordinar negligence will usuall not be sufficient for a recover. b. True. 6f gross negligence is proven% the CPA firm can and probabl will be held liable for losses to third parties. c. True. See a. d. alse. ?ross negligence 3constructive fraud4 is treated as actual fraud in determining who ma recover from the CPA. e. alse. Thompson 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 auditors and third parties% the answers to a. and e. would probabl both be true. The other answers would remain the same. 5-23
a.
5anover will li-el not be found liable to the purchasers of the common stoc- if the suit is brought under 9ule 1b' of the Securities E#change Act of 18"& because there was no -nowledge or intent to deceive b the auditor. 5owever% if the purchasers are original purchasers and are able to bring suit under the Securities Act of 18""% the plaintiffs will li-el succeed because the must onl prove the e#istence of a material error or omission. b. 5anover was aware that the financial statements were to be used to obtain financing from irst ational /an-. 5anover is li-el to be held responsible for negligence to the ban- as a -nown third part that relied on the financial statements. c. The plaintiffs might state a common law action for negligence. 5owever% the will most li-el not prevail due to the privit re,uirement. There was no contractual relationship between the defrauded parties and the CPA firm. Although the e#act status of the privit rule is unclear% it is doubtful that the simple negligence in this case would e#tend 5anover!s liabilit to the trade creditors who transacted business with /arton Corp. 5owever% the facts of the case as presented in court would determine this.
5-24
a.
@es. Chen was a part to the issuance of false financial statements. The elements necessar to establish an action for common law fraud are present. There was a material misstatement of fact% -nowledge of falsit 3scienter4% intent that the plaintiff ban- rel on
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the false statement% actual reliance% and damage to the ban- as a
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5-24 "#ontinue
%$result thereof. 6f the action is based upon fraud% there is no re,uirement that the ban- establish privit of contract with the CPA. oreover% if the action b the ban- is based upon ordinar negligence% which does not 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 lessor cannot claim reliance on the financial statements and cannot recover uncollected rents. Even if the lessor was damaged indirectl% his or her own fraudulent actions led to the loss% and the e,uitable principle of Dunclean hands precludes the lessor from obtaining relief. c. @es. Chen had -nowledge that the financial statements did not follow generall accepted accounting principles and he willingl prepared an un,ualified opinion. That is a criminal act because there was an intent to deceive. 5-25
1.
c
2. ".
c d
&.
d
'. *.
b b
/oth. aterial misstatements must be shown under both acts. /oth. onetar loss must be demonstrated under both acts. either. Plaintiff does not have to prove lac- of diligence under the 18"" act% but the accountant can use due diligence as a defense. Scienter must be demonstrated under the 18"& act. either. Privit applies to common law and not the 18"" and 18"& acts. 18"& act onl. 9eliance is not re,uired under the 18"" act. Scienter is re,uired under the 18"& act% but not the 18"" act.
The ban- is li-el to succeed. 9obertson apparentl -new that a)estic was Dtechnicall ban-rupt at ecember "1% 212. 9eporting standards re,uire the auditor to add an e#planator paragraph to the audit report when there is substantial doubt about an entit!s abilit to continue as a going concern. She did not include such a paragraph. To ma-e matters worse% it appears that 9obertson was convinced not to issue the report with the goingconcern paragraph because of the negative impact on a)estic Co.% not because of the solvenc of the compan. That ma be interpreted as a lac- of independence b 9obertson and ma indicate a fraudulent act% potentiall a criminal charge that could result in a prison term. 5-26
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%$9obertson!s most li-el defense is that after determining all of the facts% in part through discussion with management% she concluded that the a)estic Co. was not technicall ban-rupt and did not re,uire an e#planator paragraph in the audit report. She might also argue that even if such a report was appropriate% her failure to do so was negligence or bad )udgment% not with the intent to deceive the ban-. Such a defense does not seem to be strong given the statement about her -nowledge of a)estic!s financial condition. 9obertson might also falsel testif that she did not believe that a goingconcern problem e#isted. Such statements would be per)ur and are unprofessional and not worth of a professional accountant. Per)ur is also a criminal act and could result in further actions b the courts.
Case
5-27
)*R. 1
a. 6n order for Tha#ton to hold itchell F oss liable for his losses under the Securities E#change Act of 18"&% he must rel upon the antifraud provisions of Section 13b4 of the act. 6n order to prevail% Tha#ton must establish that: 1. There was an omission or misstatement of a material fact in the financial statements used in connection with his purchase of the 0hitlow F Compan shares of stoc-. 2. 5e sustained a loss as a result of his purchase of the shares of stoc-. ". 5is loss was caused b reliance on the misleading financial statements. &. itchell F oss acted with scienter 3-nowledge of the misstatement4. /ased on the stated facts% Tha#ton can probabl prove the first three re,uirements cited above. To prove the fourth re,uirement% Tha#ton must show that itchell F oss had -nowledge of the fraud or rec-lessl disregarded the truth. The facts clearl indicate that itchell F oss did not have -nowledge of the fraud and did not rec-lessl disregard the truth. b. The customers and shareholders of 0hitlow F Compan would attempt to recover on a negligence theor based on itchell F oss! failure to compl with auditing standards. Even if itchell F oss were negligent% 0hitlow F Compan!s customers and shareholders must also establish either that:
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5-27 )*R. 1 "#ontinue
%$1. The were thirdpart beneficiaries of itchell F oss! contract to audit 0hitlow F Compan% or 2. itchell F oss owed the customers and shareholders a legal dut to act without negligence. Although man cases have e#panded a CPA!s legal responsibilities to a third part for negligence% the facts of this case ma fall within the traditional rationale limiting a CPA!s liabilit for negligence= that is% the unfairness of imputing an indeterminate amount of liabilit to un-nown or unforeseen parties as a result of mere negligence on the auditor!s part. Accordingl% 0hitlow F Compan!s customers and shareholders will prevail onl if 314 the courts rule that the are either thirdpart beneficiaries or are owed a legal dut and 324 the establish that itchell F oss was negligent in failing to compl with auditing standards. 5-27 )*R. 2
a. The basis of >ac-son!s claim will be that she sustained a loss based upon misleading financial statements. Spe cificall% she will rel upon section 113a4 of the Securities Act of 18""% which provides the following: 6n case an part of the registration statement% when such part became effective% contained an untrue statement of a material fact or omitted to state a material fact re,uirement to be stated therein or necessar to ma-e the statements therein not misleading% an person ac,uiring such securit 3unless it is proved that at the time of such ac,uisition he -new of such untruth or omission4 ma% either at law or in e,uit% in an court of competent )urisdiction% sue ever accountant who has with his consent been named as having prepared or certified an part of the registration statement. To the e#tent that the relativel minor misstatements resulted in the certification of materiall false or misleading financial statements% there is potential liabilit. >ac-son!s case is based on the assertion of such an untrue statement or omission coupled with an allegation of damages. >ac-son does not have to prove reliance on the statements nor the compan!s or auditor!s negligence in order to recover the damages. The burden is placed on the defendant to provide defenses that will enable it to avoid liabilit. '12
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5-27 )*R. 2 "#ontinue
%$b. The first defense that could be asserted is that >ac-son -new of the untruth or omission in audited financial statements included in the registration statement. The act provides that the plaintiff ma not recover if it can be proved that at the time of such ac,uisition she -new of such Duntruth or omission. Since >ac-son was a member of the private placement group and presumabl priv to the tpe of information that would be contained in a registration statement% plus an other information re,uested b the group% she ma have had sufficient -nowledge of the facts claimed to be untrue or omitted. 6f this were the case% then she would not be reling on the certified financial statements but upon her own -nowledge. The ne#t defense available would be that the untrue statement or omission was not material. The SEC has defined the term as meaning matters about which an average prudent investor ought to be reasonabl informed before purchasing the registered securit. or section 11 purposes% this has been construed as meaning a fact that% had it been correctl stated or disclosed% would have deterred or tended to deter the average prudent investor from purchasing the securit in ,uestion. Allen% unn% and 9ose would also assert that the loss in ,uestion was not due to the false statement or omission= that is% that the false statement was not the cause of the price drop. 6t would appear that the general decline in the stoc- mar-et would account for at least a part of the loss. Additionall% if the decline in earnings was not factuall connected with the false statement or omission% the defendants have another basis for refuting the causal connection 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 the standard of due diligence re,uired b the act.
Resear#h )roble( 5-1/ 0+C +nor#e(ent
a. The complaint alleges that between 2+ and 28% (evin and Preve operated one of the largestever Pon$i schemes in South lorida. (evin and Preve raised more than G1'+ million from 1+" investors b issuing promissor notes from (evin!s compan and interests in a private investment fund the operated. The used the investor funds to purchase discounted legal settlements from a
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Resear#h )roble( 5-1 "#ontinue
%$law firm that ultimatel were not real% as no plaintiffs or defendants e#isted. 6nstead% the law firm used the funds in a classic Pon$i scheme fashion to ma-e paments due to other investors and support lavish lifestles. The Pon$i scheme collapsed in Bctober 28. b.
(evin and Preve were charged with violating of Sections '3a4% '3c4% and 1+3a4 of the Securities Act of 18""% and Section 13b4 of the Securities E#change Act of 18"& and 9ule 1b'.
3ote: 9esearch problems address current issues% using 6nternet sources. /ecause 6nternet sites are sub)ect to change% 9esearch problems and solutions ma change. An revisions to 9esearch problems will be posted on the boo-!s 0eb sit e at www.pearsonhighered.comHarens .4
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