RESUME CHAPTER 5 & 6 BUKU ARENS
Disusun Oleh : ARGAPATI LIA MAYANGSARI SYARIFAH NURWULAN CARLOS
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D3 AKUNTANSI B FAKULTAS EKONOMI UNIVERSITAS NEGERI JAKARTA
CHAPTER 5
LEGAL LIABILITY This chapter on legal liability and the preceding one on professional ethics highlight the environment in which CPAs operate. These chapters provide an overview of the importance of protecting the profession’s reputation of high ethical standards, highlight consequences accountants face when others believe they have failed to live up to those standards, and show how CPAs can be held legally liable for the professional services they provide. In this chapter we focus on legal liabili ty for CPAs both on a conceptual level and in terms of specific legal suits that have been filed against CPAs. We also discuss actions available to the profession and individual practitioners to minimize liability while, at the same time, maintaining high ethical and professional standards and meeting the needs of society.
CHANGED LEGAL ENVIRONMENT Professionals have always been required to provide a reasonable level of care while performing work for those they serve. Under common law, audit professionals have a responsibility to fulfill implied or expressed contracts with clients. Should auditors fail to provide the services or not exercise due care in their performance, they are liable to their clients for negligence and/or breach of contract, and, in certain circumstances, to parties other than their clients. Although the criteria for legal actions against auditors by third parties vary by state, the auditor generally owes a duty of care to third parties who are part of a limited group of persons whose reliance is “foreseen” by the auditor. In addition to common law liability, auditors may be heldliable to third parties under statutory law. In rare cases, auditors have even been held liable for criminal acts. A criminal conviction against an auditor can result when plaintiffs demonstrate that the auditor intended to deceive or harm others. Despite efforts by the profession to address legal liability of CPAs, both the number of lawsuits and sizes of awards to plaintiffs remain high, including suits involving third parties under both common law and the federal securities acts. No simple reasons explain this trend, but the following factors are major contributors: 1. Growing awareness of the responsibilities of public accountants by users of financial statements 2. An increased consciousness on the part of the Securities and Exchange Commission (SEC) for its responsibility for protecting investors’ interests 3. The complexity of auditing and accounting functions caused by the increasing size of businesses, the globalization of business, and the complexities of business operations 4. The tendency of society to accept lawsuits by injured parties against anyone who might be able to provide compensation, regardless of who was at fault, coupled with the joint and several liability doctrine (often called the deep-pocket concept of liability) 5. Large civil court judgments against CPA firms awarded in a few cases, encouraging attorneys to provide legal services on a contingent-fee basis, which offers the injured party a potential gain when the suit is successful, but minimal losses when it is not 6. Many CPA firms being willing to settle legal problems out of court in an attempt to avoid costly legal fees and adverse publicity, rather than pursuing resolution through the judicial process 7. The difficulty judges and jurors have understanding and interpreting technical accounting and auditing matters
DISTINGUISHING BUSINESS FAILURE, AUDIT FAILURE, AND AUDIT RISK Many accounting and legal professionals believe that a major cause of lawsuits against CPA firms is financial statement users’ lack of understanding of two concepts: 1. The difference between a business failure and an audit failure 2. The difference between an audit failure and audit risk A 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, such as a recession, poor management decisions, or unexpected competition in the industry. Audit failure : occurs when the auditor issues an incorrect audit opinion because it failed to comply with the requirements of auditing standards. Audit risk represents the possibility that the auditor concludes after conducting an adequate audit that the financial statements were fairly stated when, in fact, they were materially misstated. Audit risk is unavoidable, because auditors gather evidence only on a test basis and because well-concealed frauds are extremely difficult to detect. An auditor may fully com ply with auditing standards and still fail to uncover a material misstatement due to fraud. Accounting professionals tend to agree that in most cases, when an audit has failed to uncover material misstatements and the wrong type of audit opinion is issued, it is appropriate to question whether the auditor exercised due care in performing the audit. In cases of audit failure, the law often allows parties who suffered losses to recover some or all of the losses caused by the audit failure. In practice, because of the complexity of auditing, it is difficult to determine when the auditor has failed to use due care. Also, legal precedent makes it difficult to determine who has the right to expect the benefit of an audit and recover losses in the event of an audit failure. Neverth eless, an auditor’s failure to follow due care often results in liability and, when appropriate, damages against the CPA firm.
LEGAL CONCEPTS AFFECTING LIABILITY A CPA is responsible for every aspect of his or her public accounting work, including auditing, taxes, management advisory services, and accounting and bookkeeping services. If a CPA failed to correctly prepare and file a client’s tax return, the CPA can be held liable for any penalties and interest that the client was required to pay plus the tax preparation fee charged. In some states, the court can also assess punitive damages. Most of the major lawsuits against CPA firms have dealt with audited or unaudited financial statements. The discussion in this chapter is restricted primarily to those two aspects of public accounting. restricted primarily to those two aspects of public accounting. First, we examine several legal concepts pertinent to lawsuits involving CPAs.
Prudent Person Concept There is agreement within the profession and the courts that the auditor is not a guarantor or insurer of financial statements. The auditor is expected only to conduct the audit with due care, and is not expected to be perfect. This standard of due care is often called the prudent person concept.
Liability for the Acts of Others Generally, the partners, or shareholders in the case of a professional corporation, are jointly liable for the civil actions against any owner. It is different, however, if the firm operates as a limited liability partnership (LLP), a limited liability company (LLC), a general corporation, or a professional corporation with limited liability. Under these business structures, the liability for one owner’s actions does not extend to another owner’s personal assets, unless the other owner was directly involved in the actions of the owner causing the liability. Of course, the firm’s assets are all subject to the damages that arise.
Lack of Privileged Communication Several states have statutes that permit privileged communication between the client and auditor. Even then, the intent at the time of the communication must have been for the communication to remain confidential. A CPA can refuse to testify in a state with privileged communications statutes. However, that privilege does not extend to federal courts.
Sources of Legal Liability The remainder of this chapter addresses the four sources of auditor’s legal liability: 1. Liability to clients 2. Liability to third parties under common law 3. Civil liability under the federal securities laws 4. Criminal liability
LIABILITY TO CLIENTS A typical lawsuit brought by a client involves a claim that the auditor did not discover an employee theft as a result of negligence in the conduct of the audit. The lawsuit can be for breach of contract, a tort action for negligence, or both. Tort actions are more common because the amounts recoverable under them are normally larger than under breach of contract. Tort actions can be based on ordinary negligence, gross negligence, or fraud.
LIABILITY TO THIRD PARTIES UNDER COMMON LAW In addition to being sued by clients, CPAs may be liable to third parties under common law. Third parties include actual and potential stockholders, vendors, bankers and other creditors, employees, and customers. A CPA firm may be liable to third parties if a loss was incurred by the claimant due to reliance on misleading financial statements. A typical suit occurs when a bank is unable to collect a major loan from an insolvent customer and the bank then claims that misleading audited financial statements were relied on in making the loan and that the CPA firm should be held responsible because it failed to perform the audit with due care.
Auditor Defenses Against Third-Party Suits Three of the four defenses available to auditors in suits by clients are also available in third-party lawsuits: lack of duty to perform the service, nonnegligent performance, and absence of causal connection. Contributory negligence is ordinarily not available because a third party is not in a position to contribute to misstated financial statements. A lack of duty defense in third-party suits contends lack of privity of contract. The extent to which privity of contract is an appropriate defense and the nature of the defense depend heavily on the approach to foreseen users in the state and the judicial jurisdiction of the case.
CIVIL LIABILITY UNDER THE FEDERAL SECURITIES LAWS The Securities Act of 1933 imposes an unusual burden on the auditor. Section 11 of the 1933 act defines the rights of third parties and auditors, which are summarized as follows: 1. Any third party who purchased securities described in the registration statement may sue the auditor for material misrepresentations or omissions in audited financial statements included in the registration statement. 2. Third-party users do not have the burden of proof that they relied on the financial statements or that the auditor was negligent or fraudulent in doing the audit. Users must only prove that the audited financial statements contained a material misrepresentation or omission. 3. The auditor has the burden of demonstrating as a defense that (1) an adequate audit was conducted or (2) all or a portion of the plaintiff’s loss was caused by factors other than the misleading financial statements. The 1933 act is the only common or statutory law where the burden of proof is on the defendant.
CRIMINAL LIABILITY A fourth way CPAs can be held liable is under criminal liability for accountants. CPAs can be found guilty for criminal action under both federal and state laws. Under state law, the most likely statutes to be enforced are the Uniform Securities Acts, which are similar to parts of the SEC rules. The more relevant federal laws affecting auditors are the 1933 and 1934 securities acts, as well as the Federal Mail Fraud Statute and t he Federal False Statements Statute.
Unfortunately, a few notorious criminal cases have involved CPAs. Historically, one of the leading cases of criminal action against CPAs is United States v. Simon, which occurred in 1969.
THE PROFESSION’S RESPONSE TO LEGAL LIABILITY The AICPA and the profession as a whole can do a number of things to reduce practitioners’ exposure to lawsuits: 1. Seek protection from nonmeritorious litigation 2. Improve auditing to better meet users’ needs 3. Educate users about the limits of auditing
PROTECTING INDIVIDUAL CPAs FROM LEGAL LIABILITY Practicing auditors may also take specific action to minimize their liability. Some of the more common actions are as follows: 1. Deal only with clients possessing integrity . There is an increased likelihood of having legal problems when a client lacks integrity in dealing with customers, employees, units of government, and others. A CPA firm needs procedures to evaluate the integrity of clients and should dissociate itself from clients found lacking integrity. 2. Maintain independence. Independence is more than merely financial. Independence requires an attitude of responsibility separate from the client’s interest. Much litigation has arisen from auditors’ too-willing acceptance of client representations or from client pressure. The auditor must maintain an attitude of healthy professional skepticism. 3. Understand the client’s business . In several cases, the lack of knowledge of industry practices and client operations has been a major factor in auditors failing to uncover misstatements. 4. Perform quality audits . Quality audits require that auditors obtain appropriate evidence and make appropriate judgments about the evidence. It is essential, for example, that the auditor understands the client’s internal controls and modify the evidence to reflect the findings. 5. Improved auditing reduces the likelihood of failing to detect misstatements and the likelihood of lawsuits. 6. Document the work properly . The preparation of good audit documentation helps the auditor perform quality audits. Quality audit documentation is essential if an auditor has to defend an audit in court, including an engagement letter and a representation letter that define the respective obligations of the client and the auditor. 7. Exercise professional skepticism . Auditors are often liable when they are presented with information indicating a problem that they fail to recognize. Auditors need to strive to maintain a healthy level of skepticism, one that keeps them alert to potential misstatements, so that they can recognize misstatements when they exist.
CHAPTER 6
AUDIT RESPONSIBILITIES AND OBJECTIVES OBJECTIVE OF CONDUCTING AN AUDIT OF FINANCIAL STATEMENTS The purpose of an audit is to provide financial statement users with an opinion by the auditor on whether the financial statements are presented fairly, in all material respects, in accordance with the applicable financial accounting framework.
MANAGEMENT’S RESPONSIBILITIES Distinguish management’s responsibility for the financial statements and internal control from the auditor’s responsibility for verifying the financial statements and effectiveness of internal control. The responsibility for adopting sound accounting policies, maintaining adequate internal control, and making fair representations in the financial statements rests with management rather than with the auditor. Because they operate the business daily, a company’s management knows more about the company’s transactions and related assets, liabilities, and equity than the auditor. In contrast, the auditor’s knowledge of these matters and internal control is limited to that acquired during the audit.
AUDITOR’S RESPONSIBILITIES The overall objectives of the auditor are: (a) To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework; and (b) To report on the financial statements, and communicate as required by auditing standards, in accordance with the auditor’s findings.
Material Versus Immaterial Misstatements Misstatements are usually considered material if the combined uncorrected errors and fraud in the financial statements would likely have changed or influenced the decisions of a reasonable person using the statements. Reasonable Assurance Assurance is a measure of the level of certainty that the auditor has obtained at the completion of the audit. The auditor is responsible for reasonable, but not absolute, assurance for several reasons: 1. Most audit evidence results from testing a sample of a population such as accounts receivable or inventory. Sampling inevitably includes some risk of not uncovering a material misstatement. Also, the areas to be tested; the type, extent, and timing of those tests; and the evaluation of test results require significant auditor judgment. Even with good faith and integrity, auditors can make mistakes and errors in judgment. 2. Accounting presentations contain complex estimates, which inherently involve uncertainty and can be affected by future events. As a result, the auditor has to rely on evidence that is persuasive, but not convincing. 3. Fraudulently prepared financial statements are often extremely difficult, if not impossible, for the auditor to detect, especially when there is collusion among management. Errors Versus Fraud Auditing standards distinguish between two types of misstatements: errors and fraud. An error is an unintentional misstatement of the financial statements, whereas fraud is intentional . For fraud, there is a distinction between misappropriation of assets , often called defalcation or employee fraud, and fraudulent financial reporting, often called management fraud. Professional Skepticism Auditing standards require that an audit be designed to provide reasonable assurance of detecting both material errors and fraud in the financial statements.
Auditor’s Responsibilities for Detecting Material Errors Auditors spend a great portion of their time planning and performing audits to detect unintentional mistakes made by management and employees. Auditors find a variety of errors resulting from such things as mistakes in calculations, omissions, misunderstanding and misapplication of accounting standards, and incorrect summarizations and descriptions. Throughout the rest of this book, we consider how the auditor plans and performs audits for detecting both errors and fraud.
Auditor’s Responsibilities for Detecting Material Fraud Auditing standards make no distinction between the auditor’s responsibilities for searching for errors and fraud. In either case, the auditor must obtain reasonable assurance about whether the statements are free of material misstatements. The standards also recognize that fraud is often more difficult to detect because management or the employees perpetrating the fraud attempt to conceal the fraud , similar to the ZZZZ Best case. Still, the difficulty of detection does not change the auditor’s responsibility to properly plan and perform the audit to detect material misstatements, whether caused by error or fraud.
Auditor’s Responsibilities for Discovering Illegal Acts Direct-Effect Illegal Acts Certain violations of laws and regulations have a direct financial effect on specific account balances in t he financial statements. Indirect-Effect Illegal Acts Most illegal acts affect the financial statements only indirectly. Evidence Accumulation When There Is No Reason to Believe Indirect-Effect Illegal Acts Exist Many audit procedures normally performed on audits to search for errors and fraud may also uncover illegal acts. Evidence Accumulation and Other Actions When There Is Reason to Believe Direct- or Indirect-Effect Illegal Acts May Exist The auditor may find indications of possible illegal acts in a variety of ways. When the auditor believes that an illegal act may have occurred, several actions are necessary to determine whether the suspected illegal act actually exists: 1. The auditor should first inquire of management at a level above those likely to be involved in the potential illegal act. 2. The auditor should consult with the client’s legal counsel or other specialist who is knowledgeable about the potential illegal act. 3. The auditor should consider accumulating additional evidence to determine whether there actually is an illegal act.
FINANCIAL STATEMENT CYCLES Cycle Approach to Segmenting an Audit A common way to divide an audit is to keep closely related types (or classes) of transactions and account balances in the same segment. This is called the cycle approach. For example, sales, sales returns, cash receipts, and charge-offs of uncollectible accounts are the four classes of transactions that cause accounts receivable to increase and decrease.
SETTING AUDIT OBJECTIVES
For any given class of transactions, several audit objectives must be met before the auditor can conclude that the transactions are properly recorded. These are called transaction-related audit objectives in the remainder of this book. For example, there are specific sales transactionrelated audit objectives and specific sales returns and allowances transaction-related audit objectives. Similarly, several audit objectives must be met for each account balance. These are called balance-related audit objectives . For example, there are specific accounts receivable balance-related audit objectives and specific accounts payable balance-related audit objectives. We show later in this chapter that the transaction-related and balance-related audit objectives are somewhat different but closely related. The third category of audit objectives relates to the presentation and disclosure of information in the financial statements. These are called presentation and disclosurerelated audit objectives. For example, there are specific presentation and disclosurerelated audit objectives for accounts receivable and notes payable.
Assertions About Classes of Transactions and Events Management makes several assertions about transactions. These assertions also apply to other events that are reflected in the accounting records, such as recording depreciation and recognizing pension obligations. Occurrence The occurrence assertion concerns whether recorded transactions included in the financial statements actually occurred during the accounting period. For example, management asserts that recorded sales transactions represent exchanges of goods or services that actually took place. Completeness This assertion addresses whether all transactions that should be included in the financial statements are in fact included. For example, management asserts that all sales of goods and services are recorded and included in the financial statements. Accuracy The accuracy assertion addresses whether transactions have been recorded at correct amounts. Using the wrong price to record a sales transaction and an error in calculating the extensions of price times quantity are examples of violations of the accuracy assertion. Classification The classification assertion addresses whether transactions are recorded in the appropriate accounts. Recording administrative salaries in cost of sales is one example of a violation of the classification assertion. Cutoff The cutoff assertion addresses whether transactions are recorded in the proper accounting period. Recording a sales transaction in December when the goods were not shipped until January violates the cutoff assertion.
Assertions About Account Balances Assertions about account balances at year-end address existence, completeness, valuation and allocation, and rights and obligations. Existence The existence assertion deals with whether assets, liabilities, and equity interests included in the balance sheet actually existed on the balance sheet date. Completeness This assertion addresses whether all accounts and amounts that should be presented in the financial statements are in f act included. Valuation and Allocation The valuation and allocation assertion deals with whether assets, liabilities, and equity interests have been included in the financial statements at appropriate amounts, including any valuation adjustments to reflect asset amounts at net realizable value. Rights and Obligations This assertion addresses whether assets are the rights of the entity and whether liabilities are the obligations of the entity at a given date.
Assertions About Presentation and Disclosure Occurrence and Rights and Obligations This assertion addresses whether disclosed events have occurred and are the rights and obligations of the entity. For example, if the client discloses that it has acquired another company, it asserts that the transaction has been completed. Completeness This assertion deals with whether all required disclosures have been included in the financial statements. Accuracy and Valuation The accuracy and valuation assertion deals with whether financial information is disclosed fairly and at appropriate amounts. Classification and Understandability This assertion relates to whether amounts are appropriately classified in the financial statements and footnotes, and whether the balance descriptions and related disclosures are understandable.
TRANSACTION-RELATED AUDIT OBJECTIVES General Transaction-Related Audit Objectives Occurrence—Recorded Transactions Exist This objective deals with whether recorded transactions have actually occurred. Inclusion of a sale in the sales journal when no sale occurred violates the occurrence objective. Completeness—Existing Transactions Are Recorded This objective deals with whether all transactions that should be included in the journals have actually been included. Accuracy—Recorded Transactions Are Stated at the Correct Amounts This objective addresses the accuracy of information for accounting transactions and is one part of the accuracy assertion for classes of transactions.
General Balance-Related Audit Objectives Existence—Amounts Included Exist This objective deals with whether the amounts included in the financial statements should actually be included. For example, inclusion of an account receivable from a customer in the accounts receivable trial balance when there is no receivable from that customer violates the existence objective. Completeness—Existing Amounts Are Included This objective deals with whether all amounts that should be included have actually been included. Failure to include an account receivable from a customer in the accounts receivable trial balance when a receivable exists violates the completeness objective.
PRESENTATION AND DISCLOSURE-RELATED AUDIT OBJECTIVES HOW AUDIT OBJECTIVES ARE MET Plan and Design an Audit Approach (Phase I) For any given audit, there are many ways in which an auditor can accumulate evidence to meet the overall audit objective of providing an opinion on the financial statements. Two overriding considerations affect the approach the auditor selects: 1. Sufficient appropriate evidence must be accumulated to meet the auditor’s professional responsibility. 2. The cost of accumulating the evidence should be minimized.
Perform Tests of Controls and Substantive Tests of Transactions (Phase II) Before auditors can justify reducing planned assessed control risk when internal controls are believed to be effective, they must first test t he effectiveness of the controls. The procedures for this type of testing are commonly referred to as tests of controls.
Perform Analytical Procedures and Tests of Details of Balances (Phase III) There are two general categories of phase III procedures. Analytical procedures use comparisons and relationships to assess whether account balances or other data appear reasonable.
Complete the Audit and Issue an Audit Report (Phase IV) After the auditor has completed all procedures for each audit objective and for each financial statement account and related disclosures, it is necessary to combine the information obtained to reach an overall conclusion as to whether the financial statements are fairly presented. This highly subjective process relies heavily on the auditor’s professional judgment. When the audit is completed, the CPA must issue an audit report to accompany the client’s published financial statements.
