Auditing and assurance services 14e by arens chapter 05

Learning Objective 2Explain why the failure of financial statement users to differentiate among business failure, audit failure, and audit risk has resulted in lawsuits... Business Fai

Legal Liability

Chapter 5

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Learning Objective 1 Understand the litigious environment in

which CPAs practice.

Changed Legal Environment

Audit professionals have a contractual responsibility with clients

Auditors are liable for negligence

The number of lawsuits and sizes of

Changed Legal Environment

Growing awareness by financial statement users

 Increased consciousness of the SEC

 Complexity in business drives complexity in

Major contributors:

Changed Legal Environment

Large civil court judgments against CPA firms

 Willingness of CPA firms to settle out of court

 Judges’ and jurors’ difficulty in understanding technical accounting and auditing matters

Major contributors (cont.):

Learning Objective 2

Explain why the failure of financial

statement users to differentiate among

business failure, audit failure, and audit

risk has resulted in lawsuits.

Business Failure, Audit Failure,

and Audit Risk

Business Failure, Audit Failure,

and Audit Risk

 Audit failureAuditor issues an incorrect opinion from

a failure to follow GAAS

Business Failure, Audit Failure,

and Audit Risk

 Audit risk

The risk that the auditor fails to find a material misstatement and issues anunqualified opinion

Learning Objective 3

Use the primary legal concepts

and terms concerning accountants’

liability as a basis for studying

legal liability of auditors.

Prudent person concept

Liability for the acts of others

Lack of privileged communicationLegal Concepts Affecting

Liability

Legal Terms Affecting

Legal Terms Affecting

CPAs’ Liability

Breach of contract

Contract Law

Third party beneficiary

Legal Terms Affecting

CPAs’ LiabilityOther terms:

Learning Objective 4 Describe accountants’ liability to

clients and related defenses.

Four Major Sources of Auditors’

Legal Liability

Liability to ClientsThe most common source of lawsuits

against CPAs is from clients.

Auditor’s Defenses Against

Learning Objective 5

Describe accountants’ liability to

third parties under common law

and related defenses.

Liability to Third Parties Under

Common Law

Ultramares

Foreseen Users

 Credit alliance

Restatement of torts

Foreseeable user

Auditor Defenses Against

Third-Party Suits

Learning Objective 6

Describe accountants’ civil liability

under the federal securities laws

and related defenses.

Securities Act of 1933The Securities Act imposes an

unusual burden on the auditor

Securities Exchange

Act of 1934

Auditor liability under this act oftencenters on the audited financial statementsissued in annual reports

Rule 10b-5 of the Securities

Rule 10b-5

SEC SanctionsSEC can sanction or suspend practitioners.

SEC has temporarily suspended a number of

individual CPAs from auditing SEC clients

Foreign Corrupt Practices Act of 1977

Bribing a foreign official for the purpose

of exerting business related influence

is illegal

Learning Objective 7 Specify what constitutes criminal

liability for accountants.

Criminal Liability

Sarbanes-Oxley Act

This act makes it a felony to destroy

or create documents to impede orobstruct a federal investigation

Auditor Defenses –

1933 & 1934 Acts

Learning Objective 8

Describe what the profession and

the individual CPA can do and

what is being done to reduce

the threat of litigation.

The Profession’s Response

to Legal Liability

 Research in auditing

Standard and rule setting

Set requirements to protect auditors

Establish peer review requirements

The Profession’s Response

Protecting Individual CPAs

from Legal Liability

Personnel

Protecting Individual CPAs

from Legal Liability

 Understand the client’s business

Perform quality audits

Document the work properly

Obtain an engagement and a representation letter

Protecting Individual CPAs

from Legal Liability

 Carry adequate insurance

Seek legal counsel

Choose a form of organization with limited liability

Exercise professional skepticism

End of Chapter 5