Solution manual auditing and services 2e by louwers MODC

C.3 Under common law liability, clients can bring suit against auditors for either breach of contract or tort actions.. In certain jurisdictions, auditors can be liable to foreseen parti

MODULE C

Legal Liability

LEARNING OBJECTIVES

Review Checkpoints Exercises, Problems,and Simulations

1 Identify and describe auditors’ exposure to

2 Specify the characteristics of auditors’

liability under common law and cite some

specific case precedents

3, 4, 5, 6, 7, 8, 9 54, 55, 56, 57, 58, 59,

60, 61, 62, 64 (partial)

3 Describe auditors’ liability to third parties

4 Specify the civil and criminal liability

provisions of the Securities Act of 1933

13, 14, 15, 16, 17 65 (partial), 66, 73

5 Specify the civil and criminal liability

provisions of the Securities Exchange Act of

1934

18, 19, 20, 21, 22 64 (partial), 65

(partial), 67, 68, 69

6 Understand recent developments that affect

auditors’ liability to clients and third parties 23, 24, 25, 26 63, 70, 72

SOLUTIONS FOR REVIEW CHECKPOINTS

C.1 Auditors owe clients the responsibility to perform services in accordance with the contract

(engagement letter) and to conduct the audit in accordance with generally accepted auditing standards

Auditors owe third parties the responsibility of conducting the audit in accordance with generally accepted auditing standards

In each of these situations, auditors can be held liable if their failure to perform in accordance withthe contract or generally accepted auditing standards results in an economic loss to clients or third parties

C.2 Common law liability uses legal precedent to identify the responsibility of parties in situations

where there is no violation of a written law or statute Clients and nonshareholder third parties can bring suit against auditors for common law liability

Statutory liability involves the violation of a written law Third-party shareholders can bring suit against auditors for statutory liability

C.3 Under common law liability, clients can bring suit against auditors for either breach of contract or

tort actions Prior to bringing suit, clients must demonstrate:

1 They suffered an economic loss

2 Auditors did not perform in accordance with the terms of the contact (for breach of

contract)

3 Auditors failed to exercise the appropriate level of professional care (for torts)

4 The loss was the result of the breach of contract or failure to exercise the appropriate

level of professional care

C.4 Auditors owe clients the responsibility for conducting the audit using the appropriate level of

professional care If they do not do so, they have tort liability for ordinary negligence, gross negligence, or fraud

C.5 To bring suits against auditors under common law, third parties must demonstrate:

1 They suffered an economic loss

2 Auditors failed to exercise the appropriate level of professional care

3 The financial statements were materially misstated

4 The loss was caused by reliance on the materially misstated financial statements

C.6 The Ultramares Corp v Touche case concludes that if auditors conduct their work with such

gross negligence as to amount to constructive fraud or constructive deceit, they may be liable for

damages The decision, and also a part of the “rule” from Ultramares, was that auditors are not

liable to unidentified third parties for ordinary negligence One can infer that liability for ordinary negligence might be imposed when third-party beneficiaries are known (but this was not explicit

in the court opinion)

The Ultramares rule(s) is (are) being eroded today No longer is privity the shield that it was in

1931, and auditors are being held responsible for a greater degree of care However, in some

C.7 Privity refers a situation in which parties have a contractual relationship Auditors owe contracting

parties (e.g clients) a duty to perform the audit with the appropriate level of professional care Liability can be imposed for situations in which auditors exhibit ordinary negligence

A primary beneficiary is the party an accounting service is intended to benefit The distinguishing feature of a primary beneficiary is that this party is either named in the contract or auditors know

of this party by name Auditors are generally liable to primary beneficiaries for ordinary

negligence

Foreseen parties are groups or individuals that client intends the information to benefit and that could reasonably be expected to rely on auditors’ work In certain jurisdictions, auditors can be liable to foreseen parties for ordinary negligence when the plaintiff justifiably relied on the information and suffered a loss on such reliance

Foreseeable parties are the creditors, investors, or potential investors that might be expected to rely on auditors’ work In some jurisdictions, auditors can be liable to foreseeable parties for ordinary negligence

C.8 Auditors’ defenses against clients under common law include:

1 Auditors exercised the appropriate level of professional care (torts) or performed the

engagement in accordance with the terms of the contract (breach of contract)

2 The client’s economic loss was caused by a factor other auditors’ failure to demonstrate

an appropriate level of professional care or breach of contract (causation defense)

3 Actions on the part of the client were, in part, responsible for the loss (contributory

negligence)

Auditors’ defenses against third parties under common law include:

1 The third party did not have appropriate standing to sue in the jurisdiction

2 The third party did not rely on the financial statements

3 The third party’s economic loss was caused by other events beyond auditors’ scope of

C.10 Regulation S-X contains requirements for audited annual and unaudited interim financial

statements filed with the SEC

Regulation S-K contains requirements relating to all other business, analytical and supplementary financial disclosures in SEC filings

Financial Reporting Releases are SEC staff reports that express new rules and policies about accounting and disclosures required or encouraged by the SEC

Staff Accounting Bulletins contain unofficial but important interpretations of Regulation S-X and Regulation S-K by SEC staff.

C.11 Under the integrated disclosure system, the required annual report to shareholders (prepared in

conformity with Regulation S-X and S-K) can be used as the core of the 10-K annual report required by the Securities Exchange Commission

C.12 Liability under statutory law arises when purchasers or sellers of securities suffer an economic loss

and the financial statements contain a material misstatement

C.13 Section 11 of the Securities Act of 1933 effectively shifts the burden of proof regarding the

appropriate level of professional care during the examination to auditors, whereas this proof is the plaintiff’s duty under common law

Furthermore, the plaintiff does not have to be in a privity relationship or known third-party beneficiary relationship with auditors Also, the plaintiff does not have to prove reliance on the materially misstated financial statements or that the loss resulted from the materially misstated financial statements

C.14 In a civil suit under section 11 of the Securities Act of 1933, the plaintiff only has to prove that a

loss was suffered and that the financial statements contained a material misstatement

To avoid liability, the defendant auditors can either prove that (1) the engagement was conducted according to GAAS (“due diligence” defense) or (2) the loss was caused by other factors

C.15 Section 11 of the Securities Act of 1933 holds officers, directors, and underwriters to a lesser

degree of responsibility for information that is presented on the authority of an expert (such as auditors) As a result, they may rely on the expert and not be held responsible for conducting a reasonable investigation on their own Therefore, as auditors assume more responsibility for this type of information, officers, directors, and underwriters have less responsibility

C.16 Section 17 of the Securities Act of 1933 is the antifraud provision relating to the offer or sale of

securities Section 24 of the Securities Act of 1933 defines criminal penalties and relates to willful violation of duties with respect to a statutory registration or requirement to register a sale of securities

C.17 In Escott v BarChris Construction Corp., the court concluded that auditors did not conduct an

appropriate review of subsequent events and, in fact, did not perform steps included in the audit program

C.18 Under the Securities Exchange Act of 1934, purchasers or sellers of securities can bring suit by

proving:

1 They suffered an economic loss

2 The financial statements were materially misstated

3 The loss was caused by reliance on the materially misstated financial statements

4 Auditors were aware that the financial statements were materially misstated

C.20 Under section 32 of the Securities Exchange Act of 1934, criminal penalties include fines of up to

$5 million and imprisonment for up to 20 years (these levels represent increases provided by the Sarbanes-Oxley Act) In addition, violations of the provisions of Securities Exchange Act of 1934

by entities other than natural persons (such as accounting firms) are punishable by fines up to $25 million

C.21 Scienter is the intent or knowledge of inappropriate actions prior to committing those actions (for

example, if auditors have knowledge of misstatements in the financial statements and intentionally

fail to disclose these misstatements in their reports) Ernst & Ernst v Hochfelder and Denise L Nappier et al v PricewaterhouseCoopers both concluded that parties could not recover damages

against auditors because they were unable to demonstrate scienter on the part of the defendants.C.22 The major differences between auditors’ liability under the Securities Act of 1933 and Securities

and Exchange Act of 1934 are:

1 The Securities Act of 1933 applies to original purchasers of securities under a registered

offering while the Securities and Exchange Act of 1934 applies to purchasers and sellers

of securities under ongoing exchanges after the initial offering Auditors are liable for ordinary negligence, gross negligence, or fraud under the Securities Act of 1933; they are only liable for gross negligence or fraud under the Securities Exchange Act of 1934

2 Auditors have the burden of proof under the Securities Act of 1933; plaintiffs (purchasers

or sellers of securities) have the burden of proof under the Securities Exchange Act of 1934

3 Under the Securities Act of 1933, auditors’ defenses are that a GAAS audit was

conducted or the loss was caused by other factors; under the Securities and Exchange Act

of 1934, auditors’ defenses are that the audit was conducted in good faith and auditors were not aware of the materially misstated financial statements

C.23 Some of the major changes in auditors’ liability under Sarbanes-Oxley include:

1 Extending the statute of limitations for bringing a suit under the Securities and Exchange

Act

2 Increasing both the monetary fines and imprisonment penalties for violations of the

Securities and Exchange Act

3 Increasing the imprisonment penalties for mail fraud and wire fraud

4 Providing monetary fines and imprisonment penalties for the alteration and destruction of

documents

5 Increasing the period over which records must be retained by accounting firms

C.24 Joint and several liability is a doctrine that allows a successful plaintiff to recover the full amount

of a damage award from the any defendant(s), regardless of the defendant’s relative degree of fault Proportionate liability only permits recover from defendant(s) based on their relative degree

of fault

C.25 The Private Securities Litigation Reform Act provided the following terms for proportionate

liability:

1 The total responsibility for loss is divided among all parties responsible for the loss

2 However, if other defendants are insolvent, a solvent defendant’s liability is extended to

50 percent more than the proportion found at trial

3 Only the defendants who knowingly committed a violation of securities laws remain

jointly and severally liable for all the plaintiffs’ damages

The Class Action Fairness Act expanded federal jurisdiction over class action lawsuits and moves

many class action cases from state courts to federal courts

C.26 To reverse the perceived concerns with the Private Securities Litigation Reform Act (attorneys

filing securities class action lawsuits in state courts that follow joint and several liability

doctrines), Congress enacted the Securities Litigation Uniform Standards Act This act’s most significant provision requires that class action lawsuits with 50 or more parties must be filed in theFederal courts

SOLUTIONS FOR MULTIPLE CHOICE-QUESTIONS

C.27 a Incorrect Constructive fraud represents reckless behavior, not a lack of

reasonable care

b Incorrect Fraud represents intention to deceive

c Incorrect Gross negligence is similar to constructive fraud and represents lack of

minimal care

d Correct Ordinary negligence represents lack of reasonable care and is often

proven by demonstrating that auditors failed to follow GAAS in conducting the audit

C.28 a Incorrect Joint and several liability can impose the entire amount of loss in a case

against auditors, which is less favorable than proportionate liability

b Incorrect The reasonably foreseeable user approach provides auditors with the

greatest exposure to liability to third parties for ordinary negligence

c Incorrect The foreseen third party approach is more favorable to auditors than the

reasonably foreseeable approach, but auditors may still be exposed to the entire amount of the loss

d Correct Proportionate liability is most favorable to auditors because they will

only be liable for damages to the extent they were found to be at fault.C.29 d Correct The difference between the perception of the users of the statements

and auditors’ knowledge of the audit objective is known as the expectations gap One common example of the expectations gap is users’ belief that a GAAS audit will uncover all instances of fraud

C.30 a Incorrect Breach of contract depends solely on the performance of auditors and

the client per the contract (engagement letter)

b Correct A tort is a lawsuit filed by the plaintiff who believes that they have

suffered damage due to another party’s failure to exercise the appropriate level of professional care

c Incorrect Securities litigation is a term that defines criminal and civil actions

regarding unfair or criminal practices in the purchase or sale of securities

d Incorrect Constructive fraud is a term used to define repetitive actions that show

a pattern of recklessness or disregard for the truth or other party’s well being While constructive fraud may be the cause of the losses, the wording in the question does not suggest that such a fraud occurred

C.31 a Incorrect This is the total amount of the loss, and auditors were not determined to

be 100% at fault

b Incorrect Auditors’ liability cannot be zero because they were found to be

partially at fault

c Correct Auditors pay 45%, which is the 30% at fault plus another 15% (or 50%

of the level at fault) because they are the only solvent defendant

d Incorrect Since auditors are the only solvent defendant, liability is not limited to

the 30% at fault (see (c) above).

C.32 a Correct When auditors knowingly commit violations, the joint and several

liability doctrine applies, and auditors pay all the damages as the only solvent defendant

b Incorrect See (a) above Under proportionate liability, auditors would be liable

for some extent of the damages, even if they did not knowingly committhe violations

c Incorrect See (a) above The fact that auditors knowingly committed these

violations make them liable for the entire amount of the damages

d Incorrect See (a) above The fact that auditors knowingly committed these

violations make them liable for the entire amount of the damages.C.33 a Incorrect The accountant and client have a privity relationship for the consulting

services

b Correct The accountant’s best defense would be to prove that the client did not

carry out its part of the recommendations from the consulting work

c Incorrect Plaintiffs can always measure some damages, and suit would not be

brought if the client did not have good reason to measure damages

d Incorrect While the accountant can argue that the work was done properly, choice

(b) would provide a better defense

C.34 a Correct The Credit Alliance view holds auditors responsible to primary

beneficiaries for ordinary negligence, who are identified and known to name by auditors

b Incorrect This is the broadest view of privity, as defined by Rosenblum, Inc v Adler.

c Incorrect This is the restatement of torts view of privity.

d Incorrect Since (a) is a correct response, this is not correct.

C.35 a Correct The engagement letter obtained at the beginning of the engagement is

the most effective method of expressing the nature of limits on compilation and review engagements

b Incorrect Compilation and review engagements do not result in the preparation of

auditors’ opinions

c Incorrect Reporting the nature of the work at the conclusion of the engagement is

not as effective as doing so in the engagement letter at the beginning of

the engagement (see (a) above).

d Incorrect Management letters are delivered at the conclusion of the engagement,

so as in (c) above, reporting the nature of the work at the conclusion of

the engagement is not as effective as doing so at the beginning of the engagement

C.36 a Correct A prospectus is a set of information available to prospective investors

that is required by the SEC This information includes the entity’s financial statements

C.37 a Incorrect Because the selection “both” is correct (choice d).

b Incorrect Because the selection “both” is correct (choice d).

c Incorrect Because the selection “both” is correct (choice d).

d Correct Both laws contain both civil and criminal liability sections

C.38 a Incorrect Foreseeable third parties are parties that might use auditors’ work;

however, they are not known to auditors by name

b Incorrect Foreseen third parties are parties that might reasonably be expected to

use auditors’ work; however, they are not known to auditors by name

c Incorrect There is no designation known as “general third party”

d Correct Primary beneficiaries are known by name to auditors and, in some

cases, are specifically identified in the contract (engagement letter).C.39 a Incorrect Privity is not a necessary condition to bring suit under the Securities

Exchange Act of 1934

b Incorrect Prior to bringing suit, the investor would need to demonstrate that a

loss was suffered

c Correct These are appropriate defenses under the Securities Exchange Act of

1934 and demonstrate lack of scienter

d Incorrect Entities are required to file financial statements with the Securities and

Exchange Commission for their shares to be traded on national exchanges

C.40 NOTE TO INSTRUCTOR: Since this question asks which of the statements is not true, the

response labeled “correct” is not true and those labeled “incorrect” are true.

a Incorrect The Securities Act of 1933 relates to the initial issuance of securities

b Incorrect Auditors’ liability typically arises because of their involvement with

audited financial statements

c Correct Third parties are only required to demonstrate that the financial

statements are materially misstated; they are not required to demonstrate reliance on these financial statements

d Incorrect Auditors are liable for ordinary negligence under the Securities Act of

1933

C.41 a Incorrect Information related to auditor changes is not required to be disclosed in

the 10-K annual report

b Incorrect Information related to auditor changes is not required to be disclosed in

the S-1 registration statement

c Incorrect Information related to auditor changes is not required to be disclosed in

the 10-Q quarterly reports

d Correct Information related to auditor changes is one of the “special events”

entities must report on Form 8-K

C.42 a Incorrect Section 11(b)(A) requirement seems to be satisfied, since the chair

produced the information about the planned use of the proceeds, made

a reasonable investigation, and the information is not made on the authority of another “expert.”

b Incorrect Section 11(b)(B) requirement seems to be satisfied, since the consulting

engineer is an expert and made a reasonable investigation connected with his or her own work

c Incorrect Section 11(b)(C) requirement seems to be satisfied, since the president

relied on the work of the consulting engineer expert and had no reason

to believe the engineer’s report was erroneous

d Correct In this case, while the officers relied on auditors’ work, they were

aware of materially misstated financial statements and, therefore, liable

under Section 11(b)C.

C.43 a Correct Under both common law and section 10(b), plaintiffs must prove they

suffered losses

b Incorrect Unlike common law, section 10(b) does not have a privity requirement

(“any purchaser or seller” can sue the accountants)

c Incorrect Under both common law and section 10(b) plaintiffs must prove

reliance

d Incorrect Under both common law and section 10(b) plaintiffs must prove their

reliance caused their losses

C.44 a Incorrect Credit Alliance v Arthur Andersen established auditors’ liability to

primary beneficiaries for ordinary negligence

b Incorrect Fleet National Bank v Gloucester Co established auditors’ liability to

foreseen third parties for ordinary negligence

c Correct Rosenblum, Inc v Adler established auditors’ liability to foreseeable

third parties for ordinary negligence, which provides broader exposure

for auditors than the groups in choices (a) and (b).

d Incorrect Ultramares did not establish any exposure for auditors to liability to

third parties for ordinary negligence, just gross negligence or fraud

C.45 a Incorrect While this is a difference between these two acts, (b) is also a

difference; therefore, the best answer is (c).

b Incorrect While this is a difference between these two acts, (b) is also a

difference; therefore, the best answer is (c).

c Correct Both the burden of proof and required level of professional care differ

across the two acts

d Incorrect See (c) above.

C.46 a Incorrect The SEC does not guarantee or represent that the information in the

registration statement is true

b Incorrect Registration is not insurance against loss from the investment

c Correct Financial information that has been examined by independent auditors

is either included in the registration statement or incorporated by reference

d Incorrect Inside information about the entity’s trade secrets is not provided in the

registration statement (If it were, it would no longer be inside information!)

C.47 a, b, c Incorrect These are all elements of lawsuits under common law that must be

proved by the plaintiffs prior to brining suit As a result, they would not

be available as defenses for auditors

d Correct While the plaintiff has the responsibility to prove AOW failed to

exercise the appropriate level of professional care, conducting the audit

in accordance with generally accepted auditing standards would be an effective defense

C.48 a Incorrect Regulation D governs the nonpublic issuance of securities to limited

groups of investors

b Incorrect Form 8-K is the periodic special events report

c Incorrect Form SB-1 is one registration forms of the Securities Act of 1933

d Correct Regulation S-X is the compendium of accounting rules that governs the

form and content of Forms 10-K and 10-Q

C.49 a Correct The Ernst & Ernst v Hochfelder case related to the failure of plaintiffs

to prove scienter

b Incorrect The Escott v BarChris Construction Corp case demonstrated ordinary

negligence on the part of auditors in a review of subsequent events

c Incorrect Smith v London Assurance Corp was related to ordinary negligence on

the part of auditors in failing to identify an embezzlement scheme occurring at a client

d Incorrect The Ultramares case was related to auditors’ liability for ordinary

negligence (and not scienter) to third parties

C.50 a Correct Form 10-K is the annual report

b Incorrect Form 10-Q is the quarterly report

c Incorrect Form 8-K is the periodic special events report

d Incorrect Regulation S-X provides guidelines for the content of financial

information submitted to the SEC

C.51 a Incorrect Scienter must be demonstrated under the Securities Exchange Act of

1934; under the Securities Act of 1933, auditors are responsible for ordinary negligence

b Correct Plaintiffs must establish that the financial statements were materially

misstated

c Incorrect Proving reliance on the materially misstated financial statements is not

necessary

d Incorrect Proving that reliance on the materially misstated financial statements

caused the loss is not necessary

C.52 c Correct Sarbanes-Oxley Act is the common name for the United States Public

Company Reform and Investor Protection Act of 2002

C.53 NOTE TO INSTRUCTOR: Since this question asks which of the statements is not true, the

response labeled “correct” is not true and those labeled “incorrect” are true.

a Correct The Sarbanes-Oxley Act does not include new definitions or situations

that constitute securities fraud The amendments in the Act provide greater penalties for auditors, but do not increase auditors’

responsibilities for identifying fraud

b Incorrect The Sarbanes-Oxley Act requires that the CEO and CFO certify the

financial statements

c Incorrect The Sarbanes-Oxley Act specifies penalties for destruction of records in

federal investigations for both accounting firms and auditors

d Incorrect The Sarbanes-Oxley Act increases penalties for mail fraud and criminal

violations of the Securities Exchange Act of 1934

SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS

C.54 Breach of Contract

a Auditors can be in breach of contract for:

 Failing to meet established deadlines

 Failing to provide the services described in the contract

 Charging fees differently then agreed in the contract

b Clients can be in breach of contract for:

 Failing to provide documents as agreed in the contract

 Failing to pay audit fees in a manner described in the contract

 Failing to make available key personnel as agreed in the contract

 Failing to disclose information known by management (e.g known frauds) as

agreed in the contract

c The best defenses are:

 There is no breach of contract (i.e., auditors met all the contract provisions)

 The breach of contract was due to the client’s failure to perform as specified

under the contract

 Fulfillment of the contract became impossible because of circumstances beyond

auditors’ control (for example, auditors cannot be liable for breaching a provision of a contract to count inventory held in a warehouse if the inventory was destroyed)