Chapter 20 ACCT 4400

Legal Liability
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Terms in this set (...)

Claims against auditors were (common/uncommon) before the 1970's
Uncommon
What 2 events made it more common for auditors to be sued?
A slump in the economy in the early 1970's and the recession of the 1980's
What led to the 2nd surge of auditors being sued?
The recession of 1990-1992
Why did Congress refocus attention on auditors in the Sarbanes-Oxley Act of 2002?
Due to several high profile frauds
Dodd Frank Act
A result of the Global credit crisis; increased scrutiny in auditing profession again
4 general stages in the initiation and disposition of audit-related disputes
1. The occurrence of events that result in losses for users of the financial statements
2. The investigation by plaintiff attorneys before filinf suit to link the user losses with allegations of material omission or misstatements of financial statements
3. The legal process that commences with the filing of the suit, and
4. The final resolution of the dispute
2 classes of law
1. Common law
2. Statutory law
Case law developed over time by judges
Common law
Written law enacted by the legislative branch of government
Statutory law
Occurs when the client or auditor fails to meet the terms and obligations established in the contract, which is normally finalized in the engagement letter. Third parties may have privity of contract.
Breach of contract
All law that does not relate to criminal matters
Civil Law
Lawsuit filed by one or more individuals on behalf of all persons who may have invested on the basis of the same false and misleading information
Class action
Statutory law that defines the duties citizens owe to society and prescribe to penalties for violations
Criminal law
Actions taken with the knowledge and intent to deceive
Fraud
An extreme, flagrant, or reckless departure from professional standards of due care. This is also referred to as constructive fraud.
Gross negligence
An absence of reasonable or due care in the conduct of an engagement. Due care is evaluated in terms of what other professional accountants would have done in similiar circumstances
Ordinary negligence
A contract or specific agreement exists between 2 parties. Absent a contractual or fiduciary relationship, the accountant does not owe a duty of care to an injured party
Privity
Acting with intent to deceive, defraud, or with knowledge of a false representation
Scienter
A wrongful act, other than breach of contract, for which civil action may be taken
Tort
2 types of common law liabilities
1. liability to clients
2. liability to third parties
2 types of federal statutory law
1. civil liability
2. criminal liability
4 actions of auditors (common law- liability to clients)
1. Breach of contract
2. Negligence
3. Gross negligence/constructive fraud
4. Fraud
3 actions of auditors (common law- liability to third parties)
1. Negligence
2. Gross negligence/constructive fraud
3. Fraud
3 actions of auditors (federal statutory law-civil liability)
1. Negligence
2. Gross negligence/constructive fraud
3. Fraud
1 actions of auditors (federal statutory law-criminal liability)
Willful violation of federal statutes
Common Law-Clients requires what?
Due Care
If an engagement is performed without due care, the CPA may be held liable for what?
an actionable tort in negligence.
For Common Law Negligence a client must prove what 4 things?
1. A duty was owed to the client.
2. Failure to act in accordance with that duty.
3. A causal connection between the auditor's negligence and the client's damage.
4. Actual loss or damage to the client.
What 6 things must the auditor show to defend him/herself of common law negligence to a client?
1. No duty was owed to the client.
2. The client was negligent.
3. The auditor's work was performed in accordance with professional standards.
4. The client suffered no loss.
5. Any loss was caused by other events.
6. The claim is invalid because the statute of limitations has expired.
4 legal standards for third party ordinary negligence
1. Privity
2. Near Privity
3. Forseen 3rd parties
4. Reasonably Forseeable 3rd parties
Example of privity case
Ultramares (1931)
Example of near privity case
Credit Alliance (1985) and Security Pacific Business Credit, Inc. (1992)
Example of forseen third parties case
Rusch Factors, Inc. (1968)
Example of reasonably forseeable third parties case
H. Rosenblum, Inc. (1983)
For common law-third parties, third party must prove what 4 things?
1. The auditor had a duty to the plaintiff to exercise due care.
2. The auditor breached that duty and was negligent in not following the professional standards.
3. The auditor's breach of due care was the direct cause of the 3rd party's injury.
4. The 3rd party suffered an actual loss as a result
For common law-third parties, auditor must prove what 6 things?
1. No duty was owed to the 3rd party (level of duty required depends on the case law followed by the courts).
2. The 3rd party was negligent.
3. The auditor's work was performed in accordance with professional standards.
4. The 3rd party suffered no loss.
5. Any loss was caused by other events.
6. The claim is invalid because the statute of limitations has expired.
Third party must prove what 5 things when suing for fraud?
1. A false representation by the CPA.
2. Knowledge or belief by the CPA that the representation was false.
3. The CPA intended to induce the 3rd party to rely on the false representation.
4. The 3rd party relied on the false representation.
5. The 3rd party suffered damages.
Three major statutes provide sources of statutory liability for auditors. What are they?
1. The Securities Act (1933)
2. The Securities Exchange Act (1934)
3. Sarbanes Oxley Act of 2002
Which act generally regulates the disclosure of information in a registration statement for a new public offering of securities?
Securities Act of 1933
What 2 things must the 3rd party prove under the Securities Act of 1933?
1. The 3rd party suffered losses by investing in the registered security.
2. The audited financial statements contained a material omission or misstatement.
Which act is concerned primarily with ongoing reporting by companies whose securities are listed and traded on a stock exchange (but covers all documents filed with the SEC)?
Securities Exchange Act of 1934
What 4 things must the 3rd party prove under the Securities Act of 1934?
1. A material, factual misrepresentation or omission.
2. Reliance on the financial statements.
3. Damages suffered as a result of reliance on the financial statements.
4. Scienter (gross negligence or recklessness may be enough).
Provides for proportionate liability for defendants based on percentage of responsibility and a specific statement of fraud at the beginning of the case
Private Securities Litigation Reform Act of 1995
Prevents plaintiffs from seeking to evade the protections that Federal law provides against abusive litigation by filing suit in State, rather than Federal Court
Securities Litigation Uniform Standards Act of 1998
Expands federal jurisdiction to include multistate class actions where there is more than $5 million in dispute. Expected to help in more consistent dismissal of dubious claims
Class Action Fairness Act of 2005
What was the most sweeping securities law since 1934?
Sarbanes Oxley Act of 2002
What 4 things did the Sarbanes Oxley Act of 2002 do?
1. Creation of PCAOB
2. Stricter Independence Rules
3. Audits of Internal Control
4. Increased Reporting Responsibilities
3 SEC and PCAOB sanctions
1. Suspend Practicing Privilege
2. Impose Fines
3. Remedial Measures
Passed in 1977 in response to the discovery of bribery and other misconduct on the part of more than 300 American companies.
Foreign Corrupt Practices Act (FCPA)
An auditor may be subject to administrative proceedings, civil liability, and civil penalties under which act?
Foreign Corrupt Practices Act (FCPA)
Auditors can be held _________ under the laws discussed in the previous section. Criminal prosecutions require that some form of criminal intent be present, such as _____. However, __________ can also be deemed criminal.
criminally liable; fraud; gross negligence
Which of the following is not an activity that would take place during the legal process stage of the four general stages in the initiation and disposition of audit-related disputes (according to Chapter 20)?

A) Filing of a complaint or suit.
B) Hiring another public accounting firm to investigate potential fraud.
C) Discovery or the investigation by the plaintiff attorneys to link user losses with material misstatements in the financial statements.
D) Preparation for trial.
B) Hiring another public accounting firm to investigate potential fraud.
Which of the following is the best defense a CPA firm can assert to a suit for common-law fraud based on its unqualified opinion on materially false financial statements?

A) Lack of scienter.
B) Lack of privity.
C) Contributory negligence on the part of the client.
D) A disclaimer contained in the engagement letter.
A) Lack of scienter.
One of the most common ways for a CPA firm to demonstrate a "lack of duty" type of legal defense is by the use of

A) An engagement letter.
B) A client representation letter.
C) The Private Securities Litigation Reform Act of 1995.
D) A set of audit working papers adhering to GAAS.
A) An engagement letter.
Which of the following statements is correct in most jurisdictions regarding the liability of a CPA who negligently expresses an opinion on an audit of a client's financial statements?

A) The CPA is liable only to those third parties who are in privity of contract with the CPA.
B) The CPA is liable only to the client.
C) The CPA is liable to anyone in a class of third parties who the CPA knows will rely on the opinion.
D) The CPA is liable to all possible foreseeable users of the CPA's opinion.
C) The CPA is liable to anyone in a class of third parties who the CPA knows will rely on the opinion.
Based on the "Ultramares Doctrine" (1931), which of the following parties would a court likely hold an accountant liable for ordinary negligence?

Parties In Privity of Contract Forseen Parties
A. No No
B. No Yes
C. Yes No
D. Yes Yes

A) A
B) B
C) C
D) D
C) C
Individuals and other companies that believe they relied on misstated financial statements of a public company in making an investment decision, and lost money as a result, will generally bring action against the external auditors based on

A) Breach of contract.
B) Negligence.
C) Constructive fraud.
D) Statutory law.
D) Statutory law.
When a company registers a public security offering in accordance with the provisions of the Securities Act of 1933, the law provides the investor with

A) Audited financial information about the company.
B) An SEC assurance that the information in the registration statement is true.
C) FDIC Insurance against loss from the investment in the first thirty days of ownership.
D) All of the above.
A) Audited financial information about the company.
Which of the following is true with regard to the 2002 Sarbanes-Oxley Act legislation that followed the Enron and WorldCom accounting scandals?

A) It extended the auditor's responsibility for financial statements of subsidiaries.
B) It extended the auditor's responsibilities for events after the end of the audit period.
C) It lengthened the statute of limitations for actions related to Rule 10b-5 claims.
D) None of the above are true.
C) It lengthened the statute of limitations for actions related to Rule 10b-5 claims.
All of the following are provisions of the Sarbanes-Oxley Act of 2002 except:

A) Delegation of authority and responsibility to the SEC.
B) Creation of the Public Company Accounting Oversight Board [PCAOB].
C) Elimination of the Auditing Standard Board's authority to set standards for the audit of non-public companies.
D) Increased responsibilities to corporate officers and board members.
C) Elimination of the Auditing Standard Board's authority to set standards for the audit of non-public companies.
An auditor can be held criminally liable for

A) Illegal acts under common law.
B) Illegal acts under statutory law.
C) Negligent acts when the third party has privity status.
D) Tort of contract for failing to follow due professional care.
B) Illegal acts under statutory law.
Auditors can be sued under common law by third parties for

A) Breach of contract.
B) Negligence.
C) Willful violation of federal statutes.
D) All of the above.
B) Negligence.
To prevail in a third party suit alleging negligence, the third party must prove the following:

A) The auditor had a duty to the third party plaintiff to exercise due care.
B) The auditor had a duty to the client to exercise due care.
C) The auditor's breach of due care was the direct cause of the client's injury.
D) The auditor cooperated with the client in the commission of fraud.
A) The auditor had a duty to the third party plaintiff to exercise due care.
Joint and several liability means that the auditor can be responsible for

A) Punitive damages.
B) Only a small part of the liability.
C) For the entire loss.
D) For treble damages.
C) For the entire loss.
Rule 10(b)-5 relates to

A) The Securities Act of 1933.
B) The Securities Act of 1934.
C) The Sarbanes-Oxley Act of 2002.
D) The Racketeer Influenced and Corrupt Organizations Act.
B) The Securities Act of 1934.
Which of the following is the best statement of the general standard of performance owed by an auditor in his or her professional work?

A) To do the job correctly and discover all irregularities.
B) To follow generally accepted accounting principles (GAAP).
C) To act as a professional and not commit fraud.
D) To exercise the skill and care of the ordinarily prudent professional in the same circumstances.
D) To exercise the skill and care of the ordinarily prudent professional in the same