Chapter 4 Auditing - Legal Liability of CPAs (Review Questions)
Terms in this set (19)
Explain why the potential liability of auditors for professional "malpractice" exceeds that of physicians or other professionals.
The number of litigants or injured parties to a physician or attorney negligence case is usually limited to the professional's patient or client. If CPAs are negligent in expressing an opinion on financial statements, millions of investors as well as firm creditors may sustain losses.
Distinguish between ordinary negligence and gross negligence within the context of the CPAs' work.
Ordinary negligence, is when a party acts fails to exercise the degree of care that a reasonably prudent person would have used under similar circumstances. Gross negligence - lack of even slight care, indicative of a reckless disregard for one's professional responsibilities. An example: substantial failures on the part of an auditor to comply with GAAS.
What is meant by the word privity? How does privity affect the auditor's liability under common law?
Privity is the relationship between parties to a contract. A CPA firm is in privity with the client which it
is serving, as well as with any third party beneficiary, such as a creditor bank named in the engagement
letter (the contract between the CPA firm and its client). Under common law, if the auditors do not
comply with their obligations to the client, resulting in damages, the client may sue and recover its losses
by proving that the auditors were negligent in performing their duties under the contract.
Define the term third-party beneficiary.
Third-party beneficiary - A person, aside from the auditors or their client, who is named in a contract (or known to the contracting parties) with the intention that such person should have definite rights and benefits under the contract.
Distinguish between common law and statutory law.
Common law represents judicial interpretation of a society's concept of fairness. Statutory law are written laws that are created by state or federal legislative bodies.
Briefly describe the different common law precedents set by the ULTRAMARES v TOUCHE & CO CASE and the ROSENBLUM v ADLER case.
The primary difference between the Ultramares and the Restatement approaches relates to whether the
CPA has liability for ordinary negligence to third parties not specifically identified as users of the CPA's
report. Under the Ultramares approach a CPA may be held liable for ordinary negligence to a third party
only when that CPA (1) was aware that the financial statements were to be used for a particular purpose
by a known party or parties, and (2) some action of the CPA indicates such knowledge. Under the
Restatement approach the specific identity of the third parties need not be known to the CPA to establish
liability for ordinary negligence. However, such liability for ordinary negligence is only to a limited class
of known or intended users of the audited financial statements.
Briefly describe the differences in liability to third parties under the known user, foreseen user, and foreseeable user approaches to CPA liability.
In Ultramares v. Touche, the New York Court of Appeals ruled that auditors could be held liable to third
parties (not in privity of contract) for gross negligence or fraud, but not for acts of ordinary negligence.
In Rosenblum v. Adler, the New Jersey Supreme Court ruled that auditors could be held liable for
ordinary negligence to any "foreseeable" third parties who utilize the financial statements for "routine
What landmark case was embraced by the court in the case of CREDIT ALLIANCE CORP v ARTHUR ANDERSEN & CO? Identify the two factors that the court stated must be proved for the auditors to be held liable for ordinary negligence to a third party.
The Credit Alliance Corp. case embraced the landmark Ultramares v. Touche & Co. precedent. The
court stated that before the auditors may be held liable for ordinary negligence to a third party, (1) the
auditors must have knowledge of reliance on the financial statements by that party for a particular
purpose, and (2) some action by the auditors must indicate that knowledge.
Compare auditors' common law liability to clients and third-party beneficiaries with their common law liability to other third parties.
Contrast JOINT and SEVERAL LIABILITY with PROPORTIONATE LIABILITY.
JOINT & SEVERAL LIABILITY is a legal concept that holds a class of defendants jointly responsible for losses attributed to the class as well as liable for any share of losses that cannot be collected from those unable to pay their share. PROPORTIONATE LIABILITY is a method of allocating damages to each group that is liable according to that group's pro rate share of any damages recovered by the plaintiff.
Compare the rights of plaintiffs under common law with the rights of persons who purchase securities registered under the Securities Act of 1933 and sustain losses. Emphasize the issue of who must bear the burden of proof.
Legal actions under common law require the plaintiffs to bear most of the burden of affirmative proof.
The plaintiffs must prove they sustained losses, that they relied upon financial statements that were
misleading, that this reliance caused their losses, and that the auditors were guilty of a certain degree of
negligence. In legal actions brought under the Securities Act of 1933, the burden of proof is shifted to
the auditors, who must show that they were not negligent (the due diligence defense) or that misleading
financial statements were not the proximate cause of the plaintiffs' losses.
State briefly a major distinction between the Securities Act of 1933 and the Securities Exchange Act of 1934 with respect to the type of transactions regulated.
Securities Act of 1933 is a federal securities statute covering registration statements for securities to be sold to the public (initial offering). The act requires auditors to exercise "due diligence" and creates both civil and criminal penalties for misrepresentation.
Securities Act of 1934 regulates public companies to fine annual audited financial statements with the SEC (after going public). The act requires auditors to "act in good faith" and creates civil and criminal penalties for misrepresentation.
Why was the ERNST & ERNST v. HOCHFELDER decision considered a "victory" for the accounting profession?
The Hochfelder v. Ernst decision is regarded as a "victory" for the accounting profession because it is
one of the few decisions to limit, rather than expand, auditors' legal liability to third parties. In this
decision the U.S. Supreme Court ruled that ordinary negligence was not a sufficient degree of misconduct
for auditors to be held liable to third parties under Rule 10b-5 of the Securities Exchange Act of 1934.
How was the CONTINENTAL VENDING case unusual with respect to penalties levied against auditors?
The Continental Vending case was unusual in that it involved criminal charges against the CPAs for
violating provisions of the Securities Acts. Although there was no intent to defraud on the part of the
CPAs, they were convicted of criminal fraud on the basis of gross negligence. The president of the
United States later pardoned the three CPAs.
Why did congress enact the Racketeer Influenced and Corrupt Organizations Act? Why has it been of concern to auditors? What subsequent developments have reduced this concern?
The Racketeer Influenced and Corrupt Organizations Act was passed by Congress to prosecute mobsters
and racketeers who influence legitimate businesses.
It has been of concern to CPAs because the act broadly defines the term "racketeering activities"
to include fraud in the sale of securities. Therefore, the act was used successfully in a small number of
cases against CPAs. Of particular concern is the Act's provision that allows treble damages to be
awarded. Concern about the RICO Act has been reduced based on the United States Supreme Court
ruling in Reves v. Ernst & Young. In that case, the court decided accountants could not be held liable
unless it can be proven that they actually participated in the operation or management of the organization.
How does the SEC regulate auditors who appear and practice before the commission?
The SEC has issued Rules of Practice to govern the appearance and practice before the commission of
CPAs, attorneys, and others. Rule of Practice 2(e) gives the power of suspension or disbarment to the
SEC. In addition, the Public Company Accounting Oversight Board (under the authority of the SEC) may
conduct investigations and disciplinary proceedings regarding both registered public accounting firms,
and professional employees (including owners). Board sanctions include monetary damages, suspension
of firms and accountants from working on engagements for publicly traded companies, and referral of
criminal cases to the Justice Department.
In the 1136 TENANTS' CORPORATION case, what was the essential difference in the way the client and CPAs viewed the work to be done in the engagement?
In the 1136 Tenants' Corporation case, the client contended that the auditors had been retained to
perform all necessary accounting and auditing services. The CPAs argued that they had been retained to
do "write-up" work only, consisting of maintaining accounting records and preparing financial statements
and tax returns. This difference was critical because the client contended the CPAs had been negligent in
not discovering a defalcation. The case illustrated the importance of an engagement letter to define the
services to be performed.
Comment on the following statement: While engagement letters are useful for audit engagements, they are not necessary for compilation and review engagements.
Engagement letters are important both for audits and for accounting and review services performed by
CPAs. Oral arrangements are unsatisfactory when a dispute arises as to the services to be rendered by
Rogers and Green, CPAs, admit they failed substantially to follow GAAS in their audit of Martin Corporation. "We were overworked and understaffed and never should have accepted the engagement," said Rogers. Does this situation constitute fraud on the part of the public accounting firm? Explain.
No. Rogers and Green appear to be guilty of gross negligence, which often is considered tantamount to
constructive fraud. However, actual fraud involves knowledge of misrepresentation within the financial
statements and an intention to deceive users of those statements. Although Rogers and Green failed
substantially to comply with generally accepted auditing standards, there is no indication that they knew
of misrepresentation in the statements or intended to deceive third parties.
Gross negligence may be considered constructive fraud, because the auditors are misleading the
public as to the degree of credibility that they are able to add to the statements. While such conduct is
highly unprofessional, it is still quite different from attesting to the "fairness" of financial statements
known by the auditors to be misleading.