Chapter 20 – Legal Liability
20-1
CHAPTER 20
LEGAL LIABILITY
Answers to Review Questions
20-1 The four general stages in the initiation and disposition of audit-related disputes are: (1)
the occurrence of events that result in losses for users of the financial statements, (2) the
investigation by plaintiff attorneys before filing suit to link the user losses with
plaintiffs and their attorneys before initiating legal proceedings. The third stage involves
activities such as filing of complaints, discovery, trial preparation, and the trial. The last
stage involves the resolution of the dispute, which may include a summary judgment, a
settlement to avoid or discontinue litigation, or a court decision on appeal after a trial.
20-2 Proportionate liability is where each defendant is liable solely for the portion of the
damages that correspond to the percentage of responsibility of that defendant. Under the
20-3 Under common law, an auditor can be held liable to clients for breach of contract,
negligence, gross negligence/constructive fraud, and fraud. A client would prefer to sue
20-4 The elements required for establishing an auditor’s liability for negligence to clients are
(1) the duty to conform to a required standard of care, (2) failure to act in accordance
20-5 The four standards that have evolved for defining the extent of the auditor’s liability to
third parties are (1) privity, (2) near privity, (3) foreseen persons or classes, and (4)
reasonably foreseeable third parties. The traditional view held that auditors had no
liability under common law to third parties who did not have a privity relationship with
the auditor. Privity here means that the obligations that exist under a contract are
between the original parties to the contract, and failure to perform with due care results in
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of the Law of Torts is applied to an accountant’s third-party liability suit. The
Restatement is a compendium of common law prepared by legal scholars and presents an
alternative view to the traditional Ultramares doctrine or rule. Finally, a small number of
states have adopted a more expansive view of auditors’ liability to third parties: the
reasonably foreseeable third parties approach. The reasons cited for extending auditors’
liability beyond privity include auditors’ ability to spread the risk through the use of
liability insurance.
Auditors’ liability to third parties under common law is complex because court rulings
are not consistent across federal and state jurisdictions.
20-6 The Securities Act of 1933 generally regulates the disclosure of material facts in a
registration statement for a new public offering of securities. The Securities Exchange
Act of 1934 is concerned primarily with ongoing reporting by companies whose
securities are listed and traded on a stock exchange or who meet certain other statutory
requirements.
It is easier for a plaintiff to sue an auditor under the Securities Act of 1933, because
favorable for plaintiffs than common law since the auditor must prove that he or she was
not negligent.
20-7 Under Rule 10b-5 of the Securities Exchange Act of 1934, the following elements must
be proved by a plaintiff: (1) the existence of a material, factual misrepresentation or
omission, (2) reliance by the plaintiff on the financial statements, (3) damages suffered as
a result of reliance on the financial statements, and (4) scienter.
The Ernst & Ernst v. Hochfelder case was significant because the Supreme Court
ruled that an action under Rule 10b-5 may not be maintained by showing that the
20-8 Prior to the passage of the Private Securities Litigation Reform Act of 1995, auditors sued
under federal statutory law were held to the legal doctrine of joint and several liability.
The Act of 1995 limits the legal responsibility to proportionate liability, where each
defendant is liable solely for the portion of the damages that corresponds to each
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In 1998, Congress passed the Securities Litigation Uniform Standards Act in response
to concerns that plaintiff lawyers would circumvent the federal legislation and protections
brought by the 1995 Act by bringing class action suits involving nationally traded
securities to state court. As a result of the 1998 Act, most large class actions against
auditors alleging securities fraud must be brought to federal court.
The Tellabs, Inc. v. Makor Issues & Rights, Ltd case made it harder for prosecutors to
hold auditors liable for fraud. In this case, the Supreme Court ruled that in determining
whether the plaintiff’s complaint provides evidence of scienter, a court must consider
both fraudulent and nonfraudulent plausible causes and the plaintiff “must demonstrate
that it is more likely than not that the defendant acted with scienter.” In other words, the
20-9 Numerous sections of the Sarbanes-Oxley Act include criminal provisions, the Act
enhances prosecutorial tools available in major fraud cases by expanding statutory
prohibitions against fraud and obstruction of justice, increasing criminal penalties for
traditional fraud and cover-up crimes, and strengthening sentencing guidelines applicable
to large-scale financial frauds. The Act adds a new securities fraud offense and increases
authorized penalties for securities and financial reporting fraud (e.g., up to 25 years in
20-10 Rule 2(e) of the Rules of Practice empowers the SEC to suspend for any person the
privilege of appearing and practicing before it. These sanctions can be applied not only
to an individual auditor but also to an entire accounting firm. Typically, if a firm is faced
with suspension, it will agree to some type of consent agreement in which the firm does
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monetary penalties and requirements for remedial measures, such as training, new quality
control procedures, and the appointment of an independent monitor.
20-11 The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 has a primary
mission “To promote the financial stability of the United States by improving the
accountability and transparency in the financial system.” The Dodd-Frank act impacts the
auditing profession in several ways. Specifically mentioned in the chapter are
• The Act gives the PCAOB authorization to share its inspection and investigation
reports with non–US regulators, which will greatly improve the PCAOB’s ability to
entitled to 10 to 30 percent of any government recovery in excess of $1 million.
While not specifically mentioned in the chapter, the Act also authorizes the PCAOB to
create a program through which it can monitor the auditors of non-public broker-dealers.
20-12 The external auditor may detect activities that violate the FCPA including violations of
codes of conduct that prohibit bribery, insufficient detail to accurately reflect
transactions, inadequate systems of internal control, and other violations of the record-
20-13 Auditors can be held criminally liable under various statutes and regulations. Criminal
prosecutions require that some form of criminal intent be present, although many of the
laws described in this chapter contain provisions for criminal penalties if the auditor’s
actions reflect gross negligence or fraud.
Answers to Multiple-Choice Questions
20-14
d
20-20
c
20-15
c
20-21
c
20-16
b
20-22
a
20-17
d
20-23
b
20-18
b
20-24
d
20-19
d
20-25
d
Solutions to Problems
20-26 City Bank is not likely to prevail against Salam based on ordinary negligence. In order to
establish a cause of action for negligence against Salam, City must prove that:
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• Salam breached that legal duty by failing to perform the audit with the due care or
was City within a foreseen (known and intended) class of third-party beneficiaries who
were to receive the audited financial statements.
City Bank is likely to prevail against Salam based on constructive fraud. To establish a
cause of action for constructive fraud, City must prove that:
• Salam made a materially false statement of fact.
• Salam lacked a reasonable ground for belief that the statement was true. Constructive
Under the facts of this case, Salam is likely to be liable to City based on constructive
fraud. Salam made a materially false statement of fact by rendering an unqualified
opinion on Bell’s financial statements. Salam lacked a reasonable ground for belief that
the financial statements were fairly presented by recklessly departing from the standards
of due care in that it failed to investigate other embezzlements, despite having knowledge
of at least one embezzlement, and did not notify Bell’s management of the matter. Salam
intended that others rely on the audited financial statements. City justifiably relied on the
audited financial statements in deciding to loan Becker $600,000 and damages resulted
evidenced by Becker’s default on the City loan.
20-27 a. The elements necessary to establish negligence are:
• A legal duty to protect the plaintiff (Musk) from unreasonable risk.
b. The elements necessary to establish a violation of Rule 10b-5 include:
• A material misstatement or omission.
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c. Apple is not in privity of contract with Musk because there is no direct contractual
relationship between them. Therefore, in the absence of other factors, Apple would
not be liable to Musk for Apple’s alleged negligence based on the Ultramares
decision. However, the privity defense would not protect Apple if Musk could prove
that Apple had committed actual or constructive fraud (that is, Apple owes a duty to
all parties, including third parties, to practice its profession in a nonfraudulent
manner).
20-28 a. 1. Union Bank will be successful in its negligence suit against Meng. To be
successful in a lawsuit for accountant’s negligence, there must be:
• Duty.
• Breach.
discover the overstatement of accounts receivable. Meng’s failure to confirm
accounts receivable was a violation of Meng’s duty to comply with generally
accepted auditing standards. Union relied on Meng’s opinion in granting the loan
and, as a result, suffered a loss.
2. Union Bank will be successful in its common-law fraud suit against Meng. To be
successful in a lawsuit for common-law fraud, there must be:
• An intentional material misstatement or omission.
suffered a loss as a result of this fraudulent omission.
b. Butler’s stockholders who purchased stock will also be successful in their suit against
Meng under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934.
Under the act, stock purchasers must show:
• Intentional material misstatement or omission (scienter).
the purchasers who relied on Meng’s opinion.
20-29 a. Knox would recover from Garson for fraud. The elements of fraud are: the
misrepresentation of a material fact (because Garson issued an unqualified opinion on
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misleading financial statements; Garson’s opinion did not include adjustments for or
disclosures about the embezzlements and insider stock transactions); knowledge or
scienter (because Garson was aware of the embezzlements and insider stock
transactions); and a loss sustained by Knox (because of Sleek’s default on the loan).
b. 1. The general-public purchasers of Sleek’s stock offerings would recover from
Garson under the liability provisions of Section 11 of the Securities Act of 1933.
Section 11 of the Act provides that anyone, such as an accountant, who submits
or contributes to a registration statement or allows material misrepresentations or
was material. Garson’s action was intentional or, at a minimum, a result of gross
negligence or recklessness (scienter). These purchasers relied on Garson’s
opinion on the financial statements and incurred a loss.
Solutions to Discussion Cases
20-30 a. The bases for shareholders’ and creditors’ suits against CD&A under state
common law include:
• Breach of contract: The relationship between CD&A and Lestrad is contractual
and requires that the CPAs’ performance be rendered in a competent manner. The
shareholders and creditors may claim breach of contract as third-party
beneficiaries of the contract between the CPAs and Lestrad, since it could be held
that the contract was entered into for their benefit and therefore they are in privity
with the CPAs.
• Negligence: The shareholders and creditors could assert an independent claim of
negligence in addition to the action for breach of contract. Negligence will be
deficiencies or lapses in their professional work of such a magnitude that they
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constitute gross negligence or a reckless disregard for the truth.
b. The bases for shareholders’ and creditors’ suits against Conan Doyle &
Associates (CD&A) under the federal Securities Acts include:
• That a violation of the 1933 act has occurred as a result of misstatements or
omissions in the prospectus or elsewhere in the registration statement required in
order to “sell” the securities. The Securities and Exchange Commission has ruled
merger that were filed with the SEC.
• That a violation of the proxy rules of the Securities Exchange Act of 1934
resulted from misstatements in or omissions from the merger proxy statement
used in soliciting shareholder approval.
20-31 Students will form their own opinions. Possible arguments for and against include:
Yes SOX Will Deter Fraud
• By requiring top executives to certify the fairness of financial statements and the
effectiveness of internal controls, SOX will deter fraud because top executives will
take their responsibility for financial reporting more seriously.
• SOX improves corporate governance and tone at the top as well as other controls,
No SOX Will Not Deter Fraud
• Honesty and ethical behavior cannot be legislated.
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fraud.