Chapter 6 Discussion Questions
1. Distinguish between common-law liability and statutory liability for auditors. What is the basis for the
difference in liability?
Common law liability arises from legal opinions issued by judges in deciding cases. These opinions become legal
precedent and guide other judges in deciding on similar cases in the future. Common law cases are civil suits.
Statutory liability reflects legislation passed at the state or federal level; the legislation establishes certain courses of
2. Explain the difference between the ethical responsibilities of auditors and auditor legal obligations.
Auditor legal obligations are a minimum requirement. The securities acts establish statutory liabilities and common
law decisions establish civil liability. The law establishes minimum requirements for ethical conduct. The problem
is when auditor responsibilities are not clear it is the ethical standards of the profession in the form of the Principles
of Professional Conduct embodied in the AICPA Code that should guide auditors. Auditor ethical responsibilities
3. Is there a conceptual difference between an error and negligence from a reasonable care perspective?
Give examples of each of your response.
Errors are unintentional mistakes or omissions. Error may involve mistakes in gathering or processing data or
testing, misinterpretation of facts, mistakes in the application of GAAP or GAAS. A simple error is transposing
numbers when entered into the data-base system (i.e., $492 recorded as $429). There can be errors in math,
4. Distinguish between the legal concepts of actually foreseen third-party users and reasonably foreseeable
third-party users. How does each concept establish a basis for an auditor’s legal liability to third
parties?
Actually foreseen third party users are a limited range of individuals or organizations that the client intends the
information to benefit. The auditor need not know the exact identity of the third party. However, it owes a duty to
persons who the professional knows will rely on the information. The auditor would be liable to any plaintiff that
Foreseeable third party users are individuals or organizations that the client intends the information to benefit. The
reasonably foreseeable third party user group would also include a limited class of potential users that the accountant
could reasonably foresee (but may not be known to the auditor at the time of the audit) relying on the auditors’ work.
5. Describe what the law requires with respect to the legal ruling in Credit Alliance v. Arthur Andersen &
Co. Do you think the ruling establishes a fair basis for an auditor’s legal liability to third parties?
Credit Alliance establishes the criteria of a near privity relationship. Near privity is a relationship so close to privity,
as to approach privity. A three point test was established by the court in Credit Alliance v. Arthur Andersen & Co.:
The ruling and three point test is seen as a way of limiting auditors’ liability to third parties closer to the primary
beneficiary criteria of Ultramares. This seems to be a fair basis for establishing legal liability of auditors since it is
6. Explain the legal basis for a cause of action against an auditor. What are the defenses available to the
auditor to rebut such charges? How does adherence to the ethical standards of the accounting profession
relate to these defenses?
A client or a third party must prove that (1) the CPA accepted a duty of professional care to exercise skill,
prudence, and diligence; (2) the CPA breached his/her duty of due professional care through negligence; (3) the
client or third party suffered losses; and (4) the damages were caused (causation or proximate cause) by the CPA’s
7. A subsequent event is one that occurs after the date of the financial statements (i.e., December 31, 2013)
but prior to the auditor having dated (or possibly issued) the audit report (i.e., March 15, 2014). One
type of subsequent event is where additional evidence becomes available before the statements have been
issued that sheds light on certain estimates previously made in the statements. A good example is
additional evidence about the collectibility of a receivable that relates to its valuation in the December
31, 2013, financial statements but is not uncovered until January 31, 2014. Why is it important from an
auditing perspective that an auditor be required to adjust the financial statement amounts for some
material subsequent events? If an auditor fails to live up to this standard, what is the potential liability
exposure for the auditor?
If the auditor is aware of a subsequent event that would change the reader’s or investor’s mind about the company
and its financial statements, that subsequent event must be disclosed. Typically, such events have a direct effect on
financial statement amounts. For example, the post-balance sheet date collection of a material receivable that had
been written off at the balance sheet should lead to eliminating the write-off because the auditor knows prior to the
8. What are the legal requirements for a third party to sue an auditor under Section 10 and Rule 10b-5 of
the Securities Exchange Act of 1934? How do these requirements relate to the Hochfelder decision?
A plaintiff must prove the following under Rule 10b-5 of the Securities Act of 1934: 1) loss or damages; 2) financial
statements were misleading; 3) reliance on the misleading statement; 4) misleading statements are the direct cause of
9. Valley View Manufacturing Inc., sought a $500,000 loan from First National Bank. National insisted that
audited financial statements be submitted before it would extend credit. Valley View agreed to this and
also agreed to pay the audit fee. An audit was performed by an independent CPA who submitted her
report to Valley View to be used solely for the purpose of negotiating a loan from National.
National, upon reviewing the audited financial statements decided in good faith not to extend the credit
desired. Certain ratios which as a matter of policy were used by National in reaching its decision, were
deemed too low. Valley View used copies of the audited financial statements to obtain credit elsewhere. It
was subsequently learned that the CPA, despite the exercise of reasonable care, had failed to discover a
sophisticated embezzlement scheme by Valley View’s chief accountant. Under these circumstances, what
liability does the CPA have?
Under the situation, if the CPA can show due care and competency in the performance of the audit, the CPA would
not be liable. The CPA will need to show that the audit was planned and performed to detect material misstatements,
but that it is not absolute assurance that all misstatements, and especially sophisticated embezzlement by the chief
accountant, will be discovered. The CPA would be liable to Valley View for ordinary negligence. The CPA would
10. Nixon and Co., CPAs, issued an unmodified opinion on the 2013 financial statements of Madison Corp.
These financial statements were included in Madison’s annual report and Form 10-K filed with the SEC.
Nixon did not detect material misstatements in the financial statements as a result of negligence in the
performance of the audit. Based upon the financial statements, Harry purchased stock in Madison.
Shortly thereafter, Madison became insolvent, causing the price of the stock to decline drastically. Harry
has commenced legal action against Nixon for damages based upon Section 10(b) and Rule 10b-5 of the
Securities Exchange Act of 1934. What would be Nixon’s best defense to such an action? Explain.
Harry must show that he suffered a loss, that the financial statements were misleading and that he relied on the
financial statements to make his investment in Madison. Nixon’s defense against the legal action would be evidence
of the audit performed with due care due care, non-negligent performance and absence of causation or proximate
11. Distinguish between legal and illegal insider trading. Evaluate the ethics of the practice.
Legal insider trading is the legal buying and selling by a corporate insider who owns more than 10% of the shares.
The owner must report all trades over that percentage to the SEC. Illegal trading is illegal only when a person bases
his or her trade of stocks in a public company on information not publicly available. Not only is trading on
nonpublic information illegal, not reporting trades to the SEC are illegal as well. Illegal trading also includes giving
tips to another person about nonpublic information. The SEC’s job is to make sure that all investors are making
12. The legal concept of in pari delicto holds that in a “case of equal or mutual fault [in a financial fraud] the
position of the defending party [auditor] is the stronger one.” The predicate for this defense is
imputation: holding the corporation responsible for the acts of its officers. The leading case authority is
Cenco Inc. v. Seidman & Seidman, a 1982 case where the court permitted an auditor to invoke the in pari
delicto doctrine to defeat a claim against it for failing to detect fraud by the management of an audit
client. From an ethical perspective, do you think auditors should be able to escape legal liability for
failing to uncover fraud under the doctrine?
It depends on whether it is ethical or not. If the auditor truly was duped by management but exercised due care in
performing the audit, gathering evidence, and approaching the audit with the necessary degree of professional
skepticism, then the fact that management went to great lengths to fool the auditors should place more burden for
13. According to a 2012 study by Fortune magazine, 86.5 percent of Fortune 100 companies have adopted
clawback provisions that allow them to recover cash bonuses or stock from errant executives.
Apparently, such provisions now have become a widely accepted corporate governance practice. What
practice(s) typically trigger clawback actions by the SEC? Do you think trying to enforce contested
clawbacks are in shareholders’ best interests? Why or why not?
SOX requires the SEC to pursue the repayment of incentive compensation from senior executives that are involved
in a fraud. Dodd-Frank mandates the SEC to require that U.S. public companies include a clawback provision in
their executive compensation contracts that lead to payments in a situation where materially misstated statements
existed during the compensation period (i.e., bonuses while the earnings were manipulated may lead to clawback of
the bonus payments). As yet, the SEC has rarely used this clawback provision against executives. A working paper