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5-1
Chapter 5
Legal Liability
Concept Checks
P. 118
1. Several factors that have affected the increased number of lawsuits against
CPAs are:
responsibility for protecting investors’ interests.
The greater complexities of auditing and accounting due to the
Society’s increasing acceptance of lawsuits.
basis.
The willingness of many CPA firms to settle their legal problems out
of court.
2. Business failure is the risk that a business will fail financially and, as a
result, will be unable to pay its financial obligations. Audit risk is the risk that the
recently issued audited financial statements were fairly stated. Many auditors
3. The difference between fraud and constructive fraud is that in fraud the
5-2
P. 129
1. The four major sources of auditor legal liability are:
Liability to clients.
2. Liability to clients under common law has remained relatively unchanged
for many years. If a CPA firm breaches an implied or expressed contract with a
except in the case of gross negligence.
the services (foreseen users). Still others have rejected the Ultramares doctrine
entirely and have held the CPA liable to anyone who relies on the CPA’s work, if
3. Under the 1934 act, the burden of proof is on third parties to show that
they relied on the statements and that the misleading statements were the
cause of the loss. The principal focus of accountants’ liability under the 1934
act is on Rule 10b-5. Under Rule 10b-5, accountants generally can only be held
Review Questions
5-1 The most important positive effects are the increased quality control by
CPA firms that is likely to result from actual and potential lawsuits and the ability
of injured parties to receive remuneration for their damages. Negative effects
5-3
Copyright © 2017 Pearson Education, Inc.
5-2 Audit risk is the risk that the auditor concludes, after conducting an audit
in accordance with the relevant auditing standards, that the financial statements
were fairly stated when in fact they were materially misstated. Audit failure
occurs when the auditor issues an incorrect audit opinion because it failed to
comply with the relevant auditing standards. There is some level of audit risk on
every audit engagement because it would be prohibitively costly for auditors to
test every transaction and balance. Auditors gather evidence on a test basis,
and thus may fail to detect a misstatement even though they comply with
5-4 Many CPA firms willingly settle lawsuits out of court in an attempt to
minimize legal costs and avoid adverse publicity. This has a negative effect on
the profession when a CPA firm agrees to settlements even though it believes
that the firm is not liable to the plaintiffs. This encourages others to sue CPA
5-5 Contributory negligence used in legal liability of auditors is a defense used
by the auditor when he or she claims the client or user also had a responsibility
in the legal case. An example is the claim by the auditor that management knew
5-6 An auditor’s best defense for failure to detect a fraud is an audit properly
conducted in accordance with auditing standards. The Principles in auditing
standards (see Chapter 2) note that the objective of an audit is to obtain
reasonable assurance that the financial statements are free of material
5-7 An engagement letter from the auditor to the client specifies the
responsibilities of both parties and states such matters as fee arrangements and
5-4
5-7 (continued)
easily disputed.
5-8 In more recent years, the auditor’s liability to a third party has become
affected by whether the party is known or unknown. Now a known third party,
under common law, usually has the same rights as the party that is privy to the
5-9 The differences between the auditor’s liability under the securities acts of
1933 and 1934 are because the 1933 act imposes a heavier burden on the
auditor. Third party rights as presented in the 1933 act are:
registration statement may sue the auditor.
2. Third party users do not have the burden of proof that they relied
1. The statements were not materially misstated.
2. An adequate audit was conducted.
3. The user did not incur the loss because of misleading financial
statements.
The liability of auditors under the 1934 act is not as harsh as under the
1933 act. In this instance, the burden of proof is on third parties to show that
The principal focus of accountants’ liability under the 1934 act is on Rule
10b-5. Under Rule 10b-5, accountants generally can only be held liable if they
intentionally or recklessly misrepresent information intended for third-party use.
5-5
Copyright © 2017 Pearson Education, Inc.
5-10 The auditor’s legal liability to the client can result from the auditor’s failure
to properly fulfill his or her contract for services. The lawsuit can be for breach
of contract, which is a claim that the contract was not performed in the manner
agreed upon, or it can be a tort action for negligence. An example would be the
client’s detection of a misstatement in the financial statements, which would
have been discovered if the auditor had performed all audit procedures required
in the circumstances (e.g., misstatement of inventory resulting from an inaccurate
physical inventory not properly observed by the auditor).
The auditor’s liability to third parties under common law results from any
loss incurred by the claimant due to reliance upon misleading financial statements.
omission.
Civil liability under the Securities Act of 1933 provides the right of third
parties to sue the auditor for damages if a registration statement or a prospectus
contains an untrue statement of a material fact or omits to state a material fact
that results in misleading financial statements. The third party does not have to
the auditor for negligence.
Civil liability under the Securities Act of 1934 relates to audited financial
statements issued to the public in annual reports or 10-K reports. Rule 10b-5 of
the act prohibits fraudulent activity by direct sellers of securities. Several federal
would be an auditor’s certifying financial statements that he or she knows
overstate income for the year and the financial position of the company at the
audit date.
1. Suspend the right to conduct audits of SEC clients.
2. Prohibit a firm from accepting any new clients for a period.
5-6
Copyright © 2017 Pearson Education, Inc.
5-12 The Sarbanes-Oxley Act of 2002 made it a felony to destroy or create
documents to impede or obstruct a federal investigation. As a result of the
Sarbanes-Oxley Act, a person may face fines and imprisonment for altering or
destroying documents.
5-13 Some of the ways in which the profession can positively respond and
reduce liability in auditing are:
1. Continued research in auditing.
of auditing.
3. The AICPA can establish requirements that the better practitioners
always follow in an effort to increase the overall quality of auditing.
4. Establish new peer review requirements.
settling out of court.
the attest function.
7. Improper conduct and performance by members must be sanctioned.
8. Lobby for changes in state and federal laws concerning accountants’
liability.
Multiple Choice Questions From CPA Examinations
5-14 a. (1) b. (4) c. (3)
5-15 a. (3) b. (2) c. (4)
Multiple Choice Questions From Becker CPA Exam Review
5-16 a. (4) b. (3) c. (2)
Discussion Questions and Problems
5-17 1. The plaintiff will most likely not be able to seek restitution from
Brogan’s personal assets given the firm operates as a limited liability
recklessness.
5-7
5-17 (continued)
despite the company’s subsequent bankruptcy.
4. Under common law, CPAs do not have the right to withhold
information from the courts on the grounds that the information is
privileged. Confidential discussions between the client and the
the documentation requested by the subpoena.
5. Spencer Cullen will most likely be liable for gross negligence for
failure to obtain sufficient appropriate evidence to examine the
5-18 1. c (fraud)
i (gross negligence)
2. d (ordinary negligence)
h (privity of contract)
3. a (due diligence)
supervise them, but likely did not intend to deceive the bank. At a
minimum, Marquez’s behavior constitutes constructive fraud,
which is extreme or unusual negligence without intent to deceive
(also called recklessness).
