Download Discuss Auditor Liability

Rittenberg/Schwieger/Johnstone
Auditing: A Business Risk Approach
Sixth Edition
Chapter 18
Professional Liability
Copyright © 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo,
and South-Western are trademarks used herein under license.
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Increased Responsibility of the
Public Accountant
The responsibility of public accountants to
safeguard the public's interest has
increased as the number of investors has
increased, as the relationship between
corporate managers and stockholders has
become more impersonal, and as
government increasingly relies on
accounting information.
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Discuss Auditor Liability
Auditor liability to their clients and third-party user
groups is derived from the following laws:
Contract law - Liability is based on breach of contract.
The contract is usually between the public accounting
firm and the client for performance of a professional
service, such as an audit performed according to
GAAS
Common law - Liability concepts developed through
court decisions and based on auditor negligence,
gross negligence or fraud
Statutory law - Liability based on state statutes or
Federal securities laws. The most important of these to
the auditing profession are the Securities Act of 1993
and the Securities and Exchange Act of 1934
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Factors Leading to Increased
Litigation against Auditors
Awareness by users of financial information of
the possibilities and rewards of litigation
Joint and several liability statutes that permit a plaintiff
to collect the full amount of the settlement from any
defendant, even those only partially responsible for
the loss (i.e. deep pockets theory)
Increased audit complexity caused by computerized
systems, new types of transactions and operations,
more complicated accounting standards, more
international business
More demanding audit standards for detection of
errors and fraud
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Factors Leading to Increased
Litigation against Auditors (continued)
Pressures to reduce audit time and improve
audit efficiency
Misunderstanding by users that an unqualified
opinion is an insurance policy against
misstatements (expectations gap)
Contingent-fee-based compensation for law
firms, especially in class action lawsuits
Class-action lawsuits which allow law firms to
combine defendants into one legal action
Punitive damages
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Potential Liability
To understand the potential liability, the
auditor must understand:
Concepts of breach of contract and tort
Parties who may bring suit
Legal precedence and statutes that may be
as a standard against which auditor
performance may be evaluated
Auditor defenses
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Causes of Legal Action
Causes of legal action
Breach of contract
Negligence: failure to exercise a reasonable
level of care that causes damage to another
Gross negligence: failure to exercise even a
minimal level of care (reckless disregard) but
without intent to harm or damage anyone
Fraud: intentional concealment or
misrepresentation of material facts that cause
damages to those deceived (scienter)
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Civil Liability
Auditors may be held civilly liable by
clients and third parties who use
audited financial statements. This civil
liability is based
Contract law
Common law
Statute
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Breach of Contract
Breach of contract occurs when auditor
fails to perform a contractual duty
Breach actions include
failing to complete the engagement within the
agreed-upon time
withdrawing from the engagement without
sufficient justification
violating client confidentiality
failing to provide professional quality work
Parties to the contract can file suit
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Breach of Contract (continued)
Court remedies to a breach include
order auditors to fulfill the contract (specific
performance)
issue injunction to prohibit the auditor from continuing
the breach
order auditor to pay compensatory (actual) damages
Auditor defenses include
auditor did not breach the contract
client was contributory negligent
client losses were not caused by the breach
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Common Law Liability
To prevail, a plaintiff must generally prove four
things:
Existence and amount of damages
Financial statements were materially misleading
Plaintiff relied on the statements and as a result,
suffered damages (causality)
Auditor misconduct - the level of misconduct that must
be proved depends on who the plaintiff is, and the
jurisdiction in which the suit is filed
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Who are the plaintiffs under
common law?
The courts have ruled auditors can be held liable by
clients and third parties reasonably expected to
rely on audited statements.
Generally, courts have classified third-party users
into 3 groups:
Identified users are specific individual users who the
auditor knows will use the statements to make a
specific decision
Foreseen users while not individually known, belong to
a specific group of users whom the auditor knows will
use the statements
Foreseeable users belong to a general class of users
whose members may or may not use the financial
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statements
Level of Auditor Misconduct
The level of auditor misconduct a third-party plaintiff must
prove depends on which group the plaintiff belongs to
and the jurisdiction in which the case is tried:
Restatement
User
Credit Alliance
Identified
Negligence
Foreseen Gross negligence
Foreseeable Gross negligence
Citizens State
of Torts
Bank/Rosenblum
Negligence
Negligence
Negligence
Negligence
Gross negligence Negligence
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Auditor Liability
Auditor liability under Federal statute was
established by the Securities Act of 1933, and
the Securities Exchange Act of 1934, and most
recently modified by Sarbanes/Oxley Act of 2002
Auditors found to be unqualified, unethical, or in
willful violation can be disciplined by the SEC.
Sanctions include
Temporarily or permanently revoking the firm's
registration with the Public Company Accounting
Oversight Board
Civil penalties of up to $750,000 per violation
Require continuing education of firm personnel
Investors in public companies may sue auditors
under common law, statutory law, or both.
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Securities Act of 1933
Requires companies to file S-1 Registration statement with SEC
before they issue new securities to the public
Audited financial statements are included in the Registration
statement (and prospectus)
Because it covers the issue of new securities, the Act requires a
very high standard of care. Plaintiffs need prove only
 financial statements were materially misleading
 plaintiff suffered damages
 plaintiffs do not need to prove reliance on the statements or
auditor misconduct
Auditor defenses include
 proving financial statements were not materially misstated
 proving plaintiff damages were not caused by the misleading
financial statements
 proving auditor acted with due professional care
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Securities Exchange Act of 1934
The Securities Exchange Act of 1934 regulates trading of
securities after their initial issuance (secondary market)
and the filing of periodic reports with the SEC. These
reports include annual reports and 10-Ks, quarterly
financial reports and 10-Qs, and 8-Ks.
The 1934 Act holds auditors to a much lower standard of
care than the 1933 Act. Under the 1934 Act, plaintiffs
must prove
 Existence and amount of damages
 Financial statements were materially misleading
 Plaintiff relied on the statements and as a result, suffered
damages (causality)
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Securities Exchange Act of 1934
Auditor misconduct - the level of misconduct that
must be proved is the subject of much debate. In
Ernst & Ernst v. Hochfelder, the U.S. Supreme
Court held that
Congress had intended that the plaintiff prove the
auditor acted with scienter
However, the Court reserved judgment as to
whether gross negligence would be sufficient to
impose liability
In several cases following Hochfelder, judges
and juries have used a standard of "reckless
conduct" to hold auditors liable
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Criminal Liability to Third Parties
Both the 1933 and 1934 Acts provide for
criminal actions against auditors—guilty
persons can be fined or imprisoned for up
to five years.
Key cases regarding auditor criminal liability
Continental Vending (U.S. v Simon)
Equity Funding
U.S. v Duncan
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Policies to Help Assure Auditor
Independence
Periodic rotation of audit engagement partner
Prohibit certain non-audit services for public company
audit clients
Restrict other non-audit services for audit clients
Firm policies including training programs that
emphasize auditor independence and requiring each
auditor to sign a statement of independence
External quality reviews: Sarbanes/Oxley Act requires
the PCAOB perform quality reviews of registered
public accounting firms
Internal reviews: concurring partner reviews and
interoffice reviews
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Approaches to Mitigate Liability
Exposure (Defensive Auditing)
Defensive auditing means taking special actions
to avoid lawsuits. In addition to establishing
good quality controls and quality/peer reviews,
firms can take other actions
Use engagement letters for all financial statement and
consulting engagements
Client screening
Do not accept engagements for which the firm is not
qualified
Maintain complete and accurate audit documentation
Limited liability partnerships
Carry sufficient professional liability insurance
Tort reform
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