Download Legal Environment Affecting Audits

Chapter 4
Legal Environment Affecting Audits
Learning Objectives
1. Learn the meaning of legal standing and the
characteristics of various legal standing classifications
of plaintiffs.
2. Describe the processes that occur in a legal action
resulting in a trial.
3. Understand different causes of action typically used
in cases against auditors along with likely defenses
and damages.
4. Recognize various statutory laws that may affect
auditors in civil and criminal actions.
Auditors and Risk
 Audit Risk
 The possibility that the auditors issue opinions
that ICFR is effective and financial statements
are fair when that is not true
 Audit failure occurs when an auditor issues an
inappropriate audit report
 Audit failures are exposed when fraud is
discovered or a company goes bankrupt
Who Can Sue the Auditor?
 A plaintiff who has standing can bring a
legal cause of action against an auditor
 Four descriptions of standing apply:
1. Privity
2. Near privity
3. Foreseen third parties
4. Foreseeable third parties
Cause of Action
 Negligence – absence of due
professional care
 Fraud
 Breach of Contract
 Statutory violations
 Only those in close proximity will be
granted standing for negligence
Privity
 Defined as “the connection or
relationship between two parties each
having a legally recognized interest in
the same subject matter”
 Ultramares case – a person or entity
must have privity with an auditor in
order to collect damages if an auditor
is negligent
Near Privity
Near privity – Three part test
1. did the auditor know the financial statements
were to
be used for a specific purpose?
2. did the auditor know the third party?
3. some action by the auditor showing an
understanding that the third party was going
to rely on the financial statements
Foreseen Third Parties
 A majority of the states and the federal government use this
standard when determining standing of a potential plaintiff.
 From Restatement of Torts, 2d. Section 552
 Accountant can be liable for failure to use reasonable care or skill
 Liability is limited to the loss suffered
 Liability is owed only to those to whom the accountant intended to
provide the information or knew the recipient intended it for
 Accountant knows the recipient intended to rely on the information
 Foreseeable third parties are a far broader class, and the
foreseeable third party standard is only used by Mississippi
and Wisconsin.
Civil Legal Action
 Majority of cases against accountants are
civil cases covered by tort law
 Tort law addresses a situation where a
party suffers a loss and wants damages
Arbitration, Negotiation and Settlement
 Arbitration is a process in which negotiation
occurs conducted by an independent arbitrator
 Arbitration may be mandated by contract or
voluntarily entered into by both parties
 Many times disputes are settled before going
to trial
A Legal Action
 Step 1: - A complaint is a document stating the facts as stated
by the plaintiff.
Proposed course of action
Remedies being sought
Dollar amount of damages sought by the auditor
 Step 2: The Answer – defendant’s response.
 Step 3: Discovery – fact-finding using documents and
depositions
 Step 4: Trial
 Step 5: After the proceedings, if a judgment is made, damages
are awarded; appeal is possible
Depositions, Purposes and Possible Outcomes
 Discovering facts sufficient to establish or defend
against the allegations
 Establishing a defendant’s testimony under oath
 Obtaining an admission of the alleged negligence
 Narrowing the contested factual aspects of the case;
both parties may “stipulate” or state that they agree
about certain facts
 Establishing testimony that can be used to impeach or
discredit a witness at a later point during the trial
Causes of Action, Defenses and Potential Damages
 The cause of action is the legal theory used to allege
wrongdoing by the defendant
 Attempts of proof and defenses are tailored for the
cause of action
 Legal cases can be civil or criminal
 Requirements to prove the guilt in a criminal case are
stricter and potential damages more severe
 In a criminal case, the plaintiff is the government
 Prison time is possible in criminal cases
Negligence and Gross Negligence
 Negligence: “conduct which falls below the standard
established by law for the protection of others against
unreasonable risk of harm”
 To prove negligence on the part of an auditor
1. The financial statements were materially misleading
2. The auditor was negligent in the performance of the audit engagement
a. The auditors did not meet professional standards of a “reasonable man” or
“prudent person”
b. The auditors did not perform to their own professional standards
3. The plaintiff relied on the financial statements
4. The auditor was known or responsible to the plaintiff
5. The plaintiff was damaged by relying on the statements
Defenses to Negligence
 Due professional care was used
 No duty of care existed
 The plaintiff did not rely on the financial
information
 The negligent behavior did not cause the
damages
 The plaintiff was culpable of contributory
negligence
Damages
 Compensatory damages
 Limited to the loss the plaintiff suffered
 Punitive damages
 Gross negligence is “reckless disregard”
 A finding of gross negligence can result in punitive
damages
 Ultramares is most often cited case re negligence
 Liability may be
 Joint and severally
 Separate and proportionate
Fraud
 Proofs required for a finding of fraud
 The financial statements were materially misleading
 The auditor knowingly misrepresented or intentionally
omitted items within the financial statements
 The plaintiff relied on the financial statements
 The auditor was responsible to the plaintiff; standing
 The plaintiff was damaged by relying on the financial
statements
 Defense: That the auditor did not knowingly or
intentionally perform the act or omit the information
Relevant Fraud Cases
 State Street Trust Co. v. Alwin C. Ernst
 Houbigant v. Deloitte & Touche
 Reisman v. KPMG Peat Marwick
Breach of Contract
 Breach of contract claim is valid only if:
 The plaintiff had a contract with the auditor and the auditor did not
comply with the requirements of the contract.
 Third-party beneficiary plaintiffs are usually not successful because they do
not have privity with the auditor
 Defenses
 The contract was not breached
 The plaintiff did not have privity of contract
 Damages, typically compensatory
 Relevant case
 National Medical Transportation Network v. Deloitte and Touche
Statutory Civil Law
 First main cause of action: Securities Act of 1933
 Any third party who purchases securities described in a registration
statement may sue the auditor for any material misrepresentation or
omission in the financial statements
 No requirement to prove anything except that there was a material
misrepresentation or omission in the financial statements
 Section 11(b) defense – due diligence
 Section 11(e) defense – lack of causal connection
 Damages, compensatory with proportionate liability
 Relevant cases
 Escott v. Barchris Construction.
 Bernstein v. Crazy Eddie.
Statutory Civil Law continued
 Second main cause of action: Securities Exchange Act of 1934
 Section 10b-5 targets fraud
 Defense: prove that intent to deceive does not exist; plaintiff
can then still allege negligence but that is not sufficient to
bring a case under the 1934 Act
 Damages, compensatory and punitive with proportionate
liability
 Relevant cases


Ernst & Ernst v. Hochfelder (1976)
Nappier v. Price Waterhouse (2002)
Possible Government Actions
Following can be used to bring civil actions against auditors:
 SEC Rules of Practice – sanctions and penalties imposed by the SEC can
effectively put a CPA firm out of business
 RICO – Racketeer Influenced and Corrupt Organization Act
 Used for civil and criminal actions
 Typically used for federal mail or wire violations; fraud
 Foreign Corrupt Practices Act
 Makes bribing foreign officials illegal
 Requires companies to maintain reasonable records and have an
adequate system of internal control
 Sarbanes-Oxley Act of 2002
 PCAOB is mandated to inspect public accounting firms that do audits
of public companies and can assess fines
Criminal Actions




Fraud
Fraud under the SEC Acts of 1933 and 1934
Obstruction of Justice
Sarbanes – Oxley Act, misleading an auditor
Appendix A – United States Court Systems




Federal and State courts
Stare Decisis
Subject matter Jurisdiction
PSLRA 1995, SLUSA 1998
Copyright
“Copyright © 2011 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted
in Section 117 of the 1976 United States Copyright Act without
the express written permission of the copyright owner is
unlawful. Request for further information should be addressed
to the Permissions Department, John Wiley & Sons, Inc. The
purchaser may make back-up copies for his/her own use only and
not for distribution or resale. The Publisher assumes no
responsibility for errors, omissions, or damages, caused by the
use of these programs or from the use of the information
contained herein.”