4 - 1 copyright 2003 pearson education canada inc. chapter 4 legal liability

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CHAPTER 4

Legal Liability

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In recent years,the accounting

profession has facedincreasinglitigation

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U.S. litigationexplosion!

- in 1991, the “Big 6” accounting firms in the U.S. incurred costs of $447 million in defense and settlement of lawsuits

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U.S. litigationexplosion!

- in 1991, the “Big 6” accounting firms in the U.S. incurred costs of $477 million in defense and settlement of lawsuits- currently, the U.S. profession’s total liability exposure is $30 billion

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Who might sue an auditor and Who might sue an auditor and whywhy??

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Will Canadian Auditors be Will Canadian Auditors be Subjected to the U.S. Liability Subjected to the U.S. Liability

Crisis?Crisis?

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- few jury trials for civil suits involving auditors -- judges knowledgeable- small punitive damages-more effective cost sanctions- class action suits less common- less aggressive regulatory environment

Will Canadian Auditors be Will Canadian Auditors be Subjected to the U.S. Liability Subjected to the U.S. Liability

Crisis?Crisis?

Likely Not!

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Who might sue an auditor and Who might sue an auditor and whywhy??

- A client may sue an auditor for failing to discover a defalcation (common law liability to client)

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Who might sue an auditor and Who might sue an auditor and whywhy??

- a client- A third party may sue an auditor; e.g., a bank may sue an auditor for failing to discover that a borrower’s financial statements are partially misstated (common law liability to third parties)

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Who might sue an auditor and Who might sue an auditor and whywhy??

- a client- a third party- A combined group of shareholders may sue an auditor for not discovering materially misstated financial statements (liability under provincial securities acts)

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Who might sue an auditor and Who might sue an auditor and whywhy??

- a client- a third party- a combined group of shareholders- The federal government may prosecute an auditor for knowingly issuing an incorrect audit report (criminal liability)

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One reason for lawsuits against auditors One reason for lawsuits against auditors is a is a lack of understandinglack of understanding on the part of on the part of

financial statement users regarding:financial statement users regarding:

businessfailure

auditfailure

auditrisk

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One reason for lawsuits against auditors One reason for lawsuits against auditors is a is a lack of understandinglack of understanding on the part of on the part of

financial statement users regarding:financial statement users regarding:

businessfailure

auditfailure

auditrisk

What do these terms mean?What do these terms mean?

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businessfailure

Business failure occurs when a busi-ness is unable to repay its lenders ormeet investor expectations.

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businessfailure

Business failure occurs when a busi-ness is unable to repay its lenders ormeet investor expectations.Business failure is the result of unfavour-able economic or business conditionssuch as a recession, poor managementdecisions, or unexpected competition.

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Audit failure occurs when an auditorissues an erroneous audit opinion asa result of an underlying failure to comply with GAAS.

auditfailure

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Audit risk is the risk that the auditor, while appropriately following GAAS, willconclude that the financial statementsfairly stated when, in fact, they are not.

auditrisk

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businessfailure

auditfailure

auditrisk

Under which of these concepts shouldUnder which of these concepts shouldan auditor be held responsible for an auditor be held responsible for

financial damage suffered by a client orfinancial damage suffered by a client orother parties?other parties?

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businessfailure

auditfailure

auditrisk

Under which of these concepts should an Under which of these concepts should an auditor be held responsible for financial auditor be held responsible for financial

damage suffered by a client orother parties?damage suffered by a client orother parties?

no yesno, but

difficult todetermine

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Three legal Three legal conceptsconcepts apply apply to auditor liability:to auditor liability:

1. the prudent person concept.An auditor is expected to con-duct the audit with due carebut the auditor is not ex-pected to be perfect.

I’m a prudentpractitioner!!

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1. the prudent person concept.2. liability for the acts of others. The partners of a partnership are jointly liable for civil actions of a partner.

Three legal Three legal conceptsconcepts apply apply to auditor liability:to auditor liability:

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1. the prudent person concept.2. liability for the acts of others. The partners of a partnership are jointly liable for civil actions of a partner. Partners may also be liable for work of others such as employees, other public accounting firms, and specialists.

Three legal Three legal conceptsconcepts apply apply to auditor liability:to auditor liability:

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1. the prudent person concept.2. liability for the acts of others.3. lack of privileged communication. In general, auditors do not have the right under common law to withhold information from the courts on the grounds that the in- formation is privileged.

Three legal Three legal conceptsconcepts apply apply to auditor liability:to auditor liability:

COURT

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Several legal Several legal termsterms apply apply to auditor liability:to auditor liability:

Related to negligence and fraud:- negligence - absence of reasonable care

reasonablecare

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Several legal Several legal termsterms apply apply to auditor liability:to auditor liability:

Related to negligence and fraud:- negligence - absence of reasonable care

Plaintiff must prove:1. defendant owed duty of care2. defendant was negligent3. plaintiff suffered a loss4. connection exists between defendant’s

negligence and plaintiff’s loss

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Several legal Several legal termsterms apply apply to auditor liability:to auditor liability:

Related to negligence and fraud:- negligence- tort action for negligence - failure to meet social or professional obligations which caused an injury to another party

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Several legal Several legal termsterms apply apply to auditor liability:to auditor liability:

Related to negligence and fraud:- negligence- tort action for negligence - constructive fraud - existence of such recklessness that even though there was no intent to deceive or do harm, court will impute fraud

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Several legal Several legal termsterms apply apply to auditor liability:to auditor liability:

Related to negligence and fraud:- negligence- tort action for negligence - constructive fraud - fraud - a false assertion made know- ingly or recklessly

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Several legal Several legal termsterms apply to apply to auditor liability:auditor liability:

Related to negligence and fraud:- negligence- tort action for negligence - constructive fraud - fraud - a false assertion made know- ingly or recklessly- plaintiff must prove: - defendant intended plaintiff to act on the assertion - plaintiff did act on the assertion - plaintiff suffered a loss

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Several legal Several legal termsterms apply apply to auditor liability:to auditor liability:

Related to contract law:- breach of contract - failure of one or both parties in a contract to fulfill the requirements of the contract

CONTRACT

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Several legal Several legal termsterms apply apply to auditor liability:to auditor liability:

Related to contract law:- breach of contract - failure of one or both parties in a contract to fulfill the requirements of the contract

Parties who have a relationship that is established by a contract are said to have privity of contract.

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Several legal Several legal termsterms apply apply to auditor liability:to auditor liability:

Related to contract law:- breach of contract - third-party beneficiary - a third party who does not have privity of contract but is known to the contracting parties and is intended to have certain rights and benefits under the contract

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Several legal Several legal termsterms apply apply to auditor liability:to auditor liability:

Related to common and statutory law:- common law - laws that have been de- veloped through court decisions rather than through government statutes

COURT commonlaw

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Several legal Several legal termsterms apply apply to auditor liability:to auditor liability:

Related to common and statutory law:- common law - statutory law - laws that have been passed by the Canadian government

statutorylaw

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Several legal Several legal termsterms apply apply to auditor liability:to auditor liability:

Related to assessed proportion of liability:- joint and several liability - the assess- ment against a defendant of the full loss suffered by a plaintiff regardless of the extent to which other parties shared in the wrongdoing

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Several legal Several legal termsterms apply apply to auditor liability:to auditor liability:

Related to assessed proportion of liability:- joint and several liability - separate and proportionate liability - the assessment against a defendant of that portion of the damage caused by the defendant’s negligence

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Several legal Several legal termsterms apply apply to auditor liability:to auditor liability:

Contributory negligence

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Several legal Several legal termsterms apply apply to auditor liability:to auditor liability:

Contributory negligence- when plaintiff also partly caused his or her loss or injuries

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Auditor’s Defenses Against Client SuitsAuditor’s Defenses Against Client Suits

lack of duty

absence ofnegligence

contributorynegligence

absenceof causal connection

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Auditor’s Defenses Against Client SuitsAuditor’s Defenses Against Client Suits

The auditor claims that there was no im-plied or expressed contract.A common way for an auditor to demon-strate a lack of duty to perform is by useof an engagement letter.

lack of duty

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Auditor’s Defenses Against Client SuitsAuditor’s Defenses Against Client Suits

The auditor claims that the audit was performed in accordance with GAAS.Even if there were undiscovered errorsor irregularities, the auditor is not re-sponsible if the audit was properly conducted.

absence ofnegligence

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Auditor’s Defenses Against Client SuitsAuditor’s Defenses Against Client Suits

The auditor claims that if the client hadperformed certain obligations, the losswould not have occurred.

contributorynegligence

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Auditor’s Defenses Against Client SuitsAuditor’s Defenses Against Client Suits

The auditor claims that there is a lack ofa close causal connection between theauditor’s breach of the due care stan-dard and the damages suffered by theclient.

absenceof causal connection

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Liability to Third Parties Liability to Third Parties under Common Lawunder Common Law

An auditor may be liable to third parties if aloss was incurred by theclaimant due to reliance onmisleading financialstatements.

AceCompany

2004Financial

Statements

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An auditor may be liable to third partiesif a loss was incurred by the claimant due to reliance on misleading financialstatements.

Third parties include:- actual shareholders- potential shareholders - creditors (bankers)

- employees- customers - vendors

Liability to Third Parties Liability to Third Parties under Common Lawunder Common Law

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Liability to Third Parties Liability to Third Parties under Common Lawunder Common Law

Auditor liability to third parties was es-tablished, in part, by a 1931 court deci-sion, Ultramares v. Touche.The key aspect of the resulting Ultra-mares Doctrine is that ordinary negli-gence is insufficient for liability to thirdparties, because of the lack of privity ofcontract between the third party and theauditor, unless the third party is a prima-ry beneficiary.

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Liability to Third Parties Liability to Third Parties under Common Lawunder Common Law

The Ultramares Doctrine also specifies thatif there has been fraud or constructive fraud,the auditor could be held liable to moregeneral third parties.In recent years, the courts have broadened the Ultramares Doctrine to allow recovery bythird party foreseen users.

?

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Liability to Third Parties Liability to Third Parties under Common Lawunder Common Law

The Ultramares Doctrine also specifies that if there has been fraud or constructive fraud, the auditor could be held liable to more general third parties.In recent years, the courts have broadened the Ultramares Doctrine to allow recovery by third party foreseen users.

membersof a limited class of users

who the auditor is aware will rely on the financial statements

- Hedley Byrne v. Heller & Partners- Haig v. Bamford- Toromont v. Thorne

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What’s the Current Status of What’s the Current Status of Duty of CareDuty of Care of Auditors? of Auditors?

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Contraction of foreseeability concept?

Caparo Industries v. Dickmans

What’s the Current Status of What’s the Current Status of Duty of Care of Auditors?Duty of Care of Auditors?

Unclear!

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Liability to Third Parties Liability to Third Parties under Common Lawunder Common Law

In recent years, the courts have broadened the Ultramares Doctrine to allow recovery bythird party foreseen users.An even broader interpretation of the rights ofthird-party beneficiaries is to use the conceptof foreseeable users.

?

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Liability to Third Parties Liability to Third Parties under Common Lawunder Common Law

In recent years, the courts have broadened the Ultramares Doctrine to allow recovery bythird party foreseen users.An even broader interpretation of the rights ofthird-party beneficiaries is to use the conceptof foreseeable users.

users that the auditor

should have reasonablybeen able to foresee as

being likely users offinancial statements

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The four defenses available to auditors insuits by clients are also available in third-party suits.

However, contributory negligence would be lesscommonly used.

lack of duty

absence ofnegligence

contributorynegligence

absenceof causal connection

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Criminal LiabilityCriminal LiabilityAuditors may be found guilty for crimi-nal action under federal laws.

It is illegal to defraud another personthrough knowingly being involved withfalse financial statements.

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Criminal LiabilityCriminal LiabilityAuditors may be found guilty for crimi-nal action under federal laws.

It is illegal to defraud another personthrough knowingly being involved withfalse financial statements.

Few Canadian Cases

- U.S. v. Simon- U.S. v. Natelli- U.S. v. Weiner- ESM Government

Securities v. Alexander Grant

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What can the What can the auditing profession auditing profession

do to reduce do to reduce auditors’ exposure auditors’ exposure

to lawsuits?to lawsuits?

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What can the auditing profession do to What can the auditing profession do to reduce auditors’ exposure to lawsuits?reduce auditors’ exposure to lawsuits?

- encourage auditing research regarding litigation and improvements in auditing practice- establish standards and rules that meet the changing needs of auditing- establish requirements that protect auditors- establish practice inspection requirements- oppose unwarranted lawsuits- educate financial statement users about auditing and the auditor’s opinion- sanction auditors for improper conduct- lobby for changes in laws

COURT

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What canWhat canindividual public individual public

accountantsaccountants do to do to reduce their reduce their exposure to exposure to

lawsuits?lawsuits?

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What can What can individual public individual public accountantsaccountants do to reduce their do to reduce their

exposure to lawsuits?exposure to lawsuits?- deal only with clients possessing integrity- hire, train, and supervise qualified personnel- follow the standards of the profession- maintain independence- understand the client’s business- perform quality audits- document the work properly- obtain an engagement letter and a representation letter- maintain confidential relations- carry adequate insurance- seek legal counsel

COURT

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Confidentiality vs. Association Confidentiality vs. Association with False and Misleading with False and Misleading

InformationInformation

Which responsibility is higher?

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Confidentiality vs. Association Confidentiality vs. Association with False and Misleading with False and Misleading

InformationInformation

Which responsibility is higher?

No Canadian cases exist

In U.S.- Consolidata- Funds of Funds

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Civil Liability Under U.S. Civil Liability Under U.S. Federal Securities LawsFederal Securities Laws

The Securities Act of 1933 deals with informa-tion in registration statements and prospec-tuses and concernsonly reporting require-ments related to newsecurities.

Ace Company

1 share of commonstock

Ace Company

1 share of commonstock

Ace Company

1 share of commonstock

Ace Company

1 share of commonstock

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Civil Liability Under U.S. Civil Liability Under U.S. Federal Securities LawsFederal Securities Laws

Section 11 of the 1933 act defines rights:- Any third party who purchased securitiesdescribed in the registration statement may sue the auditor for material misrepresenta-tions or ommissions in audited statements...- Third party users do not have the burden ofproof that they relied on the financial state-ments or that the auditor was negligent orfraudulent. The user must only prove that theaudited statements contained a material mis-representation or omission.

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Civil Liability Under U.S. Civil Liability Under U.S. Federal Securities LawsFederal Securities LawsSection 11 of the 1933 act defines rights:

As defenses, the auditor must

demonstrate (1) an adequateaudit was conducted, or (2) all or partof the plaintiff’s loss was caused by

factors other than the misleading statements.

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Civil Liability Under U.S. Civil Liability Under U.S. Federal Securities LawsFederal Securities Laws

The Securities Exchange Act of 1934 also results in auditor liability related to auditedfinancial statements and information issuedto the public and the SEC in monthly (8-K), quarterly (10-Q), and annual (10-K) reports.

AceCompany

2004Financial

Statements

8-K

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10-Q

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10-K

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Civil Liability Under U.S. Civil Liability Under U.S. Federal Securities LawsFederal Securities Laws

The principal focus on auditor liability underthe 1934 act has been Rule 10b-5. This ruleprohibits, by interstate commerce, mail, or anational securities exchange:- any device, scheme, or artifice to defraud- untrue statements of material fact or omis-sion of material facts necessary to make thestatements not misleading- fraud or deceit in connection with the pur-chase or sale of any security

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lack of duty

nonnegligentperformance

contributorynegligence

absenceof causal connection

xThree of the four defenses available to auditors in

suits by clients are also available for suits under the1934 act.

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The U.S. SEC has the power to The U.S. SEC has the power to sanctionsanction or or suspendsuspend practitioners practitioners

from auditing SEC companies.from auditing SEC companies.

SEC

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RICORICOThe U.S. Racketeer Influenced and CorruptOrganization (RICO) Act allows an individual to seek damages when it can be demonstratedthat the defendant was engaged in a patternof racketeering activity.

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RICORICOThe U.S. Racketeer Influenced and Corrupt Organization (RICO) Act allows an individualto seek damages when it can be demonstratedthat the defendant was engaged in a patternof racketeering activity.In a 1993 U.S. Supreme Court decision, thecourt ruled that outside professionals suchas accountants who do not help run corruptbusinesses can not be sued under the provi-sions of RICO.

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U.S. Foreign Corrupt Practices U.S. Foreign Corrupt Practices ActAct

The U.S. Foreign Corrupt Practices Act:- forbids offering a bribe to an official of a for- eign country for the purpose of exerting in- fluence and obtaining or retaining business

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U.S. Foreign Corrupt Practices U.S. Foreign Corrupt Practices ActAct

The U.S. Foreign Corrupt Practices Act:- forbids offering a bribe to an official of a for-eign country for the purpose of exerting in-fluence and obtaining or retaining business- requires SEC companies to maintain rea-sonably complete and accurate records andan adequate system of internal control

How does thisaffect auditors?

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U.S. Foreign Corrupt Practices U.S. Foreign Corrupt Practices ActAct

The U.S. Foreign Corrupt Practices Act:- forbids offering a bribe to an official of a for-eign country for the purpose of exerting in-fluence and obtaining or retaining business- requires SEC companies to maintain rea-sonably complete and accurate records andan adequate system of internal control

The Act may affectauditors through their responsibilityto review and evaluate systems of

internal control as a part of an audit.