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  • 7/30/2019 arens chapter 5

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    2003 Prentice Hall Business Publishing,Auditing and Assurance Services 9/e, Arens/Elder/Beasley 5 - 1

    Legal Liability

    Chapter 5

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    Learning Objective 1

    Understand the litigious

    environment in which

    CPAs practice.

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    Changed Legal Environment

    Audit professionals have a responsibility under

    common law to fulfill implied or expressedcontracts with clients.

    They are liable to their clients for negligence

    and/or breach of contract should they fail toprovide the services or not exercise due care

    in their performance.

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    Learning Objective 2

    Explain why the failure of financial

    statement users to differentiateamong business failure, audit

    failure, and audit risk hasresulted in lawsuits.

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    Business Failure, Audit

    Failure, and Audit Risk

    BusinessFailure

    Audit

    Failure

    AuditRisk

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    Business Failure, Audit

    Failure, and Audit Risk

    Business failure

    It occurs when a business is unable torepay its lenders or meet the

    expectations of its investors because

    of economic or business conditions.

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    Business Failure, Audit

    Failure, and Audit Risk

    Audit failure

    It occurs when the auditor issues anerroneous audit opinion as the result

    of an underlying failure to comply

    with the requirements of generallyaccepted auditing standards (GAAS).

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    Business Failure, Audit

    Failure, and Audit Risk

    Audit risk

    It represents the risk that the auditor willconclude that the financial statements

    are fairly stated and an unqualified

    opinion can be issued when, in fact,they are materially misstated.

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    Learning Objective 3

    Use the primary legal concepts

    and the terms concerningaccountants liability as a

    basis for studying legalliability of auditors.

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    Lack ofprivileged

    communication

    Liability for

    the acts

    of others

    Prudent

    person

    concept

    Legal Concepts

    Affecting Liability

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    Federal

    securities laws

    Third party

    Client

    Major Sources of

    Auditors Legal Liability

    Criminal

    liability

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    Learning Objective 4

    Describe accountants liability

    to clients and related defenses.

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    Liability to Clients

    The most common

    source of lawsuits

    against CPAs

    is from clients.

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    Legal Terms Affecting

    CPAs Liability

    Terms related to negligence and fraud

    Ordinary

    negligence

    Gross

    negligence

    Constructive

    fraud

    Fraud

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    Legal Terms Affecting

    CPAs Liability

    Terms related to contract law

    Breach of

    contract

    Third party

    beneficiary

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    Legal Terms Affecting

    CPAs Liability

    Other terms

    Common

    law

    Statutory

    law

    Joint andseveral

    liability

    Separate and

    proportionate

    liability

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    Auditors Defenses

    Against Client Suits

    Lack of duty

    Nonnegligent performance

    Contributory negligence

    Absence of causal connection

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    Learning Objective 5

    Describe accountants liability

    to third parties under common

    law and related defenses.

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    Liability to Third Parties

    Under Common Law

    Ultramares doctrine

    Foreseen users

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    Foreseen Users

    Credit alliance

    Restatement of torts

    Foreseeable users

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    Learning Objective 6

    Describe accountants civil

    liability under the federal

    securities laws and

    related defenses.

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    Securities Act of 1933

    The Securities Act imposes an

    unusual burden on the auditor.Section 11 of the 1933 act defines the

    rights of third parties and auditors.

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    Securities Exchange

    Act of 1934

    The liability of auditors under this act oftencenters on the audited financial statements

    issued to the public in annual reports or

    submitted to the SEC as a part of annual

    Form 10-K reports.

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    Auditor Defenses1934 Act

    Nonnegligent performance

    Lack of duty

    Absence of casual connection

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    SEC Sanctions

    The SEC has the power in certain circumstances

    to sanction or suspend practitioners from doingaudits for SEC companies.

    Rule 2 (e) of the SECsRules of Practice says:

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    SEC Sanctions

    The commission may deny, the privilege of

    appearing or practicing before it in any way toany person who is found by the commission

    (1) not to possess the requisite qualifications to

    represent others, or (2) to be lacking in character

    or integrity or to have engaged in unethical or

    improper professional conduct.

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    Racketeer Influenced and

    Corrupt Organization Act

    This act allows an injured party to seek treble(triple) damages and recovery of legal fees

    in cases where it can be demonstrated

    that the defendant was engaged in a

    pattern of racketeering activity.

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    Foreign Corrupt

    Practices Act of 1977

    This act makes it illegal to offer a bribeto an official of a foreign country for

    the purpose of exerting influence and

    obtaining or retaining business.

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    Learning Objective 7

    Specify what constitutes

    criminal liability

    for accountants.

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    Criminal Liability

    CPAs can be held liable under

    criminal liability for accountants.CPAs can be found guilty for criminal

    action under both federal and state laws.

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    Learning Objective 8

    Describe what the profession and

    the individual CPA can do and

    what is being done to reduce

    the threat of litigation.

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    The Professions Response

    to Legal Liability

    Research in auditing

    Standard and rule settingSet requirements to protect auditors

    Establish peer review requirements

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    The Professions Response

    to Legal Liability

    Oppose law suits

    Education of usersSanction members for improper

    conduct and performance

    Lobby for changes in laws

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    Protecting Individual CPAs

    from Legal Liability Example

    Deal only with clients possessing integrity

    Hire qualified personnelFollow the standards of the profession

    Maintain independence

    i di id l

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    Protecting Individual CPAs

    from Legal Liability Example

    Understand the clients business

    Perform quality auditsDocument the work properly

    Obtain an engagement and a representation letter

    Maintain confidential relations

    i di id l C A

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    Protecting Individual CPAs

    from Legal Liability Example

    Carry adequate insurance

    Seek legal counselChoose a form of organization with limited liability

    Exercise professional skepticism

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    End of Chapter 5