copyright © 2007 pearson education canada 1 chapter 4: legal liability

Copyright © 2007 Pearson Education Canada1

Chapter 4: Legal Liability

Copyright © 2007 Pearson Education Canada4-2

Chapter 4 objectives Identify sources of legal liability Distinguish between a business failure and an

audit failure Explain the concept of privileged communication List who can sue the auditor, and discuss the

auditor’s potential defences Discuss what individual accountants and the

accounting profession are doing to respond to legal liability


Sources of legal liability

Why do you believe that an auditor might be sued or liable?

Check your answers on Table 4-1 (p. 82)


Confusing business and audit failure

Business failure: when a business cannot repay its debts, perhaps due to poor management, a shift in demand, or economic factors

Audit failure: when the auditor issues an incorrect audit opinion (e.g. an unqualified opinion when it should be qualified)


Think of an example …

Think of a recent business failure that was publicized in your area

Were the auditors sued? If so, do you think that it was a business

failure, or an audit failure, or both? Was fraud involved?


Role of audit risk

The auditor uses audit risk to help decide how much evidence to collect

Audit risk is the risk that the auditor will conclude that the financial statements are fairly stated, when they are not (For example, if the auditor chooses audit risk of 3%, there is a 3% risk of material error in the financial statements)


Practice problem 4-20 (p. 106)

How does management integrity affect the audit process?

Is the auditor responsible to consider organized criminal activity?


Expectation gap

There is an expectation gap when two different groups expect different outcomes in a particular situation

Here, we use the term ‘expectation gap’ to refer to the difference between what users actually expect and what the audit report actually provides


What do users expect?

Think about the different users of financial statements

What might the difference in expectations be among these users with respect to the auditor’s report?


Terminology and context

Before moving on, take a look at some of the legal terms covered on pages 84 to 87

We will focus on three of these:– Prudent person– Joint and several liability– Lack of privileged communication



Clarifying terminology Use this question with a series of true and

false questions to test your understanding of key legal terms


Prudent person

The auditor is not expected to be perfect How is the standard of performance set? According to the courts it is based upon

“reasonable care and diligence in the performance of obligations” – this means that the auditor does his/her best given the training and experience required


Joint and several liability

The partner in charge of an audit engagement is responsible for his/her employees, other partners on the engagement, as well as work performed by other audit firms, internal auditors or specialists

Limited liability could be present if the firm formed a limited liability partnership


Lack of privileged communication

Lawyers may refuse to provide information to the courts that was given to them by their clients (called privileged communication)

Accountants do not have this right They must provide information to the

courts when subpoenaed



Think about the typical accounting firm Think of as many specific examples as you

can – who would the partner in the public accounting firm be held liable for?


Who can sue the auditor? Clients (the business entity

or organization that hired the auditor)

Third parties:– Owners or shareholders

(existing or potential)– Vendors– Bankers, Canada

Revenue Agency or other creditors

– Customers– Employees, etc.



Fiduciary duty?What is it?When is an

auditor responsible?


Five possible defences againstthird-party suits (p. 94)

Lack of duty of care Absence of misstatement Non-negligent performance Absence of causal connection Contributory negligence

Preferably used in the above order during a suit.


Lack of duty of care (also called “lack of privity”)

The auditor claims that there was no duty to the party that is suing

There is a duty of reasonable care to the client

An engagement letter helps identify that there is no duty of care to find fraud


Practice problem 4-13 (pp. 104-5)

The bank lent some more money After relying upon the financial statements Lo, and behold, the company went

bankrupt And the bank sued the auditors (of

course?) So are the auditors liable?


Absence of misstatement

The statements were in accordance with GAAP

There were no material errors in the financial statements

The financial statements accurately portray the financial statements of the organization


Non-negligent performance

The audit was done in accordance with generally accepted auditing standards

The auditors are not responsible for undiscovered errors or fraud because their audit was done appropriately

CICA Assurance Handbook or expert witness used to support this defence


Absence of causal connection

This defence claims that there is no connection between the auditor’s breach (i.e. an audit failure) and the client’s loss

For example, the client relied upon others (such as a banker) or upon their own expertise when deciding to invest or lend money


Contributory negligence

The auditor accepts partial blame, i.e. accepts that the audit was not conducted in accordance with GAAS

However, the auditor also places blame on the party that is suing the auditor, e.g. management did not correct internal control weaknesses


No damages

There is one additional defence that arises from the definition of a tort action for negligence (p. 86), and it is simply:

“No damages” This defence is simply the fact that the

plaintiff did not lose any money by relying upon the financial statements



Deliberate fraud on the part of the client

Overstatement of accounts receivable and inventory

Is the auditor liable? Why or why not? What defence would

be used?


Preventing excess legal costs

Both the accounting profession and the individual practitioner need to respond to the potential of legal liability


The profession’s response to legal liability

Conduct research in auditing Set standards and rules Set requirements to protect auditors Establish practice inspection requirements Defend unjustified lawsuits Educate users Sanction members for improper conduct or

performance Lobby for changes in laws


The individual practitioner’s response to legal liability

Deal only with clients possessing integrity Hire qualified personnel and train and

supervise them properly Follow the standards of the profession Maintain independence Understand the client’s business Perform quality audits


The individual practitioner’s response to legal liability (cont’d)

Document the work properly Obtain an engagement letter and a

management representation letter Maintain confidential relations Carry adequate insurance Seek legal counsel (when warranted)



It is important to follow up all errors

This practice problem looks at a firm’s internal quality control and supervision processes

copyright © 2007 pearson education canada 1 chapter 4: legal liability

Documents

audit engagement

audit report

audit firms

audit failureexplain

audit process

audit failurebusiness

role of audit riskthe

auditor responsible