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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
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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)
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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)
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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?
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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)
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Practice problem 4-20 (p. 106)
How does management integrity affect the audit process?
Is the auditor responsible to consider organized criminal activity?
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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
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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?
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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
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Practice problem 4-14 (p. 105)
Clarifying terminology Use this question with a series of true and
false questions to test your understanding of key legal terms
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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
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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
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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
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Practice problem 4-4 (p. 103)
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?
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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.
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Practice problem 4-19 (p. 106)
Fiduciary duty?What is it?When is an
auditor responsible?
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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.
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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
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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?
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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
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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
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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
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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
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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
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Practice problem 4-18 (p. 106)
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?
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Preventing excess legal costs
Both the accounting profession and the individual practitioner need to respond to the potential of legal liability
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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
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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
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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)