Transcript Legal Liability of Audtiors - Lorsbach's Auditing Resource

Legal Liability of Auditors
Or, Sometimes Called the
Malpractice Maze.
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Legal Liability of Auditors:
A Historical Perspective
Before 1930: Few lawsuits
1930-1945:
A number of precedent
setting cases (Depression)
1945-1966:
Few major lawsuits
1976-1990:
Many major lawsuits
(Several Recessions)
Many major lawsuits?
2001 - ????
Common Thread: Business Failures
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Primary Plaintiffs
Clients
Breach of Contract or Negligence
3rd
Party Beneficiaries (Users of F.S.)
Negligence
Government
Violate Security Laws or
Negligence for Gov’t Insured
Financial Institutions
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What is Negligence?
 Ordinary
Negligence: Violation of a
Legal Duty to Exercise a Degree of Care that
an Ordinarily Prudent Person (CPA) Would
Exercise Under Similar Circumstances.
 Gross
Negligence: Reckless Disregard
for Professional Responsibilities.
How to Determine:
 Reference
to Professional Stds (GAAS)
 CPA as an Expert Witness
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Most Likely Client Lawsuits

Late F.S. or Tax Returns

Failure to Find Fraud

Errors in Proposed F.S. Adjustments

Errors in Tax Returns

Disclosure of Confidential Info
Result to Client: Usually A Loss
Legal Basis: Common Law
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Client Must Prove
 CPA Accepted Duty to Exercise Due
Professional Care
(Level of care should be included in the
engagement letter - based on level of service.)
 Breach of Duty (through negligence)
 Client Suffered Loss
 Loss Resulted from CPA’s Negligence
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3rd Party Lawsuits

Basically an Inferred Breach of Contract.

3rd Party Must be in Privity (Contractual
Relationship) with the CPA.

Privity is Defined by Precedent Setting
Cases and Varies by State.

Generally, there are 3-levels Defining
Privity in terms of the Universe of
Potential 3rd Parties Who Can Sue CPAs.

Some States Enacted Laws to Define.
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Required Proof Under
Common Law
3rd Parties Plaintiffs Must Prove:
1. Loss Sustained
2. Auditor Was Negligent
3. 3rd Party Relied on the F.S.
4. F.S. Either Misleading or Had
Misstatement Which is the Proximate
Cause for the Loss.
5. Privity (as defined by state precedent or law)
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3 Basics Approaches to Defining
3rd Party Privity - Common Law

Ultramares Approach
 Liable to Identified/Known Third-Parties
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3rd Party Liabilities Under Common Law
Ultramares
Liable to known specific
3rd party like B of A for a
specific purpose
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3 Basics Approaches to Defining
3rd Party Privity - Common Law

Ultramares Approach
 Liable to Identified/Known Third-Parties

Restatement of Torts Approach
 Liable to Foreseen Class(es) of Third Parties
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3rd Party Liabilities Under Common Law
Ultramares
Liable to known specific 3rd
party like B of A for a specific
purpose
Restatement of Torts
Liable to known classes of
3rd parties like “banks” for a
specific purpose
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3 Basics Approaches to Defining
3rd Party Privity - Common Law

Ultramares Approach
 Liable to Identified/Known Third-Parties

Restatement of Torts Approach
 Liable to Foreseen Class(es) of Third Parties

Rosenblum Approach
 Liable to All Foreseeable Third Parties
These apply for ordinary negligence. A CPA is liable to
almost anyone for Gross negligence.
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3rd Party Liabilities Under Common Law
Ultramares
Liable to known specific 3rd
party like B of A for
a specific purpose
Restatement of Torts
Liable to known classes of 3rd parties
like “banks” for a
specific purpose
Rosenblum Approach
Liable to all 3rd parties for normal
business purposes
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Ultramares Approach
to Auditor Liability
Selected Cases
Ultramares Corporation v. Touche (1931)--Landmark case under
common law establishing auditors could be held liable to thirdparty beneficiaries for ordinary negligence and to other third
parties for gross negligence.
Credit Alliance Corp. v. Arthur Andersen & Co. (1985)--A commonlaw case establishing auditors must show knowledge of reliance
on financial statements by a particular third party for a particular
purpose to be held liable.
Observation
Auditors must have been aware that the financial statements were
to be used for a particular purpose by a known specific third party
to be liable to that party for ordinary negligence.
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Restatement of Torts Approach to
Auditor Liability
Selected Case
Rusch Factors, Inc. v. Levin (1986)--A common-law
decision in which the auditors were found liable for
ordinary negligence to a third party not specifically
identified to the auditors, although the auditors were
aware of the intended use of the financial statements by
this class of user.
Observation
To be held liable for ordinary negligence, the auditors
must have been aware that the financial statements were
to be used for a particular purpose, although the identity
of the third party need not necessarily be known.
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Rosenblum Approach to
Auditor Liability
Selected Case
Rosenblum v. Adler (1983)--Established that the
auditors could be held liable for ordinary negligence to
all third parties that the CPAs could reasonably
foresee as users of the financial statements for routine
business purposes.
Observation
Opens the door to liability for ordinary negligence to
virtually all third parties who use the client’s financial
statements for a normal business purpose (lending,
investing, granting credit, acquisitions/mergers, etc).
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Common Law Liability to
Third Parties - Recap
Parties Who May Recover
for Ordinary Negligence
Approach

Ultramares

Known 3rd party beneficiary

Restatement
of Torts

Known class of intended 3rd
party users

Rosenblum

Any 3rd party auditors could
reasonably foresee as user
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Primary Federal Securities Laws
 Securities Exchange Act of 1933
Applies to purchasers of securities
(stocks & bonds) from the issuer.
(Secondary purchasers can also use this act for up to
one year after the registration statement.)
 Securities Exchange Act of 1934
Applies to purchases of securities from
secondary sources.
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Civil Liability Under Federal
Securities Laws
What must be proved by 3rd party?
Misleading
Act
Loss?
F/S?
Reliance?
33 Act
Yes
Yes
No
34 Act,
Yes
Sec. 18
Yes
Yes
Standard of
Auditor
Liability
Auditor must prove
due diligence
___________________________________________________________
34 Act,
Yes
Yes
Yes
Third party must prove
Sec. 10
auditor scienter (intent
to deceive, defraud,
manipulate)
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Auditor must prove
good faith
(no gross negligence)
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Criminal Liability Under
Federal Securities Acts
Selected Case
United States v. Simon (Continental Vending) (1969)-A highly publicized case in which auditors were
held criminally liable for gross negligence. Two
audit partners and a manager were convicted of
filing false statements with a government agency,
mail fraud, and violating Section 32 (a) of the
Securities Exchange Act of 1934. This case also
was largely responsible for the development of
required disclosure of related party transactions
(originally issued as SAS No. 6, and now contained
in FASB Statement No. 57).
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Criminal Liability Under
Federal Securities Acts
Selected Case
United States v. Arthur Andersen (2002)—Arthur Andersen
was accused of the wholesale destruction of documents
relating to the Enron Corporation collapse. The jury found,
based primarily on an email message that an Arthur
Andersen attorney advised a partner to revise a memo to
omit certain information, including a comment that an Enron
press release that included an earnings announcement was
misleading. Loss of this case effectively put Arthur Andersen
out of business. The conviction was overturned by the
U.S. Supreme Court.
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Liability for “Unaudited”
Financial Statements
Selected Case
1136 Tenants Corporation v. Max Rothenberg and
Company
(1971)--A
landmark
case
for
accountants’ liability when they are associated
with unaudited financial statements. The case
demonstrated the importance of engagement
letters to clearly establish an understanding with
the client regarding the nature of the services to
be provided. It also illustrated the need to follow
up on unusual findings even when the CPAs are
not performing audits.
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Preventing Litigation

Emphasize GAAS and professional ethics with staff.

Investigate prospective clients thoroughly.

Obtain a thorough knowledge of the client’s business.

Use engagement letters to prevent misunderstandings.

Carefully assess the risk of errors and fraud, including
those indicated by weaknesses in internal control.

Exercise extreme care in audits of clients that have a
high degree of business risk, as indicated by such
factors as financial difficulties.

Carefully prepare and review working papers.
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To Improve Chances of Winning

Retain Legal Counsel Familiar With
CPA’s Legal Liability.

Maintain Adequate Professional Liability
Insurance - AICPA has a Group purchase
Plan for Smaller Firms.
(During all the lawsuits in the late 1980s and early
1990s, premiums skyrocketed so high that many
smaller firms stop accepting audit engagements.)
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