CHAPTER 20
LEGAL LIABILITY
Answers to Review Questions
20-1
The four general stages in the initiation and disposition of audit-related disputes
are : (1) the occurrence of events that result in losses for users of the financial
statements, (2) the investigation by plaintiff attorneys before filing suit to link the
user losses with allegations of material omissions or misstatements of financial
statements, (3) the legal process which commences with the filing of the suit, and
(4) the final resolution of the dispute. The first stage, the loss-generating events,
includes the events that resulted in the losses; for example, client bankruptcy,
financial distress, fraudulent financial reporting, and misappropriation of assets.
The second stage, pre-suit investigation, may involve investigation activities by
plaintiffs and their attorneys before initiating legal proceedings. The legal process
makes up the third stage. The stage involves activities such as filing of
complaints, discovery, trial preparation, and the trial. The last stage involves the
resolution of the dispute, which may include a summary judgment, a settlement to
avoid or discontinue litigation, or a court decision on appeal after a trial
20-2 Proportionate liability is where each defendant is liable solely for the portion of
the damages that correspond to the percentage of responsibility of that defendant. Under
the doctrine of joint and several liability, each defendant is held fully liable for all
assessed damages, regardless of the extent to which they contributed to the injury.
20-3 Under common law, an auditor can be held liable to clients for beach of contract,
negligence, gross negligence/constructive fraud, and fraud. A client would prefer to sue
an auditor for a tort action because larger amounts for damages can be assessed than for a
breach of contract.
20-4 The elements required for establishing an auditor's liability for negligence to
clients are (1) the duty to conform to a required standard of care, (2) failure to act in
accordance with that duty, (3) a causal connection between the auditor's negligence and
the client's damage, and (4) actual loss or damage to the client.
20-5 The three standards that have evolved for defining the extent of the auditor's
liability to third parties are (1) privity, (2) foreseen persons or classes, and (3) reasonably
foreseeable third parties. The traditional view held that auditors had no liability under
common law to third parties who did not have a privity relationship with the auditor.
Privity here means that the obligations that exist under a contract are between the original
parties to the contract, and failure to perform with due care results in a breach of that duty
only to those parties. Many courts have reexamined the privity notion and substituted the
concept of public responsibility. Under the foreseen persons or classes approach, Section
522 of the Restatement (Second) of the Law of Torts is applied to an accountant's thirdparty liability suit. The Restatement is a compendium of common law prepared by legal
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scholars and presents an alternative view to the traditional Ultramares rule. Finally, a
small number of states have adopted a more expansive view of auditors' liability to third
parties: the reasonably foreseeable third parties approach. The reasons cited for
extending auditors' liability beyond privity include auditors' ability to spread the risk
through the use of liability insurance.
Auditors' liability to third parties under common law is complex because court
rulings are not always consistent across federal and state jurisdictions.
20-6 The Securities Act of 1933 generally regulates the disclosure of material facts in a
registration statement for a new public offering of securities. The Securities Exchange
Act of 1934 is concerned primarily with ongoing reporting by companies whose
securities are listed and traded on a stock exchange or who meet certain other statutory
requirements.
It is easier for a plaintiff to sue an auditor under the Securities Act of 1933,
because the plaintiff does not have to prove negligence or fraud, reliance on the auditor's
opinion, a causal relationship, or a contractual relationship; the plaintiff need only prove
that a loss was suffered by investing in the registered security and that the audited
financial statements contained a material omission or misstatement. The misstatement
can be the result of mere ordinary negligence. Thus, this act, and in particular Section 11,
is more favorable for plaintiffs than common law since the auditor must prove that he or
she was not negligent.
20-7 Under Rule 10b-5 of the Securities Exchange Act of 1934, the following elements
must be proved by a plaintiff: (1) the existence of a material, factual misrepresentation or
omission, (2) reliance by the plaintiff on the financial statements, (3) damages suffered as
a result of reliance on the financial statements, and (4) scienter.
The Ernst & Ernst v. Hochfelder case was significant because the Supreme Court
ruled that an action under Rule 10b-5 may not be maintained by showing that the
defendant was negligent but that scienter, or intent to deceive, had to be present.
20-8 Rule 2(e) of the Rules of Practice empowers the SEC to suspend for any person
the privilege of appearing and practicing before it. These sanctions can be applied not
only to an individual auditor but also to an entire accounting firm. Typically, if a firm is
faced with suspension, it will agree to some type of consent agreement in which the firm
does not admit guilt but agrees to lesser sanctions. These sanctions may include not
taking on new SEC clients for a specified period of time and submitting to special
reviews to ensure that the alleged problems have been corrected.
20-9
The Foreign Corrupt Practices Act (FCPA) prohibits corporate officers from
knowingly participating in bribes to foreign officials to obtain or retain business.
It also imposes record-keeping and internal control requirements on public
companies. Basically, corporations must keep their books, records, and accounts
in sufficient detail to accurately reflect the transactions. Companies are also
required to develop and maintain adequate systems of internal control.
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Under the FCPA auditors may be subject to administrative proceedings, civil
liability, and civil penalties.
20-10 The Racketeer Influenced and Corrupt Organizations Act (RICO) was enacted by
Congress in 1970 to combat the infiltration of legitimate businesses by organized crime.
RICO provides civil and criminal sanctions for certain types of illegal acts. Racketeering
activity includes a long list of federal and state crimes, with mail fraud and wire fraud the
most common acts alleged against auditors.
Plaintiffs seek to sue auditors under RICO because the law provides for treble
damages in civil RICO cases.
20-11 Auditors can be held criminally liable under various statutes and regulations.
Criminal prosecutions require that some form of criminal intent be present, although
many of the laws described in this chapter contain provisions for criminal penalties if the
auditor's actions reflect gross negligence.
20-12 The following steps can be taken to minimize legal liability against auditors:
At the professional level:
 Establishing stronger auditing and attestation standards.
 Continually updating the Code of Professional Conduct and sanctioning members
who do not comply with it.
 Educating users.
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At the firm level:
Instituting sound quality control and review procedures.
Ensuring that members of the firm are independent.
Following sound client acceptance and retention procedures.
Being alert for risk factors that may result in lawsuits.
Performing and documenting work diligently.
Answers to Multiple-Choice Questions
20-13
20-14
20-15
20-16
20-17
20-18
D
C
B
D
B
D
20-19
20-20
20-21
20-22
20-23
20-24
C
C
B
A
B
D
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