Electronic
Presentations
in Microsoft®
PowerPoint®
Prepared by
Brad MacDonald
SIAST
© 2003 McGraw-Hill
Ryerson Limited
Chapte
r
1
7
Legal Liability
Copyright © 2003 McGraw-Hill Ryerson Limited
2
Learning Objective 1
List some ways that auditors can get into
civil and criminal legal trouble.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
3
The Legal Environment
Record-setting damages have been
awarded and professional liability insurance
premiums have increased dramatically.
– Accountants are potentially liable for
monetary damages and criminal penalties for
failure to perform services properly.
• Class action suits can result in large
damages.
• Lawyers take on these suits on a
contingency fee basis.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
4
Lawsuit Causes and Frequency
Based on a study of 129 cases, legal issues arise
from:
–
–
–
–
–
33%
15%
29%
13%
7%
- Misinterpretation of accounting principles
- Misinterpretation of auditing standards
- Faulty implementation of auditing procedures
- Client fraud
- Fraud by the auditor
– Lawsuits against auditors have increased from:
• 181 cases in 1960 – 1972 to
• 239 cases in 1973 - 1985
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
5
Audit Responsibilities
Users of audit reports expect auditors will
detect fraud, theft, and illegal acts and
report them publicly.
– Auditors take responsibility for detecting
material misstatements.
– An expectation gap exists between the
diligence users expect and the diligence
auditors are able to accept.
• This disparity leads to lawsuits, even when
auditors have performed well.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
6
Common Law and Statutory Law
Common law is based on precedents and
past decisions in the courts.
– Common law is not enacted by legislation.
– Statutory law is all of the laws enacted by a
legislature.
– Prior to Enron, the major source of liability for
accountants was common law. In the postEnron world this appears to be changing.
• Sarbanes-Oxley Act and other laws
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
7
Learning Objective 2
Specify the characteristics of accountants’
liability under common law and cite some
specific case precedents.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
8
Liability Under Common Law
Legal liabilities of PAs may arise from
– basis of law of contracts or
– tort actions for negligence
• Tort refers to a private or civil wrong or
injury.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
9
Characteristics of
Common Law Actions
Burden of proof on the plaintiff:
– Plaintiff must prove the following:
• That there was damage or loss.
• That there was a privity or beneficiary relationship.
• That financial statements were materially
misleading.
• That the statements were relied on.
• That the statements were the direct cause of the
loss.
• That the accountant was negligent in performance
of duties.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
10
Characteristics of
Common Law Actions
Clients may bring a lawsuit for breach of
contract.
– The relationship of direct involvement
between parties to a contract is known as
privity.
• When privity exists, the plaintiff usually
need only show that the defendant was
negligent.
• See Smith v. London Assurance Corp.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
11
Characteristics of
Common Law Actions
Third parties may file a lawsuit under the tort law
of negligence.
– Negligence is failure to perform a duty with requisite
standard care.
– Plaintiff must demonstrate:
• There is a duty of care owed the plaintiff.
• There must be a breach in that duty.
• For example, a failure to comply with GAAS is a breach.
• There must be proof that damage resulted.
• There must be a reasonably proximate connection
between the breach of duty and the resulting
damages.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
12
Characteristics of
Common Law Actions
The auditor’s best defense is to
demonstrate that at least one of the four
elements is missing.
– Demonstrate that there was no breach of
duty, the audit was conducted in accordance
with GAAS.
– In some cases, a defense of contributory
negligence may be used.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
13
Due Care to Whom?
To whom do auditors owe a duty of care?
– to the contractual party (client).
– to the financial stakeholders (owners):
• Owners cannot sue on behalf of the
corporation.
• Stakeholders can only take action as third
parties.
• Need to establish damages separate from the
corporation.
• Foss V. Harbottle (1842)
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
14
Due Care to Whom?
– Third Parties:
• In the case of fraud or constructive fraud,
the auditor is held liable to third parties.
• Ultramares Corporation v. Touche (1931)
• Reasonably foreseeable third parties can
sue in the case of negligence.
• Hedley Byrne v. Heller and Partners (1964)
• Includes shareholders, lenders, some
prospective shareholder and lenders.
• This decision has been upheld in a number of
subsequent cases.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
15
Defenses of the Accountant
The primary defense against a negligence
claim is to offer evidence that the audit had
been conducted in accordance with GAAS
with due professional care.
– Other defenses that show that one of the
other factors in negligence is missing are also
available to the auditor.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
16
Liability in Compilation and
Review Services
Approximately 11% of losses involve
compilation and review engagements.
– Accountants are still expected to perform
these services in accordance with
professional standards.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
17
Due Care: Its Meaning
Due care implies the careful application of
all the standards of the profession.
– Due care is that of a reasonably prudent
practitioner. Neither the highest nor minimum
standards would be considered due care.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
18
Other Elements of Negligence
In Canada and the United States there is
joint and several liability.
– Any of several defendants are liable to
plaintiffs for the entire amount of damages.
Limited Liability Partnerships (LLPs)
– Negligent partner is liable to the extent of
personal assets; other partners are liable only
to the extent of the assets of the partnership.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
19
Liability when Auditor is Associated with
Misleading Financial Information
When the auditor is associated with
misleading statements, the courts may
conclude the auditor is fraudulently
negligent.
– There are then no limits on third-party liability.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
20
Learning Objective 3
Specify the characteristics of accountants’
liability under statutory law.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
21
Auditors’ Liability Under
Statutory Law
The SEC laws give the SEC the legal right
to decide what is GAAP.
– Increasingly the OSC (Ontario Securities
Commissions) and the Quebec regulators
are seeking more enforcement power
over professionals such as accountants
operating in the capital markets.
– Canadian statutory law is the Canadian
Business Corporations Act and the related
provincial corporation acts.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
22
Auditors’ Liability Under
Statutory Law
Canada Business Corporations Act:
– S 161 Conditions under which the auditor is not considered
independent .
– S 162 and 163 Conditions of appointing and retiring the auditor.
– S 168 Auditors rights and responsibilities:
• attend shareholders meetings
• provide written statement of reasons for resignation
• to make an audit examination unimpeded and gain access
to data the auditor considers necessary
– S44-47 identify the financial statements subject to audit and
specify that the financial statements must be in conformity with
the CICA Handbook.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
23
Other Issues
Fiduciary duty of accountants:
– An accountant may be a fiduciary in many different
situations.
– Allegations of breach of fiduciary responsibility are
increasing.
Confidentiality v. Misleading Financial Statements
– Consolidata Services v. Alexander Grant (1981): The
auditor should have maintained confidentiality.
– Fund of Funds v Arthur Anderson (1982): The
auditor should have broken confidentiality to avoid
misleading statements.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
24
Other Issues
Legal liability implications for auditor practice
– Be wary of the type of clients being accepted.
– Know thoroughly the client’s business.
– Perform quality audits.
Legal liability for failure to disclose illegal acts
– Reduce auditor liability by
• reducing likelihood of misinterpretation of GAAS
• establishing recommendations for auditors
• providing a defence for auditors
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
25
Is There an Auditor Liability
Crisis in Canada?
In the US, pending suits against auditors exceed
$20 billion.
Differences from the US:
– Jury trials in USA - Judge in Canada.
– Punitive damages rare in Canada.
– Unsuccessful party must pay 50 to 60% of the legal
fees of the opposing side and other costs in Canada.
– Class actions are rare in Canada.
– US national regulator the SEC - nothing comparable
in Canada.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
26
Some Developments Concerning
the Liability Crisis
Private Securities Litigation Reform Act
– Objectives:
• Discourages abusive claims of investors
losses due to fraudulent financial
statements.
• Provides more protection against securities
fraud.
• Increases the flow of forward-looking
financial statements.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
27
Some Developments Concerning
the Liability Crisis
How the Act meets its Objectives:
– Establishes specific pleading requirements.
– Reduces the effectiveness of discovery in
coercing settlements.
– Mandates sanctions for frivolous claims.
– Provides for proportionate liability.
– Codifies the auditors’ responsibility to search
for and disclose fraud.
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
28
Appendix 17A
US Statutory and Common Law.
– Foreign Corrupt Practices Act of 1977
– Racketeer Influenced and Corrupt Organization Act
(RICO)
– Liability Under Statutory Law
• Federal False Statements Statute
• Federal Mail Fraud Statute
• Federal Conspiracy Statute
• Securities Act of 1933
• Securities and Exchange Act of 1934
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
29
Liability under Statutory Law
SEC Regulation of Accounting and Accounting
– Rules of practice
– Establish accounting rules and regulations
– Regulation S-X contains requirements for audited financial
statements and unaudited interim financial statements
– Relationship with the FASB (Financial Accounting Standards
Board)
Integrated Disclosure System
– Form 10-K file annual reports
Regulation of Auditing Standards, Security
Sales and Periodic Reporting
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
30
Liability Provisions:
Securities Act of 1933
Section 11 - General Liability
Section 11 - Privity not required. Any purchaser
can sue any accountant
Comparison of common law and statutory
litigation
Section 11 - Exemption
Section 13 - Statute of Limitations
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
31
Liability Provisions:
Securities Act of 1933
Section 11 - Due Diligence Defence “reasonable
examination was performed”
Section 11(e) - Causation Defence
Section 17 - Antifraud
Section 24 - Criminal Liability
United Sates v. Benjamin (1964)
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
32
Liability Provisions:
Securities and Exchange Act of 1934
Section 10 - General antifraud section used
against accountants frequently
– Fischer v. Kletz (“Yale Express”) (1967) and
Ernst and Ernst v. Hochfelder (1976) plaintiffs must prove scienter - intention to
deceive
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
33
Liability Provisions:
Securities and Exchange Act of
1934
Section 18 - Civil Liability
Good Faith Defense - laintiff must prove
reliance on the financial statements.
Section 32 - Criminal Liability
– Continental Vending (1969)
Extent of Liability
Chapter 17
Copyright © 2003 McGraw-Hill Ryerson Limited
34