Legal Liability
Chapter 5
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Learning Objective 1
Understand the litigious environment in
which CPAs practice.
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Changed Legal Environment
Audit professionals have a
contractual responsibility with clients.
Auditors are liable for negligence.
The number of lawsuits and sizes of
awards remain high.
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Changed Legal Environment
Major contributors:
Growing awareness by financial statement
users
 Increased consciousness of the SEC
 Complexity in business drives complexity in
auditing and accounting functions
 Litigious society
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Changed Legal Environment
Major contributors (cont.):
Large civil court judgments against CPA firms
 Willingness of CPA firms to settle out of court
 Judges’ and jurors’ difficulty in understanding
technical accounting and auditing matters
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Learning Objective 2
Explain why the failure of financial
statement users to differentiate among
business failure, audit failure, and audit
risk has resulted in lawsuits.
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Business Failure, Audit Failure,
and Audit Risk
 Business failure
A business is unable to meet its
obligations or investor expectations due
to economic or business conditions.
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Business Failure, Audit Failure,
and Audit Risk
 Audit failure
Auditor issues an incorrect opinion from
a failure to follow GAAS.
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Business Failure, Audit Failure,
and Audit Risk
 Audit risk
The risk that the auditor fails to find a
material misstatement and issues an
unqualified opinion.
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Learning Objective 3
Use the primary legal concepts
and terms concerning accountants’
liability as a basis for studying
legal liability of auditors.
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Legal Concepts Affecting
Liability
Prudent person concept
Liability for the acts of others
Lack of privileged communication
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Legal Terms Affecting
CPAs’ Liability
Terms related to negligence and fraud:
Ordinary negligence
Gross negligence
Constructive fraud
Fraud
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Legal Terms Affecting
CPAs’ Liability
Contract Law
Breach of
contract
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Third party
beneficiary
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Legal Terms Affecting
CPAs’ Liability
Other terms:
 Common law
 Statutory law
 Joint and several liability
 Separate and proportionate liability
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Learning Objective 4
Describe accountants’ liability to
clients and related defenses.
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Four Major Sources of Auditors’
Legal Liability
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Liability to Clients
The most common source of lawsuits
against CPAs is from clients.
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Auditor’s Defenses Against
Client Suits
Lack of duty to perform
Nonnegligent performance
Contributory negligence
Absence of causal connection
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Learning Objective 5
Describe accountants’ liability to
third parties under common law
and related defenses.
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Liability to Third Parties Under
Common Law
Ultramares
doctrine
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Foreseen
users
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Foreseen Users
 Credit alliance
Restatement of torts
Foreseeable user
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Auditor Defenses Against
Third-Party Suits
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Learning Objective 6
Describe accountants’ civil liability
under the federal securities laws
and related defenses.
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Securities Act of 1933
The Securities Act imposes an
unusual burden on the auditor.
Section 11 of the 1933 act defines the
rights of third parties and auditors.
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Securities Exchange
Act of 1934
Auditor liability under this act often
centers on the audited financial statements
issued in annual reports
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Rule 10b-5 of the Securities
Exchange Act of 1934
Section 10 and rule 10b-5 are often called
the antifraud provisions of the 1934 act.
“Scienter” states that auditors must have
the knowledge and intent to deceive in
order to be liable for violation of
Rule 10b-5.
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SEC Sanctions
SEC can sanction or suspend practitioners.
SEC has temporarily suspended a number of
individual CPAs from auditing SEC clients.
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Foreign Corrupt
Practices Act of 1977
Bribing a foreign official for the purpose
of exerting business related influence
is illegal.
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Sarbanes-Oxley Act of 2002
CEO and CFO are required to certify
financial statements filed with the SEC.
Management must report on the
effectiveness of internal controls over
financial reporting.
Auditors must opine on internal controls
over financial reporting.
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Learning Objective 7
Specify what constitutes criminal
liability for accountants.
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Criminal Liability
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Sarbanes-Oxley Act
This act makes it a felony to destroy
or create documents to impede or
obstruct a federal investigation.
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Auditor Defenses –
1933 & 1934 Acts
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Learning Objective 8
Describe what the profession and
the individual CPA can do and
what is being done to reduce
the threat of litigation.
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The Profession’s Response
to Legal Liability
 Research in auditing
Standard and rule setting
Set requirements to protect auditors
Establish peer review requirements
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The Profession’s Response
to Legal Liability
 Oppose lawsuits
 Education of users
 Sanction members for improper conduct
and performance
 Lobby for changes in laws
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Protecting Individual CPAs
from Legal Liability
Honest Clients
Follow
Professional
Standards
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Qualified
Personnel
Maintain
Independence
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Protecting Individual CPAs
from Legal Liability
 Understand the client’s business
Perform quality audits
Document the work properly
Obtain an engagement and a representation letter
Maintain confidential relations
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Protecting Individual CPAs
from Legal Liability
 Carry adequate insurance
Seek legal counsel
Choose a form of organization with limited liability
Exercise professional skepticism
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End of Chapter 5
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