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Chapter 17

Chapter 17. Professional Liability. What is the public accountant’s responsibility?.

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Chapter 17

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  1. Chapter 17 Professional Liability

  2. What is the public accountant’s responsibility? • The responsibility of public accountants to safeguard the public's interest has increased as the number of investors has increased, as the relationship between corporate managers and stockholders has become more impersonal, and as government increasingly relies on accounting information.

  3. Discuss Auditor Liability Auditor liability to their clients and third party user groups is derived from the following laws: • Contract law - Liability is based on breach of contract. The contract is usually between the public accounting firm and the client for performance of a professional service, such as an audit performed according to GAAS • Common law - Liability concepts developed through court decisions and based on auditor negligence, gross negligence or fraud • Statutory law - Liability based on state statutes or Federal securities laws. The most important of these to the auditing profession are the Securities Act of 1993 and the Securities and Exchange Act of 1934

  4. Factors leading to increased litigation against auditors: User awareness of the possibilities and rewards of litigation • Joint and several liability statutes that permit a plaintiff to collect the full amount of the settlement from any defendant, even those only partially responsible for the loss (i.e. deep pockets theory) • Increased audit complexity caused by computerized systems, new types of transactions and operations, more complicated accounting standards, more international business • More demanding audit standards for detection of errors and fraud

  5. Factors leading to increased litigation against auditors: • Pressures to reduce audit time and improve audit efficiency • Misunderstanding by users that an unqualified opinion is an insurance policy against misstatements (expectations gap) • Contingent-fee-based compensation for law firms, especially in class action lawsuits • Class action lawsuits which allow law firms to combine defendants into one legal action • Punitive damages

  6. Discuss Potential Liability To understand the potential liability, the auditor must understand: • Concepts of breach of contract and tort • Parties who may bring suit • Legal precedence and statutes that may be as a standard against which auditor performance may be evaluated • Auditor defenses

  7. Discuss Causes of Legal Action Causes of legal action • Breach of contract • Negligence: failure to exercise a reasonable level of care that causes damage to another • Gross negligence: failure to exercise even a minimal level of care (reckless disregard) but without intent to harm or damage anyone • Fraud: intentional concealment or misrepresentation of material facts that cause damages to those deceived (scienter)

  8. Comment on Civil Liability Auditors may be held civilly liable by clients and third parties who use audited financial statements. This civil liability is based • Contract law • Common law • Statute

  9. Define Breach of Contract Breach of Contract occurs when auditor fails to perform a contractual duty • Breach actions include • failing to complete the engagement within the agreed-upon time • withdrawing from the engagement without sufficient justification • violating client confidentiality • failing to provide professional quality work • Parties to the contract can file suit

  10. Define Breach of Contract • Court remedies to a breach include • order auditors to fulfill the contract (specific performance) • issue injunction to prohibit the auditor from continuing the breach • order auditor to pay compensatory (actual) damages • Auditor defenses include • auditor did not breach the contract • client was contributory negligent • client losses were not caused by the breach

  11. Review Common Law Liability To prevail, a plaintiff must generally prove four things: • Existence and amount of damages • Financial statements were materially misleading • Plaintiff relied on the statements and as a result, suffered damages (causality) • Auditor misconduct - the level of misconduct that must be proved depends on who the plaintiff is, and the jurisdiction in which the suit is filed

  12. Who are the plaintiffs under common law? The courts have ruled auditors can be held liable by clients and third parties reasonably expected to rely on audited statements. Generally, courts have classified third party users into 3 groups: • Identified users are specific individual users who the auditor knows will use the statements to make a specific decision • Foreseen users while not individually known, belong to a specific group of users whom the auditor knows will use the statements • Foreseeable users belong to a general class of users whose members may or may not use the financial statements

  13. Level of Auditor Misconduct The level of auditor misconduct a third party plaintiff must prove depends on which group the plaintiff belongs to and the jurisdiction in which the case is tried:

  14. Auditor Liability Auditor liability under Federal statute was established by the Securities Act of 1933, and the Securities Exchange Act of 1934, and most recently modified by Sarbanes/Oxley Act of 2002 Auditors found to be unqualified, unethical, or in willful violation can be disciplined by the SEC. Sanctions include • Temporarily or permanently revoking the firm's registration with the Public Company Accounting Oversight Board • Civil penalties of up to $750,000 per violation • Require continuing education of firm personnel Investors in public companies may sue auditors under common law, statutory law, or both.

  15. Securities Act of 1933 Requires companies to file S-1 Registration statement with SEC before they issue new securities to the public Audited financial statements are included in the Registration statement (and prospectus) Because it covers the issue of new securities, the Act requires a very high standard of care. Plaintiffs need prove only • financial statements were materially misleading • plaintiff suffered damages • plaintiffs do not need to prove reliance on the statements or auditor misconduct Auditor defenses include • proving financial statements were not materially misstated • proving plaintiff damages were not caused by the misleading financial statements • proving auditor acted with due professional care

  16. Securities Exchange Act of 1934 The Securities Act of 1934 regulates trading of securities after their initial issuance (secondary market) and the filing of periodic reports with the SEC. These reports include annual reports and 10-Ks, quarterly financial reports and 10-Qs, and 8-Ks. The 1934 Act holds auditors to a much lower standard of care than the 1933 Act. Under the 1934 Act, plaintiffs must prove • Existence and amount of damages • Financial statements were materially misleading • Plaintiff relied on the statements and as a result, suffered damages (causality)

  17. Securities Exchange Act of 1934 • Auditor misconduct - the level of misconduct that must be proved is the subject of much debate. In Ernst & Ernst v. Hochfelder, the U.S. Supreme Court held that • Congress had intended that the plaintiff prove the auditor acted with scienter • However, the Court reserved judgment as to whether gross negligence would be sufficient to impose liability • In several cases following Hochfelder, judges and juries have used a standard of "reckless conduct" to hold auditors liable

  18. Criminal Liability to Third Parties Both the 1933 and 1934 Acts provide for criminal actions against auditors - guilty persons can be fined or imprisoned for up to five years. Key cases regarding auditor criminal liability • Continental Vending (U.S. v Simon) • Equity Funding • U.S. v Duncan

  19. Policies to Help Assure Auditor Independence Periodic rotation of audit engagement partner • Prohibit certain non-audit services for public company audit clients • Restrict other non-audit services for audit clients • Firm policies including training programs that emphasize auditor independence and requiring each auditor to sign a statement of independence • External quality reviews: Sarbanes/Oxley Act requires the PCAOB perform quality reviews of registered public accounting firms • Internal reviews: concurring partner reviews and interoffice reviews

  20. Approaches to Mitigate Liability Exposure (Defensive Auditing) Defensive auditing means taking special actions to avoid lawsuits. In addition to establishing good quality controls and quality/peer reviews, firms can take other actions • Use engagement letters for all financial statement and consulting engagements • Client screening • Do not accept engagements for which the firm is not qualified • Maintain complete and accurate audit documentation • Limited liability partnerships • Carry sufficient professional liability insurance • Tort reform

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