Many accounting and legal professionals believe that a major cause of lawsuits against CPA firms is financial statement users' lack of __
understanding two concepts: 1. The difference between a business failure and an audit failure. 2. The difference between an audit failure and audit risk.
business failure
A business failure occurs when a business is unable to repay its lenders or meet the expectations of its investors because of economic or business conditions.
audit failure
Audit failure occurs when the auditor issues an incorrect audit opinion because it failed to comply with the requirements of auditing standards, such as assigning unqualified assistants to perform certain audit tasks.
audit risk
Audit risk represents the possibility that the auditor concludes after conducting an adequate audit that the financial statements were fairly stated when, in fact, they were materially misstated. Audit risk is unavoidable, because auditors gather evidence
prudent person concept
The prudent person concept is a legal concept pertinent to lawsuits involving CPAs. The auditor is expected only to conduct the audit with due care, and is not expected to be perfect.
liability for the act of others
Liability for the act of others is a legal concept pertinent to lawsuits involving CPAs. The partners, or shareholders in the case of a professional corporation, are jointly liable for the civil actions against any owner. If the firm is, however, an LLP,
lack of privileged communication
CPAs do not have the right to withhold information from the courts on the grounds that the information is privileged under common law. A CPA can refuse to testify in the state with privileged communications statutes, however, that privilege does not exten
ordinary negligence
Absence of reasonable care that can be expected of a person in a set of circumstances. For auditors, it is in terms of what other competent auditors would have done in the same situation.
gross negligence
Lack of even slight care, tantamount to reckless behavior, that can be expected of a person. Some states do not distinguish between ordinary and gross negligence.
constructive fraud
Existence of extreme or unusual negligence even though there was no intent to deceive or do harm. Constructive fraud is also termed recklessness. Recklessness in the case of an audit is present if the auditor knew an adequate audit was not done, but still
fraud
Occurs when a misstatement is made and there is both knowledge of its falsity and the intent to deceive.
breach of contract
Failure of one or both parties in a contract to fulfill the requirements of the contract. An example is the failure of a CPA firm to deliver a tax return on the agreed-upon date. Parties who have a relationship that is established by contract are said to
third-party beneficiary
A third party who does not have privity of contract but is known to the contracting parties and is intended to have certain rights and benefits under the contract. An example is a bank that has a large loan outstanding at the balance sheet date and requir
common law
Laws that have been developed through court decisions rather than through government statutes.
statutory law
Laws that have been passed by the U.S. Congress and other governmental units. The Securities Act of 1933 and 1934 and Sarbanes-Oxley Act of 2002 are important statutory laws affecting auditors.
joint and several liability
The assessment against a defendant of the full loss suffered by a plaintiff, regardless of the extent to which other parties shared in the wrongdoing. For example, if management intentionally misstates financial statements, an auditor can be assessed the
separate and proportionate liability
The assessment against a defendant of that portion of the damage caused by the defendant's negligence. For example, if the courts determine that an auditor's negligence in conducting an audit was the cause of 30% of a loss to a defendant, only 30% of the
What are the four sources of auditor's legal liability?
1) Liability to clients. 2) Liability to third parties under common law. 3) Civil liability under the federal securities laws. 4) Criminal liability.
In audits, __ is often conclusive evidence of negligence.
failure to meet auditing standards
List the four sources of liabilities along with an example of a potential claim.
liability to clients - client sues auditor for not discovering a material fraud during the audit; liability to third parties under common law - bank sues auditor for not discovering that a borrower's financial statements are materially misstated; civil li
The CPA firm normally uses one or a combination of four defenses when there are legal claims by clients: __
lack of duty to perform the service, nonnegligent performance, contributory negligence, and absence of causal connection.
lack of duty
One of four CPA firm defenses. The lack of duty to perform the service means that the CPA firm claims that there was no implied or expressed contract.
nonnegligent performance
One of four CPA firm defenses. For nonnegligent performance in an audit, the CPA firm claims that the audit was performed in accordance with auditing standards. The prudent person concept also establishes in law that the CPA firm is not expected to be inf
contributory negligence
One of four CPA firm defenses. A defense of contributory negligence exists when the auditor claims the client's own actions either resulted in the loss that is the basis for damages or interfered with the conduct of the audit in such a way that prevented
absence of causal connection
One of four CPA firm defenses.To succeed in an action against the auditor, the client must be able to show that there is a close causal connection between the auditor's failure to follow auditing standards and the damages suffered by the client.
Third parties include __
actual and potential stockholders, vendors, bankers and other creditors, employees, and customers.
foreseen users
Members of a limited class of users that the auditor knows will rely on the financial statements. The three leading approaches taken by the courts are credit alliance (narrow), restatement of torts (more broad), and foreseeable user (most broadest).
credit alliance
To be liable, an auditor must (1) know and intend that the work product would be used by the third party for a specific purpose, and (2) the knowledge and intent must be evidenced by the auditor's conduct.
restatement of torts
Used by most states, the Restatement Rule is that foreseen users must be members of a reasonably limited and identifiable group of users that have relied on the CPA's work, such as creditors, even though those persons were not specifically known to the CP
foreseeable user
Currently used by only two states. Under this concept, any users that the auditor should have reasonably been able to foresee as likely users of the client's financial statements have the same rights as those with privity of contract.
What defenses are available in third-party lawsuits?
Only 3 of the 4, lack of duty to perform the service, nonnegligent performance, and absence of causal connection.
__ is the only common or statutory law where the burden of proof is on the defendant.
The 1933 act
The only parties who can recover from auditors under the 1933 act are __
the original purchasers of securities.
Summarize section 11 of the 1933 act
any third party who purchased securities described in the registration statement may sue the auditor for material misrepresentation or omissions in audited financial statements included in the registration statement; third-party users do not have the burd
The auditor is responsible for making sure that the financial statements are fairly stated beyond __
the date of issuance, up to the date the registration statement becomes effective, which can be several months later.
securities act of 1993
The Securities Act of 1933 deals only with the reporting requirements for companies issuing new securities, including the information in registration statements and prospectuses.
securities exchange act of 1934
The liability of auditors under the Securities Exchange Act of 1934 often centers on the audited financial statements issued to the public in annual reports submitted to the SEC as part of annual form 10-K reports.
__ often called the __, as they prohibit any fraudulent activities involving the purchase or sale of any security.
Section 10 and Rule 10b-5 are; antifraud provisions of the 1934 act
__ ruled that __, is required before CPAs can be held liable for violation of Rule 10b-5.
The U.S. Supreme Court; scienter, which is knowledge and intent to deceive
What defenses are available under the 1934 act?
The same as common-law suits by third parties - nonnegligent performance, lack of duty, and absence of causal connection.
The SEC has the power in certain circumstances to __
sanction or suspend practitioners from doing audits for SEC companies, generally because of lack of appropriate qualifications or having engaged in unethical or improper professional conduct.
Foreign Corrupt Practices Act of 1977
The act makes it illegal for all U.S. domestic firms, public or private, to offer a bribe to an official of a foreign country for the purpose of exerting influence and obtaining or retaining business.