Legal Liability

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LEGAL
LIABILITY
CHAPTER 5
Copyright © 2017 Pearson Education, Ltd. 5-1

CHAPTER 5 LEARNING OBJECTIVES
5-1 Understand the litigious environment in which CPAs practice.

5-2 Explain why the failure of financial statement users to
differentiate among business failure, audit failure, and audit risk
has resulted in lawsuits.
5-3 Use the primary legal concepts and terms concerning
accountants’ liability as a basis for studying legal liability of
auditors.
5-4 Describe accountants’ liability to clients and related defenses.

CHAPTER 5 LEARNING OBJECTIVES
5-5 Describe accountants’ liability to third parties under common

law and related defenses.
5-6 Describe accountants’ civil liability under the federal securities
laws and related defenses.
5-7 Specify what constitutes criminal liability for accountants.
5-8 Describe how the profession and individual CPAs can reduce the
threat of litigation.

OBJECTIVE 5-1
Understand the litigious
environment in which CPAs
practice.

CHANGED LEGAL ENVIRONMENT
• Professionals, including CPAs, are held to a high level of

performance.
• Under common law, auditors must fulfill contracts with
clients and may also be held liable to third parties.
• Auditors may also be held liable to third parties based
on statute, including the Securities Act of 1933, the
Securities Exchange Act of 1934, and the Sarbanes-
Oxley Act.

CHANGED LEGAL ENVIRONMENT (CONT.)
Increase in the number of lawsuits and the sizes of the awards to
plaintiffs
Reasons for this trend include:
• Growing awareness of the responsibilities of CPAs
• Increased effort by the SEC to protect investors’ interests
• Increased complexity of auditing and accounting
• Litigious society

CHANGED LEGAL ENVIRONMENT (CONT.)
Reasons for increased litigation against CPAs (cont):
• Recession and tough economic times resulting in business failures
• Attorneys often provide legal services on a contingent-fee basis
• CPA firms willing to settle legal cases out of court
• Difficulties of judges and juries understanding technical accounting
and auditing matters

OBJECTIVE 5-2
Explain why the failure of financial
statement users to differentiate among
business failure, audit failure, and audit
risk has resulted in lawsuits.

DISTINGUISHING BUSINESS FAILURE,
AUDIT FAILURE, AND AUDIT RISK
Important distinctions:
1. The difference between a business failure and an audit failure
2. The difference between an audit failure and audit risk
• A business failure occurs when a business is unable to repay its

lenders or meet the expectations of investors

• Audit failure occurs when the auditor issues an incorrect audit
opinion because the auditor did not comply with auditing
standards
• 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
In cases when an audit failed to uncover material misstatements
and the wrong type of opinion was issued, it is appropriate to
question whether the auditor exercised due care in performing the
audit.
If the auditor did not exercise due care, the auditor can be held
liable for the incorrect opinion.

The “expectation gap” contributes to the amount of
litigation against auditors.
The “expectation gap” refers to the difference between what an
auditor’s responsibilities are and what the user expects from the
auditor.
• Auditor’s responsibility: to perform the audit in accordance with
auditing standards
• User expectation: is often that the auditor guarantees the accuracy
of the financial statements, and even guarantees the viability of
the business

OBJECTIVE 5-3
Use the primary legal concepts and terms
concerning accountants’ liability as a basis
for studying legal liability of auditors.

LEGAL CONCEPTS AFFECTING LIABILITY
Some basic legal concepts involved in determining liability:
• Prudent person concept
• Liability for the acts of others
• Lack of privileged communication
• Legal terms affecting CPAs liability
• Sources of legal liability:
1. Liability to clients
2. Liability to third parties under common law
3. Civil liability under federal securities laws
4. Criminal liability
Some examples of these classifications of liability are included in Figure 5-1.

OBJECTIVE 5-4
Describe accountants’ liability to clients
and related defenses.

LIABILITY TO CLIENTS
The most common source of lawsuits against CPAs is from

clients regarding negligent acts, which are detailed in
Table 5-1.
For example, see summary of Cenco Incorporated v. Seidman
& Seidman, in Figure 5-2.

LIABILITY TO CLIENTS
Auditors normally use one, or a combination of, the

following four defenses with claims filed by clients:
• Lack of duty to perform service
• Non-negligent performance
• Contributory negligence
• Absence of causal connection
Figure 5-3 discusses a case in which the auditor was not
engaged to perform an audit. As a result of this case,
auditors and clients typically sign engagement letters
detailing the expectations of the engagement.

OBJECTIVE 5-5
Describe accountants’ liability to
third parties under common law and
related defenses.

LIABILITY TO THIRD PARTIES UNDER COMMON LAW
The Ultramares Doctrine resulted from a precedent-setting auditing
case from 1931.
Even though the auditors were negligent, they were not liable to the
creditors because the creditors were not the primary beneficiary.

LIABILITY TO THIRD PARTIES UNDER COMMON LAW (CONT.)
Courts have since broadened the Ultramares Doctrine to include third parties who
are considered foreseen users.
Foreseen users are a class of users that the auditor knows will rely on the financial
statement. The Rusch Factors case in Figure 5-5 involves foreseen users.

The broadest interpretation of third-party beneficiaries is the concept of foreseeable
users. This includes any user that the auditor should have reasonably been able to
foresee as a likely user of the client’s financial statements. Table 5-2 summarizes the
different approaches to third-party liability under common law.

Auditor Defenses Against Third-Party Suits

Of the four defenses that are available to auditors in
suits against them by clients, three are also available in
suits against them by third parties:
• Lack of duty to perform service
• Nonnegligent performance
• Absence of causal connection

OBJECTIVE 5-6
Describe accountants’ civil liability
under the federal securities laws and
related defenses.

CIVIL LIABILITY UNDER THE FEDERAL
SECURITIES LAWS
The Securities Act of 1933—Deals with reporting

requirements for the issuance of new securities.
The only parties who can recover from auditors under
the 1933 Act are the original purchasers of the securities.
Figure 5-6 details a case filed under the Securities Act of
1933.

SECURITIES LAWS (CONT.)
The Securities Exchange Act of 1934—Deals with
subsequent reporting by the public company. Suits filed under
this Act usually involve the audited financial statements.
Rule 10b-5 of the Securities Exchange Act of 1934—the
antifraud provision of the law.
In Hochfelder v. Ernst & Ernst, the court ruled that scienter,
which is the knowledge and intent to deceive, is required for
a CPA to be held liable under Rule 10b-5.
Figure 5-7 details this case.

Rule 10b-5 of the Securities Exchange Act of 1934 (cont.)
In Howard Sirota v. Solitron Devices, Inc., the court ruled that
the auditor knew all of the relevant facts of the fraud, but
made poor judgments. Figure 5-8 details this case.
In subsequent suits under Rule 10b-5, courts have ruled that
poor judgment is not proof of fraud.
Auditor defenses under the 1934 Act are the same as under
common law: lack of duty, nonnegligent performance, and
absence of causal connection.

SEC and PCAOB Sanctions—The SEC Rules of Practice and the
PCAOB Rules of the Board permit them to deny a CPA from being
associated with financial statements for lack of qualifications or
having engaged in unethical behavior.
Foreign Corrupt Practices Act of 1977—This Act makes it
illegal to offer a bribe to a foreign official for the purpose of
exerting influence or retaining business.
FCPA also requires SEC companies to have reasonably complete
and accurate records, as well as an adequate system of internal
control.

Sarbanes-Oxley Act of 2002—increases the responsibilities
of public companies and their auditors
Requires that auditors express an opinion on the effectiveness of
internal control, which could expose auditors to legal liability based
on their opinion.
The PCAOB may also sanction registered CPA firms for violations
of the Act.
Table 5-3 summarizes the sources of liability for auditors.
Table 5-4 summarizes the defenses available to auditors.

OBJECTIVE 5-7
Specify what constitutes criminal liability
for accountants.

CRIMINAL LIABILITY
Criminal Liability for Accountants
Federal laws make it a criminal offense to defraud another
person through knowingly being involved with false financial
statements.
The Sarbanes-Oxley Act of 2002 made it a felony to destroy
documents to impede or obstruct a federal investigation.
These provisions were enacted in response to United States v.
Andersen, in which the auditor, Andersen, was held
responsible for shredding documents in the Enron case.
This case is detailed in Figure 5-9.

OBJECTIVE 5-8
Describe how the profession and individual
CPAs can reduce the threat of litigation.

THE PROFESSION’S RESPONSE TO LEGAL LIABILITY
The AICPA and the profession as a whole can do the following

to reduce practitioners’ exposure to legal liability:
1. Seek protection from non-meritorious litigation.
2. Improve auditing to better meet users’ needs.
3. Educate users about the limits of auditing.
One law change that has helped in this area is the Private
Securities Litigation Reform Act of 1995, which limits the
liability of auditors by providing for proportionate liability.

THE PROFESSION’S RESPONSE TO LEGAL LIABILITY
Protecting Individual CPAs from Legal Liability
Practicing auditors may take the following actions to minimize their
liability:
• Deal only with clients possessing integrity.
• Maintain independence.
• Understand the client’s business.
• Perform quality audits.
• Document the work properly.
• Exercise professional skepticism.
It is also important for CPAs to carry adequate insurance and choose a
form of organization that provides some form of legal liability
protection to owners.

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https://www.youtube.com/watch?

Copyright © 2017 Pearson Education, Ltd. 5-1

5-1 Understand the litigious environment in which CPAs practice.

Copyright © 2017 Pearson Education, Ltd. 5-2

5-5 Describe accountants’ liability to third parties under common

Copyright © 2017 Pearson Education, Ltd. 5-3

Copyright © 2017 Pearson Education, Ltd. 5-4

• Professionals, including CPAs, are held to a high level of

Copyright © 2017 Pearson Education, Ltd. 5-5

Copyright © 2017 Pearson Education, Ltd. 5-6

Copyright © 2017 Pearson Education, Ltd. 5-7

Copyright © 2017 Pearson Education, Ltd. 5-8

• A business failure occurs when a business is unable to repay its

Copyright © 2017 Pearson Education, Ltd. 5-9

Copyright © 2017 Pearson Education, Ltd. 5-10

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The most common source of lawsuits against CPAs is from

Copyright © 2017 Pearson Education, Ltd. 5-17

Auditors normally use one, or a combination of, the

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Auditor Defenses Against Third-Party Suits

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The Securities Act of 1933—Deals with reporting

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The AICPA and the profession as a whole can do the following

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