Auditing and accounting

1. LEGAL
LIABILITY
CHAPTER 5
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2. 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.
5-5 Describe accountants’ liability to third parties under common
law and related defenses.
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3. Copyright © 2017 Pearson Education, Inc. 5-3
OBJECTIVE 5-1
Understand the litigious
environment in which CPAs
practice.

4. 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.
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5. CHANGED LEGAL ENVIRONMENT (CONT.)
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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

6. CHANGED LEGAL ENVIRONMENT (CONT.)
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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

7. Copyright © 2017 Pearson Education, Inc. 5-7
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.

8. 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
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9. DISTINGUISHING BUSINESS FAILURE,
AUDIT FAILURE, AND AUDIT RISK
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• 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.

10. DISTINGUISHING BUSINESS FAILURE,
AUDIT FAILURE, AND AUDIT RISK
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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

11. Copyright © 2017 Pearson Education, Inc. 5-11
OBJECTIVE 5-3
Use the primary legal concepts and terms
concerning accountants’ liability as a basis
for studying legal liability of auditors.

12. 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.
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13. Copyright ©2017 Pearson Education, Inc. 5-13

14. Copyright © 2017 Pearson Education, Inc. 5-14
OBJECTIVE 5-4
Describe accountants’ liability to clients
and related defenses.

15. LIABILITY TO CLIENTS
The most common source of lawsuits against CPAs is from
clients regarding negligent acts.
Auditors normally use one, or a combination of,
the following four defenses with claims filed by
clients:
• Lack of duty to perform service
• Nonnegligent performance
• Contributory negligence
• Absence of causal connection
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