AUDIT CH 4 VENUS
l. The 1136 Tenants' case was important because of its emphasis upon the legal liability of the CPA when associated with:
(2) Unaudited financial statements. (l) (2) The 1136 Tenants case was a landmark case concerning auditors' liability when they are associated with unaudited financial statements.
f. Under common law, the CPAs who were negligent may mitigate some damages to a client by proving:
(1) Contributory negligence. (f) (1) Contributory negligence, negligence on the part of the plaintiff, may be used as a defense and the court may limit or bar recovery by a plaintiff whose own negligence contributed to the loss.
k. The most significant result of the Continental Vending case was that i(k) (1) The Continental Vending case was a landmark in establishing auditors' potential criminal liability under the Securities Exchange Act of 1934. The case involved audited financial statements, was brought under statutory law, and did not involve registration statements (which are covered by the Securities Act of 1933).
(1) Created a more general awareness of the possibility of auditor criminal prosecution. (k) (1) The Continental Vending case was a landmark in establishing auditors' potential criminal liability under the Securities Exchange Act of 1934. The case involved audited financial statements, was brought under statutory law, and did not involve registration statements (which are covered by the Securities Act of 1933).
i. Which of the following elements is most frequently necessary to hold a CPA liable to a client?
(3) Failed to exercise due care. (3) A CPA may be found liable to a client when due care has not been exercised.
COMMAND LAW
Develops through case decisions generally arising due to breach of contract, negligence, and fraud.
BREACH OF CONTRACT
When damages result due to a failure of one or both parties to a contract to perform in accordance with the contract's provisions.1 A public accounting firm might be sued by the client for breach of contract, for example, if the firm has failed to perform the engagement in accordance with the engagement letter and the client has suffered resulting damages.
e. Which of the following cases reaffirmed the principles in the Ultramares case?
(1) Credit Alliance Corp. v. Arthur Andersen & Co. (e) (1) The Credit Alliance Corp. v. Arthur Andersen & Co. case reaffirmed the principles in the Ultramares case by clarifying the conditions necessary for parties to be considered third-party beneficiaries.
g. Under the Securities and Exchange Act of 1934, auditors and other defendants are generally faced with:
(3) Proportionate liability. (g) (3) The Private Securities Litigation Reform Act of 1995 amended the Securities and Exchange Act of 1934 to place limits on the amount of the auditors' liability through establishing proportionate liability.
j. Which statement best expresses the factors that purchasers of securities registered under the Securities Act of 1933 need to prove to recover losses from the auditors?
(3) The purchasers of securities must prove that the financial statements were misleading; then, the burden of proof is shifted to the auditors to show that the audit was performed with "due diligence." (j) (3) Under the Securities Act of 1933 purchasers of securities who sustain losses need only prove that the financial statements contained in the registration statement were misleading. Then the burden is shifted to the auditors to prove that they performed the audit with "due diligence."
h. A CPA issued an unqualified opinion on the financial statements of a company that sold common stock in a public offering subject to the Securities Act of 1933. Based on a misstatement in the financial statements, the CPA is being sued by an investor who purchased shares of this public offering. Which of the following represents a viable defense?
(4) The false statement is immaterial in the overall context of the financial statements. (h) (4) A CPA may avoid liability under the 1933 Act by proving that their negligence was not the proximate cause of the plaintiff's loss. Accordingly, a finding that the false statement is immaterial would in all circumstances represent a viable defense.
c. In cases of breach of contract, plaintiffs generally have to prove all of the following, except:
2) The CPAs made a false statement. (c) (2) The plaintiffs need not prove that the CPA made a false statement, it is enough to prove losses and breach of a duty that the CPA had.
d. If the CPAs provided negligent tax advice to a public company, the client would bring suit under:
4) Common law. d) (4) Negligent tax advice would ordinarily result in a suit brought under common law. Note that the client is not covered under the Securities Act of 1933 or the Securities Exchange Act of 1934.
Contract.
CPAs enter into a contract with their client (ordinarily through the engagement letter) and agree to provide services.
CONSTUCTIVE FRAUD
Differs from Fraud in that in that it does not involve a misrepresentation with intent to deceive. Gross negligence on the part of an auditor has been interpreted by the courts as constructive fraud.
To establish CPA liability, a client must prove the following elements:
Duty. The CPAs accepted a duty of due professional care to exercise skill, prudence, and diligence. Breach of duty. The CPAs breached their duty of due professional care through negligent performance. Losses (damages). The client suffered losses. Causation (proximate cause). The damages were caused by the CPAs' negligent performance.
4-18. Comment on the following statement: While engagement letters are useful for audit engagements, they are not necessary for compilation and review engagements.
Engagement letters are important both for audits and for accounting and review services performed by CPAs. Oral arrangements are unsatisfactory when a dispute arises as to the services to be rendered by the CPAs.
4-28 a. If a CPA performs an audit recklessly, the CPA will be liable to third parties who were unknown and not foreseeable to the CPA for:
Gross negligence. (a) (2) A CPA will be liable to third parties who were unknown and not foreseeable for gross negligence. It should be pointed out that if the third party had been "foreseeable," liability might be established for ordinary negligence under a court following the Rosenblum v. Adler decision.
NEGLIGENCE/ORDINARY OR SIMPLE NEGLIGENCE
Is a violation of a legal duty to exercise a degree of care that an ordinary prudent person would exercise under similar circumstances. For the CPA, negligence is failure to perform a duty in accordance with applicable standards. For practical purposes, negligence may be viewed as "failure to exercise due professional care."
FRAUD
Is defined as misrepresentation by a person of a material fact, known by that person to be untrue or made with reckless indifference as to whether the fact is true, with the intention of deceiving the other party and with the result that the other party is injured.
CONTRIBUTORY NEGLIGENCE
Is one means of showing that the auditors' negligence was not the cause (or sole cause) of the client's loss.
Gross Negligence
Is the lack of even slight care, indicative of a reckless disregard for one's professional responsibilities. Substantial failures on the part of an auditor to comply with generally accepted auditing standards might be interpreted as gross negligence.
JOINT AND SEVERAL LIABILITY
Joint and several liability represents another approach to liability that in general benefits a plaintiff's litigation against multiple defendants. The defendants are liable for their pro rata share of any damages awarded (as is the case with proportionate liability), but they also may be held liable for damages of other defendants who prove to be unable to pay their share of the damages. Using our earlier example in which the CPAs were found to be 50 percent responsible for losses, if the management consultants did not have the ability to pay all of the losses attributed to them, the auditors as joint defendants would be required to make up the difference.
STATUTORY LIABILITY
Liability under both the federal securities laws and state securities laws, often called "blue sky" laws. The Securities Act of 1933, which applies to initial stock offerings, imposes liability on CPAs for their audit work relating to financial statements used to register the securities for sale.
COMPARATIVE/PROPORTIONATE NEGLIGENCE
Permits juries to examine the issue of causation and assess a percentage figure of fault to the CPAs, any other defendants, and the client. This system permits the allocation of damages among the parties based on the extent to which each is at fault.
B. Which of the following approaches to auditors' liability is least desirable from the CPA's perspective?
The Rosenblum approach. The Rosenblum Approach provides more third parties the ability to recover damages from the CPA who has performed an engagement with ordinary negligence, and accordingly, is least desirable from the perspective of the CPA. The Ultramares Approach is most desirable, and the Restatement Approach (also known as the Foreseen User Approach) is between the two extremes.
4-12. State briefly a major distinction between the Securities Act of 1933 and the Securities Exchange Act of 1934 with respect to the type of transactions regulated.
The Securities Act of 1933 regulates the initial sale of securities in interstate commerce (new issues), and the Securities Exchange Act of 1934 regulates trading of securities after initial distribution.
4-1. Explain why the potential liability of auditors for professional "malpractice" exceeds that of physicians or other professionals.
There are several reasons why the potential legal liability of CPAs for professional "malpractice" exceeds that of physicians and other professionals. One reason is the vast number of people who may sustain damages. If a physician or attorney commits a serious error, the number of injured parties generally is limited to one individual patient or client. When a CPA's report is in error, literally millions of investors may sustain losses. Second, the federal Securities Acts regarding CPAs' liability are unique in that much of the burden of proof is shifted to the defendant. Normally, defendants are "presumed innocent until proven guilty." Under the federal Securities Acts, however, CPAs charged with "malpractice" must prove their innocence. Finally, when investors sustain losses in the many millions of dollars, the economics of the situation dictates bringing suit against the CPAs even if the prospects for recovery appear remote. When the possible dollar recovery is smaller, which usually is the case in other professional malpractice suits, the plaintiffs are more likely to be deterred from filing suit simply by the costs of litigation.
Statutory Law
lIABILITY THAT DEVELOPS when a governmental unit (e.g., a state or the federal government) passes laws and regulations that either implicitly or explicitly impose potential liability upon CPAs.
