Auditing Chapter 4

statutory

- securities act of 1933 - securities exchange act of 1934

criminal liability - US vs. Arthur Andersen

-Enron case -first major accounting firm ever convicted of a felony -loss of case effectively put andersen out of business -conviction was later overturned by the US supreme court

Primary sources of Common Law

Breach of contract negligence fraud

KEY DISTINCTION between

Gross vs. ordinary negligence

privity

a contract/ agreement between two parties

Loss sustained by client; suit brought under common law.

liable

scope of CPA liability

potential liability may exceed that of other professions because... # of parties suffering significant losses, possibly millions of investors as well as firm creditors, amounts can be excessive in some cases exceeding the limits of professional liability insurance

A method of allocating damages to each group that is liable according to that group's pro-rata share of any damages recovered by the plaintiff. For example, if the plaintiff was awarded a total of $500,000 and the CPAs were found to bear 30 percent of the responsibility for the damages, the CPAs would be assessed $150,000.

proportionate liability

breach of duty

-auditor did not perform obligations listed in the engagement letter -performance did not meet professional standards -does not imply auditors were negligent whenever misstatements due to errors or fraud are later found

Elements of proof by the client under common law

-duty: CPAs accepted a duty of due professional care -breach of duty: CPAs breached that duty -losses: suffered by plaintiff -causation: (Proximate cause) losses were caused by CPAs performance

What type(s) of liability do CPA's have in the United States? A) Both common law and statutory law B) Only common law C) Only statutory law D) Neither common law nor statutory law

A) Both common law and statutory law

The concept of privity may be important in defending auditors against potential claimants. Privity in general only allows: A) Clients to sue their auditors. B) Lenders of the client to sue the auditor. C) Anyone that relied upon the audited financial statements to make a decision to sue the auditor as long as the auditor knew or should have known of such reliance. D) Shareholders who relied upon the audited financial statements to make an investment decision.

A) Clients to sue their auditors.

Ordinarily a claim of negligence against a CPA states that the CPAs performed their duties: A) Without due professional care. B) With reckless disregard of professional responsibilities. C) With wanton disregard to GAAS. D) With reckless disregard to GAAP.

A) Without due professional care.

A CPA is considered 5% responsible for an investor's loss. Under which concept is it most likely that the CPA will be held liable for 100% of the damages if the other defendants are bankrupt? A) Common law liability B) Joint and several liability C) Proportionate liability D) Statutory liability

B) Joint and several liability

A common stock investor's burden of proof relating to a CPA's deficiency of performance under the 1933 Securities Act, when compared to the 1934 Securities Exchange Act, is: A) Greater. B) Less. C) Equal. D) Indeterminate.

B) Less.

Under which common law approach is an unidentified third party least likely to be able to recover damages from a CPA who is guilty of ordinary negligence? A) Due Diligence Approach B) Ultramares Approach C) Restatement of Torts Approach D) Rosenblum Approach

B) Ultramares Approach

Which of the following is not correct concerning the Securities Act of 1933 and Securities Exchange Act of 1934 with regard to auditor liability? A) The 1933 Act holds auditors to a higher standard of performance. B) The 1934 Act provides protection to more third parties. C) The 1933 Act relates to common law liability, while the 1934 Act relates to statutory law liability. D) Only the 1934 Act is affected by the Private Securities Litigation Reform Act of 1995 provision for proportionate liability under certain circumstances.

C) The 1933 Act relates to common law liability, while the 1934 Act relates to statutory law liability.

Establishing "due diligence" is most directly related to court cases tried under: A) Common law by third parties. B) Common law by clients. C) The 1933 Securities Act. D) The 1934 Securities Exchange Act.

C) The 1933 Securities Act.

Under common law rules, a claimant suing a CPA firm based on an audit of financial statements must prove each of the following except: A) A loss was sustained. B) Reliance upon the audited financial statements was a proximate cause of the loss. C) The loss sustained was material to the claimant. D) The auditors were guilty of either ordinary or gross negligence, depending upon the claimant's recovery rights.

C) The loss sustained was material to the claimant.

Under which common law approach are auditors most likely to be held liable for ordinary negligence to a "reasonably foreseeable" third party? A) Due Diligence Approach B) Ultramares Approach C) Restatement of Torts Approach D) Rosenblum Approach

D) Rosenblum Approach

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: Strict liability for all damages incurred. Gross negligence. Either ordinary or gross negligence. Breach of contract.

Gross negligence.

Which of the following approaches to auditors' liability is least desirable from the CPA's perspective? The Ultramares approach. The Rosenblum approach. The Restatement of Torts approach. The Foreseen User approach.

The Rosenblum approach.

tort

a wrongful act, other than a breach of contract, for which civil action may be taken

scienter

acting with the intent to deceive, defraud, or with other knowledge of false representation

Fraud

actions taken with the knowledge and intent to deceive

civil law

all law that does not relate to "criminal"

ordinary negligence

an absence of reasonable or due are in the conduct of an engagement

observation -- auditor liability

auditors must be aware that the FS were able to be used for a particular purpose by a known 3rd party to be liable to that party for ordinary negligence

Restatement Approach (also known as the Foreseen User Approach) is

between the two extreme of rosenblum and ultramares

Failure of one or both parties to a contract to perform in accordance with the contract's provisions.

breach of contract

Unwritten law that has developed through court decisions; it represents judicial interpretation of a society's concept of fairness.

common law

forseen 3rd party or restatement of torts approach to AL - rush factors v. Levin

common law auditors found liable for ordinary negligence to a 3rd party not specifically identified to the auditors, although the auditors were aware of the intended use of the FS

credit alliance corp. v. arthur andersen -- near privity

common law, auditors must demonstrate knowledge of reliance on FS by 3rd party for a particular purpose to be held liable for ordinary negligence to that party

ultramares corp v. touche - privity

common law, established that auditors can be held liable to 3rd party beneficiaries for ordinary negligence and to other 3rd parties for gross negligence

Performing duties with such recklessness that persons believing the duties to have been completed carefully are being misled. The person performing the duties does not have knowledge of misrepresentations within the financial statements.

constructive fraud

duty

defined by GAAS, the engagement letter and the legal considerations

Implied breach of contract

difficult to prove and defend

Reasonably Foreseeable Third Parties Approach to Auditor Liability - rosenblum v. adler

established that the auditors could be held liable for ordinary negligence to all 3rd parties that the CPAs could reasonably forsee as users of the financial statements for routine business purposes

gross negligence

extreme, flagrant or reckless departure from professional standards of due care (constructive fraud)

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 intent to deceive and with the result that another party is injured.

fraud

forseen 3rd party or restatement of torts approach to AL - observation

held liable for ordinary negligence, the auditors must have been aware that the FS were to be used for a particular purpose, although the identity of the 3rd party need not necessarily be known

due care is evaluated

in terms of what other professional accountants would have done under similar circumstances

class action

lawsuit filed by one or more individuals on behalf of all persons who may have invested on the basis of the same false and misleading information

Loss sustained by a bank named as a third-party beneficiary in the engagement letter; suit brought under common law.

liable

Loss sustained by a lender not in privity of contract; suit brought in a state court that adheres to the Rosenblum v. Adler precedent.

liable

Losses to stockholders purchasing shares at a public offering; suit brought under the Securities Act of 1933.

liable

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

third parties

must establish that losses resulted from CPAs performance CPA breached a duty of due professional care

Violation of a legal duty to exercise a degree of care that an ordinarily prudent person would exercise under similar circumstances.

negligence

Loss sustained by trade creditor, not in privity of contract; suit brought in a state court that adheres to the Ultramares v. Touche Co. precedent.

not liable

Losses sustained by stockholders; suit brought under Sections 18(a) and 10(b) of the Securities Exchange Act of 1934.

not liable

breach of contract

occurs when the client or auditor fails to meet the terms and obligations established in the contract (engagement letter) - can be expressed or implied - third parties may have privity of the contract

Reasonably Foreseeable Third Parties / Rosenblum Approach to Auditor Liability - observation

opens the door to liability for ordinary negligence to virtually all 3rd parties who rely on the FS

preventing litigation

place emphasis within the firm on complying with GAAS and professional ethics -retain legal counsel that is familiar with CPAs legal liability -maintain adequate professional liability -investigate prospective clients throughouly -obtain a thorough knowledge of client's business

Damage to another is directly attributable to a wrongdoer's act. This issue may be raised as a defense in litigation—that is, the defense may argue that some other factor caused the loss.

proximate cause

legal environment today

responsibility of public accountants to safeguard the publics interest has increased

Intent to deceive, manipulate, or defraud. This concept is used in the 1934 Securities Exchange Act to establish auditor liability.

scienter

A federal securities statute covering registration statements for securities to be sold to the public.

securities act of 1933

criminal law

statutory (written) law that defines the duties citizens owe to society and prescribes penalties for violations

Written law created by state or federal legislative bodies.

statutory law

typical case --

third party seeks to establish that it sustained a loss caused by relying on misleadnig finsnacial statements which included an audit report that was inadequate -gross negligence will establish liability -ordinary negligence depends on jursidiction