Chapter 20

Legal Liability

McGraw-Hill/Irwin

Copyright 2012 by The McGraw-Hill Companies, Inc. All

Largest CPA firm payouts in recent class actions

Company

Cendant Corp.

CPA firm

Ernst & Young

Deloitte &
Adelphia
Touche
Tyco International PwC
Baptist
Foundation of
Arthur
Arizona
Andersen
Parmalat
Deloitte &
Finanziaria
Touche
HealthSouth Corp. Ernst & Young
Superior Bank
FSB
Ernst & Young
Rite Aid Corp.
KPMG
Lernout &
Hauspie Speech
Products
KPMG
Arthur
Sunbeam Corp.
Andersen
Arthur

Settlement

Year filed

$633,500,000

1998

$367,500,000
$225,000,000

2002
2002

$217,000,000

1999

$157,500,000
$142,500,000

2004
2002

$125,000,000
$125,000,000

2002
1999

$115,000,000

1999

$110,000,000

1998

LO# 2

One way to classify law is common law vs. statutes

Two Classes of Law

Common Law

Statutory Law

Case law
developed over
time by state court
judges

Statutes enacted
by Congress,
interpreted by
federal judges
20-3

Another way to classify law:

who the auditor is liable to

The

auditor might be liable to who

engaged the auditor (usually, but not
always, the company that is audited)
The auditor might be liable to users
(called 3rd parties) of the financial
statements.
Here is where auditor liability is unique,
as we will learn

LO# 2

Overview

20-5

LO# 2

Overview

20-6

LO# 3

Common Lawliability to who engaged the auditor

Since there is an agreement, there can be contract
liability as well as tort liability

Requires Due
Care

Bottom line: if auditor

performs with due care
he is not liable, if not,
he is liable.

Types of Liability
to the Client

May be held liable

for breach of
contract (contract
law)

Negligence
Gross
negligence
Fraud
These are all
genres of tort
law
20-7

LO# 3

Negligence (liability to company

that engaged the auditor)

Requires Due
Care

If an engagement is
performed without due
care, the CPA may be
held liable for an
actionable tort in
negligence. Tort law
and GAAS - defines
what is due care.
20-8

LO# 3

Common Law Negligence: liability of auditor to company

that engaged the auditor
Company must prove, inter alia, that the
behavior of the auditor constitutes a lack of
due care. Different courts use different
language, but #1 is the easiest for the
company to prove, since it is just barely a
lack of due care. #2 is harder to prove, and
#3 is the hardest to prove.

1. Ordinary negligence or negligence

2. Gross negligence, recklessness or statutory fraud.
3. Actual fraud or knowing fraud.
20-9

LO# 3

Common Law Negligence: Client

Auditors
Defense

1. No duty was owed to the client.

2. The client was negligent.
3. The auditors work was performed in accordance with
professional standards.
4. The client suffered no loss.
5. Any loss was caused by other events.
6. The claim is invalid because the statute of limitations has
expired.
20-10

Common law liability to 3rd party users of financials

As noted above theres only tort law liability to 3rd

party users of financials (theres no contract so
theres no possible breach of contract)
We also noted there are 3 severity levels of bad
(less than due care) auditor behavior. #1 is
easiest for 3rd party users to prove against an
auditor, but in a traditional 3rd party privity or
Ultramares state, e.g. New York, if that is all that
3rd party users can prove against the auditor, they
lose and the auditor wins (not liable).
1. Ordinary negligence or negligence
2. Gross negligence, recklessness or statutory fraud.
3. Actual fraud or knowing fraud.

LO# 4

Common Law - 3rd party Ordinary Negligence / Negligence

Four approaches for 3rd Parties: Privity or
Ultramares is arguably the most important ,
because it is the original approach and it is what
New York uses. Know how to apply it. Simply
know that the other 3 approaches exist.

Privity

Near Privity
Foreseen
3rd Parties

Reasonably
Foreseeable
3rd Parties
20-12

LO# 4

Common Law3rd Parties

Negligence
Third Party
Must Prove
1. The auditor had a duty to the plaintiff to exercise due care.
2. The auditor was worse than negligence or ordinary
negligence (i.e. committed gross negligence, recklessness,
constructive fraud, actual fraud or knowing fraud).
3. The auditors breach of due care was the direct cause of the
3rd partys injury.
4. The 3rd party suffered an actual loss as a result.

20-13

LO# 4

Common Law3rd Parties

Negligence
Auditors
Defense

1. Auditors behavior was not worse than negligence or ordinary

negligence.
2. The 3rd party was negligent.
3. The 3rd party suffered no loss.
4. Any loss was caused by other events.
5. The claim is invalid because the statute of limitations has
expired.
20-14

LO# 4

Fraud 3 parties
rd

Third Party
Must Prove

1. A false representation by the CPA.

2. Knowledge or belief by the CPA that the representation was
false.
3. The CPA intended to induce the 3rd party to rely on the false
representation.
4. The 3rd party relied on the false representation.
5. The 3rd party suffered damages.
20-15

LO# 5

Statutory Liability
Two major federal statutes provide
sources of statutory liability for
auditors:
The Securities Act
of 1933

The Securities
Exchange Act of
1934

20-16

LO# 5

Securities Act of 1933

Only applies re an offering of securities.

Could be an IPO or could be

A secondary or other kind of offering

20-17

LO# 5

Securities Act of 1933 auditors worst liability exposure to

3rd parties because a) very little must be proved, b) no
privity defense allowed, and c) auditor has burden of proof
that he performed with due care (due diligence defense)

3rd Party Must Merely Prove to

win the sue

1. The 3rd party suffered losses by investing in the registered

security.
2. The audited financial statements contained a material
omission or misstatement.

20-18

LO# 6

Securities Exchange
Act of 1934
Applies to offerings plus ongoing reporting (e.g. 10K
or 10Q) by public companies.

Section 10(b) and Rule 10b-5 are the greatest source of

liability for auditors under this act.

20-19

LO# 6

Securities Exchange Act of 1934

3rd Party Must Prove

1. A material, factual misrepresentation or omission.

2. Reliance on the financial statements.
3. Damages suffered as a result of reliance on the financial
statements.
4. Scienter (gross negligence or recklessness is enough).
If 3rd party proves auditor committed knowing fraud then auditor
faces joint/several liability instead of proportionate liability
This means that the auditor could have to pay all the money, if
the lawsuit is lost, instead of just his proportionate share

20-20

LO# 9

SEC and PCAOB Sanctions

Suspend
Practicing
Privilege

Impose
Fines

Remedial
Measures

20-21