- A client may sue an auditor for failing to discover a defalcation (common law liability to client

- A third party may sue an auditor; e.g.,a bank may sue an auditor for failing to discover that a borrower’s financial statements are partially misstated (common law liability to third parties)

- A combined group of stockholders may sue an auditor for not discovering materially misstated financial statements (liability under federal securities acts

- The federal government may prosecute an auditor for knowingly issuing an incorrect audit report (criminal liability, Arthur Andersen in Enron case

-when a business is unable to repay its lenders or meet investor expectations

-result of unfavorable economic or business conditions such as a recession, poor management decisions, or unexpected competition.

-Auditor NOT responsible

-occurs when an auditor issues an erroneous audit opinion as a result of an underlying failure to comply with GAAS.

-Auditor responsible

-is the risk that the auditor, while competently following GAAS, will conclude that the financial statements fairly stated when, in fact, they are not. -Auditor NOT responsible but hard to determine

Three legal concepts apply to auditor liability

1. the prudent person concept. An auditor is expected to conduct the audit with due care but the auditor is not expected to be perfect

2. liability for the acts of others. The owners of a public accounting firm (partners of a partnership, shareholders of a professional corporation) are jointly liable for civil actions of an owner

3. lack of privileged communication. In general, auditors do not have the right under common law to withhold information from the courts on the

grounds that the information is privileged

-absence of reasonable care

-absence of even slight care, tantamount to reckless behavior

-existence of extreme or unusual negligence even though there was no intent to deceive or do harm

-a misstatement is made and there is both the knowledge of its falsity and the intent to deceive

-failure of one or both parties in a contract to fulfill the requirements of the contract

-Parties who have a relationship that is established by a contract

-a third party who does not have privity of contract but is known to the contracting parties and is intended to have certain rights and benefits under the contract

-laws that have been developed through court decisions rather than through government statutes

-laws that have been passed by the U.S. Congress and other governmental units

-the assessment against a defendant of the full loss suffered by a plaintiff regardless of the extent to which other parties shared in the wrongdoing

-the assessment against a defendant of that portion of the damage caused by the defendant’s negligence

-The auditor claims that there was no implied or expressed contract.

-A common way for an auditor to demonstrate a lack of duty to perform is by use of an engagement letter

-The auditor claims that the audit was performed in accordance with GAAS. Even if there were undiscovered errors or irregularities, the auditor is not responsible if the audit was properly conducted

-The auditor claims that if the client had performed certain obligations, the loss would not have occurred

-The auditor claims that there is a lack of a close causal connection between the auditor’s breach of the due care standard and the damages suffered by the client

-An auditor may be liable to third parties if a loss was incurred by the claimant due to reliance on misleading financial statements.

Third parties include:

-actual stockholders

-potential stockholders

-creditors

-employees

-customers

-vendor

Ultramares v. Touche 1931

Ultramares Doctrine

-ordinary negligence is insufficient for liability to third parties, because of the lack of privity of contract between the third party and the auditor, unless the third party is a primary beneficiary [A known third party]

-specifies that if there has been fraud or gross negligence, the auditor could be held liable to more general third parties

-the courts have broadened the Ultramares Doctrine to allow recovery by third party foreseen users (members of a limited class of users who the auditor is aware will rely on the financial statement)

-An even broader interpretation of the rights of third-party beneficiaries is to use the concept of foreseeable users (users that the auditor should have reasonably been able to foresee as being likely users of financial statements)

-Lack of duty, non-negligent performance, absence of causal connection. NOT contributory negligence

-deals with information in registration statements and prospectuses and concerns only reporting requirements related to new securities.

-Any third party who purchased securities described in the registration statement may sue the auditor for material misrepresentations or omissions in audited statements...

-Third party users do not have the burden of proof that they relied on the financial statements or that the auditor was negligent or fraudulent. The user must only prove that the audited statements contained a material misrepresentation or omission

-Any third party can sue

-No burden of proof

-as defenses the auditor must demnstrate (1) an adequate audit was conducted or (2) all or part of the plaintiffs loss was caused by factors other than the misleading statements.

-results in auditor liability related to audited financial statements and information issued to the public and the SEC in monthly (8-K), quarterly (10-Q), and annual (10-K) reports

-rule prohibits, by interstate commerce, mail, or a national securities exchange:

     -any device, scheme, or artifice to defraud

     -untrue statements of material fact or omission of material facts necessary to make the statements not misleading

     -fraud or deceit in connection with the purchase or sale of any security

-The Racketeer Influenced and Corrupt Organization (RICO) Act allows an individual to seek damages when it can be demonstrated that the defendant was engaged in a pattern of racketeering activity

-In a 1993 U.S. Supreme Court decision, the court ruled that outside professionals such as accountants who do not help run corrupt businesses can not be sued under the provisions of RICO

-forbids offering a bribe to an official of a foreign country for the purpose of exerting influence and obtaining or retaining business

-requires SEC companies to maintain reasonably complete and accurate records and an adequate system of internal control

-The act may affect auditors through their responsibility to review and evaluate systems of internal control as a part of an audit

-Auditors may be found guilty for criminal action under both federal and state laws.

-These laws make it a criminal offense to defraud another person through knowingly being involved with false financial statements

-SOX made it a felony to destroy or create documents to impede or obstruct a federal investigation

- encourage auditing research regarding litigation and improvements in auditing practice

-establish standards and rules that meet the changing needs of auditing

-establish standards that protect auditors

-establish peer review requirements

-oppose unwarranted lawsuits

-educate financial statement users about auditing and the auditor’s opinion

-sanction auditors for improper conduct

-lobby for changes in laws

-deal only with clients possessing integrity

-hire, train, and supervise qualified personnel

-follow the standards of the profession

-maintain independence

-understand the client’s business

-perform quality audit

-document the work properly

-obtain an engagement letter and a representation letter

-maintain confidential relations

-carry adequate insurance

-seek legal counsel

-choose a form of organization with limited liability

-System of Proportionate Liability

-Plaintiffs to pay Defendants’ Reasonable Attorneys’ Fees and Expenses

-Stay of Discovery

-Limits Punitive Damages

-Limits on the Rights of Third Parties to Sue

-Modifications in the Appointment of Lead Plaintiffs

-Safe-Harbor Provision

-New Limits on Establishing Damages

-Whistle Blowing