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Chapter 4 Professional Liability and the Need for Quality Auditor Judgments and Ethical Decisions

Chapter 4 Professional Liability and the Need for Quality Auditor Judgments and Ethical Decisions. Learning Objectives. Discuss the liability environment in which auditors operate and explore the effects of lawsuits on audit firms

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Chapter 4 Professional Liability and the Need for Quality Auditor Judgments and Ethical Decisions

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  1. Chapter 4Professional Liability and the Need for Quality Auditor Judgments and Ethical Decisions

  2. Learning Objectives • Discuss the liability environment in which auditors operate and explore the effects of lawsuits on audit firms • List laws from which auditor liability is derived and describe the causes of legal action against auditors • Describe possible causes of action, remedies or sanctions, and auditor defenses under both common law and statutory law

  3. Learning Objectives • Articulate a framework for making quality professional decisions and apply this framework in selected audit settings • Articulate a framework for making quality ethical decisions and apply this framework in selected settings • Describe and apply the IESBA’s Code of Ethics and the AICPA’s Code of Professional Conduct

  4. THE AUDIT OPINION FORMULATION PROCESS

  5. PROFESSIONAL JUDGMENT IN CONTEXT • Audits of two of KPMG LLP’s largest sub prime mortgage lending clients, New Century Financial Corporation and Countrywide, led the firm to settle litigation charges in 2010 for $44.7 million and $24 million, respectively • KPMG had given both companies unqualified audit opinions just before the housing crash of 2007

  6. PROFESSIONAL JUDGMENT IN CONTEXT • KPMG was subsequently accused of: • Violating professional standards • Lacking independence • Being negligent • The firm defended itself by arguing that its audits were not the cause of financial woes and it was the failed business model of the two companies that led to investor losses

  7. PROFESSIONAL JUDGMENT IN CONTEXT • How does the business environment affect the litigation risk faced by audit firms? (LO 1) • Should auditors be held liable when their client’s business fails or its financial statements contain a fraud that the auditors did not detect? (LO 2) • What defenses do auditors use in response to litigation? (LO 3) • What actions can auditors take to minimize litigation exposure? (LO 3, 4, 5, 6)

  8. Learning Objective 1 Discuss the Liability Environment in Which Auditors Operate and Explore the Effects of Lawsuits on Audit Firms

  9. Effects of Lawsuits on Audit Firms • Litigation cases are expensive for audit firms • Result in monetary losses • Consume time of audit firm members • Hurt their reputation • Practice protection costs are second-highest costs for audit firms after employee compensation costs

  10. Reasons for Litigation against Audit Firms • Liability doctrines permit a recovery of full amount of settlement from an external audit firm even though that firm is found to be only partially responsible for the loss • Deep-pocket theory: Suing another party based on perceived ability of that party to pay damages • Class action suits and associated user awareness of possibilities and rewards of litigation

  11. Reasons for Litigation on Audit Firms • Contingent-fee-based compensation for law firms • Misunderstanding by some users of financial statements that an unqualified audit opinion represents an insurance policy against investment losses

  12. Liability Doctrines • Joint and several liability: Apportions losses among all defendants who have an ability to pay for damages, regardless of level of fault • Designed to protect users suffering losses because of misplaced reliance on materially misstated financial statements

  13. Liability Doctrines • Private Securities Litigation Reform Act (PSLRA) of 1995 • Designed to curb frivolous securities class action lawsuits brought under federal securities laws against low performing stock of companies • Liability is proportional unless auditor knowingly participated in a fraud • Proportionate liability: Payment by an individual defendant based on degree of fault

  14. Class Action Lawsuits • Brought on behalf of a large group of plaintiffs to: • Consolidate lawsuits • Encourage consistent judgments • Minimize litigation costs • Plaintiff shareholders may bring suit for themselves and all others in a similar situation • Allows underprivileged individuals to seek compensation for damages

  15. Contingent-Fee Compensation for Lawyers • Lawyers work on contingent fee basis • Contingent fee:Depends on finding or results of services • Contingent-fee cases: Lawsuits brought by plaintiffs with compensation for their attorneys being contingent on the outcome of the litigation

  16. Audits Viewed as an Insurance Policy • Expectations gap: Shareholders mistakenly believe that they are entitled to recover losses on investments for which auditor provided unqualified opinion on financial statements • Encourages large lawsuits against auditors even for cases when auditor is partially or not at fault

  17. Learning Objective 2 List Laws from Which Auditor Liability is Derived and Describe the Causes of Legal Action against Auditors

  18. Laws from Which Auditor Liability is Derived • Common law: Liability concepts developed through court decisions based on negligence, gross negligence, or fraud • Contract law: Liability occurred where there is a breach of contract • Contract is between external auditor and client for performance of financial statement audit

  19. Causes of Legal Action • Statutory law: Developed through legislation • Securities Act of 1933 • Securities Exchange Act of 1934 • Sarbanes-Oxley Act of 2002 • Breach of contract • Failure to perform a contractual duty that has not been excused • For audit firms, parties to a contract include clients and designated third-party beneficiaries

  20. Causes of Legal Action • Negligence: Failure to exercise reasonable care, thereby causing harm to another or to property • Gross negligence • Failure to use minimal care or evidence of activities that show a recklessness or careless disregard for truth • Evidence may not be present, but inferred by jury because of carelessness of defendant’s conduct

  21. Causes of Legal Action • Fraud: Intentional concealment or misrepresentation of a material fact • Intending to deceive another person • Causing damage to deceived person • Scienter: Knowledge on part of person making representations, at the time they are made, that they are false

  22. Parties that May Bring Suit against Auditors • Client and third-party users - Anyone who can support a claim that damages were incurred based on misleading audited financial statements can bring a claim against an auditor • Can accuse auditor of: • Breach of contract • Tort: A civil wrong, other than breach of contract, based on negligence, constructive fraud, or fraud

  23. Exhibit 4.1 - Overview of Auditor Liability

  24. Learning Objective 3 Describe Possible Causes of Action, Remedies or Sanctions, and Auditor Defenses under both Common Law and Statutory Law

  25. Common-Law Liability to Clients - Breach of Contract • Auditors are expected to fulfill contractual responsibilities to clients • Can be held liable to clients under contract law and/or under common law for breach of contract • Can be sued under concepts of negligence, gross negligence, and fraud

  26. Common-Law Liability to Clients - Breach of Contract • Causes for action against auditor for breach of contract • Violating client confidentiality • Failing to provide audit report on time • Failing to discover a material error or employee fraud • Withdrawing from an audit engagement without justification

  27. Common-Law Liability to Clients - Breach of Contract • Remedies for breach of contract • Requires specific performance of contract agreement • Grant of an injunction to prohibit auditor from doing certain acts • Provide for the recovery of amounts lost as a result of breach • When an injunction is not appropriate the client is entitled to recover compensatory damages

  28. Common-Law Liability to Clients - Breach of Contract • Auditor’s arguments as defenses against a breach of contract suit • Auditor exercised due professional care in accordance with contract • Client was contributory negligent • Client’s losses not caused by breach

  29. Auditing in Practice - Moss Adams and the Meridian Mortgage Funds Fraud • This case illustrates that auditors can be held liable for failing to detect a fraud, even when management is perpetrating it and concealing it • Audit firms can face serious litigation risk when: • Clients are acting fraudulently • They conduct audits in a way that allows those relying on the financial statements to question audit quality

  30. Common-Law Liability to Third Parties • To win a claim against the auditor, third parties suing under common law must prove that: • They suffered a loss • The loss was due to reliance on misleading financial statements • The auditor knew, or should have known, that financial statements were misleading

  31. Differing Requirements for Auditor Liability to Third Parties • Foreseeability and negligence: Common Law • The Ultramares case: Third-party beneficiary test • Expansion of Ultramares: Identified user test • Foreseen user test • Foreseeable user test

  32. Foreseeability and Negligence -Common Law • Critical point in determining the type of claim is the likelihood that an auditor could foresee the user relying upon audited financial statements • Less foreseeable plaintiffs need to establish a gross negligence claim • Foreseeable users, in some jurisdictions, have to establish only a negligence claim

  33. The Third-Party Beneficiary Test • New York Court of Appeals in 1931, Ultramares Corporation v. Touche case • Court held auditors liable to third parties for fraud and gross negligence, but not for negligence • Third-party beneficiary: A person who was not a party to a contract, but is named in contract as one to whom contracting parties intended that benefits be given • For liability to be established, a third-party beneficiary must be specifically identified as a user

  34. The Identified User Test • Credit Alliance Corp. v. Arthur Andersen & Co., New York Court of Appeals extended auditor liability for ordinary negligence to identified users • Identified user: The auditor has specific knowledge that known users will be utilizing financial statements in making specific economic decisions

  35. Foreseen User Test • Restatement (Second) of Torts expanded auditor liability for negligence to: • Identified users • Foreseen users: Individually unknown third parties who are members of a known or intended class of third-party users who the auditor can foresee will use the statements • Client must inform auditor that third parties intend to use financial statements • Auditor does not have to know identity of third party

  36. Foreseeable User Test • Some courts have extended auditor liability to foreseeable users of audited financial statements • Foreseeable users: • Not known by auditors to be using financial statements • Recognized by general knowledge as current and potential creditors and investors who will use them

  37. EXHIBIT 4.2 - FORESEEABILITY CONCEPTS FOR AUDITOR’S COMMON-LAW LIABILITY TO THIRD PARTIES

  38. Auditor Liability under Statutory Law • Primary federal statutes affecting auditor liability for public clients • Securities Act of 1933 • Securities Exchange Act of 1934 • Sarbanes-Oxley Act of 2002 • Enacted to assure that investors in public companies have access to full and adequate disclosure of relevant information

  39. Auditor Liability under Statutory Law • Auditors found unqualified, unethical, or in willful violation of any provision of federal securities laws can be disciplined by SEC • Possible sanctions available to SEC • Temporarily or permanently revoking firm’s registration with PCAOB • Imposing a civil penalty of up to $750,000 for each violation • Requiring special continuing education of firm personnel

  40. Securities Act of 1933 • Requires companies to file registration statements with the SEC before issuing new securities to public • Registration statement contains: • Information about company itself • Lists of its officers and major stockholders • Plans for using proceeds from new securities issue

  41. Securities Act of 1933 • Prospectus • First part of a registration statement filed with SEC • Issued as part of a public offering of debt or equity • Used to solicit prospective investors in a new security issue containing, among other items, audited financial statements • Securities Act of 1933 imposes liability for misstatements in a prospectus

  42. Securities Act of 1933 • Section 11 • Most important liability section from the perspective of external auditors • It imposes penalties for misstatements contained in registration statements • Accuracy of registration statement is determined at its effective date

  43. Securities Act of 1933 • SEC intends to assure full and fair disclosure of public financial information • An auditor may be held liable to purchasers of securities for negligence, or gross negligence and fraud • Purchasers need to prove that: • They incurred a loss • Financial statements were materially misleading or not fairly stated

  44. Securities Act of 1933 • In their defense, auditors must prove that: • Due professional care was used • Statements were not materially misstated • The purchaser did not incur a loss caused by the misleading financial statements

  45. Securities Exchange Act of 1934 • Regulated companies are required to file periodic reports with the SEC and stockholders Annual reports to shareholders and 10-Ks • Annual reports filed with the SEC • Both contain audited financial statements • 10-Ks must be filed within 60 to 90 days of the end of the fiscal year Quarterly financial reports to shareholders and 10-Qs • Quarterly reports filed with the SEC • 10-Qs must be filed within 40 to 45 days of end of each of first three quarters • 10-Qs must be reviewed by auditors 8-Ks • Reports filed with the SEC describing occurrence of important events

  46. Securities Exchange Act of 1934 • Prohibits material misrepresentations or omissions and fraudulent conduct • Provides a general antifraud remedy for purchasers and sellers of securities • Auditor may be held liable for fraud when a plaintiff alleges being misled by misstatements in financial statements

  47. Securities Exchange Act of 1934 • Act makes it unlawful to: • Make any untrue statement of a material fact • Omit to state a material fact necessary for understanding financial statements • Basic elements for a successful case for securities fraud • Material misrepresentation or omission • Fraudulent conduct in connection with purchase or sale of a security

  48. Securities Exchange Act of 1934 • Scienter, when making the misrepresentation or omission • Reliance upon fraudulent conduct • Measurable monetary damages • A causal connection between misrepresentation or omission and economic loss • Showing compliance with generally accepted accounting principles (GAAP) is an acceptable defense by an auditor

  49. Securities Exchange Act of 1934 • Criminal actions against auditors who: • Willfully violate provisions of either Act and related rules or regulations • Know that financial statements are false and misleading and who issue inappropriate opinions • Resolutions in these cases • Injunctions and disgorgement orders • Civil penalties • Suspending individuals from serving as directors of securities issuers or participating in securities industry

  50. Learning Objective 4 Articulate a Framework for Making Quality Professional Decisions and Apply This Framework in Selected Audit Settings

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