AUDITING CHAPTER 5

1. AUDITINGCHAPTER 5 Legal Liability By David N. Ricchiute

2. TOPICS • Issues of liability to clients, 3rd parties • Common law liability to foreseen 3rd parties & Restatement of Torts • Auditors & the Securities Acts • Statutory liability to securities purchasers, sellers & securities litigation reform • Liability for criminal offenses • Responsibility to detect, report illegal acts • Minimizing risk of legal liability GBW 8th ed. Ch. 5

3. ISSUES CONTRIBUTING TO LEGAL LIABILITY • Joint-and-several liability • Allowed plaintiffs to recover against auditor alone • Revised by Private Securities Litigation Reform Act of 1995 • Changed to proportionate liability, i.e., auditor’s share • Privity doctrine limits liability to parties to contract • Expanded to include certain 3rd parties GBW 8th ed. Ch. 5

4. ISSUES IN CIVILITY LIABILITY • Source of law for suit • Who is plaintiff? • What is auditor’s potential liability • Who has the burden of proof, plaintiff or defendant? • Penalty is monetary damages GBW 8th ed. Ch. 5

5. SUMMARY OF ISSUES:Sources of Law • Common law • Written opinions of prior courts • Statutory law • Written statutes established by Congress, state legislatures • Securities Act of 1933 • Securities Exchange Act of 1934 GBW 8th ed. Ch. 5

6. SUMMARY OF ISSUES: Plaintiff • Under common law • Breach of contract • Client • 3rd party primary beneficiaries • Tort (wrongful act) • Foreseen 3rd parties • Foreseeable 3rd parties • Under Securities Act 1933 • Initial purchasers • Under Securities Exchange Act of 1934 • Subsequent purchasers, sellers GBW 8th ed. Ch. 5

7. SUMMARY OF ISSUES: Auditor’s Potential Liability • Ordinary negligence • Lack of reasonable care in performing services • Departure from GAAS • Gross negligence • Lack of minimum care in performing services • Reckless departure from GAAS • Fraud • Intentional misstatement or omission of material fact • Constructive fraud lacks intent GBW 8th ed. Ch. 5

8. SUMMARY OF ISSUES: Burden of Proof • Plaintiff had damage, loss • Materially misstated financial statements • Reliance on financial statements, advice • Deficient auditor conduct GBW 8th ed. Ch. 5

9. COMMON LAW: Legal Action • Breach of contract • Allege violations of GAAS or confidentiality • Tort (wrongful act) • Allege injury due to negligence, gross negligence, fraud GBW 8th ed. Ch. 5

10. COMMON LAWPrimary Beneficiaries • Specifically identified to auditors • Beneficiaries of services • Privity of contract • Breach of contract • Threshold for primary beneficiaries ordinary negligence GBW 8th ed. Ch. 5

11. COMMON LAW: 3rd Parties • General identity, reliance on statements known • Foreseen 3rd parties • Not specifically identified though known • Creditors • Foreseeable 3rd parties • Bondholders, shareholders • Uses tort law • Threshold for 3rd parties gross negligence or fraud GBW 8th ed. Ch. 5

12. RESTATEMENT OF TORTS • Accepted in majority of states • Establishes auditor’s liability to foreseen 3rd parties • Treats as primary beneficiaries • Report used to influence plaintiff who provided funding GBW 8th ed. Ch. 5

13. PRIVITY DOCTRINE • Used in states that don’t accept Restatement of Torts • Established in Ultramares Corp v. Touche (1931) • Auditors liable to 3rd parties for fraud • Reaffirmed in Credit Alliance • Established linkage test to link auditor to plaintiff GBW 8th ed. Ch. 5

14. LIABILITY TO FORESEEABLE 3RD PARTIES • Most liberal interpretation of culpability • Used only in Mississippi & Wisconsin GBW 8th ed. Ch. 5

15. STATUTORY LAW Securities Act of 1933 • New issues of securities (IPO) • Registration statement (S-1) filed with SEC • Auditor’s involvement • Auditor of annual reports • Reviews statements • Reviews S-1 for consistency with statements • Issues “comfort letter’ to underwriters (SAS 72) GBW 8th ed. Ch. 5

16. STATUTORY LAW:Securities Exchange of 1934 • Regulates trading of securities • Requires registration with SEC & periodic reporting (10-k, 10-q) • Antifraud provisions of Section 10(b) & Rule 10b-5 • Protect purchasers, sellers from manipulation, deception by auditor GBW 8th ed. Ch. 5

17. AUDITOR’S LIABILITY UNDER ’33, ’34 ACTS • ’33 Act • Derives from association with registration statement • ’34 Act • Derives from association with 10-k, 10-q • Liable for untrue statements or omissions of material fact GBW 8th ed. Ch. 5

18. STATUTORY LAW: Private Securities Litigation Reform Act • 1995 • Sanctions lawyers who sue auditors for frivolous or factually impertinent arguments • Retains joint-and-several liability for knowingly perpetrating fraud • Applies proportional liability for less culpable defendants GBW 8th ed. Ch. 5

19. MAJOR CASES • Securities Act 1933 • Escott v. BarChris Construction Corp. (1961) • Material, Misleading statements with registration • Securities Exchange Act 1934 • Ernst & Ernst v. Hochfelder (1976) • Auditors not liable in absence of scienter (intent to deceive) GBW 8th ed. Ch. 5

20. CRIMINAL LIABILITY: 1930s • Securities Act 1933 & Securities Exchange Act 1934 • Willfully making a false statement or omitting a material fact • Federal Mail Fraud Statute • Mailing, conspiracy to mail false statements • Major case • United States v. Simon (Continental Vending) 1969 GBW 8th ed. Ch. 5

21. CRIMINAL LIABILITY:1990s • Racketeer Influenced & Corrupt Organizations Act (RICO) • Intended to curtail movement of organized crime into legitimate business • Applies to auditors who are engaged in the management of a business GBW 8th ed. Ch. 5

22. FOREIGN CORRUPT PRACTICES ACT • Illegal acts by US multinational companies overseas • Influencing foreign governments, officials, etc. by payments, gifts • Multinationals must implement sufficient internal controls to • Comply with authorization • Record as necessary • Restrict access to assets GBW 8th ed. Ch. 5

23. COPING WITH LIABILITY • Arbitration, mediation • Practice development • Client acceptance, retention • Engagement letters • GAAS & Quality control • Professional liability insurance • Countersuits • Limited liability partnerships (LLPs) GBW 8th ed. Ch. 5