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Auditing & Assurance Services 8e Module C

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Module C

Legal Liability

When men are pure, laws are useless; when men are corrupt, laws are broken.

‒Benjamin Disreali, British prime minister and author (1804-1881)

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The Legal Environment

Auditors

Client

Third-party user of financial statements

Performs services in accordance with contract

Conduct a GAAS audit

Rely on audited financial statements in making economic decisions

Issue auditors’ report

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Watch more detailed explanation on legal environment & lawsuits by client and third parties (Video C-1 on Blackboard ‘Learning Materials’).

Third Parties

Shareholders

Other third-parties

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Lesson 3, and Module C of the textbook, is all about auditors’ legal liability. To whom are auditors held accountable? When a client company hires an audit firm, the audit firm writes a contract, which we call an ‘engagement letter’ in audit, and both parties sign it. So if the client thinks that the auditor did not fulfill the responsibilities that are described in the contract or did not conduct the audit in conformity with GAAS, the client may bring a lawsuit against the auditor. In other words, auditors may be held liable for their failure to deliver the service they agreed to deliver to their clients. But there is more. We discussed in Lesson 1 that auditors’ job is providing assurance on financial statements for parties who use that information to make their economic decisions, such as individual shareholders and financial institutions. These information users may also want to hold auditors liable if they think the audited financial statements were misstated and they suffered an economic loss by using the information included in those misstated financial statements. They are technically ‘third-parties’ because, unlike clients, they are not parties that have binding contract with each other. But auditors are still responsible for those third parties’ loss to a certain extent. In this lesson, we are going to look at various types of lawsuits brought by clients or third party users of financial statements and learn about laws these lawsuits are based on.

Sources of Auditor Liability

Common law: Uses legal precedent to identify responsibility.

Auditors’ Liability to Clients

Auditors’ Liability to Nonshareholder third parties

Statutory liability: Based on violations of written statutes.

Auditors’ Liability to Shareholders

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Common Law

Breach of contract: Services not performed by auditors in manner described in contract

Tort liability: Obligation based on failure of auditors to exercise appropriate level of professional care

Ordinary negligence is lack of reasonable care

Gross negligence is lack of minimal care (similar to constructive fraud)

Fraud is a intentional misrepresentation of fact an individual knows to be false

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Common Law Liability: Clients

Clients may bring a lawsuit against auditors based on…

1) Breach of contract

Contractual relationship with client (through engagement letter) creates potential liability

2) Tort liability

Liable for ordinary negligence, gross negligence, and fraud

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Let’s jump to page 6, and start from the lawsuits brought by a client. Like I said on page 3, a client can bring a lawsuit when the auditor did not deliver audit service in a way that is described in the engagement letter, i.e. the contract. That would be a breach of contract. But clients can also hold auditors liable for general negligence. That is, no matter whether it is explicitly written in the contract or not, there is a certain level of care and performance that a reasonable person would expect from a professional. Also, GAAS we discussed in Lesson 2 also describes how auditors should perform an audit. So if an auditor fails to deliver that level of service, such substandard performance can result in a civil lawsuit and the auditor’s legal liability. That is called tort liability.

Proof and Defenses: Clients

Clients (Plaintiffs) must show ALL of the following:

Plaintiffs suffered economic loss

Auditors breached contract or failed to exercise appropriate care

The loss was caused by the breach of contract or failure of auditors to exercise the appropriate level of care

Auditors (Defendants) may attempt to mitigate clients’ claims by using one of the following:

Auditors exercised appropriate level of care (for tort liability suit) or performed the engagement in accordance with contract (for breach of contract suit).

The client’s loss was caused by a factor other than auditors’ failure (causation defense)

clients were partially responsible for loss (contributory negligence)

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For every type of lawsuit, we are going to see what the plaintiffs need to prove in order to successfully hold the auditor liable for their action, and what auditors can show to defend themselves. In most of the lawsuits, the plaintiff has the burden of proof, so has to show more. For example, in a lawsuit brought by the client, the client needs to prove all three things you see on this slide. The fact that the plaintiff has to prove all of these implies that auditors can defend themselves by successfully disproving ‘one’ of the plaintiffs’ arguments.

Common Law Liability: Third Parties

Types of Third Parties

Primary beneficiaries: Known by name to the auditor

Foreseen: Parties who could reasonably be expected to rely on the auditors’ work

Foreseeable: Parties whose decisions normally rely on audited financial statements and opinions on those financial statements

Known

to Auditor

Less Known to Auditor

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The second type of lawsuit we will see is suits brought by third parties. We are going to look at non-shareholder third parties first, and then look at shareholders separately because there are specific laws that are only applicable to shareholder-brought lawsuits.

These third parties are users of audited financial statements. Then, should auditors be responsible for every single party who has ever seen and used the financial statements they audited? Not exactly. There are third parties that are more closely related to auditors than others. The law breaks them down into three categories. The first one is the primary beneficiary who auditors already knew. What does that mean? Let’s say a company explained to an auditor they just hired that Bank XYZ demanded ‘audited’ financial statements before the bank makes a decision about whether to lend money to the company (By the way, in this example, this company would be a private company because, for a public company, annual audits are already mandatory regardless of the bank’s demand). With that information already known, the auditor audits the company’s financial statements, issues an auditor report with a clean, unmodified opinion, and attaches it to the financial statements. In that case, the bank is ‘the primary beneficiary’ because auditors has known that a specific bank will use and probably rely on their audit work while conducting the audit.

But if the company explained to auditors that they are going to use the audited financial statements to get a loan from a bank, but did not mention a specific bank, Bank XYZ is a ‘foreseen’ party. Auditors must have foreseen that some kind of bank would rely on their audit work, but did not know exactly which bank that would be.

The ‘foreseeable parties’ are even less known to auditors. They are basically anybody who relied on audited financial statements and audit opinions for a reasonable purpose. The ‘Rosenblum v. Adler’ case described in the textbook perfectly illustrates a foreseeable party. I recommend everyone read that.

Common Law Liability: Third Parties

Auditors are generally liable to all third parties for gross negligence and fraud

Liability for ordinary negligence: Depends on jurisdiction.. (You don’t need to memorize which state have which laws)

Legal Precedents

Ultramares: Concludes auditors are not liable for ordinary negligence

Credit Alliance v. Arthur Andersen: Liable to primary beneficiaries for ordinary negligence

Fleet National Bank (restatement of torts): Liable to foreseen third parties for ordinary negligence (in addition to primary beneficiaries)

Rosenblum v. Adler: Liable to foreseeable third parties for ordinary negligence (in addition to primary beneficiaries and foreseen third parties)

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So why do we care about these different types of third parties? Because depending on whether you are a primary beneficiary, foreseen party, or foreseeable party, you may or may not be able to claim your loss to auditors. If auditors’ actions were extremely reckless or fraudulent, then all these parties can claim their losses to auditors and the types of third parties don’t affect the result of the claim. But it matters when you want to argue that you suffered a monetary loss due to auditors’ ‘ordinary negligence’, which means auditors’ performance did not meet the level expected for a professional auditor but negligence was not severe enough to be ‘gross negligence’. And the result depends on jurisdictions. Some states can allow foreseeable parties to recover their loss from auditors, while in some states, only primary beneficiaries and foreseen parties have standing to proceed with lawsuits. For the purpose of this course, you do not need to know which states have what kind of laws, but you need to know that a third party’ standing in the lawsuit against auditors can vary across jurisdictions.

Proof and Defenses: Third Parties

Third parties must show all of the following:

Economic loss

Auditors failed to exercise appropriate level of care

Financial statements contained a material misstatement

Loss caused by reliance on misstated financial statements

Auditors can use one of the following as a defense:

Lack of appropriate standing (relationship with auditor) to bring suit

Third party’s loss is caused by factors other than the financial statements and auditors examination (causation defense)

Auditor exercised appropriate level of care in accordance with professional standards (e.g. GAAS).

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And what the plaintiffs have to prove and what auditors can show to defend themselves are similar to client-initiated lawsuits. These lists start to change from the next type of lawsuit we see in this module, ‘shareholder-initiated’ lawsuits.

Summary of Liability for Ordinary Negligence

Ultramares: Liable for Gross Negligence and Fraud

Credit Alliance v. Arthur Andersen:

Liable to Primary Beneficiaries for Ordinary Negligence

Fleet National Bank v. Gloucester Co:

Liable to Foreseen

Third Parties for

Ordinary Negligence

(restatement of torts)

Rosenblum v. Adler:

Liable to Reasonably Foreseeable

Third Parties for

Ordinary Negligence

Less Exposure for Auditors More Exposure for Auditors

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Summary of Common Law Liability

Liability to clients

Breach of contract

Tort liability for ordinary negligence, gross negligence, and fraud

Liability to third parties

Only tort liability, unless they have a contract with auditors

Auditors are liable to all for gross negligence and fraud

Liability for ordinary negligence depends upon relationship and jurisdiction

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Statutory Liability

Violations of specific ‘written’ laws or statutes

Securities Acts

Regulate securities trading in the U.S.

Require issuers to disclose of important financial and nonfinancial information using GAAP

Require annual filings of financial statements to be audited

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Securities Act of 1933 (Securities Act)

Regulates initial issuance of securities by registrants to investing public

New registrants are required to file registration statement with SEC that includes audited financial statements.

Investors who invested in initial issuance of securities of a company can file a civil lawsuit against the company’s auditors under Section 11 of the Securities. To bring suit, investors must show all of the following:

Loss

Financial statements contained a material misstatement

*No need to show reliance on financial statements or that loss was caused by misstatement

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Instructor Note: As you can see, this is the most generous case to plaintiffs among all the cases of legal liability of auditors we learn in this chapter (fewer things to prove)

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Liability Under Securities Act

Auditors responsible for ordinary negligence, gross negligence, and fraud

Auditors must show one of the following as a defense

Due diligence (auditors performed a proper GAAS audit)

Causation (loss resulted from factors other than misstatements)

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Instructor Note: You can see here that defenses for auditors are similar to ones for lawsuits brought by clients or non-shareholder third parties under common law. The difference is that, in this case, the plaintiffs do not have the burden to prove there is a causation between the plaintiffs’ loss and results of the audit (=misstatements) to claim their loss against auditors.

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Criminal Liability Under Securities Act

Criminal Liability (Section 24)

Auditors must have “willfully” violated provisions of the Securities Act (fraud or gross negligence)

Possible penalties for defendants: monetary fines, prison terms, or both

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Securities Exchange Act of 1934 (Securities Exchange Act)

Regulates daily trading of securities and requires periodic financial statements and information to be filed with the SEC

Reports that issuers (public companies) must be filed with SEC

Form 10-K: Annual Financial Statements (must be audited)

Form 10-Q: Quarterly Financial Statements (reviewed)

Form 8-K: “Current events” report filed as appropriate

(Example: Microsoft’s 8-K announcing an executive’s departure. Click!)

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Liability under the Securities Exchange Act of 1934

To bring suit against auditor, investors must show:

Economic loss,

Financial statements contained a material misstatement,

Loss caused by reliance on financial statements (burden of proof shifted to investor),

And auditors were aware that the financial statements contained a material misstatement (has been interpreted as gross negligence)

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Instructor Note: Under Securities Exchange Act of 1934, auditors cannot be held liable for ordinary negligence. Auditors are liable only for fraud or gross negligence where auditors intentionally or recklessly overlooked misstatements.

*Understand the differences between Securities Act of 1933 and Securities Exchange Act of 1934.

Liability under the Securities Exchange Act of 1934 (continued)

Auditors liable for gross negligence and fraud

Scienter is a mental state embracing the intent to deceive, manipulate, or defraud

Defenses for auditors

Auditors acted in good faith and were not aware of material misstatements

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Criminal Liability Under Securities Exchange Act

Criminal Liability (Section 32)

Did auditors act “willfully and knowingly”?

(Similar to Section 24 of Securities Act)

Fines of up to $5 million and imprisonment for up to 20 years

Example: United States vs. NATELLI (“National Student Marketing”) in textbook

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Summary of Auditors’ Liability

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Factors Contributing to Auditors’ Exposure to Litigation

Highly-publicized failures (WorldCom, Enron)

Investor awareness of ability to recover monetary losses from auditors (“deep pockets”) - an attractive target for plaintiff attorneys

Complex accounting standards

Joint and several liability (see ‘Proportionate Liability’ on page 701 of textbook, in ‘The Changing Landscape of Auditors’ Liability’ section for further explanations)

Availability of class action suits

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Watch more detailed explanation on auditors’ exposure to litigation (Video C-2 on Blackboard ‘Learning Materials’).

So far in this module, we have seen that auditors have a pretty significant exposure to litigation. So why do all these people go after the auditors?

First, the pressure has increased after the accounting scandals in early 2000s, such as Enron and WorldCom. These scandals are accounting frauds committed by certain companies, but at the same time, they are audit failures. Auditors have, probably intentionally, overlooked the client’s misstatements. After these incidents, public has better idea of auditors’ responsibilities in financial reporting and what audit failure looks like. That leads to more scrutiny to auditors.

Next, we’d better look the second and fourth bullet point together. When would investors be most likely to sue auditors? Probably when they’ve incurred loss from their investment in the company which auditors audited. When do investors incur loss? When the company they invest in is not preforming well. Then what usually happens to companies that are not doing well? They don’t have money, and maybe on the verge of bankruptcy. So investors go after auditors instead of, or in addition to, the client company because auditors are a more viable source they can recover their money from. In other words, auditors have more money than the client company, or we can say auditors have a ‘deeper pocket’.

And how the plaintiffs can recover their loss from auditors is closely related to the law of joint and several liability. When multiple parties are responsible for the loss or injury of a plaintiff, joint and several liability rule directs that each party is ‘independently’ liable for the full extent of loss. That means the plaintiff can demand the full amount from either party, instead of collecting a half from one party and the other half from the other party.

[Whiteboard]

Now let’s apply this to a financial misstatement situation. The investor rely on a set of financial statements to make investment decisions. The financial statement for public companies is audited and most of the times the auditor issue an unmodified opinion on that financial statement, assuring investors there is no material misstatement there. But let’s say those statements were, in fact, misstated, in other words, were not prepared in conformity with GAAP. And because the information in the financial statement was misleading, the investor ended up losing a lot of money from that investment.

Now the investor wants to hold the company and the auditor liable. The investor files a lawsuit against both parties, and win. Since two defendants are both responsible for the investor’s loss, ideally, the company and the auditor should share the full value of the judgment decided by the court. But as I said, in a lot of cases of like this, the company is financially struggling and may have already gone bankrupt, even. Then what happens? The auditor ends up bearing the responsibility for the full amount of penalty. The auditor can later seek to recover the part of that amount from the company, but you can imagine that is going to be unlikely. In conclusion, because of this joint and several responsibility rule, auditors can end up bearing more responsibilities than they deserve. This may seem too much for auditors, so if you look at ‘proportional liability’ section on page 701 of the textbook, it discusses how a new law called Private Securities Litigation Reform Act of 1995 limited the maximum amount of liability auditors should bear in certain situations. I don’t expect you to know the details of this act, but you need to understand the concept of joint and several liability vs. proportionate liability.

Sarbanes-Oxley Act (2002)

Law passed after Enron and WorldCom scandals in an effort to strengthen corporate accountability and governance of public companies

Extends statute of limitations for bringing suit under the Securities Exchange Act

Increased penalties for mail fraud and wire fraud

Increased penalties for destruction, alteration, and falsification of records

Increased records retention requirements

Higher potential liability in civil cases

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Other Developments in Auditor Liability

Auditors not subject to RICO (and treble damages)

Limitations on aiding and abetting

Organization of firms as limited liability partnerships

Private Securities Litigation Reform Act (1995)

Proportionate liability, instead of joint and several liability

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Instructor Note: For the purpose of quizzes and exams, you do not need to know details of these rules and laws listed on page 24 and 25. What you should take away from this part of the chapter is that, while Sarbanes-Oxley Act increased financial and criminal penalties for auditors (especially for their fraudulent actions), there have been also changes that reduce auditors’ liability.

Other Developments in Auditor Liability (continued)

Class Action Fairness Act (2005)

Moves class action cases from state courts to federal courts

Securities Litigation Uniform Standards Act (1998)

Requires class action lawsuits with > 50 parties to be filed in federal courts

Auditor liability caps

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