Chapter 4 Audit

Chapter 4 Legal Liability for auditors

4-1. Understand litigious environment, which CPAs practice

According to Google dictionary, litigious environment means a controversial environment. Where a simple mishaps can end up in a heavy lawsuit. Under common law, audit professionals have the responsibility to their client to fulfill their agreed on contracts. However, if one audit fails to fulfill their contract, not only they have to take responsibility to their clients but in some circumstances, to parties other than their clients.

These parties of those who rely on audit reports, therefore auditors also have the responsibility to them as professionals. In addition to common law, auditors may be held to third parties under statutory law (hkum undang2). Although this happens only in rare cases, criminal conviction is charged to an auditor when the plaintiff demonstrates that the auditor intend to deceive or harm others.

Slide-3..Despite the efforts to address legal liability of CPAs, the lawsuit and sizes of awards to plaintiffs are very high. Including cases of those in third parties under both common law and federal securities acts. 7 major reasons why this happens is because of:

* Growing awareness of users of the financial statement upon the responsibility of the accountants * Increased consciousness of the SEC of the investors’ interest * Complexity of auditing and accounting functions (caused by globalization, expansion, and complexities of the business) * Deep Pocket Liability : Regardless of who is at fault, often the targeted defendant, even when the true (moral) culpability(whose to blame) is with another party because the deep pocket has money to pay a verdict.
For example: * a lawyer may comment that he or she sued the manufacturer of a product rather than the seller because it is the deep pocket, meaning it has more money than the seller with which to compensate the victim. * Judgments by the large civil court against CPA firms cases, encourage attorneys to provide legal services on contingent-fee basis (meaning, no win no fee basis). Which offered the injured party a potential gain when the suit is successful and minimum loss when it is not. * Many CPA firms like to settle legal problems out of court (to avoid costly legal fees and adverse publicity) rather than pursuing resolution through judicial process * The difficulty of judges and jurors of having to interpret technical auditing matters.

4-2 Distinguishing between business audit failure, and audit risk

Users’ lack of understanding in distinguishing between these 2 concepts is the reasons of lawsuits towards CPAs: -The difference between a business failure and an audit failure -The difference between an audit failure and an audit risk
1. Business Failure: is when the business is unable to repay its lenders/meet the expectations of its investors because of economic or business conditions. (e.g. recession, poor management decisions, or unexpected competition)

2. Audit failure : When auditor issues incorrect audit opinion because it fails to comply (follow) with the requirements of the accounting standard. e.g. case: When a firm assigns an unqualified assistants to perform certain audit tasks where they failed to notice material misstatements, in which a qualified assistant would. That is considered an audit failure cause by the unqualified assistant

3. Audit risk : Represents the possibility that the auditor commits a mistake in stating the materials regarding the information stated in the financial statement. It is unavoidable because the auditors gather evidence only on test basis and because a well-concealed frauds are extremely difficult to detect. An auditor may fully follow the accounting standards and still fail to uncover the misstatement due to fraud.

In cases of an audit failure, the law often allows parties who suffered losses to recover some or all of the losses caused by auditing misstatement. However, due to the complexity of auditing, it is difficult to determine whether it is the auditor whose at fault or rather just the business who is experiencing failure. For example : -When the company files for bankruptcy / cannot pay its debt, especially when the latest audit report of financial statement were said to be fairly stated. Users of this audited report are most likely to claim that an audit failure has occurred. -Or when the company files for bankruptcy and financial statements are later to be determined as to have been misstated, the auditor could be blamed as to negligent (not doing his/her job properly) although it is in accordance with the accounting standards.

This conflict between statement users and auditors is often named’ expectation gap’. An auditor is only to prepare a ‘reasonable assurance’. However, many numbers of users believe that the auditor is the guarantor of the financial statement some even believes the auditor to be the financial viability of the business.

The profession of audit should better educate the users of the statement about what auditing is about. However, auditors should recognize that in the claims of audit failure, some, results from the hope of those who suffer business loss to recover from any source, regardless who is at fault.

4-3

Several legal concepts relevant to lawsuits regarding CPAs:

* Prudent Person Concept :
The agreement between the profession and the court that : 1. Auditor is not a guarantor or insurer of financial statement 2. Auditor is expected only to conduct the audit with due care, and is not expected to be perfect.
The standard of due care is called the prudent person concept. * Liability for the Act of Others
When a company is under Limited liabilty partnership, the partners may be liable for the work of others whom they rely under the laws of the agency
If an audit improperly does his/her job then the partner can be held liable for the employee’s performance * Lack of privileged communication
Under the common law, CPAs are not supposed to withhold information under the reason that they are a privilege. A privileged communication is a private statement that must be kept in confidence by the recipient for the benefit of the communicator.
A CPA can refuse to testify in a state with privileged communications. However, that privilege does not extend in federal courts. * Legal terms affecting CPA’s liability(responsibility) 1. When an auditor fails to compile adequate audit, their liability may depend on the level of negligence(failure to use reasonable care). (can range from ordinary negligence to fraud) * Ordinary Negligence : Absence of reasonable care that can be expected of a person in a set of circumstances. For auditors, what other competent auditors would have done in the same situation.

* Gross Negligence : Slight difference with ordinary negligence, equal to reckless behavior. Some even don’t differentiate between ordinary and gross negligence

* Constructive Frauds : Unusual negligence. Recklessness. In audit, is when the auditor knew and adequate audit was not done but still issued an opinion, even when there was no intention of deceiving statement users

* Frauds : Misstatement is made and there is intention to falsify report and deceive users.

2. Distinction between joint and several liability, and separate and proportionate liability * Joint and several liability : 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. * Separate and proportionate liability: The assessment agains a defendant of that portionof the damage cause by the defendant’s negligence

Examples between :

- If Ann is struck by a car driven by Bob, who was served alcohol in Charlotte's bar, then both Bob and Charlotte may be held jointly liable for Ann's injuries. The jury determines Ann should be awarded $10 million and that Bob was 90% at fault and Charlotte 10% at fault. * Under proportionate liability, Bob would have to pay $9M and Charlotte would have to pay $1M. If Bob does not have any money, Ann only gets the $1M from Charlotte. * Under joint and several liability, Ann may recover the full damages from either of the defendants. If Ann sued Charlotte alone, Charlotte would have to pay the full $10M despite only being at fault for $1M. Charlotte would then either have to join Bob as defendant in Ann's suit against her or would have to pursue a separate action against Bob for $9M. Regardless of the outcome of that action, Charlotte would remain liable to Ann for the full $10M.