Four Major Sources of Auditors' Legal Liability
Introduction to the principles and concepts of the audit as an attestation service offered by the accounting profession. Primary emphasis is placed on Generally Accepted Auditing Standards, the role of the CPA/auditor in evidence collection, analytical review procedures and reporting, the CPA/auditor's ethical and legal responsibilities, the role of the Securities and Exchange Commission as well as other constituencies. Audit testing, including statistical sampling, internal control issues, and audit programs are discussed. --
Description:
Audit professionals have a responsibility under common law to fulfill implied or expressed contracts with clients. They are liable to their clients for negligence and/or breach of contract should they fail to provide the services or not exercise due care in their performance.
The auditor's liability has increased due to highly publicized accounting failures (like WorldCom and Enron), investor awareness of ability to recover monetary losses from auditors, increasingly complex acocunting standards, joint and several liability, class action suits, and the fact that auditors are an attractive target for plaintiff attorneys.
Sources of auditor liability include common law (which uses legal precedent to identify responsibility to clients and non-shareholder third parties). Statutory liability is based on violations of written statutes (for example, Securities Act of 1933, Securities Exchange Act of 1934) and pertains to shareholders.
There are several types of third parties: primary beneficiaries are known by name to the auditor, foreseen parties are parties that could be reasonably expected to rely on the auditors' work, and foreseeable parties are those whose decisions normally rely on audited financial statements and the opinions presented on the financial statements.
There are four major sources of auditors' legal liability: liability to clients (which can result in the client suing the auditor for not discovering a material fraud during the audit), third parties under common law (which can result in the bank suing the auditor for not discovering a borrower's financial statements are materially misstated), civil liability under federal securities laws (combined group of shareholders sues auditor for not discovering financial statements were materially misstated), and criminal liability (resulting in federal government prosecuting the auditor for issuing an incorrect audit report).
Potential auditor defenses against client suits include lack of duty to perform, non-negligent performance (auditors acting in good faith and performing their due diligence, which means performing an audit following GAAS [generally accepted auditing standards]), contributory negligence (when clients are partially responsible for the loss), and absence of causal connection (loss caused by factors other than the financial statements and auditors examination, also known as causation defense).
The Sarbanes-Oxley act extends the statue of limitations for bringing suit under the Securities Exchange Act. It increased the penalties for mail and wire fraud, as well as the penalties for destruction, alteration, and falsification of records. It also increased records retention requirements, and implemented a higher potential liability in civil cases.
In response to increased legal liability, auditors now do more research, and auditing regulators are more careful with the standards and rules they set, making sure to place requirements that protect the auditors, such as establishing peer review requirements. They oppose lawsuits and educate users, making sure to sanction members for improper conduct and performance and also lobby for changes in laws.
To protect individual CPAs from legal liability, they must be advised to exercise professional skepticism, and deal only with clients possessing integrity. They should also hire qualified personnel to help them and make sure that they themselves and their assistants follow the standards of the profession. They must maintain their independence (both in fact and in appearance), understand the client's business, perform quality audits, document the work properly, obtain an engagement and a representation letter, and maintain confidential relations.
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