Solution manual auditing and services 2e by louwers MODC

Module C - Legal Liability

MODULE C
Legal Liability
LEARNING OBJECTIVES
Review
Checkpoints

Exercises, Problems,
and Simulations

1. Identify and describe auditors’ exposure to
lawsuits and loss judgments.

1, 2

71

2. Specify the characteristics of auditors’
liability under common law and cite some
specific case precedents.

3, 4, 5, 6, 7, 8, 9

54, 55, 56, 57, 58, 59,
60, 61, 62, 64 (partial)

3. Describe auditors’ liability to third parties
under statutory law.

10, 11, 12

4. Specify the civil and criminal liability
provisions of the Securities Act of 1933.

13, 14, 15, 16, 17

65 (partial), 66, 73

5. Specify the civil and criminal liability
provisions of the Securities Exchange Act of
1934.

18, 19, 20, 21, 22

64 (partial), 65
(partial), 67, 68, 69

6. Understand recent developments that affect
auditors’ liability to clients and third parties.

23, 24, 25, 26

63, 70, 72

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Module C - Legal Liability

SOLUTIONS FOR REVIEW CHECKPOINTS

C.1

Auditors owe clients the responsibility to perform services in accordance with the contract
(engagement letter) and to conduct the audit in accordance with generally accepted auditing
standards.
Auditors owe third parties the responsibility of conducting the audit in accordance with generally
accepted auditing standards.
In each of these situations, auditors can be held liable if their failure to perform in accordance with
the contract or generally accepted auditing standards results in an economic loss to clients or third
parties.

C.2

Common law liability uses legal precedent to identify the responsibility of parties in situations
where there is no violation of a written law or statute. Clients and nonshareholder third parties can
bring suit against auditors for common law liability.
Statutory liability involves the violation of a written law. Third-party shareholders can bring suit
against auditors for statutory liability.

C.3

Under common law liability, clients can bring suit against auditors for either breach of contract or
tort actions. Prior to bringing suit, clients must demonstrate:
1.
2.
3.
4.

They suffered an economic loss.
Auditors did not perform in accordance with the terms of the contact (for breach of

contract).
Auditors failed to exercise the appropriate level of professional care (for torts).
The loss was the result of the breach of contract or failure to exercise the appropriate
level of professional care.

C.4

Auditors owe clients the responsibility for conducting the audit using the appropriate level of
professional care. If they do not do so, they have tort liability for ordinary negligence, gross
negligence, or fraud.

C.5

To bring suits against auditors under common law, third parties must demonstrate:
1.
2.
3.
4.

C.6

They suffered an economic loss.
Auditors failed to exercise the appropriate level of professional care.
The financial statements were materially misstated.
The loss was caused by reliance on the materially misstated financial statements.

The Ultramares Corp. v. Touche case concludes that if auditors conduct their work with such
gross negligence as to amount to constructive fraud or constructive deceit, they may be liable for
damages. The decision, and also a part of the “rule” from Ultramares, was that auditors are not
liable to unidentified third parties for ordinary negligence. One can infer that liability for ordinary

negligence might be imposed when third-party beneficiaries are known (but this was not explicit
in the court opinion).
The Ultramares rule(s) is (are) being eroded today. No longer is privity the shield that it was in
1931, and auditors are being held responsible for a greater degree of care. However, in some
states, the Ultramares view is still in effect.

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C.7

Privity refers a situation in which parties have a contractual relationship. Auditors owe contracting
parties (e.g. clients) a duty to perform the audit with the appropriate level of professional care.
Liability can be imposed for situations in which auditors exhibit ordinary negligence.
A primary beneficiary is the party an accounting service is intended to benefit. The distinguishing
feature of a primary beneficiary is that this party is either named in the contract or auditors know
of this party by name. Auditors are generally liable to primary beneficiaries for ordinary
negligence.
Foreseen parties are groups or individuals that client intends the information to benefit and that
could reasonably be expected to rely on auditors’ work. In certain jurisdictions, auditors can be
liable to foreseen parties for ordinary negligence when the plaintiff justifiably relied on the
information and suffered a loss on such reliance.
Foreseeable parties are the creditors, investors, or potential investors that might be expected to
rely on auditors’ work. In some jurisdictions, auditors can be liable to foreseeable parties for
ordinary negligence.

C.8

Auditors’ defenses against clients under common law include:
1.

Auditors exercised the appropriate level of professional care (torts) or performed the
engagement in accordance with the terms of the contract (breach of contract).

2.

The client’s economic loss was caused by a factor other auditors’ failure to demonstrate
an appropriate level of professional care or breach of contract (causation defense).

3.

Actions on the part of the client were, in part, responsible for the loss (contributory
negligence).

Auditors’ defenses against third parties under common law include:
1.

The third party did not have appropriate standing to sue in the jurisdiction.

2.

The third party did not rely on the financial statements.

3.

The third party’s economic loss was caused by other events beyond auditors’ scope of
responsibility.

4.

Auditors’ work was performed in accordance with professional standards (GAAS).

C.9

In lawsuits related to compilation and review, accountants can use the proper disclaimers, which
were presented in the non-audit service report, as an additional defense to insulate them from
lawsuits from third parties.

C.10

Regulation S-X contains requirements for audited annual and unaudited interim financial
statements filed with the SEC.
Regulation S-K contains requirements relating to all other business, analytical and supplementary
financial disclosures in SEC filings.
Financial Reporting Releases are SEC staff reports that express new rules and policies about
accounting and disclosures required or encouraged by the SEC.

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Staff Accounting Bulletins contain unofficial but important interpretations of Regulation S-X and
Regulation S-K by SEC staff.
C.11

Under the integrated disclosure system, the required annual report to shareholders (prepared in
conformity with Regulation S-X and S-K) can be used as the core of the 10-K annual report

required by the Securities Exchange Commission.

C.12

Liability under statutory law arises when purchasers or sellers of securities suffer an economic loss
and the financial statements contain a material misstatement.

C.13

Section 11 of the Securities Act of 1933 effectively shifts the burden of proof regarding the
appropriate level of professional care during the examination to auditors, whereas this proof is the
plaintiff’s duty under common law.
Furthermore, the plaintiff does not have to be in a privity relationship or known third-party
beneficiary relationship with auditors. Also, the plaintiff does not have to prove reliance on the
materially misstated financial statements or that the loss resulted from the materially misstated
financial statements.

C.14

In a civil suit under section 11 of the Securities Act of 1933, the plaintiff only has to prove that a
loss was suffered and that the financial statements contained a material misstatement.
To avoid liability, the defendant auditors can either prove that (1) the engagement was conducted
according to GAAS (“due diligence” defense) or (2) the loss was caused by other factors.

C.15

Section 11 of the Securities Act of 1933 holds officers, directors, and underwriters to a lesser
degree of responsibility for information that is presented on the authority of an expert (such as
auditors). As a result, they may rely on the expert and not be held responsible for conducting a
reasonable investigation on their own. Therefore, as auditors assume more responsibility for this

type of information, officers, directors, and underwriters have less responsibility.

C.16

Section 17 of the Securities Act of 1933 is the antifraud provision relating to the offer or sale of
securities. Section 24 of the Securities Act of 1933 defines criminal penalties and relates to willful
violation of duties with respect to a statutory registration or requirement to register a sale of
securities.

C.17

In Escott v. BarChris Construction Corp., the court concluded that auditors did not conduct an
appropriate review of subsequent events and, in fact, did not perform steps included in the audit
program.

C.18

Under the Securities Exchange Act of 1934, purchasers or sellers of securities can bring suit by
proving:
1.
2.
3.
4.

C.19

They suffered an economic loss.
The financial statements were materially misstated.
The loss was caused by reliance on the materially misstated financial statements.
Auditors were aware that the financial statements were materially misstated.

Auditors’ defenses under the Securities Exchange Act of 1934 are that they acted in good faith
and had no knowledge of the material misstatements.

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C.20

Under section 32 of the Securities Exchange Act of 1934, criminal penalties include fines of up to
$5 million and imprisonment for up to 20 years (these levels represent increases provided by the
Sarbanes-Oxley Act). In addition, violations of the provisions of Securities Exchange Act of 1934
by entities other than natural persons (such as accounting firms) are punishable by fines up to $25
million.

C.21

Scienter is the intent or knowledge of inappropriate actions prior to committing those actions (for
example, if auditors have knowledge of misstatements in the financial statements and intentionally
fail to disclose these misstatements in their reports). Ernst & Ernst v. Hochfelder and Denise L.
Nappier et al. v. PricewaterhouseCoopers both concluded that parties could not recover damages
against auditors because they were unable to demonstrate scienter on the part of the defendants.

C.22

The major differences between auditors’ liability under the Securities Act of 1933 and Securities
and Exchange Act of 1934 are:

C.23

C.24

1.

The Securities Act of 1933 applies to original purchasers of securities under a registered
offering while the Securities and Exchange Act of 1934 applies to purchasers and sellers
of securities under ongoing exchanges after the initial offering. Auditors are liable for
ordinary negligence, gross negligence, or fraud under the Securities Act of 1933; they are
only liable for gross negligence or fraud under the Securities Exchange Act of 1934.

2.

Auditors have the burden of proof under the Securities Act of 1933; plaintiffs (purchasers
or sellers of securities) have the burden of proof under the Securities Exchange Act of
1934.

3.

Under the Securities Act of 1933, auditors’ defenses are that a GAAS audit was
conducted or the loss was caused by other factors; under the Securities and Exchange Act
of 1934, auditors’ defenses are that the audit was conducted in good faith and auditors
were not aware of the materially misstated financial statements.

Some of the major changes in auditors’ liability under Sarbanes-Oxley include:
1.

Extending the statute of limitations for bringing a suit under the Securities and Exchange
Act.

2.

Increasing both the monetary fines and imprisonment penalties for violations of the
Securities and Exchange Act.

3.

Increasing the imprisonment penalties for mail fraud and wire fraud.

4.

Providing monetary fines and imprisonment penalties for the alteration and destruction of
documents.

5.

Increasing the period over which records must be retained by accounting firms.

Joint and several liability is a doctrine that allows a successful plaintiff to recover the full amount
of a damage award from the any defendant(s), regardless of the defendant’s relative degree of
fault. Proportionate liability only permits recover from defendant(s) based on their relative degree
of fault.

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C.25

The Private Securities Litigation Reform Act provided the following terms for proportionate
liability:
1.

The total responsibility for loss is divided among all parties responsible for the loss.

2.

However, if other defendants are insolvent, a solvent defendant’s liability is extended to
50 percent more than the proportion found at trial.

3.

Only the defendants who knowingly committed a violation of securities laws remain
jointly and severally liable for all the plaintiffs’ damages.

The Class Action Fairness Act expanded federal jurisdiction over class action lawsuits and moves
many class action cases from state courts to federal courts.
C.26

To reverse the perceived concerns with the Private Securities Litigation Reform Act (attorneys
filing securities class action lawsuits in state courts that follow joint and several liability
doctrines), Congress enacted the Securities Litigation Uniform Standards Act. This act’s most
significant provision requires that class action lawsuits with 50 or more parties must be filed in the
Federal courts.

SOLUTIONS FOR MULTIPLE CHOICE-QUESTIONS
C.27

C.28

C.29

a.

Incorrect

b.
c.

Incorrect
Incorrect

d.

Correct

a.

Incorrect

b.

Incorrect

c.

Incorrect

d.

Correct

d.

Correct

Constructive fraud represents reckless behavior, not a lack of
reasonable care.
Fraud represents intention to deceive.
Gross negligence is similar to constructive fraud and represents lack of
minimal care.
Ordinary negligence represents lack of reasonable care and is often
proven by demonstrating that auditors failed to follow GAAS in
conducting the audit.
Joint and several liability can impose the entire amount of loss in a case
against auditors, which is less favorable than proportionate liability.
The reasonably foreseeable user approach provides auditors with the
greatest exposure to liability to third parties for ordinary negligence.
The foreseen third party approach is more favorable to auditors than the
reasonably foreseeable approach, but auditors may still be exposed to
the entire amount of the loss.
Proportionate liability is most favorable to auditors because they will
only be liable for damages to the extent they were found to be at fault.
The difference between the perception of the users of the statements
and auditors’ knowledge of the audit objective is known as the
expectations gap. One common example of the expectations gap is
users’ belief that a GAAS audit will uncover all instances of fraud.

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C.30

C.31

C.32

C.33

C.34

a.

Incorrect

Breach of contract depends solely on the performance of auditors and
the client per the contract (engagement letter).
A tort is a lawsuit filed by the plaintiff who believes that they have
suffered damage due to another party’s failure to exercise the
appropriate level of professional care.
Securities litigation is a term that defines criminal and civil actions
regarding unfair or criminal practices in the purchase or sale of
securities.
Constructive fraud is a term used to define repetitive actions that show
a pattern of recklessness or disregard for the truth or other party’s well
being. While constructive fraud may be the cause of the losses, the
wording in the question does not suggest that such a fraud occurred.

b.

Correct

c.

Incorrect

d.

Incorrect

a.

Incorrect

b.

Incorrect

c.

Correct

d.

Incorrect

a.

Correct

b.

Incorrect

c.

Incorrect

d.

Incorrect

a.

Incorrect

b.

Correct

c.

Incorrect

d.

Incorrect

a.

Correct

b.

Incorrect

The Credit Alliance view holds auditors responsible to primary
beneficiaries for ordinary negligence, who are identified and known to
name by auditors.
This is the broadest view of privity, as defined by Rosenblum, Inc. v.

c.
d.

Incorrect
Incorrect

This is the restatement of torts view of privity.
Since (a) is a correct response, this is not correct.

This is the total amount of the loss, and auditors were not determined to
be 100% at fault.
Auditors’ liability cannot be zero because they were found to be
partially at fault.
Auditors pay 45%, which is the 30% at fault plus another 15% (or 50%
of the level at fault) because they are the only solvent defendant.
Since auditors are the only solvent defendant, liability is not limited to

the 30% at fault (see (c) above).
When auditors knowingly commit violations, the joint and several
liability doctrine applies, and auditors pay all the damages as the only
solvent defendant.
See (a) above. Under proportionate liability, auditors would be liable
for some extent of the damages, even if they did not knowingly commit
the violations.
See (a) above. The fact that auditors knowingly committed these
violations make them liable for the entire amount of the damages.
See (a) above. The fact that auditors knowingly committed these
violations make them liable for the entire amount of the damages.
The accountant and client have a privity relationship for the consulting
services.
The accountant’s best defense would be to prove that the client did not
carry out its part of the recommendations from the consulting work.
Plaintiffs can always measure some damages, and suit would not be
brought if the client did not have good reason to measure damages.
While the accountant can argue that the work was done properly, choice
(b) would provide a better defense.

Adler.

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C.35

a.

Correct

b.

Incorrect

c.

Incorrect

d.

Incorrect

C.36

a.

Correct

A prospectus is a set of information available to prospective investors
that is required by the SEC. This information includes the entity’s
financial statements.

C.37

a.
b.
c.

d.

Incorrect
Incorrect
Incorrect
Correct

Because the selection “both” is correct (choice d).
Because the selection “both” is correct (choice d).
Because the selection “both” is correct (choice d).
Both laws contain both civil and criminal liability sections.

C.38

a.

Incorrect

b.

Incorrect

c.
d.

Incorrect
Correct

Foreseeable third parties are parties that might use auditors’ work;
however, they are not known to auditors by name.

Foreseen third parties are parties that might reasonably be expected to
use auditors’ work; however, they are not known to auditors by name.
There is no designation known as “general third party”.
Primary beneficiaries are known by name to auditors and, in some
cases, are specifically identified in the contract (engagement letter).

a.

Incorrect

b.

Incorrect

c.

Correct

d.

Incorrect

C.39

The engagement letter obtained at the beginning of the engagement is
the most effective method of expressing the nature of limits on
compilation and review engagements.
Compilation and review engagements do not result in the preparation of
auditors’ opinions.
Reporting the nature of the work at the conclusion of the engagement is

not as effective as doing so in the engagement letter at the beginning of
the engagement (see (a) above).
Management letters are delivered at the conclusion of the engagement,
so as in (c) above, reporting the nature of the work at the conclusion of
the engagement is not as effective as doing so at the beginning of the
engagement.

Privity is not a necessary condition to bring suit under the Securities
Exchange Act of 1934.
Prior to bringing suit, the investor would need to demonstrate that a
loss was suffered.
These are appropriate defenses under the Securities Exchange Act of
1934 and demonstrate lack of scienter.
Entities are required to file financial statements with the Securities and
Exchange Commission for their shares to be traded on national
exchanges.

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C.40

C.41

C.42

C.43

C.44

NOTE TO INSTRUCTOR: Since this question asks which of the statements is not true, the
response labeled “correct” is not true and those labeled “incorrect” are true.
a.
b.

Incorrect
Incorrect

c.

Correct

d.

Incorrect

a.

Incorrect

b.

Incorrect

c.

Incorrect

d.

Correct

a.

Incorrect

b.

Incorrect

c.

Incorrect

d.

Correct

a.

Correct

b.

Incorrect

c.

Incorrect

d.

Incorrect

a.

Incorrect

b.

Incorrect

c.

Correct

d.

Incorrect

The Securities Act of 1933 relates to the initial issuance of securities.
Auditors’ liability typically arises because of their involvement with
audited financial statements.
Third parties are only required to demonstrate that the financial
statements are materially misstated; they are not required to
demonstrate reliance on these financial statements.
Auditors are liable for ordinary negligence under the Securities Act of
1933.

Information related to auditor changes is not required to be disclosed in
the 10-K annual report.
Information related to auditor changes is not required to be disclosed in
the S-1 registration statement.
Information related to auditor changes is not required to be disclosed in
the 10-Q quarterly reports.
Information related to auditor changes is one of the “special events”
entities must report on Form 8-K.
Section 11(b)(A) requirement seems to be satisfied, since the chair
produced the information about the planned use of the proceeds, made
a reasonable investigation, and the information is not made on the
authority of another “expert.”
Section 11(b)(B) requirement seems to be satisfied, since the consulting
engineer is an expert and made a reasonable investigation connected
with his or her own work.
Section 11(b)(C) requirement seems to be satisfied, since the president
relied on the work of the consulting engineer expert and had no reason
to believe the engineer’s report was erroneous.
In this case, while the officers relied on auditors’ work, they were
aware of materially misstated financial statements and, therefore, liable
under Section 11(b)C.
Under both common law and section 10(b), plaintiffs must prove they
suffered losses.
Unlike common law, section 10(b) does not have a privity requirement
(“any purchaser or seller” can sue the accountants).
Under both common law and section 10(b) plaintiffs must prove
reliance.
Under both common law and section 10(b) plaintiffs must prove their
reliance caused their losses.
Credit Alliance v. Arthur Andersen established auditors’ liability to

primary beneficiaries for ordinary negligence.
Fleet National Bank v. Gloucester Co. established auditors’ liability to
foreseen third parties for ordinary negligence.
Rosenblum, Inc. v. Adler established auditors’ liability to foreseeable
third parties for ordinary negligence, which provides broader exposure
for auditors than the groups in choices (a) and (b).
Ultramares did not establish any exposure for auditors to liability to
third parties for ordinary negligence, just gross negligence or fraud.

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C.45

C.46

C.47

C.48

C.49

C.50

a.

Incorrect

b.

Incorrect

c.

Correct

d.

Incorrect

a.

Incorrect

b.
c.

Incorrect
Correct

d.

Incorrect

a, b, c

Incorrect

d.

Correct

a.

Incorrect

b.
c.
d.

Incorrect
Incorrect
Correct

a.

Correct

b.

Incorrect

c.

Incorrect

d.

Incorrect

a.
b.
c.
d.

Correct
Incorrect
Incorrect
Incorrect

While this is a difference between these two acts, (b) is also a
difference; therefore, the best answer is (c).
While this is a difference between these two acts, (b) is also a
difference; therefore, the best answer is (c).
Both the burden of proof and required level of professional care differ
across the two acts.
See (c) above.
The SEC does not guarantee or represent that the information in the
registration statement is true.
Registration is not insurance against loss from the investment.
Financial information that has been examined by independent auditors
is either included in the registration statement or incorporated by
reference.
Inside information about the entity’s trade secrets is not provided in the
registration statement. (If it were, it would no longer be inside
information!)
These are all elements of lawsuits under common law that must be
proved by the plaintiffs prior to brining suit. As a result, they would not

be available as defenses for auditors.
While the plaintiff has the responsibility to prove AOW failed to
exercise the appropriate level of professional care, conducting the audit
in accordance with generally accepted auditing standards would be an
effective defense.
Regulation D governs the nonpublic issuance of securities to limited
groups of investors.
Form 8-K is the periodic special events report.
Form SB-1 is one registration forms of the Securities Act of 1933.
Regulation S-X is the compendium of accounting rules that governs the
form and content of Forms 10-K and 10-Q.
The Ernst & Ernst v. Hochfelder case related to the failure of plaintiffs
to prove scienter.
The Escott v. BarChris Construction Corp. case demonstrated ordinary
negligence on the part of auditors in a review of subsequent events.
Smith v. London Assurance Corp. was related to ordinary negligence on
the part of auditors in failing to identify an embezzlement scheme
occurring at a client.
The Ultramares case was related to auditors’ liability for ordinary
negligence (and not scienter) to third parties.
Form 10-K is the annual report.
Form 10-Q is the quarterly report.
Form 8-K is the periodic special events report.
Regulation S-X provides guidelines for the content of financial
information submitted to the SEC.

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C.51

a.

Incorrect

b.

Correct

c.

Incorrect

d.

Incorrect

C.52

c.

Correct

C.53

NOTE TO INSTRUCTOR: Since this question asks which of the statements is not true, the
response labeled “correct” is not true and those labeled “incorrect” are true.
a.

Correct

b.

Incorrect

c.

Incorrect

d.

Incorrect

Scienter must be demonstrated under the Securities Exchange Act of
1934; under the Securities Act of 1933, auditors are responsible for
ordinary negligence.
Plaintiffs must establish that the financial statements were materially
misstated.
Proving reliance on the materially misstated financial statements is not
necessary.
Proving that reliance on the materially misstated financial statements
caused the loss is not necessary.
Sarbanes-Oxley Act is the common name for the United States Public
Company Reform and Investor Protection Act of 2002.

The Sarbanes-Oxley Act does not include new definitions or situations
that constitute securities fraud. The amendments in the Act provide
greater penalties for auditors, but do not increase auditors’

responsibilities for identifying fraud.
The Sarbanes-Oxley Act requires that the CEO and CFO certify the
financial statements.
The Sarbanes-Oxley Act specifies penalties for destruction of records in
federal investigations for both accounting firms and auditors.
The Sarbanes-Oxley Act increases penalties for mail fraud and criminal
violations of the Securities Exchange Act of 1934.

SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS
C.54

Breach of Contract
a.

Auditors can be in breach of contract for:

Failing to meet established deadlines

Failing to provide the services described in the contract

Charging fees differently then agreed in the contract

b.

Clients can be in breach of contract for:

Failing to provide documents as agreed in the contract

Failing to pay audit fees in a manner described in the contract


Failing to make available key personnel as agreed in the contract

Failing to disclose information known by management (e.g. known frauds) as
agreed in the contract

c.

The best defenses are:

There is no breach of contract (i.e., auditors met all the contract provisions)

The breach of contract was due to the client’s failure to perform as specified
under the contract

Fulfillment of the contract became impossible because of circumstances beyond
auditors’ control (for example, auditors cannot be liable for breaching a
provision of a contract to count inventory held in a warehouse if the inventory
was destroyed)

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C.55

Common Law Responsibility for Errors and Fraud
a.

Yes, a weakness in internal control exists. It may be considered a material weakness

because the compensating control (internal auditors’ work on slow-moving inventory) did
not operate in a timely enough manner to detect the irregularity before it had gotten large.
If Ritter is a public entity registered under the Securities Exchange Act of 1934, it may
have violated the accounting and internal control provisions of the Foreign Corrupt
Practices Act.
If a material weakness in internal control exists, Huffman & Whitman are obligated to
report it to management and/or the board of directors and issue an adverse opinion on
their report on their audit of internal controls.

b.

C.56

The problem description indicates that this portion of the audit was conducted without
the appropriate level of professional care. While sampling transactions is acceptable
under generally accepted auditing standards, Whitman’s follow-up and explanation of the
missing receiving reports leaves much to be desired. At the very least he could have
reviewed the reports produced by Lock at a later date, and he could have traced the
purchases to the inventory records and perhaps noticed an over-stocking condition.
Auditors had some evidence that fraud might exist, but it appears that they failed to apply
extended audit procedures properly.

Common Law Responsibility for Errors and Fraud
Donovan’s responsibility under generally accepted auditing standards is to plan the audit to detect
errors and frauds that would have a material effect on the financial statements.
Whether McCoy would prevail depends upon two questions: (1) The materiality of the
undiscovered embezzlement and whether it was concealed by falsifying the financial statements
and (2) Donovan’s planning and performance of appropriate audit procedures. If the amount is
material, Donovan is potentially liable. If Donovan performed a careful audit exercising the
appropriate level of professional care, liability probably would not attach. If not, Donovan might

be found guilty of ordinary negligence and liable to McCoy with whom he had a privity
relationship. All the common law features (damage, reliance, cause, failure to perform with the
appropriate level of professional care, and privity) are present. The actual resolution of liability is
only a matter of their degree.
McCoy, however, can be faulted (although probably not in a contributory negligence sense) for not
informing Donovan about the anonymous letter. Donovan should have obtained signed
representations in which McCoy asserted he knew of no errors or frauds that he had not told
Donovan. With such signed representations, Donovan might not be found liable at all.
Even if Donovan is judged liable, McCoy could probably recover only the embezzled amounts
after the audit ($65,000) but not the amounts embezzled prior to the audit ($40,000).

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C. 57

C.58

Auditors’ Liability for Fraud
a.

Auditors will be liable for fraud to all third-party users of financial statements under
common law or statutory law.

b.

Fraud is a misrepresentation of fact that the individual knows to be false. Constructive
fraud (sometimes referred to as gross negligence) is the failure to provide any care in

fulfilling a duty owed to others. The primary difference between these two levels of
professional care is actual knowledge on the part of auditors, which is present under fraud
but not under constructive fraud.

c.

Auditors will be liable for constructive fraud to all third-party users under common law
and the Securities Act of 1933. To be held liable under the Securities Exchange Act of
1934, scienter (or intent and knowledge) must be shown. While scienter may be present
in situations representing constructive fraud, this will not always be the case.

d.

Clearly, auditors should be liable in cases where they intend to deceive. While intention is
not present under constructive fraud, the level of performance and lack of care is so great
that it seems appropriate to hold auditors liable for constructive fraud.

Audit Simulation: Accusation of Fraud
a.

In this case, a claim for fraud does not appear to exist. To show fraud auditors would

have to:
1.

Be aware that the inventory amounts were incorrect and not require adjustment
of these amounts or modification of the auditors’ opinion.

2.

Conclude that the inventory amounts were fairly stated without performing any
auditing procedures (reckless disregard for the truth);

Neither of these actions can be shown from the information provided. The failure to
adequately review the inventory is more likely classified as ordinary negligence, or
possibly gross negligence, rather than fraud.
b.

If auditors were charged with fraud their defenses would include:
1.

They performed the audit of inventory in accordance with generally accepted
auditing standards;

2.

Management perpetrated the fraud, which included the objective of defrauding
auditors;

3.

There was no intent or pattern of behavior on the part of auditors that indicates
that they committed a fraud.

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Module C - Legal Liability

C.59

C.60

Common Law Liability Exposure
a.

Creditors appear to be claiming that auditors knew the financial statements were not presented
in accordance with generally accepted accounting principles.

b.

If action is brought based on fraud, the lack of privity would not be an important issue.
Auditors are liable to all parties under common law in instances where they commit
fraud.

c.

Yes, the firm is liable to the creditors, because the firm was aware of the failure to disclose the
cash received as well as the contingent liability.

Common Law Liability Exposure
a.

Under a privity of contract definition, Risk Capital will not prevail. Under the strict
privity rule, parties must be signer of a contract to have a standing to sue for ordinary
negligence. Therefore, regardless of whether Wilson and Wyatt committed ordinary
negligence, Risk Capital has no legal standing to sue Wilson and Wyatt for ordinary
negligence.

b.

While debatable, under a strict primary beneficiary standard, Risk Capital will not likely
prevail. In the case of Credit Alliance v. Arthur Andersen (1985), the court held that
auditors are not liable for ordinary negligence to third parties unless (1) auditors were
aware that a particular third party intended to rely on the auditors’ opinion and the
financial statements, (2) the third party was specifically identified to auditors, and (3)
some action by auditors showed they acknowledged the third-party’s identification and
intent to rely on the opinion and financial statements. For example, auditors could include
the name of the bank and acknowledge its intended use of the financial statements in the
engagement letter. While elements (1) and (2) are present, it does not appear that element
(3) is present (acknowledgement of the third-party’s identification). In addition, the
standing of Risk Capital would vary depending upon the jurisdiction in which the case is
heard.
NOTE TO INSTRUCTOR: There is likely to be some debate about element (3). An
effective extension of this part of the problem would be to identify what type of action(s)
on the part of auditors would satisfy element (3).

c.

Under the foreseen party standard defined by restatement of torts, Risk Capital will
prevail. The restatement of torts extends liability for ordinary negligence to “foreseen”
third parties not explicitly known to auditors. Under this approach, auditors may be
subject to claims for ordinary negligence if they know that the auditors’ opinion and
financial statements will be delivered to unidentified investors and creditors. Specific
acknowledgement is not required. Auditors must only be aware that the auditors’ opinion
and financial statements will be used by some third party. In this instance, the contact
clearly specified Risk Capital and the use of the financial statements. As a result, Risk
Capital would be classified as a foreseen third party (if not a primary beneficiary).

MODC-14

Module C - Legal Liability

C.61

Common Law Liability Exposure
a.

Yes, Smith will be liable to the bank. The elements necessary to establish an action for
liability for fraud under common law are clearly present. There was a material
misstatement in the financial statements, intent and knowledge of the misstatements
(scienter), actual reliance by the bank on the materially misstated financial statements,
and economic damages resulting from that reliance. If action is based upon fraud, there is
no requirement that the bank establish privity of contract with Smith.
If the action by the bank is based on ordinary negligence, the bank may still be in position
to bring suit, depending upon the extent to which Smith was aware that his work would
be used by the bank and the jurisdiction in which this case occurred. Based on the facts
presented, it is difficult to determine whether the bank is a primary beneficiary. However,
because Smith was aware that the financial statements would be used to obtain a loan, the
bank would appear to be at least a foreseen third party and could prevail under the
restatement of torts doctrine.

C.62

b.

No, Smith will not be liable to the lessor because the lessor was a party to the “secret”
written agreement. As such, the lessor cannot claim reliance on the financial statements
and cannot recover uncollected rents. Even if the lessor was damaged indirectly, his own

fraudulent actions led to his loss, and the equitable principle of “unclean hands”
(“contributory negligence”) precludes him from obtaining relief.

c.

Smith was not independent with respect to the audit of Juniper. The lack of independence
is raised by Juniper’s threat to sue Smith in the event the loan was not obtained.

Liability in a Review Engagement
a.

Hotshot in its own right may bring an action, or the other stockholders may bring a
derivative action against Mason & Dilworth on behalf of the corporation, for failure to
exercise the appropriate level of professional care in failing to detect the fraud.
A lawsuit based on constructive fraud might be brought against Mason & Dilworth,
because the conduct of the review may be characterized as gross negligence with reckless
disregard for the truth. Individual shareholders and lending institutions will claim this is
the case, and if upheld, privity of contract will not be a valid defense.

b.

Third-party financial institutions have rights to sue accountants for failure to exercise the
appropriate level of professional care in performing review engagements. As a general
rule, third parties, even though not direct parties to a contract, may successfully assert
ordinary negligence if they can show that they are members of a class of persons intended
to benefit from the services performed by the auditors and that their use of the statements
was reasonably foreseeable by the auditors.

MODC-15

Module C - Legal Liability

C.63

C.64

Class Action Lawsuits
a.

A class action lawsuit occurs when a group of individuals come together as plaintiffs in a
common action against an defendant.

b.

Individually, plaintiffs involved in a class action may not have been able to hire an
attorney because the amount of their claim was small and did not justify the cost.
Collectively, however, there may be significant numbers of plaintiffs for an attorney to
justify the time commitment for such an action. In addition, when a class includes a large
number of plaintiffs from many jurisdictions, the plaintiffs’ attorney may choose to
initiate the action in a jurisdiction that is the most “friendly” to the plaintiffs.

c.

All of the advantages to plaintiffs in (b) can be viewed as disadvantages to defendants. In
addition, the mere fact that a class action suit makes litigation more likely to occur is a
significant disadvantage.

d.

The Class Action Fairness Act of 2005 moves many class action lawsuits to federal court
where defendants may have a better opportunity to defend themselves. In addition, the
Securities Litigation Uniform Standards Act requires class action lawsuits with 50 or
more parties to be filed in federal courts. The inability for the plaintiffs to select the court
(and jurisdiction) in which the case will be heard will likely deter many class action
lawsuits.

e.

The discussion here will vary depending on the case identified by the student. Instructors
should be sure to emphasize the fact that a small number of disgruntled plaintiffs can
expose auditors to liability to a large number of individuals.

Liability under Common Law and the Securities Act of 1933
a.

1.

Union Bank will likely be successful in its ordinary negligence suit against
Weaver. To be successful in a lawsuit for ordinary negligence under common
law, Union Bank must show that it (1) suffered an economic loss, (2) Weaver
failed to exercise the appropriate level of professional care, (3) the financial
statements contained material misstatements, and (4) Union Bank’s loss was
caused by reliance on the materially misstated financial statements.
Weaver was guilty of ordinary negligence in performing the audit by not
confirming accounts receivable, which resulted in failing to discover the
overstatement of accounts receivable. Weaver’s failure to confirm accounts
receivable violated generally accepted auditing standards and represented
ordinary negligence. Because Union Bank relied on these financial statements in
granting the loan, and because Weaver knew that Union Bank would be

provided with the financial statements in this decision process, Union Bank
assumed the role of a primary beneficiary. Auditors are generally liable to
primary beneficiaries for acts of ordinary negligence.

2.

Union Bank will be successful in its fraud suit against Weaver. To be successful
in a lawsuit for fraud under common law, Union Bank must demonstrate the
same four factors as in part (1). In addition, to demonstrate fraud, Union Bank
must prove that Weaver was aware of the material misstatement (in this case, the
failure to disclose information about the product liability lawsuit).

MODC-16


Module C - Legal Liability
C.64

Liability under Common Law and the Securities Act of 1933 (Continued)
b.

Butler’s stockholders who purchased stock under the preferred stock offering will also be
successful in their suit against Weaver under section 10(b) and Rule 10b-5 of the
Securities Exchange Act of 1934. Under the Act, the purchaser of securities must
demonstrate that:
1.
2.
3.
4.

They suffered an economic loss.
The financial statements were materially misstated.
The loss was caused by reliance on the materially misstated financial statements.
Auditors were aware that the financial statements were materially misstated.

Weaver’s failure to qualify the auditors’ opinion for Butler's potential legal liability was
material and done with intent and knowledge (scienter). Weaver will be liable for losses
sustained by the purchasers who relied on Weaver’s opinion.
C.65

Audit Simulation: Liability under the Securities Acts
a.

After the sale, Fancy will have total assets of greater than $10 million and more than 500
shareholders; as a result, Fancy will be required to register under the Securities Exchange
Act of 1934 and file reports on Forms 10-K, 10-Q, and 8-K. Fancy will become a public,
“reporting” entity. (Fancy will also be subject to the insider trading, proxy solicitation,
and other requirements.)
NOTE TO INSTRUCTOR: These dollar amounts and number of shareholders are
subject to change.

b.

Any purchaser can sue the entity for failure to file the required registration statement and
would be in position to receive a refund of their purchase price. Fancy would also be
liable for willful violation of the Securities Act of 1933, which exposes them to monetary
fines and imprisonment.

c.

Accredited investors include the following:







Financial institutions, such as banks, savings and loans, and insurance companies.
Private business development companies.
501(c)(3) charitable organizations.
Directors, general partners, or officers of the registrant.
Individuals with wealth in excess of $1 million, individual income in excess of
$200,000, or joint income in excess of $300,000.
Trusts with assets in excess of $5 million.

An offering under Regulation D is exempt from registration requirements under the
Securities Act of 1933. Under Regulation D, the securities can be sold to an unlimited
number of accredited investors (as defined above) and up to 35 additional non-accredited
investors.

MODC-17


Module C - Legal Liability
C.66

Audit Simulation: Section 11 of Securities Act of 1933: Liability Exposure
Yes, May, Clark & Company would be liable. The situation is covered by the Securities Act of
1933. Some of the key elements are as follows:



Because the Securities Act of 1933 allows any purchaser to bring suit, privity is not available
as a defense to May, Clark & Company.



Chriswell Corporation’s financial statements were materially misstated.



The fact that the market price of the debentures declined following the disclosure of the
material misstatements suggests causation. However, it is important to note that
demonstrating causation is not necessary to bring suit under the Securities Act of 1933.



While May, Clark & Company made inquiries of the financial vice president and controller
regarding material changes in Chriswell’s financial position since the date of the audit, it
made no reasonable effort to verify the results of these inquiries. This would likely be
viewed as a violation of generally accepted auditing standards and, therefore, ordinary
negligence on the part of Mary, Clark & Company.

Since May, Clark & Company are responsible up to the effective date of the registration statement,
they would likely be liable. Chriswell Corporation and its officers would also be liable.
C.67

Rule 10b-5 Liability under the Securities Exchange Act of 1934
a.

The case should be dismissed. A suit under section 10(b) and Rule 10b-5 of the Securities
Exchange Act of 1934 must establish fraud or scienter. Fraud is an intentional tort and as
such requires more than failure to exercise the appropriate level of professional care.
Although the audit was admittedly performed without the appropriate level of
professional care, Gordon & Groton neither participated in the fraudulent scheme nor did
they know of its existence. The element of scienter must exist in order to state a cause of
action for fraud under section 10(b) of the Exchange Act 1934, although auditors may
have potential exposure for gross negligence even in the absence of scienter. (Refer to the
Ernst & Ernst v. Hochfelder decision.)

b.

The plaintiffs might have stated a common law action for ordinary negligence. However,
they may not be able to prevail due to the privity requirement. There was no contractual
relationship between the defrauded parties and Gordon & Groton. Although the exact
status of the privity rule is unclear, it is doubtful that the level of ordinary negligence in
this case would extend Gordon & Groton’s liability to the customers who transacted
business with Bank & Company. However, the facts of the case as presented in court
would determine this.

MODC-18


Module C - Legal Liability
C.68

Audit Simulation: Independence and Securities Exchange Act of 1934
a.

One of the important concepts governing auditors’ independence is that auditors should

not be in a position of serving as advocates for their clients. Testifying in court on behalf
of the client’s damage claim is perilously close to serving as an advocate, although many
auditors will claim that litigation support services (in general) are appropriate and do not
impair independence.
While the litigation consulting itself may not impair independence, independence is likely
impaired by the unpaid consulting fee of $265,000. AICPA interpretations and rulings
hold that past due fees may impair auditors’ independence in certain situations.

C. 69

b.

Violations of generally accepted auditing standards are based on the failure of auditors to
exercise the appropriate level of professional care (third general standard). This violation
is based on Ward (and, therefore, AOW) not insisting upon disclosure of the appeal of the
Civic case, improper deferral of losses on new product start-up costs, and inappropriate
accrual of sales revenue.

c.

Ward and AOW appear to have violated section 10(b) by being actively involved in using
a “scheme or artifice to defraud,” namely management’s issuing the materially misstated
financial statements with full knowledge of the auditors. Ward, and hence AOW, acted
with scienter which is required by section 10(b). In addition, Ward, by willfully enabling
the 10-K to be filed with the SEC, seemingly violated section 32 of the Securities
Exchange Act of 1934 by knowingly causing materially misstated statements to be filed
(the financial statements and the auditors’ opinion).

Audit Simulation: Auditors’ Liability under Securities Exchange Act of 1934
a.

b.

Because Adam is a purchaser of securities of an established registrant, the most likely
basis for suit would be under statutory law violations of the Securities Exchange Act of
1934. Adam’s attorney can bring suit against auditors as follows:
1.

Fraud under the Securities Exchange Act of 1934, section 10b-5. In Ernst & Ernst v.
Hochfelder, the court’s decision indicated that reckless professional work might
be a sufficient basis for 10b liability even though scienter is not clearly
established. Therefore, if Adam’s attorney could prove that auditors acted
recklessly (i.e., with gross negligence), he might recover loss from auditors.

2.

Criminal liability under the Securities Exchange Act of 1934, section 32. Under
United States v. Natelli (1975), Adam’s attorney must prove that auditors acted
willfully and knowingly.

The auditors’ attorney can use the following defenses to protect auditors from legal
liabilities.
1.

With respect to civil liability, auditors’ primary defenses are that they acted in good
faith and had no knowledge of the material misstatements.

2.

With respect to the criminal charges, because the burden of proof was provided by

the plaintiff’s attorney, the auditors’ attorney should prove that the evidence does
not indicate auditors were guilty beyond a reasonable doubt. Most importantly,
fraud must be demonstrated to file criminal charges under section 32 of the
Securities Exchange Act of 1934.

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Module C - Legal Liability
C. 69

Audit Simulation: Auditors’ Liability under Securities Exchange Act of 1934 (Continued)
c.

Section 307 of the Sarbanes-Oxley Act includes a rule that requires an attorney to report
evidence of a material violation of securities law or breach of fiduciary duty or similar
violation to the chief legal counsel or the chief executive officer of the entity. If the
counsel or officer does not appropriately respond to the evidence, the attorney is required
to report the evidence to the audit committee or board of directors.
Either Adam’s attorney or Joshua Food’s auditors’ attorneys should report evidence of the
violation to the company’s management (or audit committee, if management did not take
remedial measures).

C.70

Mini-Case: Limiting Legal Liability
NOTE TO INSTRUCTOR: For this assignment, questions 1 through 3 from this Mini-Case are
applicable. All quotations are from “Auditing ‘Liability Caps’ Face Fire,” The Wall Street Journal
(November 28, 2005).

1.

It is easy to understand why accounting firms favor alternative dispute resolution. Each of
the major firms has been involved with clients who have suffered through major
accounting scandals, and often the auditors are targets of corporate and investor lawsuits.
Provisions for alternative dispute resolution efforts are included in engagement letters to
try to limit auditor liability should something go wrong.
“If [an audit client] runs into accounting problems and thinks a botched audit by [its
auditors] is to blame, it is barred from taking the accounting firm to court. Instead, [it]
has to go through mediation and arbitration. It also can't seek any damages beyond the
actual, compensatory damages related to [the auditors’] conduct.” An Ernst & Young
spokesman states that “these clauses have been part of our standard client agreements for
some time and are not new” and notes that the provisions don’t limit the ability of
investors to seek redress from the firm.

2.

If major accounting firms want liability caps as part of the engagement letter, there is
little that a company can do to have them excluded. However, it seems logical that
companies would prefer to have this language excluded, since it potentially exposes them
to greater losses.

3.

Investors would probably prefer that these caps be excluded, since they can been seen as
relieving auditors of their responsibility and encouraging less stringent audits. Further,
some critics wonder whether the good will generated by a company’s decision to limit
auditors’ liability might ultimately create a conflict of interest.
Cynthia Richson, the corporate governance officer for the Ohio Public Employees
Retirement System, states: “Some investors don't like what they see as the auditors'

attempt to avoid accountability. It does a disservice to investors…. It's not in the
company's best interests and not in the investor's best interests.”

MODC-20


Module C - Legal Liability

C.71

Mini-Case: Litigation
NOTE TO INSTRUCTOR: For this assignment, question 5 from this Mini-Case is applicable.
5.

C.72

Ernst & Young’s first defense should be that they performed their work in accordance
with professional standards. They also should be able to claim HealthSouth contributed
to, and was the primary cause, of any damages it incurred. In the securities suit, they
should only have to show that plaintiffs’ claims of scienter are untrue.

Mini-Case: Ethics
NOTE TO INSTRUCTOR: For this assignment, questions 1, 2, 3, 4, 5, and 7 from this Mini-Case
are applicable.
1.

According to the Merriam-Webster Online Dictionary corrupt means (selected meanings
relevant to this issue):






to change from good to bad in morals, manners, or actions or
to degrade with unsound principles and or moral values
to become morally debase
to cause disintegration or ruin

The term corrupt, especially as indicated in second bullet above, could be applied to the
actions of Andersen as a firm and might indicate that the firm was corrupt. It is important
here to know how the definition normally used by the 5th Circuit Court included the word
dishonest, which does not appear in any of these definitions.
2.

The issues are debatable and still center on the motives of David Duncan when he
ordered the shredding of documents and whether Andersen had an obligation to modify
its procedures if an investigation was imminent. Remember, once Andersen was served
with formal notice of an investigation, no documents were shredded.

3.

The opinions of students will vary. Clearly, the contested issues concerning jury
instructions were all decided in favor of the prosecution. The fact that by impeding an
investigation, even without meaning to do so, was allowed to indicate that an obstruction
of justice occurred could have major legal ramifications if used as a precedent. For
example, if on your way home from class you inadvertently got in the way of a police
officer responding to a crime, under the “impede” rule, could you be guilty of obstruction
of justice?

4.

Again, opinions will vary. However, with hindsight and based on the actions taken in the
KPMG investigation, the loss of one of the large CPA firms and the loss of jobs appears
to be a penalty to too many innocent people. It is probably more appropriate to seek out
individuals who engaged or directed illegal activities and take the appropriate actions
against those individuals.

5.

Students should understand that even if an action is legal it may not be ethical. Clearly,
there were some actions taken that are questionable. The principles of ethics require
auditors to act with integrity and to be mindful of the public trust. There are clearly
issues of integrity and the public trust in both the audit work and the shredding of
documents following the disclosure that Enron’s financial statements were fraudulent.

MODC-21


Module C - Legal Liability
C.72

Mini-Case: Ethics (Continued)
7.

In litigation the plaintiffs’ attorneys often name multiple defendants. They do this for two
basic reasons. First, if one of the plaintiffs is found harmless (the tort case equivalent of
“not guilty”), other plaintiffs may be found negligent or to have engaged in fraudulent
actions. Therefore, the plaintiffs may still prevail (and collect damages) against those
defendants. Second, if one or more defendant becomes insolvent (which may happen
during a long trial where legal fees can escalate and cause create cash flow problems), the

plaintiffs may collect from other defendants found liable in the lawsuit. This ability to
collect in full from those who have “the ability to pay” is the basis for joint and several
liability.
Class action lawsuits can be the most damaging to plaintiffs. Several plaintiffs
(sometimes thousands of plaintiffs) can file one lawsuit seeking damages that can total
into millions of dollars if proven. In addition, class action lawsuits may often be heard in
several jurisdictions, allowing the plaintiffs’ attorneys the ability to shop for a court they
believe will be sympathetic to their clients. If a class action lawsuit is not allowed, many
of the smaller claims may be dropped (the costs of the lawsuit outweighs the potential
reward) and even larger suits must bare the legal fees individually. Further, the defense
team is not engaging in a “winner take all” contest. Each suit, possibly heard in different
jurisdictions, will be required to prove its individual case for its plaintiff.

C.73

Kaplan CPA Exam Simulation: Securities Act of 1933
Comfort letters are not required under the Securities Act of 1933, and copies are not filed with the
SEC. However, these letters are frequently provided to underwriters as a common condition of an
underwriting agreement in connection with the offering for sale of securities under the Securities
Act of 1933.
The matters covered in a typical comfort letter are described below:
1.
A statement regarding the independence of auditors.
2.
An opinion regarding whether the audited financial statements and schedules included in
the registration statement comply in form in all material respects with the applicable
accounting requirements of the Securities Act of 1933 and the published rules and
regulations thereunder.
3.
A description of the procedures requested and performed.

4.
A disclaimer of opinion on the financial information covered by the comfort letter.
5.
A statement of specific findings as a result of applying procedures in (3) above.
6.
A statement that restricts distribution of the report.
7.
A statement that auditors have no responsibility to update report for events after a
specified cutoff date.

MODC-22