Chapter 5 Solutions Manual.docx

Chapter 5 Solutions Manual.docx

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Chapter5SolutionsManual

Chapter5

LegalLiability

ReviewQuestions

5-1SeveralfactorsthathaveaffectedtheincreasednumberoflawsuitsagainstCPAsare:

1.Thegrowingawarenessoftheresponsibilitiesofpublicaccountantsonthepartofusersoffinancialstatements.

2.AnincreasedconsciousnessonthepartoftheSECregardingitsresponsibilityforprotectinginvestors'interests.

3.Thegreatercomplexitiesofauditingandaccountingduetotheincreasingsizeofbusinesses,theglobalizationofbusiness,andtheintricaciesofbusinessoperations.

4.Society'sincreasingacceptanceoflawsuits.

5.LargecivilcourtjudgmentsagainstCPAfirms,whichhaveencouragedattorneystoprovidelegalservicesonacontingentfeebasis.

6.ThewillingnessofmanyCPAfirmstosettletheirlegalproblemsoutofcourt.

7.Thedifficultycourtshaveinunderstandingandinterpretingtechnicalaccountingandauditingmatters.

5-2ThemostimportantpositiveeffectsaretheincreasedqualitycontrolbyCPAfirmsthatislikelytoresultfromactualandpotentiallawsuitsandtheabilityofinjuredpartiestoreceiveremunerationfortheirdamages.Negativeeffectsaretheenergyrequiredtodefendgroundlesscasesandtheharmfulimpactonthepublic'simageoftheprofession.Legalliabilitymayalsoincreasethecostofauditstosociety,bycausingCPAfirmstoincreasetheevidenceaccumulated.

5-3Businessfailureistheriskthatabusinesswillfailfinanciallyand,asaresult,willbeunabletopayitsfinancialobligations.Auditriskistheriskthattheauditorwillconcludethatthefinancialstatementsarefairlystatedandanunqualifiedopinioncanthereforebeissuedwhen,infact,theyaremateriallymisstated.

Whentherehasbeenabusinessfailure,butnotanauditfailure,itiscommonforstatementuserstoclaimtherewasanauditfailure,evenifthemostrecentlyissuedauditedfinancialstatementswerefairlystated.Manyauditorsevaluatethepotentialforbusinessfailureinanengagementindeterminingtheappropriateauditrisk.

5-4Theprudentpersonconceptstatesthatapersonisresponsibleforconductingajobingoodfaithandwithintegrity,butisnotinfallible.Therefore,theauditorisexpectedtoconductanauditusingduecare,butdoesnotclaimtobeaguarantororinsureroffinancialstatements.

5-5Thedifferencebetweenfraudandconstructivefraudisthatinfraudthewrongdoerintendstodeceiveanotherpartywhereasinconstructivefraudthereisalackofintenttodeceiveordefraud.Constructivefraudishighlynegligentperformance.

5-6ManyCPAfirmswillinglysettlelawsuitsoutofcourtinanattempttominimizelegalcostsandavoidadversepublicity.ThishasanegativeeffectontheprofessionwhenaCPAfirmagreestosettlementseventhoughitbelievesthatthefirmisnotliabletotheplaintiffs.ThisencouragesotherstosueCPAfirmswheretheyprobablywouldnottosuchanextentifthefirmshadthereputationofcontestingthelitigation.Therefore,out-of-courtsettlementsencouragemorelawsuitsand,inessence,increasetheauditor'sliabilitybecausemanyfirmswillpayeventhoughtheydonotbelievetheyareliable.

5-7Anauditor'sbestdefenseforfailuretodetectafraudisanauditproperlyconductedinaccordancewithauditingstandards.SAS99（AU316）statesthattheauditorshouldassesstheriskofmaterialmisstatementsofthefinancialstatementsduetofraud.Basedonthisassessment,theauditorshoulddesigntheaudittoprovidereasonableassuranceofdetectingmaterialmisstatementsduetofraud.SAS99alsostatesthatbecauseofthenatureoffraud（includingdefalcations）,aproperlydesignedandexecutedauditmaynotdetectamaterialmisstatementduetofraud.

5-8Contributorynegligenceusedinlegalliabilityofauditorsisadefenseusedbytheauditorwhenheorsheclaimstheclientoruseralsohadaresponsibilityinthelegalcase.Anexampleistheclaimbytheauditorthatmanagementknewofthepotentialforfraudbecauseofweaknessesininternalcontrol,butrefusedtocorrectthem.Theauditortherebyclaimsthattheclientcontributedtothefraudbynotcorrectingmaterialweaknessesininternalcontrol.

5-9Anengagementletterfromtheauditortotheclientspecifiestheresponsibilitiesofbothpartiesandstatessuchmattersasfeearrangementsanddeadlinesforcompletion.Theauditormayalsousethisasanopportunitytoinformtheclientthattheresponsibilityforthepreventionoffraudisthatoftheclient.Awell-writtenengagementlettercanbeusefulevidenceinthecaseofalawsuit,giventhattheletterspellsoutthetermsoftheengagementagreedtobybothparties.Withoutanengagementletter,thetermsoftheengagementareeasilydisputed.

5-10Liabilitytoclientsundercommonlawhasremainedrelativelyunchangedformanyyears.IfaCPAfirmbreachesanimpliedorexpressedcontractwithaclient,thereisalegalresponsibilitytopaydamages.Traditionallythedistinctionbetweenprivityofcontractwithclientsandlackofprivityofcontractwiththirdpartieswasessentialincommonlaw.Thelackofprivityofcontractwiththirdpartiesmeantthatthirdpartieswouldhavenorightswithrespecttoauditorsexceptinthecaseofgrossnegligence.

ThatprecedentwasestablishedbytheUltramarescase.InrecentyearssomecourtshaveinterpretedUltramaresmorebroadlytoallowrecoverybythirdpartiesifthosethirdpartieswereknownandrecognizedtoberelyingupontheworkoftheprofessionalatthetimetheprofessionalperformedthe

5-10（continued）

services（foreseenusers）.StillothershaverejectedtheUltramaresdoctrineentirelyandhaveheldtheCPAliabletoanyonewhoreliesontheCPA’swork,ifthatworkisperformednegligently.Theliabilitytothirdpartiesundercommonlawcontinuesinastateofuncertainty.InsomejurisdictionstheprecedenceofUltramaresisstillrecognizedwhereasinothersthereisnosignificantdistinctionbetweenliabilitytothirdpartiesandtoclientsfornegligence.

5-11Inrecentyearstheauditor'sliabilitytoathirdpartyhasbecomeaffectedbywhetherthepartyisknownorunknown.Nowaknownthirdparty,undercommonlaw,usuallyhasthesamerightsasthepartythatisprivytothecontract.Anunknownthirdpartyusuallyhasfewerrights.TheapproachfollowedinmoststatesistheRestatementofTortsapproachtotheforeseenusersconcept.UndertheRestatementofTortsapproach,foreseenusersmustbemembersofareasonablylimitedandidentifiablegroupofusersthathavereliedontheCPA’swork,eventhoughthosepersonswerenotspecificallyknowntotheCPAatthetimetheworkwasdone.

5-12Thedifferencesbetweentheauditor'sliabilityunderthesecuritiesactsof1933and1934arebecausethe1933actimposesaheavierburdenontheauditor.Thirdpartyrightsaspresentedinthe1933actare:

1.Anythirdpartywhopurchasessecuritiesdescribedintheregistrationstatementmaysuetheauditor.

2.Thirdpartyusersdonothavetheburdenofproofthattheyreliedonthefinancialstatementsorthattheauditorwasnegligentorfraudulentindoingtheaudit.Theymustonlyprovethatthefinancialstatementsweremisleadingornotfairlystated.

Inconjunctionwiththesethirdpartyrights,theauditorhasagreaterburdeninthatheorshemustdemonstratethat:

1.Thestatementsarenotmateriallymisstated.

2.Anadequateauditwasconducted.

3.Theuserdidnotincurthelossbecauseofmisleadingfinancialstatements.

Theliabilityofauditorsunderthe1934actisnotasharshasunderthe1933act.Inthisinstance,theburdenofproofisonthirdpartiestoshowthattheyreliedonthestatementsandthatthemisleadingstatementswerethecauseoftheloss.

Theprincipalfocusofaccountants’liabilityunderthe1934actisonRule10b-5.UnderRule10b-5,accountantsgenerallycanonlybeheldliableiftheyintentionallyorrecklesslymisrepresentinformationintendedforthird-partyuse.Manylawsuitsinvolvingaccountants’liabilityunderRule10b-5haveresultedinaccountantsbeingliablewhentheyknewalloftherelevantfacts,butmerelymadepoorjudgments.Inrecentyears,however,courtshavedecidedthatpoorjudgmentdoesn’tnecessarilyprovefraudonthepartoftheaccountant.

5-13Theauditor'slegalliabilitytotheclientcanresultfromtheauditor'sfailuretoproperlyfulfillhisorhercontractforservices.Thelawsuitcanbeforbreachofcontract,whichisaclaimthatthecontractwasnotperformedinthemanneragreedupon,oritcanbeatortactionfornegligence.Anexamplewouldbetheclient'sdetectionofamisstatementinthefinancialstatements,whichwouldhavebeendiscoverediftheauditorhadperformedallauditproceduresrequiredinthecircumstances（e.g.,misstatementofinventoryresultingfromaninaccuratephysicalinventorynotproperlyobservedbytheauditor）.

Theauditor'sliabilitytothirdpartiesundercommonlawresultsfromanylossincurredbytheclaimantduetorelianceuponmisleadingfinancialstatements.Anexamplewouldbeabankthathasloansoutstandingtoanauditedcompany.Iftheauditreportdidnotdisclosethatthecompanyhadcontingentliabilitiesthatsubsequentlybecamerealliabilitiesandforcedthecompanyintobankruptcy,thebankcouldproceedwithlegalactionagainsttheauditorsforthematerialomission.

CivilliabilityundertheSecuritiesActof1933providestherightofthirdpartiestosuetheauditorfordamagesifaregistrationstatementoraprospectuscontainsanuntruestatementofamaterialfactoromitstostateamaterialfactthatwouldresultinmisleadingfinancialstatements.Thethirdpartydoesnothavetoproverelianc