Chapter 5 Solutions Manual.docx

1、Chapter 5 Solutions ManualChapter 5Legal Liability Review Questions5-1 Several factors that have affected the increased number of lawsuits against CPAs are:1. The growing awareness of the responsibilities of public accountants on the part of users of financial statements.2. An increased consciousnes

2、s on the part of the SEC regarding its responsibility for protecting investors interests.3. The greater complexities of auditing and accounting due to the increasing size of businesses, the globalization of business, and the intricacies of business operations.4. Societys increasing acceptance of law

3、suits.5. Large civil court judgments against CPA firms, which have encouraged attorneys to provide legal services on a contingent fee basis.6. The willingness of many CPA firms to settle their legal problems out of court.7. The difficulty courts have in understanding and interpreting technical accou

4、nting and auditing matters.5-2 The most important positive effects are the increased quality control by CPA firms that is likely to result from actual and potential lawsuits and the ability of injured parties to receive remuneration for their damages. Negative effects are the energy required to defe

5、nd groundless cases and the harmful impact on the publics image of the profession. Legal liability may also increase the cost of audits to society, by causing CPA firms to increase the evidence accumulated.5-3 Business failure is the risk that a business will fail financially and, as a result, will

6、be unable to pay its financial obligations. Audit risk is the risk that the auditor will conclude that the financial statements are fairly stated and an unqualified opinion can therefore be issued when, in fact, they are materially misstated. When there has been a business failure, but not an audit

7、failure, it is common for statement users to claim there was an audit failure, even if the most recently issued audited financial statements were fairly stated. Many auditors evaluate the potential for business failure in an engagement in determining the appropriate audit risk.5-4 The prudent person

8、 concept states that a person is responsible for conducting a job in good faith and with integrity, but is not infallible. Therefore, the auditor is expected to conduct an audit using due care, but does not claim to be a guarantor or insurer of financial statements.5-5 The difference between fraud a

9、nd constructive fraud is that in fraud the wrongdoer intends to deceive another party whereas in constructive fraud there is a lack of intent to deceive or defraud. Constructive fraud is highly negligent performance.5-6 Many CPA firms willingly settle lawsuits out of court in an attempt to minimize

10、legal costs and avoid adverse publicity. This has a negative effect on the profession when a CPA firm agrees to settlements even though it believes that the firm is not liable to the plaintiffs. This encourages others to sue CPA firms where they probably would not to such an extent if the firms had

11、the reputation of contesting the litigation. Therefore, out-of-court settlements encourage more lawsuits and, in essence, increase the auditors liability because many firms will pay even though they do not believe they are liable.5-7 An auditors best defense for failure to detect a fraud is an audit

12、 properly conducted in accordance with auditing standards. SAS 99 (AU 316) states that the auditor should assess the risk of material misstatements of the financial statements due to fraud. Based on this assessment, the auditor should design the audit to provide reasonable assurance of detecting mat

13、erial misstatements due to fraud. SAS 99 also states that because of the nature of fraud (including defalcations), a properly designed and executed audit may not detect a material misstatement due to fraud.5-8 Contributory negligence used in legal liability of auditors is a defense used by the audit

14、or when he or she claims the client or user also had a responsibility in the legal case. An example is the claim by the auditor that management knew of the potential for fraud because of weaknesses in internal control, but refused to correct them. The auditor thereby claims that the client contribut

15、ed to the fraud by not correcting material weaknesses in internal control. 5-9 An engagement letter from the auditor to the client specifies the responsibilities of both parties and states such matters as fee arrangements and deadlines for completion. The auditor may also use this as an opportunity

16、to inform the client that the responsibility for the prevention of fraud is that of the client. A well-written engagement letter can be useful evidence in the case of a lawsuit, given that the letter spells out the terms of the engagement agreed to by both parties. Without an engagement letter, the

17、terms of the engagement are easily disputed.5-10 Liability to clients under common law has remained relatively unchanged for many years. If a CPA firm breaches an implied or expressed contract with a client, there is a legal responsibility to pay damages. Traditionally the distinction between privit

18、y of contract with clients and lack of privity of contract with third parties was essential in common law. The lack of privity of contract with third parties meant that third parties would have no rights with respect to auditors except in the case of gross negligence. That precedent was established

19、by the Ultramares case. In recent years some courts have interpreted Ultramares more broadly to allow recovery by third parties if those third parties were known and recognized to be relying upon the work of the professional at the time the professional performed the 5-10 (continued)services (forese

20、en users). Still others have rejected the Ultramares doctrine entirely and have held the CPA liable to anyone who relies on the CPAs work, if that work is performed negligently. The liability to third parties under common law continues in a state of uncertainty. In some jurisdictions the precedence

21、of Ultramares is still recognized whereas in others there is no significant distinction between liability to third parties and to clients for negligence.5-11 In recent years the auditors liability to a third party has become affected by whether the party is known or unknown. Now a known third party,

22、 under common law, usually has the same rights as the party that is privy to the contract. An unknown third party usually has fewer rights. The approach followed in most states is the Restatement of Torts approach to the foreseen users concept. Under the Restatement of Torts approach, foreseen users

23、 must be members of a reasonably limited and identifiable group of users that have relied on the CPAs work, even though those persons were not specifically known to the CPA at the time the work was done. 5-12 The differences between the auditors liability under the securities acts of 1933 and 1934 a

24、re because the 1933 act imposes a heavier burden on the auditor. Third party rights as presented in the 1933 act are:1. Any third party who purchases securities described in the registration statement may sue the auditor.2. Third party users do not have the burden of proof that they relied on the fi

25、nancial statements or that the auditor was negligent or fraudulent in doing the audit. They must only prove that the financial statements were misleading or not fairly stated. In conjunction with these third party rights, the auditor has a greater burden in that he or she must demonstrate that:1. Th

26、e statements are not materially misstated.2. An adequate audit was conducted.3. The user did not incur the loss because of misleading financial statements. The liability of auditors under the 1934 act is not as harsh as under the 1933 act. In this instance, the burden of proof is on third parties to

27、 show that they relied on the statements and that the misleading statements were the cause of the loss. The principal focus of accountants liability under the 1934 act is on Rule 10b-5. Under Rule 10b-5, accountants generally can only be held liable if they intentionally or recklessly misrepresent i

28、nformation intended for third-party use. Many lawsuits involving accountants liability under Rule 10b-5 have resulted in accountants being liable when they knew all of the relevant facts, but merely made poor judgments. In recent years, however, courts have decided that poor judgment doesnt necessar

29、ily prove fraud on the part of the accountant.5-13 The auditors legal liability to the client can result from the auditors failure to properly fulfill his or her contract for services. The lawsuit can be for breach of contract, which is a claim that the contract was not performed in the manner agree

30、d upon, or it can be a tort action for negligence. An example would be the clients detection of a misstatement in the financial statements, which would have been discovered if the auditor had performed all audit procedures required in the circumstances (e.g., misstatement of inventory resulting from

31、 an inaccurate physical inventory not properly observed by the auditor). The auditors liability to third parties under common law results from any loss incurred by the claimant due to reliance upon misleading financial statements. An example would be a bank that has loans outstanding to an audited c

32、ompany. If the audit report did not disclose that the company had contingent liabilities that subsequently became real liabilities and forced the company into bankruptcy, the bank could proceed with legal action against the auditors for the material omission. Civil liability under the Securities Act

33、 of 1933 provides the right of third parties to sue the auditor for damages if a registration statement or a prospectus contains an untrue statement of a material fact or omits to state a material fact that would result in misleading financial statements. The third party does not have to prove relianc