Review Questions Solutions
Chapter 4, Legal Environment Affecting Audits
Page 136
A1 Why does audit risk create business risk for an auditor, and how does the legal environment of business affect the auditor’s business risk?
The definition of audit risk is issuing an opinion that the financial statements are fair when they are not or that internal control is effective when it is not. As a result of issuing the wrong audit opinion, bad things can happen to an auditor’s business, such as reputation damage or being sued. Elements in the legal environment affect the likelihood that an auditor will be sued and of a guilty verdict.
A2 What is meant by the term standing as it refers to a plaintiff, and why is standing important?
Legal standing refers to whether a court will permit a plaintiff to investigate a legal action against a plaintiff for a particular cause of action. Whether a plaintiff has legal standing results form the nature of the plaintiff’s relationship with the defendant and the nature of the allegation being made against the defendant. Generally, the more distant the relationship between the plaintiff and defendant, the more serious the alleged wrongdoing must be for the plaintiff to have standing.
A3 What are the various categories of standing of plaintiffs in actions against auditors? What characteristics cause a plaintiff to have each type of standing?
Privity: Results when the plaintiff and defendant have a “legally recognized interest in the same subject matter.” The most common example of this is that the plaintiff and defendant are parties to a contract.
Near privity: Permits a plaintiff who is not in actual privity with the defendant to have standing to initiate a lawsuit for the same cause of action as a plaintiff with privity. The three part test for near privity is: that the auditor understood that the financial statements were going to be used for a specific purpose; the third party was known by the auditor; the third party relied on the financial statements.
Foreseen third party: A person who could have been reasonably expected to rely on information with which the auditor is associated; the user of financial statements falls would fall into this group.
Reasonably foreseeable third party: A broader group of individuals than foreseen third parties; requires less specific knowledge on the part of the auditor as to who might be expected to use the financial statements.
A4 What important precedent did the Ultramares decision set?
A person or entity has to have privity with an auditor to be able to collect damatges if the auditor is found culpable of not greater wrongdoing than negligence.
A5 What reasons have been given for expanding auditor liability for negligence to foreseen users?
1. The increase in liability of other professions to non-privity plaintiffs.
2. A general concern for fairness to the innocent user of financial statements who is harmed by the negligent or fraudulent behavior of the auditor.
3. The ability of the auditor to absorb the damages and spread the costs of litigation to multiple clients.
Page 139
B1 What is arbitration?
Arbitration refers to a specific kind of discussion that occurs between a plaintiff and defendant that is managed by a third party called an arbitrator. The purpose of arbitration is to attempt to settle a dispute without going through a trial. Arbitration can be required by a contract or a judge, or may be entered into voluntarily by the two parties in dispute.
B2 Why might an auditor choose to settle a case rather than go through with a trial?
Auditors might choose to settle a case because of the risk that they would lose in a trial or because they decide that a trial will be more expensive than settling.
B3 What are the steps in a legal action up to and including the trial? What happens during each step?
The complaint: The plaintiff documents and serves legal papers stating the allegation of damages and what remedies are sought from the defendant.
The answer: The defendant responds to the papers served by the plaintiff.
Discovery: Each side to the dispute accumulates evidence either in the form of documents that must be produced for examination or deposition of individuals with knowledge useful to the case.
Court proceedings: Each side presents facts, examines and cross-examines witnesses and presents expert testimony. The judge either charges the jury or, if the trial is not a jury trial, examines the facts presented and the law. The outcome of the case is determined in favor of either the plaintiff or defendant.
After the proceedings: If the case was decided in favor of the plaintiff a judgment is made against the defendant who must pay the damages. The case may also be appealed by the losing party.
Page 143
C1 What are the differences between a civil and criminal case?
In a criminal case the plaintiff is the government, while in a civil case the plaintiff is the damaged party. The requirements to prove that the accused party is guilty are stricter in a criminal case, and the potential damages more severe.
C2 What is the reasonable man or prudent person standard?
Basically, it means that you are not guilty of negligence if you behave with the level of concern or care that a careful person would use. For professionals, it means that you behave in the way that a careful professional would behave.
Colley on Torts: “In all these employments where particular skill is prerequisite, if one offers his service, he is understood as holding himself out to the public as possessing the degree of skill commonly possessed by others in the same employment, and if his pretensions are unfounded, he commits a species of fraud upon every man who employs him in reliance on his pubic profession…. He undertakes for good faith and integrity, but no for infallibility, and he is liable to his employer for negligence, bad faith, or dishonesty, but not for losses consequent upon pure error or judgment..
C3 What circumstances lead to a negligence cause of action against an auditor?
1. Financial statements that are materially misleading
2. The auditor did not meet the professional standards of a prudent person, or did not meet the profession’s standards
3. The plaintiff relied on the financial statements
4. The auditor was known or was responsible to the plaintiff (standing)
5. The plaintiff was damaged by relying on the financial statements.
C4 What defenses can be used?
1. The auditor or firm acted in a professional manner; due professional care
2. No duty of care was owed the plaintiff
3. The plaintiff did not rely on the financial information
4. There was no causal connection between the negligent act and the damage the plaintiff suffered
5. Contributory negligence
C5 For what would an auditor be liable as the result of a negligence finding?
Compensatory damages; the loss the plaintiff suffered because of the auditor’s negligence
C6 How do your answers to 3, 4, and 5 change for a gross negligence cause of action?
Gross negligence would be alleged if the auditor’s behavior was charged to be with reckless disregard. The auditor would attempt to defend against the allegation by proving the audit was performed with due professional care. A gross negligence charge could result in compensatory and punitive damages. In contrast, if the auditor proved that the behavior was negligent but not grossly negligent, then the punitive damages would not be awarded.
C7 What are the main legal theories of liability, and how do they differ?
Joint and severally (joint and several) liability applies when there is more than one defendant and each defendant can be liable for the total amount of damages. Separate and proportionate is the liability theory under which each defendant is only liable for the percentage of the judgment allocated to that particular defendant.
Page 146
D1 What are the circumstances for a fraud cause of action against an auditor?
Fraud is the charge when the plaintiff is alleging intentional misstatement in or omission from the financial statements by the auditor.
D2 What defense is appropriate?
The auditor can defend by asserting that the audit was conducted with due professional care or that, even if there was negligence in the conduct of the audit, the auditor did not know of the problem or did not intend to mislead anyone by causing the financial statements to be misstated.
D3 For what amount would an auditor be liable as the result of a fraud finding?
Compensatory and punitive damages may be awarded for a finding of fraud.
D4 How do your answers for 1, 2, and 3 change for a constructive fraud cause of action?
In constructive fraud the plaintiff is not arguing that the auditor knew, only that he or she should have known. Constructive fraud is similar to gross negligence in that the auditor defends in an attempt to bring the charge back to one of negligence. If found guilty of constructive fraud the liability may include punitive damages, rather than just compensatory damages as in negligence.
D5 Why might a breach of contract cause of action be brought against an auditor?
A breach of contract cause of action would be brought if the auditor did not complete the audit.
D6 What defense is typically used?
The auditor uses the defense that the contract was not breached or that the plaintiff does not have standing to sue because of lack of privity.
D7 What unique remedy may be requested in a breach of contract case?
The damages that are possible are a monetary award or specific performance; specific performance refers to the plaintiff asking the auditor to complete the audit. Specific performance is not a probable outcome because the auditor has likely not completed the audit because it would be in violation of professional guidance.
Page 151
E1 What types of claims are brought under the 1933 Act?
The auditor may be sued if the financial statements contain a material misrepresentation or omission. Claims are related to losses that occur related to the public offering of securities.
E2 How does the burden of proof differ in a cause of action brought under the 1933 Act from one brought under a common law negligence claim?
The third party does not have the burden to prove that the financial statements were relied upon in the decision to purchase the securities or even that the auditors were negligent or committed fraud during the audit of the financial statements. The only requirement of the third party is to show there was a material misrepresentation or omission in the financial statements.
E3 What is the most well-known section of the 1934 At relating to charges brought against accountants? For what type of behavior does an auditor have liability under this section of the 1934 Act?
Section 10(b)5 which states: “It shall be unlawful for any person directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange…” to defraud, to make an untrue statement of material fact or omit a material fact in financial statements, or to “…engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person in connection with the purchase or sale of any security.”
Page 153
F1 How is SEC Rule 2(e) associated with Arthur Andersen going out of business?
Rule 2(e) states that the SEC can temporarily or permanently deny a “person” the privilege of appearing or practicing before it. The SEC refused to accept any reports issued by Arthur Andersen after the firm was convicted of felony obstruction of justice. By the time the verdict was overturned on appeal the firm had gone out of business.
F2 What are treble damages under RICO?
Treble damages means that the penalized entity must pay three times the amount of the actual assessed damages.
F3 What does the Foreign Corrupt Practices Act have to do with a public company’s system of internal control?
The FCPA requires companies to maintain reasonable records and have an adequate system of internal control.
F4 What is the content of SOX Section 104(b)? 105(c)(4)?
104(b): requires the PCAOB to inspect public accounting firms that audit pubic companies.
105(c)(4): gives the PCAOB the authority to assess penalties against a public accounting firm or an individual auditor.
Page 157
G1 What are the possible penalties for intentional (willful) material misstatements of financial statements under the 1933 Act? The 1934 Act?
1933: willfully; fined not more than $10,000, or imprisoned not more than five years, or both.
1934: willfully, knowingly; fined not more than $1,000,000, or imprisoned not more than ten years or both.
G2 What type of charge was made against Arthur Andersen?
Obstruction of justice
G3 What aspect of SOX protects auditors, and how?
303: It is a crime “…for any officer or director of an issuer to take any action to fraudulently influence, coerce, manipulate, or mislead any auditor engaged in the performance of an audit for the purposes of rendering the financial statements materially misleading.”
1