Chapter 5 Instructor's Guide

Chapter 5Legal LiabilityThe legal liability section is difficult to teach. We want the students to have a flavor for the auditor's legal responsibility without overwhelming them with material to memorize that they are unlikely to remember. The legal environment is also significantly different for individuals, depending on their employment choice. Internal and governmental auditors have little, if any, concern, while those who work for national CPA firms are greatly affected by SEC law. Smaller CPA firm employees are more concerned with client and third party common law. We also don't want students to believe that legal liability is the dominant consideration in an auditor's life.The following are the major things we try to cover:⏹Chapter opening vignette⏹The changed legal environment⏹Distinction among business failure, audit failure, and audit risk⏹Prudent person concept⏹Review of definitions⏹Liability to clients⏹Liability to third parties under common law⏹Civil liability - Securities Act of 1933⏹Civil liability - Securities Exchange Act of 1934⏹Criminal liability⏹Profession's response to liability⏹Summary of chapters 1, 2, 4, and 5Chapter Opening Vignette - “It Takes the Net Profit from Many Audits to Offset the Cost of One Lawsuit”This vignette is fairly straightforward. It shows that an auditor can get sued even when he or she does everything right. In addition, once the suit is filed, the cost of riding it out is immense. Once these realities are grasped, an auditor should be convinced and motivated to be extremely careful to avoid high-risk clients and to ensure that auditing standards are complied with.The vignette raises an important economic issue as well: the relationship between risk and fees. If auditors are too w illing to “low-bid” fees to get work, and their average fees across all clients are low, then their fee structure may not be sufficient to justify the risks they are taking.The vignette can also be used to discuss the nonmonetary costs of litigation. It is important for students to get some feel for the stress that is placed on individuals and the practice as a whole by a lawsuit.The Changed Legal Environment (page 112)It is useful to show students T-5-1 related to the history of legal liability for CPA firms. It gives them a perspective that it is fairly recent that liability has been a problem for CPAs.(See T-5-1)Next we ask students to compare the liability of CPAs and other professionals such as physicians, attorneys, and automobile manufacturers. (They are not substantially different.) It might be helpful to bring a recent article from the newspaper or business journal about a huge judgment or settlement in some other field.It is also useful to ask students to state their opinions of the costs and benefits to society of extensive liability of CPAs. Should there be no liability? Should CPAs be guarantors and insurers of the accuracy of financial statements? Is there now too much or too little liability?Review Question 5-2 is a good one to discuss at this point. We want students to think about the need for CPAs to be responsible for their actions, the cost and benefit to society of extensive liability, the need to attract competent people to the CPA profession, and the difference of opinions held by different people depending on their values.Distinguishing Business Failure, Audit Failure, and Audit Risk (page 113) Students need to be able to distinguish between business failure and audit failure. We often give the students a couple of examples of both and then ask them to distinguish whether the example represents business failure or audit failure. The opening vignette is useful when pointing out that auditors are often penalized for business failures, even when there has not been an audit failure. We use this discussion to describe the expectation gap that exists between users and the accounting profession. This provides a good opportunity to discuss how that gap can be narrowed (e.g., educating users, changing auditor professional responsibilities, etc.).This is a nice point to introduce the four major sources of legal liability for auditors that are summarized in Figure 5-1 (page 116).(See Figure 5-1)Prudent Person Concept (page 114)It is useful to go over the prudent person concept emphasizing the items in T-5-2.(See T-5-2)It is relevant to dwell on the second item and ask students about their legal responsibility as new employees when they are assigned a task they do not feel qualified to do. Students tend to have an attitude of "The CPA firm is responsible to properly supervise me and review my work, and I am only an employee."It is also relevant to ask or discuss how the prudent person concept is implemented in practice given that a "reasonable person concept" is nebulous. Discuss the use of expert witnesses and the pros and cons of having lay people sit on juries involving technical subjects.Review of Definitions (page 115)Our discussion of definitions is ordinarily limited to telling students, preferably during the class period preceding the discussion of liability, to know the definitions in the early part of the chapter. It is useful to briefly go over the legal terms in Table 5-1 (page 115).(See Table 5-1)Liability to Clients (page 116)It should be emphasized that there are more lawsuits by clients than any other source, but the suits are usually small, not reported to the press, frequently settled out of court, and usually have no significance in setting new precedents.(See T-5-3)We emphasize the plaintiff's need to establish the CPA's negligence and auditor's defenses. The auditor's primary defenses are included in T-5-4.(See T-5-4)An example using taxes, audits, or unaudited engagements can be used to illustrate the differences in the defenses.You may want to briefly summarize 1136 Tenants case (page 117) because many students may not understand what unaudited means at this point. The impact on the profession is the most important part of that case.Liability to Third Parties Under Common Law (page 119)The two most important concepts for students to understand in common law are:⏹Known versus unknown third parties and the impact on liability⏹The variation in different legal jurisdictions in their interpretationsThe graph in T-5-5depicts the environment of legal liability to third parties under common law.(See T-5-5)Each letter indicates a degree of negligence and a level of known and unknown users. For A, B, and C there is clear legal responsibility. For M, N, and O there is clear nonlegal responsibility. There is more legal responsibility for D than F, and D than J. There is no way to state whether there is more legal responsibility for F than J.Problems 5-18, 5-19, 5-20, 5-22, 5-23 and/or 5-24 are useful problems at this point.Civil Liability - Securities Act of 1933 (page 121)Most students need to be told the meaning of a registration statement and how it differs from a 10-K. Review Question 5-12 is useful for this.Ask students whether they consider the 1933 Act equitable to auditors with regard to each of the three points discussed under the Securities Act of 1933. A favorite quote about the 1933 Act was made by George O. May (1936).(See T-5-6)The BarChris case (page 122) should be referred to or discussed in reference to understanding the client's business, which is now required by the second standard of fieldwork, and AU 560 (Subsequent Events). The relationship between legal liability and SASs can be conveniently discussed at this point.Civil Liability - Securities Exchange Act of 1934 (page 122)Students need to understand that the 1934 Act applies to auditors each year for all publicly held companies.Start by going over Rule 10b-5 with the students and ask them to explain what it says. At that point spend some time on Hochfelder, especially the quote included in the summary of Hochfelder v. Ernst & Ernst (page 123).We then ask students:1. How do you believe critics of the auditing profession feel about theHochfelder case?2. Do you believe the auditor should only be responsible when there ismanipulation and deception, or should the auditor also be responsible fornegligence?The unsettled nature of the 1934 Act is then discussed along with other actions that can be used by the SEC. Case 5-28 is useful for this material. Problem 5-25 can be used to distinguish the requirements for legal liability under the 1933 and 1934 acts.Criminal Liability (page 125)We emphasize how critical criminal liability is because of the inability to insure for it, and the personal impact on partners and staff. We make the point that a person need not perceive himself as a criminal to find himself in a circumstance where he is found guilty of committing a crime.Go over the United States v. Andersen (2002) case (page 126) and discuss the role the criminal conviction played in the demise of the Andersen firm. Many students are aware of the document shredding in the case and are surprised that it was not a source of the criminal conviction.Problem 5-23, Part c, is useful at this point.The Profession's Response to Liability (page 127)It is useful to conclude the section by distinguishing between what three groups can do to reduce CPAs' liability: the profession, CPA firms, and relatively inexperienced staff. We discuss these using the material at the end of the chapter as a frame of reference. Go over the list of "individual responses" and ask students, "which of these can you do during your first two years as an auditor?"Summary of Chapters 1, 2, 4, and 5As an introduction or a summary, it is useful to relate auditing standards (including quality control standards), professional ethics, competition, and accountants' liability as forming a system for the control of the performance of audit services by CPAs at a high level. All four elements of this system are important.(See T-5-7)CHAPTER 5CROSS-REFERENCE OF LEARNING OBJECTIVES AND PROBLEM MATERIAL5-6HISTORICAL PERSPECTIVE OF LEGAL LIABILITYPRUDENT PERSON CONCEPT∙Employment of skill with reasonable care and diligence∙If one offers his or her service, he or she must have the required skills∙He or she undertakes for good faith and integrity, but not for infallibility∙He or she is liable for acts resulting from negligence, bad faith or dishonesty, but not pure errors of judgmentMOST LIKELY CAUSES OFLAWSUITS BY CLIENTS∙Alleged failure to deliver financial statements or tax returns on a timely basis∙Alleged failure to discover a fraud in audits and unaudited engagements∙Alleged errors in preparing tax returns resulting in deficiency assessments∙Alleged errors in preparing financial statements resulting in the failure to get a loanAUDITOR'S DEFENSES —SUITS BY CLIENTS∙Lack of duty to perform the service∙Nonnegligent performance (expert witness) ∙Contributory negligence∙Absence of causal connectionLIABILITY TO 3RD PARTIES - RELATIONSHIP OF "KNOWN 3RD PARTY" AND "DEGREE OF NEGLIGENCE"EXTENSIVE NEGLIGENCE•A B CD E FUNKNOWN 3RDPARTY• •G H IKNOWN 3RDPARTY USERJ K LM N O•NON-NEGLIGENCEGEORGE O. MAY, 1936OPINION OF LIABILITY UNDER THE1933 ACTI cannot believe that a law is just or can long be maintained in effect which deliberately contemplated the possibility that a purchaser may recover from a person from whom he has not bought, in respect of a statement which at the time of his purchase he had not read, contained in a document which he did not then know to exist, a sum which is not to be measured by injury resulting from falsity in such statement.THE "SYSTEM" FOR CONTROL OF THE QUALITY OF AUDIT SERVICESBY CPAsProfessional StandardsCompetitionProfessional Ethics Legal Liability。