Session 2.1 Flashcards
Legal Liability
What are the 2 types of liability to the client
- Breach of contract
- Negligence - gross - fraud
What is breach of contract?
The auditor’s failing to complete the services agreed to in the contract with the client
What is the title of the written contract between auditors and clients?
Engagement letter (it is binding)
what is negligence liability?
Engagement done without due care, which may hold the CPA liable for actionable tort and negligence
(can be sued in both assurance and non-assurance services)
What are the 4 degrees of due care?
- Due care
- Negligence
- Gross negligence
- Fraud
What is due care?
Preparing an audit plan according to the standards, attentive to avoid an audit failure
What is gross negligence?
Blatant disregard of the standards and not preparing an audit plan at all
vs negligence which is to prepare a plan, but not a proper one
What is fraud
Engaging in a deceptive scheme to profit at the expense of others parties where auditors intentionally do not prepare an audit plan
Common Law Negligence
What are the 4 points the client must prove?
- Duty was owned to him (engagement letter)
- Failure to act in accordance with that duty
- Causal connection between damage and negligence
- Actual loss or damage to the client
Common Law Negligence
What are the 6 points for which the auditor can defend itself?
- No duty was owned
- Client itself was negligent (e.g., poor internal control)
- Work was performed according to the professional standards
- No loss was suffered by the client
- No causal connection
- Statue of limitation has expired, making the claim invalid
Which of the following best describes whether a CPA has met the required standard of care in auditing an entity’s financial statements?
- Whether the client’s expectations are met with regard to the accuracy of the audited financial statements.
- Whether the statements conform to general accepted accounting principles.
- Whether the audit was conducted to investigate and discover all acts of fraud.
- Whether the CPA conducted the audit with the same skill and care expected of an ordinarily prudent CPA under the circumstances.
Whether the CPA conducted the audit with the same skill and care expected of an ordinarily prudent CPA under the circumstances.
Common Law Third Parties
What are the 4 Legal Standards for Third Parties?
- Privity (contract)
- Near Privity
- Foreseen third parties
- Reasonably foreseeable third parties
What is near privity?
Third parties whose relationship with the CPA approaches privity
What are foreseen third parties?
Third parties whose reliance should be foreseen, even if the specific person is known to the auditor
What are reasonably foreseeable parties?
Third parties whose reliance should be reasonably foreseeable, even if the specific person is unknown to the auditor
Can gross negligence be interpreted as fraud?
Some court have interpreted some cases of gross negligence as fraud
Fraud
Third party must prove what (5)
Third party rarely wins fraud cases
- False representation by the CPA
- Knowledge or belief by the CPA that the representation was false
- The CPA intended to induce the the third party to rely on the false representation
- The third party relied on the false representation
- The third party suffered damages
What are the 3 major statutes that provide sources of statutory liability for auditors?
Securities Act of 1933
Securities Exchange Act of 1934
Sarbanes-Oxley Act of 2002
What does the Securities Act of 1933 regulate?
The disclosure of information in a registration statement for a NEW public offering of securities
SECTION 11: imposes a liability on issuers and others, including auditors, for losses suffered by 3rd parties when false or misleading information is included in a registration statement
Securities Act of 1933
What does the third party must prove
- It suffered losses by investing in the registered security
- The audited financial statements contained a material omission of misstatement
Burden of proof is shifted to the auditor to prove that he or she was not negligent.
With what is the Securities Exchange Act of 1934 concerned?
Concerned primarily with ongoing reporting by companies whose securities ALREADY are listed and traded on a stock exchange
SECTION 18: imposes liability on any person who makes a material false or misleading statement in documents filed with the SEC.
SECTION 10(b) and Rule 10b-5: Greatest source of liability for auditors under this act
Securities Exchange Act of 1934
What does the third party must prove (4)
- A material, factual misrepresentation or omission
- Reliance on the financial statements
- Damages suffered as a result of reliance on the financial statements
- Scienter (gross negligence or recklessness may be enough)
(Higher burden of proof given more information available than for the IPOs)
Securities Exchange Act of 1934
What does the NEGLIGENCE third party must prove (4)
- The auditor had a duty to the plaintiff to exercise due care
- The auditor breached that duty
- Direct causal relationship between that negligence and the third party’s injury
- Third party suffered an actual loss or damage
Securities Exchange Act of 1934
What is the NEGLIGENCE auditor’s defense (6)
- No duty was owned to the third party (depends on case law by the courts)
- Third party was negligent
- Auditor’s work was in accordance with professional standards
- Third party suffered NO loss
- Lack of causal connection between loss and negligence
- Statute of limitation has expired, leading to the claim being invalid
What are the 4 main adjustments of the Sarbanes Oxley Act?
- Creation of the PCAOB
- Stricter independence rules
- Audits of internal controls
- Increased reporting responsibilities
Not just audits on financial statements, but also on the internal control
