Chapter 08 Ans

CHAPTER 8 AUDITOR’S LEGAL LIABILITY

I.

Review Questions

1.

Exampl Examples es of typi typical cal lawsu lawsuits its agai against nst CPA CPAss are a)

Alleged Alleged misst misstate atement mentss that the audit auditor or did not detec detectt in the financi financial al statements involving 1)

improp improper er or inadeq inadequate uate disclo disclosur suree

2)

inap inappr propr opria iate te valua valuati tion onss

b) Alleged Alleged failu failure re to detect detect defalcat defalcation ion as a result result of neglige negligence nce in the conduct of the audit c)

Alleged Alleged failur failuree to complet completee the audit audit on the agre agreed-o ed-on n date

d) Alleged Alleged inapp inapprop ropria riate te withdr withdrawa awall from an audit audit 2.

Refe Referr to to pag pagee 324 324,, 1st paragraph of the textbook.

3.

Refe Referr to pag pagee 329 329 of the the tex textbo tbook. ok.

4.

Refe Referr to pag pagee 341 341 of the the tex textbo tbook. ok.

5.

The The incr increa ease se in litiga litigati tion on agai agains nstt audi audito tors rs seems seems to be happ happen ening ing for two reasons: a general increase in litigation in society, and the fact that investors and creditors who suffer losses will look for “deep pockets” to pay for those losses. Most accounting firms appear to have “deep pockets.”

6.

Due (prof (profess ession ional) al) care is the standa standard rd by which which the courts courts and the profess profession ion expect expect a CPA CPA to practice. practice. A CPA who who is found found to have exercise exercised d due professional care in an engagement should not have any liability to others.

7.

The The four four grad gradat ation ionss are are none, none, negl neglige igenc nce, e, gros grosss negl neglige igenc ncee (som (somet etim imes es referred referred to as constructive constructive fraud), and fraud. fraud. At one extreme extreme is the auditor who performs performs an appropriate appropriate audit and issues issues an appropriate appropriate report. This auditor’s degree of wrongdoing is “none.” An auditor who commits fraud fraud is at the other extreme, extreme, since since he or she knows knows that the financia financiall statem statement entss are misstated misstated and yet issues an unqualifie unqualified d opinion. An auditor auditor is negligent if he or she she does does not not do what what a reas reasona onabl bly y prud pruden entt audi audito torr shou should ld do in the the circumstances. An auditor is grossly negligent if he or she consistently fails to follow the standards of the profession on an engagement. Auditors Auditors are are responsible responsible to to clients clients for neglige negligence, nce, gross gross negligence, negligence, or fraud. fraud.

8.

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Solutions Manual - Principles of Auditing and Other Assurance Services 9.

Refe Referr to to pag pagee 334 334..

10. In some some jurisd jurisdict ictions ions,, audito auditors rs can use contri contributo butory ry negligence negligence as a defens defensee when a client is suing for a tort. 11. 11. Most Most cour courts ts have have held held that that an audi audito torr has has a high higher er resp respon onsi sibi bili lity ty to comm commun unica icate te info inform rmat atio ion n beyo beyond nd that that requ requir ired ed by gene genera rall lly y acce accepte pted d accounting principles and generally accepted auditing standards. Courts have held held that that comp compli lian ance ce with with gene genera rall lly y acce accepte pted d acco account untin ing g prin princi cipl ples es is persuasive but not conclusive evidence. 12. An auditor auditor should (a) follow follow the Philippine Philippine Standards Standards on Auditing, Auditing, the Code Code of Ethics for Professional Accountants in the Philippines, and where appropriate, generally generally accepted accounting principles; principles; (b) establish and follow follow appropriate appropriate quality quality control control procedures; procedures; (c) evaluate evaluate whether whether a client has the necessary necessary integrity and appropriate reputation in the community; (d) evaluate carefully why a client wants an audit; (e) conduct the audit with appropriate professional skepticism; (f) provide for appropriate levels of consultation for issues; and (g) provide for appropriate review of the audit. 13. The prudent prudent man concept states states that a man is responsi responsible ble for conducting conducting a job in good faith and with with integrity, but is not infallible. Therefore, the auditor is expec expected ted to cond conduc uctt an audi auditt usin using g due due care care,, but but does does not not clai claim m to be a guarantor or insurer of financial statements. 14. Many Many CPA firms firms will willin ingl gly y sett settle le laws lawsui uits ts out out of cour courtt in an attem attempt pt to minimize minimize legal costs and avoid adverse publicity. publicity. This has a negative effect effect on the professi profession on when when a CPA CPA firm firm agrees agrees to settle settlement mentss even even though though it believes believes that the firm is not liable to the plaintiffs. plaintiffs. This encourages encourages others others to sue CPA firms where they probably would not to such an extent if the firms had the reputa reputation tion of contes contestin ting g the litigati litigation. on. Theref Therefore ore,, out-of out-of-co -court urt settlements settlements encourage more lawsuits lawsuits and, in essence, increase the auditor’s auditor’s liability because many firms will pay even though they do not believe they are liable. 15. Five general general ways public public accountants accountants can get into into legal difficulty: difficulty: 1.

Misint Misinterp erpret retati ation on or ignora ignorance nce of accou accounti nting ng princip principles. les. The accou accountan ntantt may not have observed the letter and spirit of PSAs, thus not insisting on comple completely tely adequa adequate te disclo disclosur suree of inform informati ation on later later determ determined ined to be important.

2.

Misinterpre Misinterpretation tation or ignorance ignorance of auditing auditing standar standards. ds. The accountant accountant may not know to do some some import important ant part of the audit audit (e.g., (e.g., obtain obtain client client representations and lawyers’ letters.).

3.

Fail Failur uree to imple implemen mentt audi auditt proced procedur ures es prope properl rly. y.

The The acco accoun untan tantt may





Auditor’s Legal Liability 4.

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Failur Failuree to discov discover er client client frau fraud. d. The audi auditor tor may may fail fail to be obser observan vantt or properly skeptical.

5A. Commission Commission of fraud fraud or actual actual participation. participation. The accountant accountant may commit commit an ille illega gall act act such such as acti activel vely y cons conspi piri ring ng with with the the clien clientt to publ publis ish h misleading misleading financial financial statements. statements. Accountants Accountants have also done such things things as offer bribes, fail to file tax returns and commit securities fraud. 5B. Misund Misunders erstand tandings ings of the nature nature of the engagement engagement.. Partic Particular ularly ly in compilation or review engagements, clients might expect more than the accountant thought he agreed to deliver and might claim damages from the accountant. 16. Errors – basically defined as unintentional mistakes, including mathematical or clerical mistakes in the accounting records, mistakes in the application of accounting principles, and oversight or misinterpretation of facts that existed at the time the financial statements were prepared. refers rs to inte intent ntio ional nal dist distor orti tion on of fina financi ncial al stat statem ement ents, s, Irregularities – refe including deliberate misrepresentations by management (sometimes referred to as management fraud), or misappropriations of assets (sometimes referred to as defalcations). Irregularities may result from misrepresentation or omission omission of the effects of events or transactions; manipulations, falsification or alteration of records or documents; omission of significant information from records or docu docume ments nts;; reco record rdin ing g of tran transa sacti ction onss with withou outt subs substa tance nce;; inte intent ntio ional nal misapplications of accounting principles; or misappropriation of assets for the benefit of management, employees or third parties. Clients’ Illegal Acts – are defined in auditing standards as violations of laws or government regulations, not including personal misconduct by client personnel unrelated to their business activities. 17. Audit risk is risk is the risk that the auditor will conclude that the financial statements are fairly stated and issue an unqualified repot when, in fact, the financial statements are materially misstated. An audit failure occurs when the auditor, as a result of his or her failure to follow PSAs, issues an erroneous audit report. 18. There There are many steps individ individual ual practitio practitioner nerss can take to minimize minimize legal legal liability including: • • • • • • •

Deal only with clients possessing integrity. Hire qualified personnel and train and supervise them properly. Follow the standards of the profession. Maintain independence. Understand the client’s business. Perform quality audits. Document the work properly.





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Solutions Manual - Principles of Auditing and Other Assurance Services • • • •

Maintain confidential relations. Carry adequate insurance. Seek legal counsel. Choose a form of organization with limited liability.

19. The expectation gap refers to the difference in the beliefs of auditors and users of financia financiall stateme statements nts concerni concerning ng the role role of the auditor auditor.. Most Most audito auditors rs believe that the conduct of the audit in accordance with GAAS is all that can be expected of them, whereas many users of financial statements believe that the auditor guarantees the financial viability of the company. II. Multiple Choice Questions 1. 2. 3. 4. 5. 6.

b c a b a c

7. 8. 9. 10. 11. 12.

a c a b a d

13. 14. 15. 16. 17. 18.

c d c a a d

19. 20. 21. 22. 23. 24.

b d b c a a

25. 26. 27. 28. 29. 30.

a c c a a c

31. b 32. b

III. Comprehensive Cases Case 1.

The answers provided in this section are based on the assumption that the traditional legal relationship exists between the CPA firm and the third party user. That is, there is no privity of contract, contract, the known versus unknown unknown third party user is not a significant significant issue, and high levels of negligence are required before there is liability. a.

Fals False. e. Ther Theree was no priv privit ity y of contr contrac actt betwee between n Tan and Caña Cañada da,, theref therefore ore,, ordina ordinary ry neglige negligence nce will will usuall usually y not be suffic sufficient ient for a recovery.

b.

True. True. If gross gross negl neglige igence nce is prov proven, en, the the CPA CPA firm firm can can and proba probably bly will be held liable for losses to third parties.

c.

True. See a.

d.

False. False. Gross Gross negli negligenc gencee (constru (constructi ctive ve fraud) fraud) is treate treated d as actual actual fraud fraud in determining who may recover from the CPA.

e.

Fals False. e. JC is is an unkn unknow own n third third part party y and wil willl proba probabl bly y be able able to recover damages only in the case of gross negligence or fraud.

Assuming a liberal interpretation of the legal relationship between auditors and third parties, the answers to a and d would probably probably both both be true. The other answers would remain the same.





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Case 2.

Yes. Normally a CPA firm will not be liable to third parties with whom whom it has neither neither dealt nor for whose benefit benefit its work was performed. performed. One notable notable exce excepti ption on to this rule rule is fraud fraud.. When When the the fina financ ncial ial statem statemen ents ts were were fraudulently prepared, liability runs to all third parties who relied upon the fals falsee info inform rmat atio ion n cont contai ained ned in them. them. Frau Fraud d can can be either either actual actual or constructive. Here, there was no actual fraud on the the part of Dantes or the firm firm in that there was no deliberate falsehood made with the requisite intent to deceive. However, However, it would appear appear that constructive constructive fraud may be present. present. Constructive fraud is found where the auditor’s performance is found to be grossly negligent. That is, the auditor really had either no basis or so flimsy a basis for his or her opinion that he or she has manifested a reckless disregard for the truth. Dantes’ Dantes’ disregard disregard for standard standard auditing procedures procedures would seem to indica indicate te such such gross gross neglige negligence nce and, and, theref therefore, ore, the firm is liable liable to third third parties who relied on the financial statements and suffered a loss as a result.

Case 3.

a. Yes. Yes. Carlos Carlos was was a party party to to the issua issuance nce of false false finan financial cial stat stateme ements nts and as such is a joint tortfeasor tortfeasor.. The elements elements necessary necessary to establish establish an actio action n for for comm common on law frau fraud d are are pres presen ent. t. Ther Theree was was a mate materi rial al missta misstateme tement nt of fact, fact, knowle knowledge dge of falsit falsity y (scient (scienter) er),, intent intent that that the plaintiff bank rely on the false statement, actual reliance, and damage to the bank as a result thereof. thereof. If the action action is based upon fraud fraud there is no requir requiremen ementt that that the bank bank establ establish ish privit privity y of contra contract ct with with the CPA. CPA. Moreover, if the action by the bank is based upon ordinary negligence, which does not require a showing of scienter, the bank may recover as a third-party third-party beneficiary beneficiary (an exception to the strict strict privity privity requirement). requirement). Thus, the bank will be able to recover its loss from Carlos under either theory.

b.

No. The lessor lessor was was a part party y to to the the secre secrett agreem agreement. ent. As such, such, the the less lessor or cannot cannot claim claim relian reliance ce on the financi financial al statem statements ents and cannot cannot recover recover uncollected uncollected rents. Even if he or she was damaged indirectly, indirectly, his or her own fraudulent actions led to his or her loss, and the equitable principle of “unclean hands” precludes him or her from obtaining relief.

c.

Yes. Yes. Carlos Carlos had had knowl knowledge edge that that the the finan financia ciall stateme statements nts did did not not follow follow genera generally lly accepte accepted d account accounting ing princi principle pless and willin willingly gly prepar prepared ed an unqualified opinion. The financial statements were not in accordance with with generally generally accepted accounting accounting principles. principles. That is a criminal act because there was an intent to deceive.

Case 4.

a. Base, Base, Umapas Umapas & Cañada Cañada is pote potentia ntially lly liable liable to its its client client becau because se of the possible negligence of its agent, the in-charge accountant on audit, in carrying out duties that were within the scope of his or her employment. Should there be a finding of negligence, liability would be limited to those losses that would have been avoided had reasonable care been exercised.





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Solutions Manual - Principles of Auditing and Other Assurance Services There being no evidence evidence of the assumption assumption of a greater greater responsibil responsibility, ity, the in-charge in-charge accountant’s conduct is governed governed by the usual standard; that is, that that the the acco account untant ant perf perfor orm m his his or her her duti duties es with with the the prof profes essi sion on’s ’s standards of competence and care. A question of fact arises as to whether the duty of reasonable care was breached when the in-charge accountant faile failed d to inve invest stig igate ate furt furthe herr after after bein being g appr appris ised ed by a compe competen tentt subordinate subordinate of exceptions exceptions to 6 percent of the vouchers vouchers payable examined. examined. Moreover, a question of causation arises as to whether further actions by the in-charge in-charge accountant would would have disclosed disclosed the fraud. If both lack of due care and causation are established, recovery for negligence will be available to the client. b.

In a prop proper erly ly orga organi nized zed liab liabil ility ity partne partners rship hip,, the the part partne ner( r(s) s) and and staf staff f responsible for the engagement and the firm would be liable, as discussed in part a. However, other partners would not be liable.

Case 5.

Ordinarily Ordinarily,, users of financial financial statements, statements, other than those who contracted for the audit and those known in advance to the auditor, may not recover for ordinary ordinary negligence negligence by the auditor auditor in the performance performance of an audit. Recovery Recovery of damages by third parties must must usually be based on fraud. fraud. Actual knowledge of falsity (scienter) is also generally required for an action based on fraud; however, this requirement may be satisfied by the auditor’s reckless disregard for the truth or gross negligence.

It appears that the three deficiencies in the audit by Gonzales & Esteban might be suffici sufficient ent to satisf satisfy y either approac approach. h. Failur Failuree to check the existence existence of certain receivables, collectibility of other receivables, and existence of security investments, taken collectively if not individually, appear to show a reckless disreg disregard ard for the truth truth by the auditor. auditor. In fact, fact, the audit audit probably probably lacks lacks sufficient sufficient competent evidential matter as a reasonable basis for an opinion regarding the financial statements under examination. The audit appears to have been conducted in a woefully inadequate fashion, without regard to the usual auditing standards and procedures necessary to exercise due professional care. Therefore, the auditors were were grossly negligent in the performance of their duties. Case 6.

Corpuz has stated that the CPA firm has “reviewed the books and records of Flores Ventures,” Ventures,” when in fact no such such “review” has occurred. A “review” of financial statements consists of limited investigatory procedures designed to provide statement users with a limited degree of assurance that the financial statements statements are in conformity conformity with generally generally accepted accepted accounting accounting principles. principles. Corpuz Corpuz’s ’s action actionss are similar similar to issui issuing ng an audito auditors’ rs’ report report witho without ut first first performing an audit. Such an action may well well be considered an act of criminal fraud, fraud, intended to mislead users of the financial financial statements. statements. If the financial financial statements of Flores Ventures turn out to be misleading, there is little doubt that any court would find the CPA firm guilty of at least constructive fraud and







Auditor’s Legal Liability

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liable to any third party who sustains a loss as a result of reliance upon the statements. The fact fact that that Corpuz Corpuz violat violated ed Vasqu Vasquez’ ez’ss policy policy of submit submittin ting g all report reportss for Vasquez’s Vasquez’s review would would not lessen the CPA firm’s firm’s liability. liability. The concept of mutual agency allows Corpuz, as a partner, to commit the firm to contracts, including including auditors’ reports reports and accountants’ accountants’ reports. reports. The fact that this report was not submit submitted ted for Vasquez’ Vasquez’ss review review might might be introd introduce uced d as evidence evidence against Corpuz in the event he is accused of criminal fraud. Case 7.

(1) (1) Yes, Yes, but only only to the exten extentt of P70, P70,00 000. 0. Beta Beta is a thir thirdd-pa part rty y benef beneficia iciary ry of the contract contract betwee between n Mega Mega and its auditors auditors,, and may therefore recover from the auditors losses caused by the CPAs’ ordinary negligence. negligence. However, the original P50,000 loan was made prior to Beta’s Beta’s relian reliance ce upon upon the negligen negligently tly audited audited financi financial al statem statements ents.. Thus, Thus, the auditors’ negligence was not the proximate cause of this portion of Beta’s loss. The auditors’ negligence may, may, however, be considered the proximate cause cause of the the P70, P70,00 000 0 loss loss incu incurr rred ed as a resu result lt of reli relianc ancee upon upon the the misleading statements.

(2) The prospects prospects for Manila’s Manila’s recovery recovery of its P30,000 P30,000 loss are are substantially substantially less than than those of Beta. Manila was was not a third-party beneficiar beneficiary y to the contra contract. ct. Thus, Thus, in many many jurisdic jurisdiction tionss follow following ing Ultramares, Manila Ultramares, Manila cannot cannot recove recoverr losses losses attrib attributa utable ble to the CPAs’ CPAs’ ordina ordinary ry neglige negligence. nce. Similarly, it is doubtful that Manila would qualify as a foreseen third party as necessa necessary ry under under the Restatement approa approach. ch. Even Even in a jurisd jurisdict iction ion accepting accepting the Rosenblum the Rosenblum precedent, precedent, which allows third parties to recover recover losses losses caused caused by the auditors’ auditors’ ordinary negligence, negligence, Manila would have to prove prove that that it was a “fores “foreseeab eeable le third third party party relyin relying g upon upon the financial financial statements for routine business purposes.” It is questionable whether the loan loan by Manila Manila was was either either “reaso “reasonabl nably y forese foreseeabl eable” e” or “routi “routine, ne,”” as Manila was a customer of Mega, not a lender.

Chapter 08 Ans

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