Solution manual auditing and services 2e by louwers MODC

Module C - Legal Liability MODULE C Legal Liability LEARNING OBJECTIVES Review Checkpoints Exercises, Problems, and Simulations Identify and describe auditors’ exposure to lawsuits and loss judgments 1, 71 Specify the characteristics of auditors’ liability under common law and cite some specific case precedents 3, 4, 5, 6, 7, 8, 54, 55, 56, 57, 58, 59, 60, 61, 62, 64 (partial) Describe auditors’ liability to third parties under statutory law 10, 11, 12 Specify the civil and criminal liability provisions of the Securities Act of 1933 13, 14, 15, 16, 17 65 (partial), 66, 73 Specify the civil and criminal liability provisions of the Securities Exchange Act of 1934 18, 19, 20, 21, 22 64 (partial), 65 (partial), 67, 68, 69 Understand recent developments that affect auditors’ liability to clients and third parties 23, 24, 25, 26 63, 70, 72 MODC-1 Module C - Legal Liability SOLUTIONS FOR REVIEW CHECKPOINTS C.1 Auditors owe clients the responsibility to perform services in accordance with the contract (engagement letter) and to conduct the audit in accordance with generally accepted auditing standards Auditors owe third parties the responsibility of conducting the audit in accordance with generally accepted auditing standards In each of these situations, auditors can be held liable if their failure to perform in accordance with the contract or generally accepted auditing standards results in an economic loss to clients or third parties C.2 Common law liability uses legal precedent to identify the responsibility of parties in situations where there is no violation of a written law or statute Clients and nonshareholder third parties can bring suit against auditors for common law liability Statutory liability involves the violation of a written law Third-party shareholders can bring suit against auditors for statutory liability C.3 Under common law liability, clients can bring suit against auditors for either breach of contract or tort actions Prior to bringing suit, clients must demonstrate: They suffered an economic loss Auditors did not perform in accordance with the terms of the contact (for breach of contract) Auditors failed to exercise the appropriate level of professional care (for torts) The loss was the result of the breach of contract or failure to exercise the appropriate level of professional care C.4 Auditors owe clients the responsibility for conducting the audit using the appropriate level of professional care If they not so, they have tort liability for ordinary negligence, gross negligence, or fraud C.5 To bring suits against auditors under common law, third parties must demonstrate: C.6 They suffered an economic loss Auditors failed to exercise the appropriate level of professional care The financial statements were materially misstated The loss was caused by reliance on the materially misstated financial statements The Ultramares Corp v Touche case concludes that if auditors conduct their work with such gross negligence as to amount to constructive fraud or constructive deceit, they may be liable for damages The decision, and also a part of the “rule” from Ultramares, was that auditors are not liable to unidentified third parties for ordinary negligence One can infer that liability for ordinary negligence might be imposed when third-party beneficiaries are known (but this was not explicit in the court opinion) The Ultramares rule(s) is (are) being eroded today No longer is privity the shield that it was in 1931, and auditors are being held responsible for a greater degree of care However, in some states, the Ultramares view is still in effect MODC-2 Module C - Legal Liability C.7 Privity refers a situation in which parties have a contractual relationship Auditors owe contracting parties (e.g clients) a duty to perform the audit with the appropriate level of professional care Liability can be imposed for situations in which auditors exhibit ordinary negligence A primary beneficiary is the party an accounting service is intended to benefit The distinguishing feature of a primary beneficiary is that this party is either named in the contract or auditors know of this party by name Auditors are generally liable to primary beneficiaries for ordinary negligence Foreseen parties are groups or individuals that client intends the information to benefit and that could reasonably be expected to rely on auditors’ work In certain jurisdictions, auditors can be liable to foreseen parties for ordinary negligence when the plaintiff justifiably relied on the information and suffered a loss on such reliance Foreseeable parties are the creditors, investors, or potential investors that might be expected to rely on auditors’ work In some jurisdictions, auditors can be liable to foreseeable parties for ordinary negligence C.8 Auditors’ defenses against clients under common law include: Auditors exercised the appropriate level of professional care (torts) or performed the engagement in accordance with the terms of the contract (breach of contract) The client’s economic loss was caused by a factor other auditors’ failure to demonstrate an appropriate level of professional care or breach of contract (causation defense) Actions on the part of the client were, in part, responsible for the loss (contributory negligence) Auditors’ defenses against third parties under common law include: The third party did not have appropriate standing to sue in the jurisdiction The third party did not rely on the financial statements The third party’s economic loss was caused by other events beyond auditors’ scope of responsibility Auditors’ work was performed in accordance with professional standards (GAAS) C.9 In lawsuits related to compilation and review, accountants can use the proper disclaimers, which were presented in the non-audit service report, as an additional defense to insulate them from lawsuits from third parties C.10 Regulation S-X contains requirements for audited annual and unaudited interim financial statements filed with the SEC Regulation S-K contains requirements relating to all other business, analytical and supplementary financial disclosures in SEC filings Financial Reporting Releases are SEC staff reports that express new rules and policies about accounting and disclosures required or encouraged by the SEC MODC-3 Module C - Legal Liability Staff Accounting Bulletins contain unofficial but important interpretations of Regulation S-X and Regulation S-K by SEC staff C.11 Under the integrated disclosure system, the required annual report to shareholders (prepared in conformity with Regulation S-X and S-K) can be used as the core of the 10-K annual report required by the Securities Exchange Commission C.12 Liability under statutory law arises when purchasers or sellers of securities suffer an economic loss and the financial statements contain a material misstatement C.13 Section 11 of the Securities Act of 1933 effectively shifts the burden of proof regarding the appropriate level of professional care during the examination to auditors, whereas this proof is the plaintiff’s duty under common law Furthermore, the plaintiff does not have to be in a privity relationship or known third-party beneficiary relationship with auditors Also, the plaintiff does not have to prove reliance on the materially misstated financial statements or that the loss resulted from the materially misstated financial statements C.14 In a civil suit under section 11 of the Securities Act of 1933, the plaintiff only has to prove that a loss was suffered and that the financial statements contained a material misstatement To avoid liability, the defendant auditors can either prove that (1) the engagement was conducted according to GAAS (“due diligence” defense) or (2) the loss was caused by other factors C.15 Section 11 of the Securities Act of 1933 holds officers, directors, and underwriters to a lesser degree of responsibility for information that is presented on the authority of an expert (such as auditors) As a result, they may rely on the expert and not be held responsible for conducting a reasonable investigation on their own Therefore, as auditors assume more responsibility for this type of information, officers, directors, and underwriters have less responsibility C.16 Section 17 of the Securities Act of 1933 is the antifraud provision relating to the offer or sale of securities Section 24 of the Securities Act of 1933 defines criminal penalties and relates to willful violation of duties with respect to a statutory registration or requirement to register a sale of securities C.17 In Escott v BarChris Construction Corp., the court concluded that auditors did not conduct an appropriate review of subsequent events and, in fact, did not perform steps included in the audit program C.18 Under the Securities Exchange Act of 1934, purchasers or sellers of securities can bring suit by proving: C.19 They suffered an economic loss The financial statements were materially misstated The loss was caused by reliance on the materially misstated financial statements Auditors were aware that the financial statements were materially misstated Auditors’ defenses under the Securities Exchange Act of 1934 are that they acted in good faith and had no knowledge of the material misstatements MODC-4 Module C - Legal Liability C.20 Under section 32 of the Securities Exchange Act of 1934, criminal penalties include fines of up to $5 million and imprisonment for up to 20 years (these levels represent increases provided by the Sarbanes-Oxley Act) In addition, violations of the provisions of Securities Exchange Act of 1934 by entities other than natural persons (such as accounting firms) are punishable by fines up to $25 million C.21 Scienter is the intent or knowledge of inappropriate actions prior to committing those actions (for example, if auditors have knowledge of misstatements in the financial statements and intentionally fail to disclose these misstatements in their reports) Ernst & Ernst v Hochfelder and Denise L Nappier et al v PricewaterhouseCoopers both concluded that parties could not recover damages against auditors because they were unable to demonstrate scienter on the part of the defendants C.22 The major differences between auditors’ liability under the Securities Act of 1933 and Securities and Exchange Act of 1934 are: C.23 C.24 The Securities Act of 1933 applies to original purchasers of securities under a registered offering while the Securities and Exchange Act of 1934 applies to purchasers and sellers of securities under ongoing exchanges after the initial offering Auditors are liable for ordinary negligence, gross negligence, or fraud under the Securities Act of 1933; they are only liable for gross negligence or fraud under the Securities Exchange Act of 1934 Auditors have the burden of proof under the Securities Act of 1933; plaintiffs (purchasers or sellers of securities) have the burden of proof under the Securities Exchange Act of 1934 Under the Securities Act of 1933, auditors’ defenses are that a GAAS audit was conducted or the loss was caused by other factors; under the Securities and Exchange Act of 1934, auditors’ defenses are that the audit was conducted in good faith and auditors were not aware of the materially misstated financial statements Some of the major changes in auditors’ liability under Sarbanes-Oxley include: Extending the statute of limitations for bringing a suit under the Securities and Exchange Act Increasing both the monetary fines and imprisonment penalties for violations of the Securities and Exchange Act Increasing the imprisonment penalties for mail fraud and wire fraud Providing monetary fines and imprisonment penalties for the alteration and destruction of documents Increasing the period over which records must be retained by accounting firms Joint and several liability is a doctrine that allows a successful plaintiff to recover the full amount of a damage award from the any defendant(s), regardless of the defendant’s relative degree of fault Proportionate liability only permits recover from defendant(s) based on their relative degree of fault MODC-5 Module C - Legal Liability C.25 The Private Securities Litigation Reform Act provided the following terms for proportionate liability: The total responsibility for loss is divided among all parties responsible for the loss However, if other defendants are insolvent, a solvent defendant’s liability is extended to 50 percent more than the proportion found at trial Only the defendants who knowingly committed a violation of securities laws remain jointly and severally liable for all the plaintiffs’ damages The Class Action Fairness Act expanded federal jurisdiction over class action lawsuits and moves many class action cases from state courts to federal courts C.26 To reverse the perceived concerns with the Private Securities Litigation Reform Act (attorneys filing securities class action lawsuits in state courts that follow joint and several liability doctrines), Congress enacted the Securities Litigation Uniform Standards Act This act’s most significant provision requires that class action lawsuits with 50 or more parties must be filed in the Federal courts SOLUTIONS FOR MULTIPLE CHOICE-QUESTIONS C.27 C.28 C.29 a Incorrect b c Incorrect Incorrect d Correct a Incorrect b Incorrect c Incorrect d Correct d Correct Constructive fraud represents reckless behavior, not a lack of reasonable care Fraud represents intention to deceive Gross negligence is similar to constructive fraud and represents lack of minimal care Ordinary negligence represents lack of reasonable care and is often proven by demonstrating that auditors failed to follow GAAS in conducting the audit Joint and several liability can impose the entire amount of loss in a case against auditors, which is less favorable than proportionate liability The reasonably foreseeable user approach provides auditors with the greatest exposure to liability to third parties for ordinary negligence The foreseen third party approach is more favorable to auditors than the reasonably foreseeable approach, but auditors may still be exposed to the entire amount of the loss Proportionate liability is most favorable to auditors because they will only be liable for damages to the extent they were found to be at fault The difference between the perception of the users of the statements and auditors’ knowledge of the audit objective is known as the expectations gap One common example of the expectations gap is users’ belief that a GAAS audit will uncover all instances of fraud MODC-6 Module C - Legal Liability C.30 C.31 C.32 C.33 C.34 a Incorrect Breach of contract depends solely on the performance of auditors and the client per the contract (engagement letter) A tort is a lawsuit filed by the plaintiff who believes that they have suffered damage due to another party’s failure to exercise the appropriate level of professional care Securities litigation is a term that defines criminal and civil actions regarding unfair or criminal practices in the purchase or sale of securities Constructive fraud is a term used to define repetitive actions that show a pattern of recklessness or disregard for the truth or other party’s well being While constructive fraud may be the cause of the losses, the wording in the question does not suggest that such a fraud occurred b Correct c Incorrect d Incorrect a Incorrect b Incorrect c Correct d Incorrect a Correct b Incorrect c Incorrect d Incorrect a Incorrect b Correct c Incorrect d Incorrect a Correct b Incorrect The Credit Alliance view holds auditors responsible to primary beneficiaries for ordinary negligence, who are identified and known to name by auditors This is the broadest view of privity, as defined by Rosenblum, Inc v c d Incorrect Incorrect This is the restatement of torts view of privity Since (a) is a correct response, this is not correct This is the total amount of the loss, and auditors were not determined to be 100% at fault Auditors’ liability cannot be zero because they were found to be partially at fault Auditors pay 45%, which is the 30% at fault plus another 15% (or 50% of the level at fault) because they are the only solvent defendant Since auditors are the only solvent defendant, liability is not limited to the 30% at fault (see (c) above) When auditors knowingly commit violations, the joint and several liability doctrine applies, and auditors pay all the damages as the only solvent defendant See (a) above Under proportionate liability, auditors would be liable for some extent of the damages, even if they did not knowingly commit the violations See (a) above The fact that auditors knowingly committed these violations make them liable for the entire amount of the damages See (a) above The fact that auditors knowingly committed these violations make them liable for the entire amount of the damages The accountant and client have a privity relationship for the consulting services The accountant’s best defense would be to prove that the client did not carry out its part of the recommendations from the consulting work Plaintiffs can always measure some damages, and suit would not be brought if the client did not have good reason to measure damages While the accountant can argue that the work was done properly, choice (b) would provide a better defense Adler MODC-7 Module C - Legal Liability C.35 a Correct b Incorrect c Incorrect d Incorrect C.36 a Correct A prospectus is a set of information available to prospective investors that is required by the SEC This information includes the entity’s financial statements C.37 a b c d Incorrect Incorrect Incorrect Correct Because the selection “both” is correct (choice d) Because the selection “both” is correct (choice d) Because the selection “both” is correct (choice d) Both laws contain both civil and criminal liability sections C.38 a Incorrect b Incorrect c d Incorrect Correct Foreseeable third parties are parties that might use auditors’ work; however, they are not known to auditors by name Foreseen third parties are parties that might reasonably be expected to use auditors’ work; however, they are not known to auditors by name There is no designation known as “general third party” Primary beneficiaries are known by name to auditors and, in some cases, are specifically identified in the contract (engagement letter) a Incorrect b Incorrect c Correct d Incorrect C.39 The engagement letter obtained at the beginning of the engagement is the most effective method of expressing the nature of limits on compilation and review engagements Compilation and review engagements not result in the preparation of auditors’ opinions Reporting the nature of the work at the conclusion of the engagement is not as effective as doing so in the engagement letter at the beginning of the engagement (see (a) above) Management letters are delivered at the conclusion of the engagement, so as in (c) above, reporting the nature of the work at the conclusion of the engagement is not as effective as doing so at the beginning of the engagement Privity is not a necessary condition to bring suit under the Securities Exchange Act of 1934 Prior to bringing suit, the investor would need to demonstrate that a loss was suffered These are appropriate defenses under the Securities Exchange Act of 1934 and demonstrate lack of scienter Entities are required to file financial statements with the Securities and Exchange Commission for their shares to be traded on national exchanges MODC-8 Module C - Legal Liability C.40 C.41 C.42 C.43 C.44 NOTE TO INSTRUCTOR: Since this question asks which of the statements is not true, the response labeled “correct” is not true and those labeled “incorrect” are true a b Incorrect Incorrect c Correct d Incorrect a Incorrect b Incorrect c Incorrect d Correct a Incorrect b Incorrect c Incorrect d Correct a Correct b Incorrect c Incorrect d Incorrect a Incorrect b Incorrect c Correct d Incorrect The Securities Act of 1933 relates to the initial issuance of securities Auditors’ liability typically arises because of their involvement with audited financial statements Third parties are only required to demonstrate that the financial statements are materially misstated; they are not required to demonstrate reliance on these financial statements Auditors are liable for ordinary negligence under the Securities Act of 1933 Information related to auditor changes is not required to be disclosed in the 10-K annual report Information related to auditor changes is not required to be disclosed in the S-1 registration statement Information related to auditor changes is not required to be disclosed in the 10-Q quarterly reports Information related to auditor changes is one of the “special events” entities must report on Form 8-K Section 11(b)(A) requirement seems to be satisfied, since the chair produced the information about the planned use of the proceeds, made a reasonable investigation, and the information is not made on the authority of another “expert.” Section 11(b)(B) requirement seems to be satisfied, since the consulting engineer is an expert and made a reasonable investigation connected with his or her own work Section 11(b)(C) requirement seems to be satisfied, since the president relied on the work of the consulting engineer expert and had no reason to believe the engineer’s report was erroneous In this case, while the officers relied on auditors’ work, they were aware of materially misstated financial statements and, therefore, liable under Section 11(b)C Under both common law and section 10(b), plaintiffs must prove they suffered losses Unlike common law, section 10(b) does not have a privity requirement (“any purchaser or seller” can sue the accountants) Under both common law and section 10(b) plaintiffs must prove reliance Under both common law and section 10(b) plaintiffs must prove their reliance caused their losses Credit Alliance v Arthur Andersen established auditors’ liability to primary beneficiaries for ordinary negligence Fleet National Bank v Gloucester Co established auditors’ liability to foreseen third parties for ordinary negligence Rosenblum, Inc v Adler established auditors’ liability to foreseeable third parties for ordinary negligence, which provides broader exposure for auditors than the groups in choices (a) and (b) Ultramares did not establish any exposure for auditors to liability to third parties for ordinary negligence, just gross negligence or fraud MODC-9 Module C - Legal Liability C.45 C.46 C.47 C.48 C.49 C.50 a Incorrect b Incorrect c Correct d Incorrect a Incorrect b c Incorrect Correct d Incorrect a, b, c Incorrect d Correct a Incorrect b c d Incorrect Incorrect Correct a Correct b Incorrect c Incorrect d Incorrect a b c d Correct Incorrect Incorrect Incorrect While this is a difference between these two acts, (b) is also a difference; therefore, the best answer is (c) While this is a difference between these two acts, (b) is also a difference; therefore, the best answer is (c) Both the burden of proof and required level of professional care differ across the two acts See (c) above The SEC does not guarantee or represent that the information in the registration statement is true Registration is not insurance against loss from the investment Financial information that has been examined by independent auditors is either included in the registration statement or incorporated by reference Inside information about the entity’s trade secrets is not provided in the registration statement (If it were, it would no longer be inside information!) These are all elements of lawsuits under common law that must be proved by the plaintiffs prior to brining suit As a result, they would not be available as defenses for auditors While the plaintiff has the responsibility to prove AOW failed to exercise the appropriate level of professional care, conducting the audit in accordance with generally accepted auditing standards would be an effective defense Regulation D governs the nonpublic issuance of securities to limited groups of investors Form 8-K is the periodic special events report Form SB-1 is one registration forms of the Securities Act of 1933 Regulation S-X is the compendium of accounting rules that governs the form and content of Forms 10-K and 10-Q The Ernst & Ernst v Hochfelder case related to the failure of plaintiffs to prove scienter The Escott v BarChris Construction Corp case demonstrated ordinary negligence on the part of auditors in a review of subsequent events Smith v London Assurance Corp was related to ordinary negligence on the part of auditors in failing to identify an embezzlement scheme occurring at a client The Ultramares case was related to auditors’ liability for ordinary negligence (and not scienter) to third parties Form 10-K is the annual report Form 10-Q is the quarterly report Form 8-K is the periodic special events report Regulation S-X provides guidelines for the content of financial information submitted to the SEC MODC-10 Module C - Legal Liability C.51 a Incorrect b Correct c Incorrect d Incorrect C.52 c Correct C.53 NOTE TO INSTRUCTOR: Since this question asks which of the statements is not true, the response labeled “correct” is not true and those labeled “incorrect” are true a Correct b Incorrect c Incorrect d Incorrect Scienter must be demonstrated under the Securities Exchange Act of 1934; under the Securities Act of 1933, auditors are responsible for ordinary negligence Plaintiffs must establish that the financial statements were materially misstated Proving reliance on the materially misstated financial statements is not necessary Proving that reliance on the materially misstated financial statements caused the loss is not necessary Sarbanes-Oxley Act is the common name for the United States Public Company Reform and Investor Protection Act of 2002 The Sarbanes-Oxley Act does not include new definitions or situations that constitute securities fraud The amendments in the Act provide greater penalties for auditors, but not increase auditors’ responsibilities for identifying fraud The Sarbanes-Oxley Act requires that the CEO and CFO certify the financial statements The Sarbanes-Oxley Act specifies penalties for destruction of records in federal investigations for both accounting firms and auditors The Sarbanes-Oxley Act increases penalties for mail fraud and criminal violations of the Securities Exchange Act of 1934 SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS C.54 Breach of Contract a Auditors can be in breach of contract for:  Failing to meet established deadlines  Failing to provide the services described in the contract  Charging fees differently then agreed in the contract b Clients can be in breach of contract for:  Failing to provide documents as agreed in the contract  Failing to pay audit fees in a manner described in the contract  Failing to make available key personnel as agreed in the contract  Failing to disclose information known by management (e.g known frauds) as agreed in the contract c The best defenses are:  There is no breach of contract (i.e., auditors met all the contract provisions)  The breach of contract was due to the client’s failure to perform as specified under the contract  Fulfillment of the contract became impossible because of circumstances beyond auditors’ control (for example, auditors cannot be liable for breaching a provision of a contract to count inventory held in a warehouse if the inventory was destroyed) MODC-11 Module C - Legal Liability C.55 Common Law Responsibility for Errors and Fraud a Yes, a weakness in internal control exists It may be considered a material weakness because the compensating control (internal auditors’ work on slow-moving inventory) did not operate in a timely enough manner to detect the irregularity before it had gotten large If Ritter is a public entity registered under the Securities Exchange Act of 1934, it may have violated the accounting and internal control provisions of the Foreign Corrupt Practices Act If a material weakness in internal control exists, Huffman & Whitman are obligated to report it to management and/or the board of directors and issue an adverse opinion on their report on their audit of internal controls b C.56 The problem description indicates that this portion of the audit was conducted without the appropriate level of professional care While sampling transactions is acceptable under generally accepted auditing standards, Whitman’s follow-up and explanation of the missing receiving reports leaves much to be desired At the very least he could have reviewed the reports produced by Lock at a later date, and he could have traced the purchases to the inventory records and perhaps noticed an over-stocking condition Auditors had some evidence that fraud might exist, but it appears that they failed to apply extended audit procedures properly Common Law Responsibility for Errors and Fraud Donovan’s responsibility under generally accepted auditing standards is to plan the audit to detect errors and frauds that would have a material effect on the financial statements Whether McCoy would prevail depends upon two questions: (1) The materiality of the undiscovered embezzlement and whether it was concealed by falsifying the financial statements and (2) Donovan’s planning and performance of appropriate audit procedures If the amount is material, Donovan is potentially liable If Donovan performed a careful audit exercising the appropriate level of professional care, liability probably would not attach If not, Donovan might be found guilty of ordinary negligence and liable to McCoy with whom he had a privity relationship All the common law features (damage, reliance, cause, failure to perform with the appropriate level of professional care, and privity) are present The actual resolution of liability is only a matter of their degree McCoy, however, can be faulted (although probably not in a contributory negligence sense) for not informing Donovan about the anonymous letter Donovan should have obtained signed representations in which McCoy asserted he knew of no errors or frauds that he had not told Donovan With such signed representations, Donovan might not be found liable at all Even if Donovan is judged liable, McCoy could probably recover only the embezzled amounts after the audit ($65,000) but not the amounts embezzled prior to the audit ($40,000) MODC-12 Module C - Legal Liability C 57 C.58 Auditors’ Liability for Fraud a Auditors will be liable for fraud to all third-party users of financial statements under common law or statutory law b Fraud is a misrepresentation of fact that the individual knows to be false Constructive fraud (sometimes referred to as gross negligence) is the failure to provide any care in fulfilling a duty owed to others The primary difference between these two levels of professional care is actual knowledge on the part of auditors, which is present under fraud but not under constructive fraud c Auditors will be liable for constructive fraud to all third-party users under common law and the Securities Act of 1933 To be held liable under the Securities Exchange Act of 1934, scienter (or intent and knowledge) must be shown While scienter may be present in situations representing constructive fraud, this will not always be the case d Clearly, auditors should be liable in cases where they intend to deceive While intention is not present under constructive fraud, the level of performance and lack of care is so great that it seems appropriate to hold auditors liable for constructive fraud Audit Simulation: Accusation of Fraud a In this case, a claim for fraud does not appear to exist To show fraud auditors would have to: Be aware that the inventory amounts were incorrect and not require adjustment of these amounts or modification of the auditors’ opinion Conclude that the inventory amounts were fairly stated without performing any auditing procedures (reckless disregard for the truth); Neither of these actions can be shown from the information provided The failure to adequately review the inventory is more likely classified as ordinary negligence, or possibly gross negligence, rather than fraud b If auditors were charged with fraud their defenses would include: They performed the audit of inventory in accordance with generally accepted auditing standards; Management perpetrated the fraud, which included the objective of defrauding auditors; There was no intent or pattern of behavior on the part of auditors that indicates that they committed a fraud MODC-13 Module C - Legal Liability C.59 C.60 Common Law Liability Exposure a Creditors appear to be claiming that auditors knew the financial statements were not presented in accordance with generally accepted accounting principles b If action is brought based on fraud, the lack of privity would not be an important issue Auditors are liable to all parties under common law in instances where they commit fraud c Yes, the firm is liable to the creditors, because the firm was aware of the failure to disclose the cash received as well as the contingent liability Common Law Liability Exposure a Under a privity of contract definition, Risk Capital will not prevail Under the strict privity rule, parties must be signer of a contract to have a standing to sue for ordinary negligence Therefore, regardless of whether Wilson and Wyatt committed ordinary negligence, Risk Capital has no legal standing to sue Wilson and Wyatt for ordinary negligence b While debatable, under a strict primary beneficiary standard, Risk Capital will not likely prevail In the case of Credit Alliance v Arthur Andersen (1985), the court held that auditors are not liable for ordinary negligence to third parties unless (1) auditors were aware that a particular third party intended to rely on the auditors’ opinion and the financial statements, (2) the third party was specifically identified to auditors, and (3) some action by auditors showed they acknowledged the third-party’s identification and intent to rely on the opinion and financial statements For example, auditors could include the name of the bank and acknowledge its intended use of the financial statements in the engagement letter While elements (1) and (2) are present, it does not appear that element (3) is present (acknowledgement of the third-party’s identification) In addition, the standing of Risk Capital would vary depending upon the jurisdiction in which the case is heard NOTE TO INSTRUCTOR: There is likely to be some debate about element (3) An effective extension of this part of the problem would be to identify what type of action(s) on the part of auditors would satisfy element (3) c Under the foreseen party standard defined by restatement of torts, Risk Capital will prevail The restatement of torts extends liability for ordinary negligence to “foreseen” third parties not explicitly known to auditors Under this approach, auditors may be subject to claims for ordinary negligence if they know that the auditors’ opinion and financial statements will be delivered to unidentified investors and creditors Specific acknowledgement is not required Auditors must only be aware that the auditors’ opinion and financial statements will be used by some third party In this instance, the contact clearly specified Risk Capital and the use of the financial statements As a result, Risk Capital would be classified as a foreseen third party (if not a primary beneficiary) MODC-14 Module C - Legal Liability C.61 Common Law Liability Exposure a Yes, Smith will be liable to the bank The elements necessary to establish an action for liability for fraud under common law are clearly present There was a material misstatement in the financial statements, intent and knowledge of the misstatements (scienter), actual reliance by the bank on the materially misstated financial statements, and economic damages resulting from that reliance If action is based upon fraud, there is no requirement that the bank establish privity of contract with Smith If the action by the bank is based on ordinary negligence, the bank may still be in position to bring suit, depending upon the extent to which Smith was aware that his work would be used by the bank and the jurisdiction in which this case occurred Based on the facts presented, it is difficult to determine whether the bank is a primary beneficiary However, because Smith was aware that the financial statements would be used to obtain a loan, the bank would appear to be at least a foreseen third party and could prevail under the restatement of torts doctrine C.62 b No, Smith will not be liable to the lessor because the lessor was a party to the “secret” written agreement As such, the lessor cannot claim reliance on the financial statements and cannot recover uncollected rents Even if the lessor was damaged indirectly, his own fraudulent actions led to his loss, and the equitable principle of “unclean hands” (“contributory negligence”) precludes him from obtaining relief c Smith was not independent with respect to the audit of Juniper The lack of independence is raised by Juniper’s threat to sue Smith in the event the loan was not obtained Liability in a Review Engagement a Hotshot in its own right may bring an action, or the other stockholders may bring a derivative action against Mason & Dilworth on behalf of the corporation, for failure to exercise the appropriate level of professional care in failing to detect the fraud A lawsuit based on constructive fraud might be brought against Mason & Dilworth, because the conduct of the review may be characterized as gross negligence with reckless disregard for the truth Individual shareholders and lending institutions will claim this is the case, and if upheld, privity of contract will not be a valid defense b Third-party financial institutions have rights to sue accountants for failure to exercise the appropriate level of professional care in performing review engagements As a general rule, third parties, even though not direct parties to a contract, may successfully assert ordinary negligence if they can show that they are members of a class of persons intended to benefit from the services performed by the auditors and that their use of the statements was reasonably foreseeable by the auditors MODC-15 Module C - Legal Liability C.63 C.64 Class Action Lawsuits a A class action lawsuit occurs when a group of individuals come together as plaintiffs in a common action against an defendant b Individually, plaintiffs involved in a class action may not have been able to hire an attorney because the amount of their claim was small and did not justify the cost Collectively, however, there may be significant numbers of plaintiffs for an attorney to justify the time commitment for such an action In addition, when a class includes a large number of plaintiffs from many jurisdictions, the plaintiffs’ attorney may choose to initiate the action in a jurisdiction that is the most “friendly” to the plaintiffs c All of the advantages to plaintiffs in (b) can be viewed as disadvantages to defendants In addition, the mere fact that a class action suit makes litigation more likely to occur is a significant disadvantage d The Class Action Fairness Act of 2005 moves many class action lawsuits to federal court where defendants may have a better opportunity to defend themselves In addition, the Securities Litigation Uniform Standards Act requires class action lawsuits with 50 or more parties to be filed in federal courts The inability for the plaintiffs to select the court (and jurisdiction) in which the case will be heard will likely deter many class action lawsuits e The discussion here will vary depending on the case identified by the student Instructors should be sure to emphasize the fact that a small number of disgruntled plaintiffs can expose auditors to liability to a large number of individuals Liability under Common Law and the Securities Act of 1933 a Union Bank will likely be successful in its ordinary negligence suit against Weaver To be successful in a lawsuit for ordinary negligence under common law, Union Bank must show that it (1) suffered an economic loss, (2) Weaver failed to exercise the appropriate level of professional care, (3) the financial statements contained material misstatements, and (4) Union Bank’s loss was caused by reliance on the materially misstated financial statements Weaver was guilty of ordinary negligence in performing the audit by not confirming accounts receivable, which resulted in failing to discover the overstatement of accounts receivable Weaver’s failure to confirm accounts receivable violated generally accepted auditing standards and represented ordinary negligence Because Union Bank relied on these financial statements in granting the loan, and because Weaver knew that Union Bank would be provided with the financial statements in this decision process, Union Bank assumed the role of a primary beneficiary Auditors are generally liable to primary beneficiaries for acts of ordinary negligence Union Bank will be successful in its fraud suit against Weaver To be successful in a lawsuit for fraud under common law, Union Bank must demonstrate the same four factors as in part (1) In addition, to demonstrate fraud, Union Bank must prove that Weaver was aware of the material misstatement (in this case, the failure to disclose information about the product liability lawsuit) MODC-16 Module C - Legal Liability C.64 Liability under Common Law and the Securities Act of 1933 (Continued) b Butler’s stockholders who purchased stock under the preferred stock offering will also be successful in their suit against Weaver under section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 Under the Act, the purchaser of securities must demonstrate that: They suffered an economic loss The financial statements were materially misstated The loss was caused by reliance on the materially misstated financial statements Auditors were aware that the financial statements were materially misstated Weaver’s failure to qualify the auditors’ opinion for Butler's potential legal liability was material and done with intent and knowledge (scienter) Weaver will be liable for losses sustained by the purchasers who relied on Weaver’s opinion C.65 Audit Simulation: Liability under the Securities Acts a After the sale, Fancy will have total assets of greater than $10 million and more than 500 shareholders; as a result, Fancy will be required to register under the Securities Exchange Act of 1934 and file reports on Forms 10-K, 10-Q, and 8-K Fancy will become a public, “reporting” entity (Fancy will also be subject to the insider trading, proxy solicitation, and other requirements.) NOTE TO INSTRUCTOR: These dollar amounts and number of shareholders are subject to change b Any purchaser can sue the entity for failure to file the required registration statement and would be in position to receive a refund of their purchase price Fancy would also be liable for willful violation of the Securities Act of 1933, which exposes them to monetary fines and imprisonment c Accredited investors include the following:       Financial institutions, such as banks, savings and loans, and insurance companies Private business development companies 501(c)(3) charitable organizations Directors, general partners, or officers of the registrant Individuals with wealth in excess of $1 million, individual income in excess of $200,000, or joint income in excess of $300,000 Trusts with assets in excess of $5 million An offering under Regulation D is exempt from registration requirements under the Securities Act of 1933 Under Regulation D, the securities can be sold to an unlimited number of accredited investors (as defined above) and up to 35 additional non-accredited investors MODC-17 Module C - Legal Liability C.66 Audit Simulation: Section 11 of Securities Act of 1933: Liability Exposure Yes, May, Clark & Company would be liable The situation is covered by the Securities Act of 1933 Some of the key elements are as follows:  Because the Securities Act of 1933 allows any purchaser to bring suit, privity is not available as a defense to May, Clark & Company  Chriswell Corporation’s financial statements were materially misstated  The fact that the market price of the debentures declined following the disclosure of the material misstatements suggests causation However, it is important to note that demonstrating causation is not necessary to bring suit under the Securities Act of 1933  While May, Clark & Company made inquiries of the financial vice president and controller regarding material changes in Chriswell’s financial position since the date of the audit, it made no reasonable effort to verify the results of these inquiries This would likely be viewed as a violation of generally accepted auditing standards and, therefore, ordinary negligence on the part of Mary, Clark & Company Since May, Clark & Company are responsible up to the effective date of the registration statement, they would likely be liable Chriswell Corporation and its officers would also be liable C.67 Rule 10b-5 Liability under the Securities Exchange Act of 1934 a The case should be dismissed A suit under section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 must establish fraud or scienter Fraud is an intentional tort and as such requires more than failure to exercise the appropriate level of professional care Although the audit was admittedly performed without the appropriate level of professional care, Gordon & Groton neither participated in the fraudulent scheme nor did they know of its existence The element of scienter must exist in order to state a cause of action for fraud under section 10(b) of the Exchange Act 1934, although auditors may have potential exposure for gross negligence even in the absence of scienter (Refer to the Ernst & Ernst v Hochfelder decision.) b The plaintiffs might have stated a common law action for ordinary negligence However, they may not be able to prevail due to the privity requirement There was no contractual relationship between the defrauded parties and Gordon & Groton Although the exact status of the privity rule is unclear, it is doubtful that the level of ordinary negligence in this case would extend Gordon & Groton’s liability to the customers who transacted business with Bank & Company However, the facts of the case as presented in court would determine this MODC-18 Module C - Legal Liability C.68 Audit Simulation: Independence and Securities Exchange Act of 1934 a One of the important concepts governing auditors’ independence is that auditors should not be in a position of serving as advocates for their clients Testifying in court on behalf of the client’s damage claim is perilously close to serving as an advocate, although many auditors will claim that litigation support services (in general) are appropriate and not impair independence While the litigation consulting itself may not impair independence, independence is likely impaired by the unpaid consulting fee of $265,000 AICPA interpretations and rulings hold that past due fees may impair auditors’ independence in certain situations C 69 b Violations of generally accepted auditing standards are based on the failure of auditors to exercise the appropriate level of professional care (third general standard) This violation is based on Ward (and, therefore, AOW) not insisting upon disclosure of the appeal of the Civic case, improper deferral of losses on new product start-up costs, and inappropriate accrual of sales revenue c Ward and AOW appear to have violated section 10(b) by being actively involved in using a “scheme or artifice to defraud,” namely management’s issuing the materially misstated financial statements with full knowledge of the auditors Ward, and hence AOW, acted with scienter which is required by section 10(b) In addition, Ward, by willfully enabling the 10-K to be filed with the SEC, seemingly violated section 32 of the Securities Exchange Act of 1934 by knowingly causing materially misstated statements to be filed (the financial statements and the auditors’ opinion) Audit Simulation: Auditors’ Liability under Securities Exchange Act of 1934 a b Because Adam is a purchaser of securities of an established registrant, the most likely basis for suit would be under statutory law violations of the Securities Exchange Act of 1934 Adam’s attorney can bring suit against auditors as follows: Fraud under the Securities Exchange Act of 1934, section 10b-5 In Ernst & Ernst v Hochfelder, the court’s decision indicated that reckless professional work might be a sufficient basis for 10b liability even though scienter is not clearly established Therefore, if Adam’s attorney could prove that auditors acted recklessly (i.e., with gross negligence), he might recover loss from auditors Criminal liability under the Securities Exchange Act of 1934, section 32 Under United States v Natelli (1975), Adam’s attorney must prove that auditors acted willfully and knowingly The auditors’ attorney can use the following defenses to protect auditors from legal liabilities With respect to civil liability, auditors’ primary defenses are that they acted in good faith and had no knowledge of the material misstatements With respect to the criminal charges, because the burden of proof was provided by the plaintiff’s attorney, the auditors’ attorney should prove that the evidence does not indicate auditors were guilty beyond a reasonable doubt Most importantly, fraud must be demonstrated to file criminal charges under section 32 of the Securities Exchange Act of 1934 MODC-19 Module C - Legal Liability C 69 Audit Simulation: Auditors’ Liability under Securities Exchange Act of 1934 (Continued) c Section 307 of the Sarbanes-Oxley Act includes a rule that requires an attorney to report evidence of a material violation of securities law or breach of fiduciary duty or similar violation to the chief legal counsel or the chief executive officer of the entity If the counsel or officer does not appropriately respond to the evidence, the attorney is required to report the evidence to the audit committee or board of directors Either Adam’s attorney or Joshua Food’s auditors’ attorneys should report evidence of the violation to the company’s management (or audit committee, if management did not take remedial measures) C.70 Mini-Case: Limiting Legal Liability NOTE TO INSTRUCTOR: For this assignment, questions through from this Mini-Case are applicable All quotations are from “Auditing ‘Liability Caps’ Face Fire,” The Wall Street Journal (November 28, 2005) It is easy to understand why accounting firms favor alternative dispute resolution Each of the major firms has been involved with clients who have suffered through major accounting scandals, and often the auditors are targets of corporate and investor lawsuits Provisions for alternative dispute resolution efforts are included in engagement letters to try to limit auditor liability should something go wrong “If [an audit client] runs into accounting problems and thinks a botched audit by [its auditors] is to blame, it is barred from taking the accounting firm to court Instead, [it] has to go through mediation and arbitration It also can't seek any damages beyond the actual, compensatory damages related to [the auditors’] conduct.” An Ernst & Young spokesman states that “these clauses have been part of our standard client agreements for some time and are not new” and notes that the provisions don’t limit the ability of investors to seek redress from the firm If major accounting firms want liability caps as part of the engagement letter, there is little that a company can to have them excluded However, it seems logical that companies would prefer to have this language excluded, since it potentially exposes them to greater losses Investors would probably prefer that these caps be excluded, since they can been seen as relieving auditors of their responsibility and encouraging less stringent audits Further, some critics wonder whether the good will generated by a company’s decision to limit auditors’ liability might ultimately create a conflict of interest Cynthia Richson, the corporate governance officer for the Ohio Public Employees Retirement System, states: “Some investors don't like what they see as the auditors' attempt to avoid accountability It does a disservice to investors… It's not in the company's best interests and not in the investor's best interests.” MODC-20 Module C - Legal Liability C.71 Mini-Case: Litigation NOTE TO INSTRUCTOR: For this assignment, question from this Mini-Case is applicable C.72 Ernst & Young’s first defense should be that they performed their work in accordance with professional standards They also should be able to claim HealthSouth contributed to, and was the primary cause, of any damages it incurred In the securities suit, they should only have to show that plaintiffs’ claims of scienter are untrue Mini-Case: Ethics NOTE TO INSTRUCTOR: For this assignment, questions 1, 2, 3, 4, 5, and from this Mini-Case are applicable According to the Merriam-Webster Online Dictionary corrupt means (selected meanings relevant to this issue):     to change from good to bad in morals, manners, or actions or to degrade with unsound principles and or moral values to become morally debase to cause disintegration or ruin The term corrupt, especially as indicated in second bullet above, could be applied to the actions of Andersen as a firm and might indicate that the firm was corrupt It is important here to know how the definition normally used by the 5th Circuit Court included the word dishonest, which does not appear in any of these definitions The issues are debatable and still center on the motives of David Duncan when he ordered the shredding of documents and whether Andersen had an obligation to modify its procedures if an investigation was imminent Remember, once Andersen was served with formal notice of an investigation, no documents were shredded The opinions of students will vary Clearly, the contested issues concerning jury instructions were all decided in favor of the prosecution The fact that by impeding an investigation, even without meaning to so, was allowed to indicate that an obstruction of justice occurred could have major legal ramifications if used as a precedent For example, if on your way home from class you inadvertently got in the way of a police officer responding to a crime, under the “impede” rule, could you be guilty of obstruction of justice? Again, opinions will vary However, with hindsight and based on the actions taken in the KPMG investigation, the loss of one of the large CPA firms and the loss of jobs appears to be a penalty to too many innocent people It is probably more appropriate to seek out individuals who engaged or directed illegal activities and take the appropriate actions against those individuals Students should understand that even if an action is legal it may not be ethical Clearly, there were some actions taken that are questionable The principles of ethics require auditors to act with integrity and to be mindful of the public trust There are clearly issues of integrity and the public trust in both the audit work and the shredding of documents following the disclosure that Enron’s financial statements were fraudulent MODC-21 Module C - Legal Liability C.72 Mini-Case: Ethics (Continued) In litigation the plaintiffs’ attorneys often name multiple defendants They this for two basic reasons First, if one of the plaintiffs is found harmless (the tort case equivalent of “not guilty”), other plaintiffs may be found negligent or to have engaged in fraudulent actions Therefore, the plaintiffs may still prevail (and collect damages) against those defendants Second, if one or more defendant becomes insolvent (which may happen during a long trial where legal fees can escalate and cause create cash flow problems), the plaintiffs may collect from other defendants found liable in the lawsuit This ability to collect in full from those who have “the ability to pay” is the basis for joint and several liability Class action lawsuits can be the most damaging to plaintiffs Several plaintiffs (sometimes thousands of plaintiffs) can file one lawsuit seeking damages that can total into millions of dollars if proven In addition, class action lawsuits may often be heard in several jurisdictions, allowing the plaintiffs’ attorneys the ability to shop for a court they believe will be sympathetic to their clients If a class action lawsuit is not allowed, many of the smaller claims may be dropped (the costs of the lawsuit outweighs the potential reward) and even larger suits must bare the legal fees individually Further, the defense team is not engaging in a “winner take all” contest Each suit, possibly heard in different jurisdictions, will be required to prove its individual case for its plaintiff C.73 Kaplan CPA Exam Simulation: Securities Act of 1933 Comfort letters are not required under the Securities Act of 1933, and copies are not filed with the SEC However, these letters are frequently provided to underwriters as a common condition of an underwriting agreement in connection with the offering for sale of securities under the Securities Act of 1933 The matters covered in a typical comfort letter are described below: A statement regarding the independence of auditors An opinion regarding whether the audited financial statements and schedules included in the registration statement comply in form in all material respects with the applicable accounting requirements of the Securities Act of 1933 and the published rules and regulations thereunder A description of the procedures requested and performed A disclaimer of opinion on the financial information covered by the comfort letter A statement of specific findings as a result of applying procedures in (3) above A statement that restricts distribution of the report A statement that auditors have no responsibility to update report for events after a specified cutoff date MODC-22 ... of persons intended to benefit from the services performed by the auditors and that their use of the statements was reasonably foreseeable by the auditors MODC- 15 Module C - Legal Liability C.63... Reporting Releases are SEC staff reports that express new rules and policies about accounting and disclosures required or encouraged by the SEC MODC- 3 Module C - Legal Liability Staff Accounting Bulletins... Securities and Exchange Act Increasing both the monetary fines and imprisonment penalties for violations of the Securities and Exchange Act Increasing the imprisonment penalties for mail fraud and wire