ACCTG 5510 1st Edition Lecture 3 Outline of Last Lecture I II III IV V VI VII VIII IX X XI XII XIII There are six organizational structures available to CPA firms Sarbanes Oxley Act Securities and Exchange Commission SEC Important forms for auditors AICPA American Institute of Certified Public Accountants Generally Accepted Auditing Standards GAAS Standard Unqualified Audit Report for non public entities The standard unqualified audit report is issued when the following conditions have been met Four Categories of Audit Reports Two Significant Audit reporting differences for public companies Lack of Consistent Application of GAAP Consistency vs Comparability Going Concern Outline of Current Lecture I Causes of lawsuits against CPA firms II Legal Terms III Four Major Sources of Auditor s Legal Liability IV Liability to Clients V CPA firms four defenses VI Liability to third parties under common law VII Securities Act of 1933 VIII Securities Exchange Act of 1934 IX Foreign Corrupt Practices Act of 1977 X Sarbanes Oxley Act These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute XI Criminal Liability XII XII Statements on Standards for Accounting and Review Services SSARS b Review Services SSARS review c Form a Report Current Lecture I II Causes of lawsuits against CPA firms a financial statement user s lack of understanding of two concepts i the difference between business failure and audit failure ii The difference between an audit failure and audit risk b Business failure occurs when a business is unable to repay its lenders or meet expectations of its investors c Audit failure occurs when the auditor issues an incorrect audit opinion because it failed to comply with the requirements of auditing standards i Audit risk the possibility that the auditor concludes after conducting an adequate audit that the financial statements were fairly stated when they were actually materially misstated d Prudent Person Concept i From Cooley on Torts Tort a wrongful act or an infringement of a right other than under contract leading to civil legal liability ii Every man who offers his service to another and is employed assumes the duty to exercise in the employment such skill as he possesses with reasonable care and diligence In all these employments where peculiar skill is prerequisite if one offers his service he is understood as holding himself out to the public as possessing the degree of skill commonly possessed by others in the same employ ment and if his pretensions are unfounded he commits a species of fraud upon every man who employs him in reliance on his public profession But no man whether skilled or unskilled undertakes that the task he assumes shall be performed successfully and without fault or error He undertakes for good faith and integrity but not for infallibility and he is liable to his employer for negligence bad faith or dishonesty but not for losses consequent upon pure errors of judgment e Under Common Law CPA s do not have the right to withhold information from the courts on the grounds that the information is privileged Legal Terms a Ordinary negligence absence of reasonable care that can be expected of a person in a set of circumstances For Auditor it is in terms of what other competent auditors would have done in the same situation b Gross Negligence Lack of even slight care tantamount to reckless behavior which can be expected of a person Some states do not distinguish between ordinary and gross negligence c Constructive Fraud existence of extreme or unusual negligence even though there was no intent to deceive or do harm Constructive fraud is also termed recklessness Recklessness in the case of an audit is present if the auditor knew an adequate audit was not done but still issued an opinion even though there was no intention of deceiving statement users d Fraud occurs when a misstatement is made and there is bother the knowledge of its falsity and the intent to deceive e Breach of contract failure of one or both parties in a contract to fulfill the requirements of the contract f Third party beneficiary the third party who does not have privity of contract but is known to the contracting parties and is intended to have certain rights and benefits under the contract A common example is a bank that has a large loan outstanding at the balance sheet date and requires an audit as part of its loan agreement While the contract for the audit engagement is between the client and the audit firm both parties are aware the bank will be relying on the audited financial statements g Common law laws that have been developed through court decisions rather than through government statutes h Statutory law laws that have been passed by the U S Congress and other government units The securities act of 1933 and 1934 along with SOX in 2002 are important laws affecting auditors i Joint and Several Liability the assessment against a defendant of the full loss suffered by a plaintiff regardless of the extent to which other parties shared in the wrong doing For Example if management intentionally misstated financial statements an auditor can be assessed the entire loss to shareholders if the company is bankrupt and management is unable to pay j Separate and Proportionate Liability the assessment against a defendant of that portion of the damage caused by the defendant s negligence For example if the courts determine that an auditor s negligence in conducting an audit was the cause of 30 of a loss to a defendant only 30 of the aggregate damage will be assessed to the CPA firm k When lawsuits are brought under the federal securities laws the separate and proportionate approach applies l III IV V Except where it can be shown that the CPA defendant had actual knowledge of fraud or has participated in fraud in this case joint and several liability applies m Under federal statutes the amount of damages under separate and proportionate liability can be increased to 150 of the amount determined to be proportionate to the CPA s degree of fault when the main defendant is insolvent Four Major Sources of Auditor s Legal Liability a Liability to Client client sues auditor for not discovering a material fraud during the audit b Liability to third parties under common law bank sues auditor for not discovering that a borrower s financial statements are materially misstated c Civil liability under federal