SM 16th Auditing and Assurance Services An Integrated Approach 16th Edition - Solution Manual

SM 16th Auditing and Assurance Services An Integrated Approach 16th Edition – Solution Manual


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SM 16th Auditing and Assurance Services An Integrated Approach 16th Edition – Solution Manual

Chapter 5

Legal Liability

  • Concept Checks

P. 118

1. Several factors that have affected the increased number of lawsuits against CPAs are:

  • The growing awareness of the responsibilities of public accountants on the part of users of financial statements.
  • An increased consciousness on the part of the SEC regarding its responsibility for protecting investors’ interests.
  • The greater complexities of auditing and accounting due to the increasing size of businesses, the globalization of business, and the intricacies of business operations.
  • Society’s increasing acceptance of lawsuits.
  • Large civil court judgments against CPA firms, which have encouraged attorneys to provide legal services on a contingent fee basis.
  • The willingness of many CPA firms to settle their legal problems out of court.
  • The difficulty courts have in understanding and interpreting technical accounting and auditing matters.

2. Business failure is the risk that a business will fail financially and, as a result, will be unable to pay its financial obligations. Audit risk is the risk that the auditor will conclude that the financial statements are fairly stated and an unmodified opinion can therefore be issued when, in fact, they are materially misstated.

When there has been a business failure, but not an audit failure, it is common for statement users to claim there was an audit failure, even if the most recently issued audited financial statements were fairly stated. Many auditors evaluate the potential for business failure in an engagement in determining the appropriate audit risk.

3. The difference between fraud and constructive fraud is that in fraud the wrongdoer intends to deceive another party whereas in constructive fraud there is a lack of intent to deceive or defraud. Constructive fraud is highly negligent performance.

P. 129

1. The four major sources of auditor legal liability are:

  • Liability to clients.
  • Liability to third parties under common law.
  • Civil liability under federal securities laws.
  • Criminal liability.

2. Liability to clients under common law has remained relatively unchanged for many years. If a CPA firm breaches an implied or expressed contract with a client, there is a legal responsibility to pay damages. Traditionally the distinction between privity of contract with clients and lack of privity of contract with third parties was essential in common law. The lack of privity of contract with third parties meant that third parties would have no rights with respect to auditors except in the case of gross negligence.

That precedent was established by the Ultramares case. In subsequent years, some courts have interpreted Ultramares more broadly to allow recovery by third parties if those third parties were known and recognized to be relying upon the work of the professional at the time that the professional performed the services (foreseen users). Still others have rejected the Ultramares doctrine entirely and have held the CPA liable to anyone who relies on the CPA’s work, if that work is performed negligently. The liability to third parties under common law continues in a state of uncertainty. In some jurisdictions, the precedence of Ultramares is still recognized, whereas in others there is no significant distinction between liability to third parties and to clients for negligence.

3. Under the 1934 act, the burden of proof is on third parties to show that they relied on the statements and that the misleading statements were the cause of the loss. The principal focus of accountants’ liability under the 1934 act is on Rule 10b-5. Under Rule 10b-5, accountants generally can only be held liable if they intentionally or recklessly misrepresent information intended for third-party use. The possible defenses available to the auditor include nonnegligent performance, lack of duty, and absence of causal connection.  The lack of duty defense necessary will depend on the jurisdiction and whether the courts follow the decision in the Hochfelder case, or determine gross negligence or reckless behavior is sufficient to hold the auditor liable. 

  • Review Questions

5-1 The most important positive effects are the increased quality control by CPA firms that is likely to result from actual and potential lawsuits and the ability of injured parties to receive remuneration for their damages. Negative effects are the energy required to defend meritless cases and the harmful impact on the public’s image of the profession. Legal liability may also increase the cost of audits to society, by causing CPA firms to increase the evidence accumulated.

5-2 Audit risk is the risk that the auditor concludes, after conducting an audit in accordance with the relevant auditing standards, that the financial statements were fairly stated when in fact they were materially misstated. Audit failure occurs when the auditor issues an incorrect audit opinion because it failed to comply with the relevant auditing standards. There is some level of audit risk on every audit engagement because it would be prohibitively costly for auditors to test every transaction and balance. Auditors gather evidence on a test basis, and thus may fail to detect a misstatement even though they comply with auditing standards. In addition, a well-orchestrated fraud can be extremely difficult to detect. 

5-3 The prudent person concept states that a person is responsible for conducting a job in good faith and with integrity, but is not infallible. Therefore, the auditor is expected to conduct an audit using due care, but does not claim to be a guarantor or insurer of financial statements.

5-4 Many CPA firms willingly settle lawsuits out of court in an attempt to minimize legal costs and avoid adverse publicity. This has a negative effect on the profession when a CPA firm agrees to settlements even though it believes that the firm is not liable to the plaintiffs. This encourages others to sue CPA firms when they probably would not to such an extent if the firms had the reputation of contesting the litigation. Therefore, out-of-court settlements encourage more lawsuits and, in essence, increase the auditor’s liability because many firms will pay even though they do not believe they are liable.

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