Hospital audit guide (1982); Industry audit guide; Audit ...
Audit Prjcy
-
Upload
amantle-wamuhle-daphney-pelaelo -
Category
Documents
-
view
216 -
download
0
Transcript of Audit Prjcy
8/2/2019 Audit Prjcy
http://slidepdf.com/reader/full/audit-prjcy 1/4
The number of lawsuits and the dollar amount of damages awarded in proceedings against accountants
have increased significantly in the past two decades. One researcher reported that between 1962 and
1987, more lawsuits were filed against accountants than in the entire history of the profession and that
the largest accounting firms collectively have paid more than $250 million in settlements of mostly audit-
related lawsuits since 1980.(1)
Because of our research, we are able to identify the key factors that contribute to this trend of growing
litigation against auditors. Increased use of financial statements has led to an attitude that investors and
creditors are consumers of financial information and, therefore, are entitled to expect more from their
purchases than they did in the past.(2) The public perceives that an audit precludes publication of
misleading financial statements and that the financial reporting system warns financial statement users of
impending business failure.(3) Although Statement on Auditing Standards No. 30 maintains that the
auditor is not an insurer or guarantor of the financial statements, the public perceives the auditor in that
role. The public's perception that an auditor acts as a "guarantor" of financial statements is part of a body
of misperceptions known as the "expectations gap." These misperceptions have resulted in an increasing
number of lawsuits against auditors. Nine Statements on Auditing Standards were issued in 1988
specifically to address these misperceptions.
The trend of court decisions and changes in legal statutes may also contribute to an increase in the
number of audit-related lawsuits. The court's application of the "fraud on the market" theory, the product
liability rule, and legal statutes have increased auditors' exposure to litigation. Under the "fraud on the
market" theory, some courts have ruled that investors need not have been aware of the misrepresentation
if reliance on the financial statements by other investors affected the price of the security.(4) The product
liability rule holds that auditors are responsible for the quality of their work product and for passing these
costs to their clients. Because these trends of litigation have developed, auditors have an acute need to
recognize factors that may lead to increased exposure to litigation. Recognizing these factors may help
auditors minimize their exposure.
Auditors have a legal liability under both common and statutory law. Common law is unwritten, has
evolved through court decisions rather than government statutes, and is state-dependent. If no precedentexists, a court may look to cases in other states, but is not bound to follow such cases. Statutory law is
created through legislation. A court is bound by statutory law unless the statute violates the federal, or a
state, constitution. A court makes its own interpretations if the statutes are unclear. Legal liability in
auditing extends to two groups: clients and third parties.
Liability Under Common Law
8/2/2019 Audit Prjcy
http://slidepdf.com/reader/full/audit-prjcy 2/4
Auditors' common law liabil ity to clients generally falls into two categories: breach of contract and tort. The
typical case would allege both breach of contract and tort. For breach of contract, the client alleges that
the auditor did not fulfill the requirements of the contract.
A suit in tort (a civil wrong other than breach of contract) may be filed by a client to claim ordinary
negligence, gross negligence, or fraud on the part of the auditor. These performance criteria are part of a
continuum along which the auditor's performance can be judged.(5) As Figure One illustrates, auditor
performance may range from innocent to fraudulent behavior. Innocence is the belief, with adequate
basis, that the opinion is correct. Errors in judgment occur when the auditor believes, but with debatable
basis, that the opinion is correct. Ordinary negligence is the failure to exercise due professional care,
whereas gross negligence is a reckless departure from due care. Gross negligence may be also
considered to be constructive fraud. Fraud requires the element of intent to deceive.
On this continuum, there are three important "gray areas." The distinction between errors of judgment and
ordinary negligence is important because auditors are not liable for errors of judgment but may be held
liable for ordinary negligence. Where does the distinction between errors of judgment and ordinary
negligence lie? The "prudent man" concept, as expressed in Cooley on Torts, describes a professional's
obligation for reasonable care as follows:
Every man who offers his services 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 possessing the degree ofskill commonly possessed by others in the same employment, 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.(6)
The distinction between ordinary negligence and gross negligence appears to be the most troublesome to
determine.(7) Although there is an inherent problem in providing unambiguous definitions of any of these
pairs of verbal terms, judges in different districts, faced with different circumstances, are most likely to
render somewhat inconsistent decisions in distinguishing between ordinary negligence and gross
negligence.
8/2/2019 Audit Prjcy
http://slidepdf.com/reader/full/audit-prjcy 3/4
The distinction between gross negligence and fraud depends on whether there is intent to deceive. In
Ernst & Ernst v. Hochfelder, (425 U.S. 185, 1976), the Supreme Court defined scienter as "a mental state
embracing intent to deceive, manipulate, or defraud."(8)
The client-plaintiff has the burden of proof in a suit against the auditor under common law. The plaintiff
must prove that the auditor accepted a duty of care and breached that duty, the client suffered damages,
and there exists a close causal connection between the auditor's breach and the client's damages.(9)
Third Party Liability
Auditors also have liability to third parties under common law. Third parties cannot sue for breach of
contract because of lack of privity but can sue in a tort action for ordinary negligence, gross negligence,
or fraud. The burden of proof in such cases is upon the third party-plaintiff to prove the elements of duty
of care, breach of that duty, damages suffered, and a causal connection between the auditor's actions
and the plaintiff's losses. A plaintiff who can prove gross negligence or fraud can recover damages or
losses suffered in any state; however, ordinary negligence recoveries vary by state. Until the late 1960s,
CPAs were liable under common law only to their clients for ordinary negligence.(10)
In 1931, the Supreme Court of New York decided the case of Ultramares Corp. v. Touche, Niven & Co.
The Ultramares Doctrine was a product of that decision. The court ruled in favor of the auditor and stated:
If a liability for negligence exists, a thoughtless slip or blunder, the failure to detect a theft or forgery
beneath the cover of deceptive entries, may expose accountants to a liability in an indeterminate amount
for a indeterminate time to an indeterminate class. The hazards of a business conducted on these terms
are sufficiently extreme to enkindle doubt whether a flaw may exist in the implication of a duty that
exposes to these consequences.(11)
The court reaffirmed this doctrine in Credit Alliance Corporation v. Arthur Andersen & Co.(12) The court
stated that certain prerequisites must be met for an auditor to be held liable to third parties for ordinary
negligence: an awareness by the auditor that the financial statements were to be used for a particular
purpose by a known third party and the existence of some conduct by the auditor that links the auditor to
the third party.(13) Satisfying these prerequisites establishes a third party beneficiary status. The
Ultramares Doctrine is not a federal ruling, but it has been followed in several states.
The impact of the Ultramares Doctrine has been diminished somewhat by the Restatement of Torts rule
and the Rosenblum rule. The Restatement of Torts rule is not a binding legal expression, but merely the
opinion of legal scholars about what the common law should be in each state. The rule extends the
auditor's liability for ordinary negligence to third parties who are members of a limited class of known or
8/2/2019 Audit Prjcy
http://slidepdf.com/reader/full/audit-prjcy 4/4
intended beneficiaries of audited financial statements. The Rosenblum rule extends the liability beyond
the Restatement of Torts rule to cover all those whom the auditor should reasonably foresee as recipients
of audited financial statements.(14)
The evolution of the auditor's liabil ity to third parties for ordinary negligence shows that decisions vary
among the states depending on the precedent being followed. On one extreme, the Ultramares Doctrine
(as modified by Credit Alliance) holds the auditor liable for ordinary negligence only to known third parties
who can link their claim to the auditor's conduct. On the other, the Rosenblum rule holds the auditor liable
for ordinary negligence to any foreseeable third party.