audited financial statements: the accountant's
TRANSCRIPT
Audited Financial Statements: The Accountant's
Pe-::.pon·:, it. iIi t:;.'. L i ·:<.b i 1 ih·.
and P~ecautions Against Li tigation
An Hono~s Thesis (ID 499)
B'Y'
,Jud i th Ann C:u 1/'
Th e·::. i·::. D i r' e e tor'
Ball State Unive~si ty
t"'lune i e. I nd i B.nB.
t·'j.:<.:;.' 1 '7'B4
G~aduation Date: May 19B4
{ 'J c; '{ :'1r,'[ OUTLlr···lE
I . In t r' o:)du c t i on
I I .
A. Bri@f HistorY B. Th@ Past 20 Years - Impact on Auditing
1. I ncr·@.:"·:::.e in neql i gene@ 2. Inc r' 12·:" se i n 1 i .:O.b i 1 i t y'
Gener·.:O.l A. The
1 •
2 B The
1
C. The 1
Pe·:·c.on·:.ibi 1 it:;." of Audi tor-=:. View of the Profession C:l ients .:0.. GAAS t,. eon fide n t i .:0.1 it .... · c. m i -=:·eoncep t ion':. clf eli en t·:. d. management responsibi 1 ty Other users of financial statements Profession's Pespons@ to the View of Others The Cohen Commission .:0 .. eonelu·:.jc)ns b. recommendations View of the Government The Securi ties and Exchange Commission a. concerned wi th disclosure b. promulgates standards and rules
I I I. Le q.:o.1 L i .:O.b i 1 i t /. of Au d i tor":-A. Important Concepts
1. t···le 9 1 i 912 n c e 2. Fr·a.ud 3. Burden of Proof
B. Common L':O.I. ... ,1
1. Cl ient .:0. . .:o.U d i tor' .. ' s 1 i .:o.b i 1 it· ... · b. c i I.} i 1 ·:o.C t i on e. burden of proof d. def@n·:-e·:.
2. Third Parties a. classes of third parties b. .:o.U d i tor' .... :. 1 i .:o.b i 1 i t y'
c . c i I .... i 1 ·:o.C t i on d. burden of proof e . de fen ·:·e .:.
C: . :3 t.:o. t u tor' 'F" L .:0. 1 .... .1
1. :::;12 C!J r' i tie .:. Ac t of 1 -;:-::::3 a. requirements of the act b. a.udi tor·· .. ·:. 1 i .:O.bi 1 i t/· c. burden of proof d. Escott v. BarChris Construction Corp.
2. Securities and Exchange Act of 1934 a. requirements of the act b. section 10(b)
1::' ·:o.u d i tor' .. ' .:. 1 i .:O.b i 1 it>"
2) burden of proof 3) Hochfe1der v. Ernst & Ernst
c . ':;e c t i on 1:3 1::' d.udi tor· .. ·:. 1 i .:'.bi 1 it::, .. 2) burden of proof
3. Other' Feder·.:'.l .3.nd :::;t.3.te Std.tute·:. a. Federal False Statements Act b. Federal Mai 1 Fraud Act c. Federal Conspiracy Statute d. :3 t .:.. t e L.:.,I ..... I·:;
D. Cr' imi n.:'.1 Li .:'.bi 1 it::. 1. De':, c r· i p t ion .~< Com p .:.. r' i son t 0 C i I.} ilL i.:.. b iIi t ~,.,
2. United States v. Simon
IV. Precautions Against Litigation A. Accounting Standards
1. Vn 01..·.11 edge ·3.n d e omp 1 i ·3.n e e 2. Beyond the Standards - Good Judgement
8. Recommendations by the Profession 1. C lie n t d.C C e p t d.n c e d.n d r' e ten t ion 2. Engagement letter
C!u d.1 it/" eon t r' 0 I 4 . 8.:.. I ·3. n e i n ':';1 gr' 01 .... .1 t h d. n d q u .:.. 1 it::" con t r' a 1 5. DefEnsive auditing 6. Legal adVice
I .. ). Cone 1 U·:· ion A. :::;ummd.r· ::,' B. New Areas Presenting New Legal Questions
1. Compi lation and review 2. For·ec.3.·:.ts
C. Thoughts on the Future
Audi tors help to preserve economic freedom. Th i·::.
statement might surprise some people, but it is the truth.
One of the major characteristics of our free economy is our
que .::. t for' per' f eo c t c om pet i t ion . Perfect competition
r' e (1 u ire .::. e f f j c i en t mar' k e t s· su p pI i e d 1) . .1 i t h c mnp 1 E' t e
i nfor·m.::'.t i on . A portion of this information is provided by
. ::'.lJdi toO,d fina.nci.::.l ·::.ta.tements .. ::'.nd other' report·::. ·::.UPI) 1 ied t,>"·
·::,.ccoun t.:<.n t·:: .• As a result, accounting and auditing
functions have become an essential element in maintaining
our free and competi tive society.
American auditing originated from Scottish and Sri tish
accountants who came to the Uni ted States during the late
1800s to check on Sri tish investments in American
i ndu·::.tr i e'::·. The::." .::..udi ted book,::, b>' check i ng in deta.i 1 the
additions and postings in an attempt to detect fraud, but
f r' ·:o.u d i) .. I.:O .. ::. u '::·IJ .::'.1 1}"' not f ou n d be c ·::..u 'se i t 1 ... ·,1·::'.S· ·:o.C c omp 1 i ·::.h e d by'
leaving cash receipts out of the books. S::.·' the e ·::'.r· 1 'T"
1'7':=:0:., the number· of in'.)e·::.tor··::. in cor·por·.:o.te ·::.tock·:: .. ::'.nd
bonds had increased dramatically. Audi tors had to change
their audi ts to accomodate stockholders and investors. The
emphasis changed from the balance sheet to the income
.::. t a. t eme n t . 1..,.1 i t h the e's t a.b I i ·::.hme n t of the f e de r' .:0. i
securi ties laws of 1933 and 1934 came the first audits
required by law.(l) Throughout the 40s and 50s, many
accountants, accounting organizations, and the SEC were
disappointed in the slowness of the accounting profession
in e·::.t.::'.bl i s.h i ng account i n'~ pro i nc i pI es·. A 1 a.c k of
understanding and agreement on the basic postulates and
principles underlying the accounting practice contributed
significantly to the delay. Ever since the principles have
bee n E' .::. t .:;.. b lis h ed, the :: .. , h.:;.. '.} e bee ncr' i tic i zed .:;. .. ::. be i n g too
br·o.:;'.d" They permit the management to influence the
impression conveyed by financial statements by allowing
them to choose between several accounting methods. The
effect of this influence can be misleading to the users of
the f,nancial statements.
Occurences in the past twenty years have had a
significant impact on auditing. Controversies~ such as the
broadness of accounting principles discussed above, along
with criticisms by the SEC, members of the accounting
profession, and other interested parties, nurture an almost
con tin u .:;.. 1 i n t e r' est b}' the fin .:;.. n c i.:;.. 1 P r' e'::· sin .:;.. c c 0 u n tin g
principles and the accounting profession.(2) t···jume r' ou .::.
·::.ca.nd.:;'.l·::. in the 1 a.te .:;.0,::, 1 .... .Ih i ch r'e'su1 ted in cour·t·::. r'ul i ng
t h.:;.. t:;..u d i tor"::, h .::'.d been neg I i ge n t in their' duties, p I u .::. the
gener·:;'.1 di s:.tr·ust of the ·::.:: .. ··::.tem b::.·· the pub1 i c due to
f.,..I.:;..ter·.~a.te C.:;'.u·::.ed a.udi tor"s to I o·::.e the i r' cr'edi bi lit::.', The
pr·ofes:.·::.i on ha.d to con·::.i de,' the adequa.c::.·· of qua.1 it:: .. · contr'ol
.:;'.nd pr·clfe·::.·::.ion.:;'.i di·::.cipl ine. AI'3o, it 1 .... .1.::..s:. time to
r' e c on .::. i de r' the hi·::. tor' i c .:;..1 i .je .:;.. t h a. t a.n ·:;..u d i tor' i·::. not
responsible for searching out fraud. Cou r' t .::. .:;'.n.j
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go' .... er·nmen t.:;'.1 agencies decided it was time to be tougher on
.:;.. u d ito r' .::. .:;.. n d pI:;.. cern 0 r' e 1 i.:;.. b iIi t :: .. ' CI nth e i r' s h 0 u 1 de r' .::. • A 1 I
of this caused the accounting profession to be greatly
concer·ned. One author stated~ "Today~ wi th fraud cases
becoming more common, and with investigations by
governmental agencies and resul ting 1 i tigation exploding in
al I directions. this disturbing trend is becoming a major
factor in the operation of accounting firms."(3)
Accountants are taking extra precautions because they are
no 1 or'jI~er' ·::·ur·e v!h.:'.t the':,,' 1 .. ' • .Ii 11 be hel d 1 i .:'.bl 02 for'. Th i·::.
p.:'.per· e::q:,] or'es the gener·.:..1 r·es.ponsi bi 1 it::,·, .:'.nd 1 e'~.:..l
I i .~.bi·1 it::,·· of .~.ccountant·::. 1 .• ' . .Ii th r·ega.r·d to a.udi ted f i na.nc i .:'.1
.::. t .~. t erne n t s· • Precautions that accountants should take
.~.g.:.. i n <;:. t 1 i t i ':d':" t i on li·J ill be inc 1 u de d, .:'.1 on g 1 .. ',1 i t h a.u d i tin'~
trends for the future.
There are many different opinions of what an audi tor's
r·e-::.ponsi bi 1 it::, .. : .::. tOl/,lar·,j his c1 i ent-:: .. ;..nd other' user"::. of
financial statements. The profession's view based on the
A I CPA Pro of e ·::.s· i on a. 1 S t .:'.n d2<.r· d·::. i·::. t h.:.. t ~ "A c e r' t i fie oj put, 1 i c
.:..ccc,urlt.:..pt ·::.hould be f.;..ir· .:'.nd c.:'.ndid v . .!i th hi·::. cl ient·:: .. :'.nd
ser·' .... e them to the be·::.t of his 2<.bi 1 i t::,··~ v . .!i th pr·c,fe·::.si on.~.l
con c e r' n for' the i r' be -::. tin t 02 r' 02 s t s l con '::. i ten t I .. ".! i t h h i -::.
r'esponsibi 1 i tie':, to the publ ic."(4) Fir·st. it i-::. impor·t.:'.nt
to look .:'.t 1 .... .Ih.~.t .:..ccount.~.nts h2<.'.)e est.:..bl i -::.hed .~.'::. the i r'
r·e·::.pc,n·::. i b iIi t::, .. to c 1 i en t·:: .. When accepting an audi t
en':;;t2<.':;;tement ~ the .:..udi tor' ha.·::. t.~.ken on the t.:..sk of eX.:'.mi n i ng
financial statements and related supporting information to
form an opinion on whether or not the financial statements
are presented fairly and conform with generally accepted
.~.ccount i n';r pro i rp: i p1 e'::· th.:'.t h2<.'.}e been con·::.i ·:;tentl:;.-· .:..ppl i ed.
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It is his duty to follow generally accepted audi ting
.:. t ·:'.n dar' d,;, • Un de r' (3AA S ~ h e h .'0<. ';. the r' e s· p 0 n .:. i b iIi t /. t 0
properly plan his examination~ to search for errors or
irregulari ties that would have a material effect on the
f i nanc i a.l ·:.ta.tement·:., a.nd to e:>::er'c i se due ':Y i l'j .;.nd c·;.r·e in
conducting his examination. As long as the audit has been
performed in accordance with GAAS~ the auditor has
f 1J 1 f il 1 e d hi;. prof e':·';· i on .:'.1 r' e ':.p on .:. i b iIi t i e':· • He Ijoes. not
guarantee or insure against errors or irregulari ties.
(; C F'A .;. 1 ':·0 h .;.s. the r' e s· p 0 n s· i b i 1 i t y t 0 k e e p c lie n t
i n f or·m·;. t i on con fide n t i .;.1 . Generally, he cannot disclose
confidenti.:'.l infor·m.;.tion I ..... iithout the cl ient····:. con·:.ent, but
this does not prevent him from complying wi th GAAP and
I~"""""-' ~HH·=' • A,;. .;. r' e s·u 1 t, i t 1 ... ·.I0U 1 d not be .:.. I.) i 01 .;. t i on of
r·e,:.pon·:.i bi 1 it::.' to .;. cl i ent if .;.n ·;.udi tor' qU.;.1 if i ed hi·:.
o~)inion on the cl ient····:. fin.:'.ncia.l st.;.tement·; .. ::'.nd di·:.clo·:.ed
t h.;. t the c 1 i e nth d. oj not c om () 1 i e d 1.' • .1 i t h GAA P •
m.;.int.E!.ining confidenti.:'.l it::.·· doe':, not d.pply in .;.11 cas·e·:·.
Some :.ituations in which accountant may be required to
d i .:. c 1 0 .:. e con f ide n t i.:.. 1 i n for' m .;. t ion inc 1 u oj e c om p 1 ian c e 1.".1 i t h.:..
,,) .:.. 1 i oj .:. u b poe n .;:.. 0 r· .:. u mm 0 n ';" .E!. I.} 0 1 u n t a. r' :: •. , qua. 1 i t ~ •. , re'·) i e 1.,',.1 u n de r'
the authorization of the AICPA. an inquiry made by the
ethics division or Trial Board of the AICPA or a simi lar
state CPA society. or an inauiry made under state
S.td.tute·: .• (5)
There has been a misconception in the past that an
a.ud i tor' .:. m·;. in obj ec t i I.)e in per·fclr·m i ng .9.lJd its is. the
c:-,_I
detection of fraud. As is stated above~ the accounting
profession maintains that the purpose of an audit is to
determine if financial statements are presented fairly.
The margin between the perceived and actual
r'e':,pon':,i bi 1 it i e'=:: .;:'.·:,·:.umed b'," d,n .;:..ccount.;:'.nt in per'for'mi ng a.n
audi t is commonly referred to as the "expectation gap."
Wi th the drastic increase in management fraud that has
occur'r'ed in the p.",,·:.t h',.Ienty· ye.:'.r":., cl ient·=.~ gOI,..'er·nment.;:..1
agencies, and users of financial statements have wanted to
inc r' e·;:' .. :. e t hi,:. g a. p b ::." r' e qui r' i n I;:) m 0 r· e r' e s· p 0 n '::. i b iIi t y for'
de tec t i ng fr'.:..ud duro i ng ,;:'.Ulj it·: .• The Statement on Audi ting
:::; t .:', n d:.. r' d .:. t,··~ 0 • issued by the AICPA sets forth the
d.udi tor·· .. ·:. r·es.pon·:.ibll i t": ... for' the detection of fr·d.ud. It
states that normal audi t examinations are not primari Iy
de·:.igned to di·:.clo·:.e fr·a.ud .;:..nd ':.hould not be r'el ied upon to
Al ':.0. if the di ·:.co'.)er·/' of .:'.11 fr·.;:"ud 1.·'·.Ier·e ·:'.n
objective of the audi tor's examination, the amount of worK
required would increase the cost to a point where no one
could afford an audi t. Even then there would be no
assurance that any existing fraud had been detected because
of the nature of fraudulent acts such as unrecorded
transactions, forgeries and collusion.
I:; u d ito r":· doh d. I.} e r' e':· p 0 n ':. i b iIi tie ':;. tot h e c lie n tin the
con du c t of d.n ,:'.U d it. bu tin f .:',1 1 i b iIi t ::." ,:'.n d c I ,;:.. i r",} o:;,··.;:..n c e ·:'.r' e
not included. It is reasonable for an audi tor to rely upon
the truthfulness of certain documents and the genuineness
of certain documents provided by management. Th i·:. i s, 1 .• "lh .; ...
·:=.ome of the r' e ':=.p on .:=. i b iIi t Y' mu s t be sh i f ted to m.9.n ·~·geme n t .
Management should be held responsible for the
misrepresentation and withholding of material n f or·m.9. t i on
fr'om ,:he ·;:'.udi tor. If an accountant fol lows customary
auditing procedures, those procedures do not disclose any
misrepresentation, and no apparent reason exists to expand
the .~.udi t pr·ocedur·es., the .~.ccount.~.nt ';houl d not be hel d
responsible for the misrepresentation.
f~ 1 on g i} . .! i t h r' e ';p on sib iIi tie s· tot h e c 1 i en t. the
.~.ccount i n'~ pr·ofe·:=.·:=.i on r·e.:'.1 i ze·:=· th.:'.t i t .~.l-=.o h.~.:= .. ~.
r·e·::.!::.on·:=. i b iii t:;.' to pr·omote pub1 i c i}.Je 1 f.9Te . Au d i t c,r' .:=. c ·~.r· r' :: •. ,
ou t t-, i .:=. r·e·;pon·::. i b iIi t·:.·· b::.' e::<pr·e·:=,·:=. i ng op i n i on':· on the
f.~.i r'ness of f i n·~.nc i .;:..1 ·:.t.~.tement·:. of pubi i cl y' t:-·.9.ded f i r·m·: .•
This ~elps to ensure that financial information available
to investors and other users of financial statements is
fair and relevant. The e::·::ch.:..nge of r'e I i .~.bl e f i n·;:'.nc i .:'.1
information is an essential element of our free marKet
.:. ::"':. t em.
The ,~e n e r' .;:.. 1 pub I i c .~. n d·:. om e c 0 u r' t s h.:.. \} e e :>:: p r' e s .:. e ,j .~.
':.1 iqhtl::.' differ'ent \}ie'...,' of tt,e r·e·:.ponsibi 1 i ty of
accountants. This is apparent from the recent criticism of
the accounting profession due to the increase In cases
brought against auditors for failure to detect
misrepresentations in financial statements. Th e Comm i·:.·:. i on
on Audi tor·····:. F.:e·:.ponsi bi 1 it i e':., .9.1':.0 c.~.ll ed the Cohen
Commission, was establ ished by the AICPA in 1974 to respond
t 0 c r' i tic j ·:·m .:.. b 0 u t the .;:.. u d i tin 9 p r' 0 f e':· .:. jon . Th e Comm j ':=.':=. i on
did a studY based on legal cases against audi tors. The
final reoort which was issued in 1978 was considered to be
.~. 1 .~. n dm .~. r' ~:: . The results lead to some very significant
The study found that a significant percentage
of financial statement users consider fraud detection to be
one of the most important objectives of the audit.
fr'equen t c·~.use of .;:..ud it f.;:.. i I ur·e·:· is the i ncorr'O?C t
interpretation or implementation of accounting or auditing
pr'oncluncemen t·: .. The profession is concerned about the
Commissions verification that courts have shown a
1.' • .1 ill i n 9n e':·':· to hoI d .~.U d i tor' .:. r' e ':'p on s i til e f or' m·~. t e r' i .:.. I
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misreoresentations in financial statements. The ·:.tudy ':'.1 ':·0
found that audi tin9 fal lures were not a resul t of a
deficiency in auditing standards and these failures can
ne'·)er· be tot.;:..] 1':," el imi n.:.ted because hum':'.n er·r·or· I.' . .li 11 .~.ll.' .. I.;:..yS
e::{ i ·:.t. (6) Some of the recommendations by the Commission
include a report by management in the annual report to
.;:.. C ~:: n OI.A.I led I~ ern·;:.. n .:.. gem e n t .' s· r e':::· P 0 n .:::. i b iIi t ::,., for' the fin -2>. n c i.;:.. 1
statements and to describe the status of internal control
and an expanded audi tor's report that wi I focus on the
company's representations contained in the report by
The e>::p.:..nded r·epor·t 1"',loul d r'equ i r'e the .~.udi tor'
to e::-::p.;:..nd hi·:::. 2')·;:'.1 u.~.t i on of i nter·n.~.1 contr·c.l. The
Commission also concluded that it is the audi tor's
r·e·:.pon·:.i bi 1 it>' to .~.ct i • .... el y' ·:.e.;:'.r·ch for' fr·':'.ud r·.~.ther· th.~.n
simply bein9 alert for i t.(7)
The 90'.}er·nmen t a 1':.0 ha.s. a. I.) i el.' . .1 of the r·espon·:. i b iIi t::,·,
of audi tors that differs from the view of the accounting
p r' of e'::·':· i on • The Securities and Exchange Commission
generally the agency that speaks for the government with
reQard to audi ting matters. The SEC can be described as a
regulatorY agency with vast quasi-legislative and
quasi-judicial powers whose rules and regulations have a
direct and significant impact on the accounting profession,
e':· p e c i .:c. 1 1 /. r' e I;:) .:c. r' din I;:) .:c. c c 0 u n t .:c. n t "s. I i .:c. b iIi t ::." • ( :::: ;. The :::; E C
t.:cYe·:, the po·:.i t i on th.:c.t the publ i c a.ccountant····:. dut·: ... i·::. to
·: .. :c.fel;:)u.:c.r·d publ i c in ter·e·:.t .:C.nd th i·:. du t::,·, ta.ke·:; (:Ir'ecedence
0 1.) e r' .:'.n y du t'r" tot h e c lie nt, The accountant"s duty is
carried out by verifying and communicating material
information from financial statements. If fol lowing GAAP
and GAAS does not result in the disclosure of such material
information, the SEC maintains that is has the power to
promulgate addi tional standards and rules.
'···Jov.,1 tha.t the gener·.:c.1 r·e·:.ponsi bi lite':. of a.udi tor':, hal . .!e
bee n e >:: ·:C.m i ned, the n e ::< t t h i n I;:) toe ::< p lor' e the i r' leg .:c. I
I i .:C.b iii t ::,' . First, some important terms that are frequently
encounter'ed 1..·.,1hen di·:.cu·:.·:.in l;:) leg.:..l I i.:C.bi lit:;.' 1,1.,1i II be
c 1 ·:C.r· i fie d .
of pr·oof.
The·E.e ter'm':' .:C.r·e ne l;:)1 i gence, fr·aud •. :C.nd bur'den
t···Je g 1 i ge n c e .:.:c.n be cIa. ·:;s· i fie d a.':· or·d i n ·:C.r· y' or'
I:) r' CI '::. '::; .• Or·d i n ·:C.r ',' n e I~ 1 i ge n c e i,:;, the f .:c. i I u r' e to u s·e
reasonable care when performing services.
is the fai lure to use even minimum care when performing
':·e r· I.} i c €' ': .• N e 1;1 I i g e n c e c .:c. n r' e':· u I t f r' om .:c. .:. p E' C i fie .:c. c tor'
from a fai lure to act. It is often predicated upon a lack
of honesty and loyal ty. In order for an accountant to be
con·::.i der'ed ne';:)l i .;:)ent, he mu'::.t f.:O.i I to per'for'm .:~.ll ·::·er·'.'! ices
in accordance with what a reasonable accountan~ would do
under simi lar circumstances.
Fr·a.ud i·:.
the intentional misrepresentation of a material fact which
deceives and then injures another party. Accor-'din9 to the
cour·t·:., fr·.:O.ud mu·:.t u·::.u.:O.ll::.· include .:O.I .. ' . .Iillful intent to
defr·.:O.ud.':: 9) Four requirements that need to be present for
f r' a,u d to oc cur' ·::r.r· e the i n ten t i on torn i '::.1 e .::r.d 1,<.lh i chi .::.
referred to as scienter, a false representation or the
con c e .::<.1 me n t of .;:.. m·::<. t t e r' of f .:o.c t t h .::<. t i '::. m·;:.. t e r i .::<.1 tot h e
tr·.:O.ns.Ot.ction in que·:.tion, ju-=.tifi.~.b]e r'el i.::<.nce b';.· the
plaintiff on the false statement, and injury as a result of
the r"= I i a.nce . The lack of any of these requirements can be
used as a defense in fraud cases.
Burden of proof means the burden of comin,;:) forward
with evidence to prove or disprove a relevant and material
fact that is beln9 disputed . In 1 i t i g.::<, t i on ·~.9a. in'::. t ·:O.n
. :o,udi tc.r·, ther'e ,:oT'e four' el ement·::. tha.t deter'mi ne the
The burden of proving any or all of
these elements rests on different parties in different
s i tu.:o. t i on'::·. These elements are damage or loss resul ting
f r' om r· eli .:0, n c e u Don fin .:0. n c i .::<. 1 .::. t .:0. tern e n t .::. 0 r' a. d'.'! ice ,
misstated financial statements or erroneous advice,
reI i ·:O.nce upc.n f i n.:<.nc i .:0.1 ·::.t.::<.tement·:. or' .:<.d i .... i ce •. :O.nd .:0.
def i c i enc::.· in the a.ud i tor' .. ' .:. conduc t. In civil cases, which
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include neq] i qence ca.':· e':· , the pa.r·t::-' li . .Ii th the bur'den of
proof must only provide evidence that welqhs qreater in his
favor to win the case. This is different than in criminal
cases where quilt or innocence must be proven beyond a
reasonable doubt.
c 1 .0<. ':.':. : fie ,j .0< .• :. c Ctfnmon 1 a.I .... .! 1 i ab iIi t Y' or' .:. t a. t u tor' :,., 1 .0<.1 .... .1
1 i.o<.bi 1 i h·'. Common law is derived from leqal precedents
e·:.t.O<.bl i ·:.hed to::.' dec i ·:.i on:· in 1 eqal c·O<.ses. A·:. a. r'esul t.
common law reflects the values of society at the time the
decisions were made. Under' common 1.0<.1.,,1 the 1 i .:<.bi 1 it·,.·· to the
cl ient is for' or·din.O<.r·::-' neg I il::)ence~ l;Jr'o':":' neql il;)ence~ or'
f r' ·3.U d . Th i·:. 1 i .3.b iIi t Y' i S b.3. ·:·e d on the con t r' a.c t u .3.1
re 1 ·3. t i on·:.h i [) be tl..'.Ieen the c 1 i en t a.nd the .3.ud I tor' 0: pro i I .... i t/· of
con t r' 3. c t ::0, ·3. n don the ·3. u d ito r' .' ';:. i n de pen den c e f r' om c 1 i e n t
contr·ol. The contr·.3.ct doe':, not h.3.' .... e to be for·m.:O.l1::.'
I.·-·.Ir itt en. It ma./· be imp1 i ed.
i .• ,Jhen ·3. client t,elie\)e·:. th.:o.t ·:O.n a.uditor· h.:o.s f.:o.iled to
properly carry out the duties of the contract. he may seek
.:0. C i I.) i 1 .0<. C t ion 0:. f b r' e .:;0. c h 0 f con t r' .:;0. c tor' tor' t . Un de r' br' e ·O<.C h
of contract~ the auditor has usually violated qenerally
accepted accounting standards or the confidential
r' e I .0<. t i on ·:.h i p be b.-.Je e n h i m·:·e I f .:;O.n d the c lie n t .O<.n d m.:<.::··· be
subject to monetary damages. One case that set an
important precedent wi th regard to breach of contract was
1136 Tenants' Corp. v. Max Rothenberg & Co. I nth i S· C .0<. ·:·e •
the .:;O.udi tor' 1.·-·.1.3.';:· hi r'ed to per'for'm ser·'..J I ces for' the cl i ent ~
1 1
but no engagemert letter was prepared. 1.,..11""1 en i t 1 ..... 1.:<.·::.
discovered that a former manager had embezzled funds, the
c 1 i en 1: ·::.ue,j the a.ud i tor' bec.;:'.u·::.e ·;:'.n .~.ud it ha.d not been
[)er·for-·med. In defense, the auditor claimed that he had not
been hired to do a complete audit, only a write-up, The
court found in favor of the plaintiff. In it·::. opinion, the
court stated that a wri te-up engagement requires certain
definitive audit procedures, hiring a CPA presumes an
audi t. an audi t may be adequately performed wi thout
indeoendent verification, and accountants have a duty to
detect defalcat~on. The first three of these ~ould have
letter',(10)
Tor·t 1 i .;:'.b iii t /. oc cur' .::. 1 .. ,.11""1 e n ·~.n ·~.c c ou n t ·;:'.n t br' e ·~.c he'::. .~.
nonco~ltr·a.ctu.;:'.1 dut:;.-· r·e·::.ul ting in injur')" to .~.nother· per·=.c,n.
Monetary damages may be awarded. I f the tor' t I .... J.~.·::.
i'ltention.~.I. the '.}ictim i= .. ~.I·::.o entitled to puniti' . .le
In .~.,jdi t i on to the tor·t 1 i .~.bi lit::.· of the
accountant. the firm also is ia.ble if the tor·t i·::.
c omrn itt e d 1 .... .1 i t h i nth e'::· cop e 0 f the .~. c c 0 u n t a. n t ." s ern 1:' i 0 ::"'m e n t .
The burden of proof in cases concerning common law
i .~.t, iIi 1:":." tot h e c lie n t i·::. p I ·~.c e d on the p I .~. i n t iff. F:e c .~.l
that the plaintiff has the burden of proving the four
e 1 em e n t .::. 0 f.;:.. u d ito r' .. ' .:. 1 i.;:.. b iIi t y : damage or loss, the
financial statements were misstated or erroneous advice
gi '·.len. r'el i ·~.nce on f i n·;:'.nc i .::<.1 ·:.t.::<.tement·5 or er·r·oneou·::.
advice, and deficient auditor conduct. Defen':::;'€":::;' ca.n be
bui 1 t on the weakness or nonexistance of any of these
e 1 eme n t ':::; .. The defenses used depend primarily on the
circumstances of the case, but there are a few that are
frequently used. TI ..... lo ·:::;.uch defen':;e':::;' .:'.r·e due d i '1 i gence .:'.nd
con t r' i bu tor' >., n e.; I i ge n c e . The defenda.n t .. ' ':::;. due d iIi gence
defense is that he did not know and in the exercise of
reasonable care would not have discovered the omission or
misrepresentation of information. The defens.e of
contr' i butor'::'" nee)] i .;:)ence c·:'.n t.e used to I imi t .:l.udi tor'
the .:.. ': c 0 u n t .:l. n t .' ':::;. f .:l. i I u r· e top e r' for m the con t r' .:.. ct.:.. n d t 0
r·epor·t tr'ue infor·ma.tion.
Au d i tor' ':::;. h -::'.'.) e a. 1 i .:l.b i ] it::.·· tot h i r' d p ·:l.r· tie ':::;. un de r'
common law as well as cl ients. Third parties are parties
who have an interest in audi ted financial statements. but
don " t ha.'.)e a cc,n tr·.:l.c t 1 .... .1 i th the ·:O.ccoun t.;:'.n t 1 •• • • .Iho a.ud i ted the
':::;. t 21. t eme n t s· • There are three classes of third parties:
primary beneficiaries, foreseen beneficiaries, and
foreseeable third parties. A primary beneficiary is not a
c1 lent but 1 .•••. li 11 r·ecei'.)e a.n .:l.udi t r·epor·t th.;:'.t h.:o.s. been
prepared expressly for his benefit. An e:{ .:O.mp ] e of .;:..
primarY beneficiary is a bank which requires audi ted
financial statements from customers who want to take out a
1 oa.n. Foreseen beneficiaries are not specifica] ly
ide n t i fie d to.;:.. 'J d ito r' ':::;.. but the i r' ,;:) e n e r' .:l. lid e n tit :: .. ' a. n d
specific purpose for relying on the audi ted financial
1 .-:. '-'
statements are known • Foreseeable third parties are not
. :.p e c i ,: i c .:'.1 1 /. cr' c;le n e r' .:'.1 1:." i de n t i fie d, tlU t .:; till m i l;;Ih t be
expected to rely on audited financial statements.
I n'· ... e·=· t or": .. :'.nd potent i .:;'.1 i n '·) e':· t or":· ' .... .Ioul d f.:;..11 i I"ItCI th i .=.
ca. t e I;' CI r' /' •
The c omm 0 n 1 .:;..1 ..•. .1 1 i .::.. b iIi t y' 0 f ·:;..u d ito r' .:. toe .:;.. C h 0 f the
third party classes varies directly with how far each is
removed from a contractual agreement wi th the auditor for
a.udi t ·:·er· I.) ice':·, Since a primary beneficiary is
·:.pec i·f i ca.l1 :: .. , i dent i f i ed to the .:;'.udi tor' by' the 0:1 i ent, the
1 i.:;'.bil it·: .. · to the pr·imaTY· benefici.:;'.r)" .:;..nd the cl ient .:;'.r·e the
fr·.:'.ud.
Foreseen beneficiaries are farther removed from the
contractual agreement than primary beneficiaries. so the
Tr·a.di t i on.:;'.11 /', .audi tor":. h.:;.' .... e been 1 i .:;'.b] e to for·e·:.een
benefici.:;'.r·ie·:, for' I~r'os':' nel;il il~ence .:;..nd fr·.aud, but in a. fel .. ,.!
cases they have been The
decisions in two cases in particular, Rusch Factors, Inc.
I.). LeI.} i n .:;..nd RY.:;..n I.). K.:;..nne. ·:.uppor·t orlji n·:'.r·/· neg] i gence .:'.':.
one of the .:;'.udi tor· .. ··:. Ii .:'.bi lit i e':· to for·e·:.een benef i c i .:;'.r· i e':·,
This is Just one example that supports the current trend to
i ncr·e·:;..se the I i .:;'.b iIi t·y· of .:;'.ccoun t.:'.n t·: ..
Since foreseeable third parties are the furthest
r' em 0 I.) e d f r' om .:;'.: 0 n t r' .:;.. c t u .:;.. 1 1 i.:;.. b iIi t) .. , .:;.. u d i tor":. h.::.. ,.} e the
I e.:;..s.t amoun t of 1 i ab iIi t::.·· to th i·:. gr·oup. Aud i tor·s .. :;..r·e
14
1 i .:'.bl e to for·e·;.ee.:'.bl e th i r·d p.:..r·t i 02-:' for' 9r'0';'-:' ne91 i g ence
·:'.n d f r' ·:..U d.
The ca-:.e of Ultramare-:. Corp. v. Touche ha-:. been the
primary ca-:.e for -:.etting a 1e9al precedent for an auditor's
Ii .:'.bi lit::,.· to IH' im':<.r··:,.· benf i c i .::<.r- i e';· .::<.nd for' e·;·e e.:'.bI 02 th i r'lj
~).:'.r tie';" During an audi t. Touche failed to uncover a
material amount of fictitious account-:. receivable.
c 0 u r' t r' u led t h.:.. t the .:.. u d j tor' 1..<.1 .:.. ';. Ii.:.. b let 0 p r' i ITJ·:'. r' )"'
or' f r·:,. u d m u .:; t 0 c cur' for' the .:.. u d ito r' t 0 bel i .:<. b 1 e t 0
fore-:.eeable third partie-:..
The civil action that can be taken a9ain-:.t audi tor-:..
the bJrden of proof~ and the damage-:. that can be awarded
.:.. r· 02 the ';. ':<.m 02 for' .:.. I I t h i r' d p .:.. r' tie '; .• Tor·t i,;, tht? ci'.}il
action that can be taken. The burden of proof i-:. on the
pl.:.. i n t iff for" the f ou r' e I erne n t .=. of au d i tor' ." s 1 i .:'.b iIi t y' • A
third party can receive both monetary and punitive damage-:..
Be ';. i de ';. the du 02 d iIi I~e n cede fen ';·02 e ::q) 1 .:.. i ned e ·:'.r· lie r' •
audi tor-:. can u-:.e the defen-:.e-:. of lack of privity and
ju·::.t i f i ':'.bl 02 r'el i ·:'.nce In c·::<.·;·e·;· i n' . .!ol',! i ng th i r·d p.::<.r·t i t?:: .•
L.:'.cl< of pro i I.} it::, .. me·:'.n·=· th.:'.t the .:'.udi tor' is. not Ii .:'.bl e to the
third party because there i-:. no contract between them. The
..i us t i f i .:'.b 1 e r' ell .:'.n cede fen ';·02 c ':'.n be u -:.e d ' .... .Ih e nth e de fen d.:'.n t
bel ie· .... e·=. th.:'.t the (:.].:..intiff 1 .. <.1':<.';. not r·e.:..-:.on.:..bl/ ju·;.tified in
rel/ing on the financial -:.tatements.
:=:; t .:'. t u tor' ::.-. 1 .:..1 ... ..1 i';. " i .... .1 r' itt 02 n I .:..' .... .1" t hat i·::. e S. t ':'. b 1 i .:; he db':,"
15
f e de r· ':1.1 .:..n d s· t .:.. tel e,~ i ·::.1 .:.. ti'..' e bod i e s . The primarY federal
statutory laws that have an affect on the accounting
profession are the Securities Act of 1933 and the
Secur ties and Exchange Act of 1934. By passing these acts.
Conl~r·es·:. Ii·.! a.·:. a.ttempt i ng to m.:..Ve a.ccount.:..nts mor·e Ii abl e to
th i r·d p.:..r· tie·: .• The Securities Act of 1933 regulates the
original offering and sale of securities. The s.a.l e of
·::·ecur· it i e·:· .:..f ter· the f i r··:.t i s·::·u·:..nce ·:..r·e not co'..'er·ed under·
thi·::. ~:;ct. The Act r·equ i r·es· th.:..t in or·der· for· ::..n ent it>' to
pub I i c 1 ::,.. ·:·e I lit .::. ·:.e cur· i tie .:., t h.:.. ten tit .:,.. mu s t f i 1 e a.
registration statement (usually an S-I) and a prospectus
This is done in an attempt to promote full
and fair disclosure and prohibi t fraudulent
misrepresentation regarding the original issuance and sale
of ·:·e cur· i tie s .
Accountants come under the 1933 Act when they aid in
the preparation of registration statements and
or·o·:·[)ec tuse·: .. The specific on which most i t i I~.:'. t i on
against accountants is based is Section 11 Under· :::;ec t i on
11. ·:..n .:..ccount.:..nt gener·.:..ll:;.' qu.:..1 if i e·:; .:..-: .. :..n e::-::per·t .:;..nd 1 •• ' • .Ii 11
incur· li.:;..bilit:~·· .:..-:. to a.n omis.·:.ion or· fa.lse ·:.ta.tement of .:;..
material fact unless he had, after a reasoGable
that the statements were true and that no material facts
1 .... .1 e r· e om itt e d . If an accountant violates Section 11, he may
be 1 i .:..bl e to the pur·ch.:..·:;er··::. clf ·:.ecur· it i e·::· for· or·d i n.:..r·::,'
16
The burden of proof under the Securi ties Act of 1933
does not rest solely upon the plaintiff or the defendant.
The plaintiff must prove that he suffered damages and loss~
and that the financial statements were material Ix misstated
or erroneous advice was given. The defendant must prove
t h:<. the ·;<.c ted 1 .. • . .1 i t h du e d iIi ge n c e an d t h .:<. t the pI .:<. i n t iff did
not rely on the financial statements.
The case of Escott v. 8arChris Construction Corp. had
great influence upon the accounting profession with regard
to I i:<.b iIi t .;... un de r· :::;e c t i on 11 of t he 1 '7'33 Ac t . I n the
case, an S-1 review was reauired to examine the events that
had occured between the balance sheet date and the
effective date of the registration statement.
Marwick, Mi tche 1 ] & Co. performed the S-1 review because
they had audi ted the most recent financial statements. The
senior who was in charge of the review was not yet a CPA
and was working on his first engagement as a senior. After
the sale of the securi ties~ 8arChris filed for banKruptcy.
Pe.:<.t. r···l.:<.r·v . .Ii ck c1 <l.imed <l. due di Ii gence defen·::.e. Trle cour· t
ruled that accountants should not be held to a standard
t h <l. t i·::. h i 9h e r· t h <l.n the on e e -;:. t <l.b I i sh e d b:~" the p r· of e .::.-;:. i on ,
but in this case the accountants did not maintain that
standard. The defendant had the burden of proving the due
d iIi ge n cede fen ·'E·e ·3.n d did not e f f e c ti'.} e 1:;.-· do ·::·CI. Th e
court/s opinion prompted the issuance of Statement on
Audi tin9 Procedure No. 47, "Subsequent Events,n. as well as
·::.etting <l. pr·ecedent th.o<.t a.udi tor·· .. s. could be held I i.3.ble for·
or·din'~'.r·::,' ne<:;ll il~ence under· the Secur·i tie-=:. Act o-F 1':;:'3::::.
The Securities and Exchan<:;le Act of 1934 taKes over
1 -=' .l .-
where the 1933 Act leaves off. It re<:;lulates the tradin<:;l of
securi ties that have previously been issued. The pur·po·::.e
of the Act is to promote fair and adequate disclosure of
public1·:.' he11j comp':'.n i e'::· on .:.. continuin';j ba.·::.i·:: .• Entitie'::'
are required to submi t periodic information as well as a
re<:;listration form (commonly form 10) to the SEC •
. :'.1'::.0 r'equ i r'e,j to en1 i ·::.t thE' ser· I.) ice'::. of .:.. C:er·t i f i ed Publ i c
Accclun t.:'.n t. Th eli .:'.b iIi t ::.' of C:PA·::. un de r' t h i'3 Ac t '3 t em'::·
f r' om the i r· i n I.) 0 1 I.) e men tin the Ij i -=:. c los u r' e p r' 0 c e s s • An
.:..ccount.:'.nt i·::. I j .:'.bl e for' er·r·or··::· in f i n·:'.nc i.:.l ·::.t.:'.tement·::.
contained in a prospectus or other filed report even thou<:;lh
it is unaudi ted if there are errors which he knew or
reaso,ably should have Known.
A purchaser or seller of a securi ty usually brings
18 of the 1934 Act.
10(b) . In f.:..c t. th i·::. ·::·ec t i on i -=:. II the most r·.:..p j dl >'
e }:: p a. n din I~ .:.. r· e·:.. 0 f 1 i.:.. b iIi t >' IJ n de r· fed e r· a. I .::. e c IJ r' i tie s 1 .::<.1 .... .1 .::.
for' f i r·m·::· .::< .. ::. I,,·)e I 1 .:...::. d i r' e c tor .::.. of f ice r"::.. .:'Tl'j p IJ b 1 i c
accountants.H(11 Accordin<:;l to Section lOeb) and Rule
lOb - 5. i t i -=:. un I at·,.1 f u Ito u .::. em·:.. i I .::.. .:.. n yin .::. t r'u men t .:.. lit y. 0 f
interstate commerce. or any national securities exchan';je to
defraud any person in connection wi th the purchase or sale
under these provisions is very broad because the provisions
1 c· '-'
cover any false or misleading statement~ regardless of
whether or not it is filed wi th the SEC.
1 i .:'.bl e to ·::.e 11 er .::. or' pur·cha.-::.er"::, for' ';lr·o·::.·::. neg! i ';lence or'
fraud for not complying wi th this section of the 1934 Act.
The burden of proof under section IOCb) rests entirely
on the plaintiff. The plaintiff must prove that he
suffered damage or loss. the statements were materially
false statements or advice. and the auditor's conduct was
deficient.
Hochfe1der v. Ernst & Ernst has been a landmark case
r·eg.;:..r·di n9 a.ccounta.nt .. ··::· 1 i .:'.bi 1 it) .. under' Pul e 101:.-5 of the
Securities and Exchange Act of 1934. The case resulted
from the discovery that the president of First Securi ties
Corporation was using the funds of investors for his own
iJ ":-e • Investors had sent funds directly to him with the
understanding that he would deeosi t the funds in an escrow
·~.CCCIIJ .-J t . He kep t his fr·a.ud a. ·::·ecr·e t by esta.b1 ish i r,,~ the
"m.;:'.i r' u 1 e" ! ..•. .1 h i c h p r' 0 hit. i ted .:;. n ) .. 0 nee] .::. e f r' om 0 pen i n':j rl i·::.
ma.i 1. When the fraud was discovered~ the accountants were
Af ter' r'u 1 i ng'::' in f.:..'''! or' of Er·n·::.t 8.,
Ernst in District Court and against them in the Court of
Appeals~ the case reached the Supreme Court. The Cour' t
and not the "intent to deceive. manipulate. or defraud~"
Er·n·::.t .~< Er·n·::t 1. ••• .1.;:. .. ::. not 1 i a.b] e.';: 12) The Court pointed out
that Congress intended for Pule 10b-5 to apply to something
much ·::.tr·onger· tha.n nel~l I gence a.nd th.3.t lOb-5 cl e.3.r·I;." ·:.ta.te·:.
·:·c i en ter· l .3.nd not mer·e ne91 i qence, 1 ..... 1 ill ·:.utt i ce. The
Ijeci·:.ion in Hochtelder· did limit the .3.ccount.3.nt ... s· lia.bi1it::,··
somewhat, but the Court lett some questions unanswered by
not addressing the question ot whether or not reckless
beh.3. '.}ior· C.3.n r·e·=.ult in li.3.billt::, .. under· :3ection 10(b) .3.nd
Pule lOb-5.
The ·:.coj:1e ot I i a.b IIi t:: .. · under· :::;ec t i on 1:::: o·f the
Securities and Exchange Aet ot 1934 is much narrower than
::::ect i on 10<b) beca.u·:.e it .:,t.pp1 i es· onl y to ·:.t.:..tements. til ed
1 .. • • .1 i t h the SEC . Under this section, persons who maKe talse
. 3.n d m i ·:.1 e .:c.d i n 9 .:;. t .:.. t eme n t .:;. I n til e d dell: ume n t .:. ·:c.r· eli .:c.b 1 e to
j:1ur·ch.:c.s.er··:. a.nd ·:::·e 11 er··:;· ot ·:::·eeur· it i e-=:· v,lho r·e 1 i ed upon the-:.e
statements it the price of the securi ties was attected by
the .:. t .:c. t eme n t .: .. In or·der· for· .:.. CPA to be 1 i a.b1 e l he mu·:::·t
The bur· den ot pr·oof urlljer· th i·:. s·ec t i on is .:.p lit
between the olaintitt and the detendant. Th e pI .:c. i n tit f
must orove that damage or loss was incurred, the statements
I ... ·.le r· e iT! i·:.·:. t .:.. ted or· e r· r· on e (jU .::. .:c.d!.) ice gi' .... en, ·:..n d her· eli e d on
the misstated statements or erroneous advice. The
detend.:..nt c·:..n .:..'}oid 1 i.:..tli 1 j t-;." b::," pr·o!..!inl~ th.:..t he .:..cted in
900d faith and had no Knowledqe of any talse or misleading
-:.t.:c.tement·:. (due di 1 i I~ence).
There are other federal statutes besides the
Secur· it j e·::· Act·:. I/ . .lh j ch mi ght .:..tfect the 1 j .:c.bi lit::, .. ot
a.c c ou n t ·:..n t .: .. These statutes are the Federal False
20
Statements Act, the Federal Mail Fraud Act, and the Federal
Conspiracy Statute. Ape r' '=::·0 n rna::." be c om eli :.. b I €? U n de r' the
Federal False Statements Act if he knowinglY and willfully
makes false statements to any department or agency of the
federal government. Accountants come under the
jurisdiction of this act when their audi ting reports
accompany financial statements in reports filed with the
The Federal Mail Fraud Act prohibits the fraudulent
u·=::.e 0·; the post.;.l ·=::·er·IJ i ce. Th i·=:: .. :..ct a.ppl i e~· to .:,.ccclunt.:'.nt·=::.
i .. ·.Jhen the::,' cer·t if::.,' f! n·:'.nc i .;:'.l=::.t.;:'.tement=::. th.:'.t thE'·:," knol .... .1 or'
should know are false and will be used in violation of the
·=::.t.:'.tute. Li .:'.bi i it::,· under' the Feder·.:'.l Consp i r·a.c::,·· ::::t.:'.tute
arises when two or more individuals agree to commi t a crime
a. 9 .;:.. in=::. t the U nit e d :::: t .;:.. t e·=::· • Accountants may be prosecuted
for conspiracy to violate any of the four federal statutes
previously mentioned.
Since statutes vary from state to state, it would not
be pr·:..ctic.;:..l to di·=::.cu·=::.~. them in ,jepth in thi·=::. p.:'.per·, but
some statutes that are common to many states should be
men t I onelj. Most states have enacted statutes that would
m.:'.ke ·;:'.n .;:..ccount.:'.nt cr·imin.;:'.lly· 1 i.;:'.ble for' obt.;:'.inin ,;:) mone::,' tl:;'"
talse pretenses and for wi 1 lfu1 ly falsifyino reports.
:::: tat e a.c c ou n t ·;:'.n c ::." I .:'.I,..)·=::. rl.:'.I.) e be e n e·=::· t .:'.b 1 i ·=::.h edt 0 r' e I.) ok e or'
suspend an accountant's right to practice if he has engaged
i nun e t h i c .:<.1 c 0"1 du ct. Many states have adopted section 101
of the Uniform Securi ties Act which is very simi lar to SEC
21
rule 10b-5 which is described above.(13) I .. ) .;:0. r' i (I U .::. .::. t .;:.. t e':·
have also enacted laws permitting CPA firms to practice in
the form of a professional corporation. These laws provide
1 i m i +.: E' d I i .:'.b iIi t::., tot h e cor' p or' ·9. t i on • HOI .... .Ie ,.) e r' '. e ·:..c h
p r' of e '=:.'::. i on .:'.1 per' ·::·on rem.::.. j n .::. per' ·::.on a.1 1 :: •. , I i .::'.b 1 e ;: or' 1 ... ·.Ior· k t h ·9. t
he personally performs.(14)
t~· ' i - 1 ,_ . .r' 1m 1 n·:, ... 1 i .9. b iIi t yin I.) 0 I \) j n g a.u d ito r' .::. h a. -=:. not 0 c cur' r' e d
'.)er·::,·· of ten in the p.9.·::.t fet.· .. 1 'y·e·9.r··:: .• There have been very few
c.9ses t",lher'e .9.udi tor'-=:, ha'.)e been hel d cr' imi n.9.11 ::,' Ii .9.bl e,
r-··10·::.t i n' . .!ol' . .!e c i·.} i I i'::'.bi lib·', Cr' i min .9.1 I j .9.b iIi t -:.' i-=:.
d iff e r" e n t f r' om c i I.) i I I i .::'.b j lit ::." i nth ·9. t C rim i n .9.·l 1 i .::'.b i 1 t:: ...
involves a wi Ilful I violation of a statute.
in ten t r'equ i r'emen t·::. 1 .... .1 j I I 1.)·9,r-·:··· a.ccor·d i ng to Clr'eceden ts ·::·e t
for each particular statute. 1 ..... lh i ] e the pI ·9. i n t iff i n ·9.
c i 1.) i I c.9.se U·::.U.9.11 ::.' 1 •• <.Ii n·::· if .::'.11 the e ' . .! j dence 1 e·9.n·:. '::.1 i (~htl :: .. '
in hi =. fa'.)or·, the pl.9.i nt i ff in ·9. cr' imi n.9.1 c·:,.·::·e 1..· • .Ii II not 1 .... .Ii n
unless the defendant's gui 1 t is proven beyond a reasonable
doubt, Most criminal c.::.ses against accountants are
!:,r·o·::.ecuted under' feder·.::'.1 1.::'.1/ . .1.
The case of the United States v. Simon is significant
to the .::..ccount i ng !:Ir·ofe·::.·::.i on bec.:'.u·::.e it est.::..bl i ·::.hed ·::'.n
.::..udi tor· ... ·::. cr' imi n.::.l 1 i .9.bi I it·: .. ,
This case, which is also referred to as the
Continental Vending case, was brought against the
accountants by the government because it was alleged that
they wi Ilful1y orepared false or misleading financial
.::. t .::.. t e"Tle n t ':; .• The audi tors used the defense that they were
f r· e e 0 f c r· i min .:.. IIi .:.. b iIi t::.-· be c a. u .::;. e the ::,. h.:.. d f 0 I I 0'.·'·.1 e d
generally accepted accounting principles. The court
convicted the audi tors of willfully making ~ false and
misleading statement and for using the postal service to
distribute this statement. The auditors received a pardon
from President Nixon. This case imposes a duty upon
accountants to disclose what they Know when they have
r·e·~·::;·on to bel i e'·.!e th.:..t ~. bu·::.i ne·::·s· ent it::,·· to .:.. m.:..ter· i .0..1
22
extent i·". oper·a.t i rjl~ for· the !:Ir· i '.).o..te benef it of its.
management rather than in the interest of its stockholders.
The accounting profession was very concerned about the
decis.icln bec.o..u·::.e it felt th.o..t compl ia.nce ' .... .Iith I3AAP .o..nd I3AA:::;
should be a strong defense.
Within recent Years, the number of cases against
accountants has increased and as a result, more precautions
are being taken. One of the first things an accountant
should do to avoid litigation is make sure he Knows and
c om 1:' 1 i e·::· 1} • .1 i t h .0.. C C 0 u n tin g.::. t .0.. n d a. r· d·::;. .0<. n d p r· 0 n 0 u n c em e n t .:: ..
These ·:..r·e the gu i del i ne·:: of the pr·ofe·=.·=.i on, .o..nd ·:..n
·~., .... .I.o..r·ene·=··=· of them i·::;. e·=··=·en t i .~.I to pr·o',) i de qu.o..1 i t:;.-· ·=·er·'·) i ce
.o..nd r·educe e::q::oo·=.ur·e to 1 it i g.:..t i on. Continuing professional
education is an excellent way to keep current on the
ever-changing standards of the accounting profession.
r·'10·=.t .o..ccounta.nt·= .. o..nd the AICPA bel i e'·)€' tha.t if tr,e
professional standards are followed, an accountant should
not t.e ·=.ubject to 1 i .:..bi 1 i t:: ... bec.o..u:;:.e cour·t·=. c.o..nnot impo·=.e
higher standards than the standards of the profession. To
,jo t hi·:. I.'-IOU 1 d i fT'P o·:·e I i a.b i 1 it::... e I.} e n i f the .3.C c ou n t .:'.n t d i ,j
everything he ought to do. Lawyers of plainti~fs disagree
li . .!i th this bec.:..u·:.e the':," bel iel.}e tha.t the pr·o·fes.sion might
have set standards too low to provide adequate care.
Courts have also ruled, as in Uni ted States v. Simon, that
c om CI I i a. n c e 1 .. ' . .1 i t h i3AA:::: .:.. n d (3AA P m .:<. Y' not CI r' e I) e n t .:.. n .:.. c c 0 u n t .:.. n t
from being liable. The SEC promulgates new rules and
regulations when it feels that accounting standards are not
accountants to comply wi th the standards, but also go
beyond the stan,jards and apply their good judgement.
C clm p Ii.:.. n c e li..\ i t h p r' 0 f e':· ';. ion .:.. I .:.. c c 0 u n tin g';, t .:.. n d.:.. r' d .=. II i,;.
no guarantee that under particular circumstances an auditor
wi I I be held blameless. There is simply no substitute for
vigilance and good judgement when it comes to avoiding
b I .:'.me . II ( 15)
Besides Knowledge of accounting principles and
pronouncements, members of the accounting profession
recommen,j other precautions that should be taKen to avoid
Ii til;J:..tion. One of the·;.e i,;. cl i ent accept.:..nce .:'.nd
r' e ten t i on . Befor'e .:'.ccep t i nl~ .:.. nel .. ,.! c I i en t. it i,;, i mpor' t.:'.n t
to do ·;.uch th i nq·:. ·3.'=· 1001< into the cl i ent···s b.3.cKgr·ound,
find out who the predecessor accountant IS, and learn all
':'.bou t the c I i en t' ';. bu';. i ne·:··=·. ~~et.:..ininq ·3. cl lent decr·e.3se·:::.
::,., 0 u r' pot e n t i.:.. IIi .:.. b iii t Y' be c·:,. u .:::. Eo :;'-' 0 u be c om e m 0 r' e f am iii ·3. r'
with his operations as time goes on.
An engagement letter is a very effective precaution.
24
The letter' i,:;: .. ;:..ctu.;:..I]::,' .;:.. con tr·,;:,.c tu.;:'.l .;:'.';Ireement th.;:'.t can
.;:..c tu.:;'.l I;.' r'educe the E'XPE'C t':'.t i on .:;).;:'.p. I t i,:;:, not r' E' qui r' E' db::.'
thE' professional standards. but most accountants USE' it
anfi~ay to spE'11 out thE' SCOPE' of thE' audit and avoid
misundE'rstandings.
Th r' ou.:;)h q u .:;..1 i t /. con t r' 0 1 ~ ':'.n ·;t.u d i t clr' doE' .:. hi·:; bE' .:. t to
apply thE' samE' hi.:;)h standards durin.:;) E'ach engagE'mE'nt.
C!u.;t.1 i 1:::.-' contr'ol c·;t.n tiE' m':'.int.:'.inE'd b::,.· ·:.ettin9 up ·:.t.:;'.nd':'.r·d
procedures to follow and propE'rly planning en.:;)a9E'mE'nts.
DthE'r' th i ngs ·:'.r·e i n l.}ol '')E'd .;:..l·:.o~ 1 ike qu.;t.1 it::,·, pE'r··:.onnE'l th.:..t
are propE'rly supervisE'd.
AnothE'r way to 9uard a.:;)ainst 1 i tigation :. to b.;t.l.;t.nce
I;;) r' 01.'0.1 t h .:.. n ,j qua lit y' con t r' 0 I • Growth brin.:;)s on things that
c .;t. n d ·:'.m .;:.. 9 E' q U .;:.. 1 ; t >' ·:;u C h.:.. ':;:. lim i t E' d '5U P E' r' I.} i s ion be c ·;:..u .:. E' the
f i r'm i·:. under··:.t.:;..ffed. e:>::ce·:.·:.i I·}e de~.dl i ne pr·es.s.ur·e •. :;..nd
hE'avy overtimE' requirE'ments. Accountants must guard
.;:..,;;)~.in·:;.t thE'sE' thinl;J':' v . .Ihile ·:;:.til1 ~.]loIAling gr·ol.' . .Ith to h~.ppen.
)efen·:.i'.)e .::<.ulji tin,;;) •. ;:.nother· c'r·eca.ution~ in'.)ol '·}e-:.
looking for and evaluating indicators of possible problems.
An .;:'.u,ji tor' ·:;.houldn···t le.;:'.'-.!e him·:.elf open to .;:..ny 1 i.;:'.bi 1 it::,·,
that :ould be prevented. Among other thin95. he should
document all his work careful IY~ be very cautious about
management representations, and consul t wi th a partner or
colle ~ . .:;)u e of ten.
The 1 .;:. .. :. t p r' e c·:.. uti 0 n p r' e':;:· e n ted her' e i·:; leg .;:.. 1 .;:.. d I.} ice •
Even though an auditor should have a good idea of whether
.;:.. n .;:.. c t i·: ill e 9:<. I the .::<.ctu.::<.l deter·min.;:'.tion i·:. usu.;:..II::.-·
.~----.---.. ----------
.-.1:" £0.-_1
beyond his professional competence. This is why he should
consul t a lawyer when questionable acts surface. One
a.uthor ·:.ta.ted,"Pr·ec.::<.ut i ona.r·::.·· I e.;:)a.1 .::<.d\) i ce, 1 ike· pr·el.)ent i 1·.Ie
medicine, may be essential to a CPA firm/s continuing
.. ' I e .;:).::<.1 rl e a.1 t h •. ' Ii ( 1.'5:..)
Th i·:. p.::<.per· h.::<.·:. e::::p 1 or'ed thE' r·es.pons i b iIi ty .::<.nd
potE'nt i a.1 Ii .::..bi 1 i ty th.3.t a.udi tor":, f.::<.ce 1 .... .Ii th r·e~~a.r·d to
·::<.U d i ted fin ·::<.n c i .~.I .:. t .::<. t erne n t .:., .::<.1 on':;I IAI i t h P r' e c ·:<.u t i on s t h .::<. t
c a.n be t .::<Y e n to qu ·3T d ·::<.9,::<, in'::, t 1 i t i q.::<. t i on • The dr' a.':· t i c
increase in management fraud in the past twenty years has
been hard on accountants because it has resulted in an
The i ncr'ease in the i r' nel;)1 i ';tence has ca.u·:.ed audi tor"":. to
publ i c I .. ·.)ho no!/·) th i nk th.::<.t the Ii .::<.bi 1 it::.·· of a.udi tor'':. ,:.houl d
be j ncr·ea.':·ed. Court decisions and regulations by the SEC
tenlj to r'eflect ·::<.n i ncr·e·3.,:·e in Ii ·::<.bi lit::.··. 1 ... ..1 i th mor'e
1 i a.bi lit::.·· pl.::<.ced on them, .::<.ccount·::<.nt·:. need to t.::..ke
precautions to decrease their chances of being sued.
New areas that wi 1 I present new legal questions in the
near future are compilations and reviews. and forecasts.
When performing a compilation and review, the accountant
c om p i 1 e':· fin ·::<T' c 1 .::<. 1 i n for' m .::<. t ion 9 i I.) e n t 0 him b :>" the c 1 i e n t
and then prepares financial statements.
the statements by performing analytical procedures to
discover unusual items and determine whether the financial
statements appear to conform to generally accepted
accounting principles. A compilation and review is not an
qudi t. so the reviewed statements should be marked
Questions almost definitely
-:._r-I-:-e -:._-:- to I/-_d-I€'th€'r- or- not -:..ccount-:..nt·:. ·:..r·€' 1 i .:._bl e for- th€'·:.€'
.:. t a. t erne n t ",.. 1 .. ·.Jh 0 the Y' m i gh t be 1 i ab 1 e to, a.n dun de r' v-Jh a. t
c i r·cum-:.t.:;'.nce-: ..
~-he i i.:'.bi 1 it::,·· of a.ccount.:'.nt·:- for' fin.:;..nci.:;..1 for·ec.:;..·:.t-::;
is uncertain at the present because an accountant's role in
the preparation and release of forecasts is uncertain. It
is not practical for anyone to expect forecasts to have a
high degree of ~ccuracy because th€'Y are basically €'ducated
I;' U e ';. '=. e ':: .. E: uti n e I.) i t d. b 1 ::'_., the r' e 1/ • .1 ill be':, om e p e 01:) let h d. t
1.'.Iill e::·::pect d_ h.,:::)her· de9r'ee of ·:;..ccur·.:;..c::,' th.:;..n the::,' ·:.hould.
The problem wi 11 be determinin9 if the auditor has any
i .:;._ tl iii t ':,' 1/ . .1 hen -:. om eon 12 r- eli e':· 0 n .:;._ for- e c d .. :. t .
What will auditors be able to expect in the future?
F.: i ':::) h t n 0 1 .... ), i t 1 00 k .:::. 1 ike the i r' Ii.:;.. b 1 iii t ;,' 1 .• ' . .1 ill con tin u €' t 0
increase, unless the values of our society change. I t i·:::.
possible that there will be a great decrease in fradulent
d.cts, ,ju-:.t .:;. .. :. ther·e h-:._·:. been .:;.. gr·e.:;..t incr·ea.·:-€' in r'ecent
/-12 ·:;..r- -:.. bu t don .' t t h ink t hi·:::. 1/ . .1 i 1 h.:..ppen in the ne·:;..r·
fu tur·2. Instead, audi tors wi 1 1 have to do somethin,:::) to
i mpr·o'._-'e the i r' cr-ed i b iii t:;.'. Since ther€' has been some
criticism of the broadness of accounting standards, the
profession might have to consider modifying them to improve
r-el d.t i on-::· 1 •• <.li th the publ i c. Th e r- e i·:. .:;..1 ':·0 -:;. .::: I i I:::)h t
I:lo·:::-·:::.i bi 1 it·:" th-:..t the gOI.}er·nment 1,<.Ii 11 t.:._ke contr-ol .:..nd be
.-,--;' L{
the sale regulator of the accounting profession if the
v . .Ih.:'.t h.:'.ppen·:" .:..udi tor":::. I. ... )i 11 h.?' .... e to be '·}er·::,·· ca.r·efu1 in
their auditing procedures and take all possible precautions
to a.'.}oi d 1 i a.bi 1 it:;.', bec.::,.u·:::.e the 1 i .:'.bi 1 i t:;.-· m.?:'·· become mor'e
than they can bear.
.: 1) Denz i 1 ' .. (. C:.:'.u·:::.e::.', Dut i es .:'.nd Li .~.bi lit! e':::· ot PIJbl i c A c c 0 u rL t .:.. n t s (D OI;.J ,J 0 n e':::· - I r·I .. '.J in, 1 9:3 2 .:.. n d 1 ':;' 7:3) ~ P p. 1 2 - 1 4 .
(2) AccolJn t i nq in Tr·.:'.n·:; it i on: Oral Histories ot Recent U.S. Experience~ ed. Thomas :::;t.:'.te Uni' .... er·:::.ib··, 1':;'74), p. 7.
,J. Bur'n':::" (The Ohio
(:3) George R. Carlett, "Relationship ot Auditing :::;t·~.nd.:'<.r·d·:::. to De tec t ion ot Fr·.~.ud," Con tempor:.~.r·::,·· Aud it i nq Pr' Dt;.l~..lfIS , e d. Hov . .Ia.r· d :::; t e t t 1 e r', (Un i ' .... e r' sit ::.' ot f<a.n '::: .. ~.':::. Printing Service, no cODyright proceedings, 1974), P. 47.
,:4) FloY',j V.I. l....Iinda.l .:'.nd Rober·t r···~. Cor·le::.··, It-Ie 8ccount i nq F'r·ote·:::.si on.~.l: .. Eth i c':::·. Re·:::.pon:.i bi 1 i t;:,·, .~.nd
!:-i·:. . ..Q.LUt;:.-·, (Engle l .... Jood C1 itt·:::.: Pr·entice-H.~.ll , Inc •• l'7'E:O) , p. ':;'2.
(5) Il .. linlj.3.1 ~ p. 94
(6) Kent St. Pierre and James Anderson, "An Analysis ot Aud it F.:.. i I ur·e·:::. B.:.sed on Documen ted Leg.:.. 1 C':'.·:::.e·:::,," :J.Qur·n.:..l ot Accountinq. Audi tinq & Finance, Spring 19:32, pp.
( 7) 1 •• <.1 i n da.l, p. 10:;:: •
(:3) I..,jind.:..l, p.
(9) Nancy E. Landahl and L. Lee Re:.pon·:;. i b iIi t;:.-· for' Fr·.~.ud De tec t i on: 1 .... .Iom.:..n CPA. ,Ju 1;:.-' 19:31, p. 22.
(10) La.ndahl~ p. 22.
( 1 1) C:.:a.1J ":-6' ~'r", p. ''7'5.
::;:;ehmi dt, ,Jr'., "Audi tor' D i .:::.p ell i n 9 .~. r·'l;:.·· t h , "
(12) An dr' ev·.1 H. B':'.r·nett ':'.nd F. FultDn Ga.ler·, ":::;cienter' :::; i nee Hochte I der' ," The CPA ,Jour·n·~.h No'h?mbe r' 19:32, p. 42.
( 14) 1 .. ,.1 i n ,j.:.. 1, p. 225.
(15) 1;..Iinda.l, pp. 142-:3.
(16) Charles Chazen, Richard L. Miller, Jr. and Kenneth I. Solomon. "When the Rules Say: 'See Your L.:'.I/ . .I/·er·, .. '" JOldr·n:. . .1 ot Accoun t.:'.ncy, ,J.:'.nu.:'.r·";.-· 1 '7'::::1, p. t.,O.
B I BL I OGPAF'H"'(
Ac ';;'OU.DJ i rfl~ i n Tr' ·:'.n .::. L t i on : Or_· ."":. . ..!.l---.:H..:....:...i ..=-:;-=. tor' i 12 s clf Pe c 12 n t U_. :::; • ~~ ;':: p 12 r'i 12 n c 12 .!.. Ed. Thorn .:.. s· .J. Bur' n .::. • The 0 h i 0 :::; t a. t e Un i '.)er··::. it:;.", 1 -:';'74.
Ba~nett, And~ew H. ~ CPA, DBA and F. Ful ton Gale~.
"Sc i enter' ::::i nce Hochfel der·." The CPEt .Jour·na.l Novembe~ 1982, PP. 40-45.
Biggs, :::;he~idan C •• J~., CPA. "Pe~spectives in Audi ting -I: or' the 19::::0 .::. ·:'.n d Be -:'-'on d. " .J ou r' n .:'.1 gf Ac I; OU.Jl.,t ·:'.n Q~.-\. May 1982, pp. 93-104.
Catlett, Geo~ge R. "Pelationship of Audi ting Standa~ds to Detection of Fraud." Contempo~a~y Audi ti"9 P~oblems. Ed. Howa~d Stettle~. Unive~si ty of Kansas P~inting :;:;er·'.)ice. t"lo cop:,"r·ight. Pr·oceedinl~-:;. clf the 1974 A~thu~ Ande~sen Unive~sity of Kansas SYmposium on ~~u d i t Pro ob 1 em'::· •
c.:'.u '::·12 ::,., De n z i 1 ", .• , .Jr'., DBA, .JD, CPA. Du tie -:;. ·:.,n d 1:- j a. b j 1 j tie '::. 0 f Pub 1 i cAe C 0 u n t a. n t -:;. • D 01 .... .1 .J 0 n e'::· - I r·I .... ,! in, 1 ';:':32 ·:'.n d 1 ':;:'73 •
Ch ·:..Z 12 n. Ch ·:'.r· 1 e'::., F.: i c h ·:'.r· d L. t"1 ill e r·. .Jr·. a.n d ~:::e nne t hI. ':;01 omon. ·'I.·.Jhen the Pu i es :::;a.::.": .. ' :31212 "'(our' La.' .... .I} .. er·. ,'" Jour·n·:.· .. L .. pf Account.;:'.nc';.'·, .J.:..nlj.;:..r·}·· 19:31, pp. 60-70.
Cr',:,. i g ~ R i ch.:'.r·d L. "The I ndependen t Pub1 i c Accclun t·:'.n t "'-:;. ::;::01 e in At te·::.t i ng F i n.;:'.nc i .;:..1 For·ec.:.,·::.t·:: .• " Cur·r·eILl. j='r'clbl em'::· in the Account i n~·ofe·::,·::.i on. ed. t,::." James A. Cashin, MBA. CPA and Do~othea E. Meye~. PhD. Hemp .::. t e .:'.d: Hof -:;. t r··;:. Un i '') .• Se r' i e'::· 1:3. 1'.)01.3.
Dunfee, Thomas W. and Irvin N. Gleim. " Cr' i min .:'.1 L i .:'.b i it·· ... :1 f A c c 0 Ij n t a. n t -:;. : Sou r' c e -:;. .:'. n d Pol i c i e -:;. • " Am e r' i can Bu'::, i ne-:;··::· L.::..I..<,1 .Jour-n.~ 3pr' i ng 1':;:'71. PI:I. 1-20.
Dz i en kO' .. · .. I·::.k: i, .John S. "Accountants ... · Li a.bi 1 i t)-·· for' Compensation and Review Engagements." e.e t.) i e l .... !....!. Ap r' ill 9::::2, p p. 75'7'-:::: 19.
l~):: a'::· L .:..1 .. • .. 1
"Independent Audi tor"::, Ga.i n Cour·t I·.)i ctor' i e'::,," Arne r' i c ·::'.n B.;:'.r· 6,':.-:;.0': i a. t i on .J our' n a.1_1. .Ju n e 19:32, p. .:;.70.
La. n d a. hI. N a. n c :;... E. ·3. n d L. Lee 3 c h mid t, .J r' . " Au d ito r' F.:e·:.pon·::.i bi'j it·: .. · for' Fr·a.ud Detect i on: Di ,:.pe1 i ng a. ("1:: .. ' t h . " 1 .... .IolI!.:..n C:P~..l... .Ju I :;... 1 '?B 1, P p. 22-::::6.
Solomon. Kenneth I~a~ Cha~les Chazen and Richa~d L. Mi 1 1e~ • • ..1 r' • II C c.m 1:1 i 1 .:;. t ion ·3. n d Pe'.) i e 1 .• ',.1 : the::;; .;:.. f e t y. F.:.. c tor' • II
.Jou.c. n ~:.L __ Q .. :L . .£ic c QU n t~r.!.f..iJ .Ju 1 ':." 19::::3. p p. 50 -5::;:.
:::; t. Pie r' r' €'. ~:::e n t ·:'.n d .J ·:..me ':;;. An de r' ·:;;·on • "An An d.l :: •.. :; i,:;, of Au ,j i t F.:..i lur'e':;;' B.:..=.ed on Documente.j Le9d.1 Ca.·::.e·::., II .1.Q!:!.f':'!l:~J :=,f Accounti~8udi tinq, .:..nd Fin.:'.nce-L :::;pr'in9 1':;:'::::2, pp. 22~'-244.
"T' ... ·)o .Jur·/· '·.)er·di ct·::. Limi t Account.:'.nt=.'· Li B.bi 1 i t::.' in Pe·::.pect to t···le91 i gence ." p. 12.
\..· . .li n d.:.. 1 • Flo:;'-'d 1..' .. 1 •. :'.nd Pober·t t···J. Cor· 1 e::.'. The Account i nq E:..c: of e j:.·::.j_on a.l..; __ E t h j c::·. F.:e sp on -:. i b i 1 i t Y..L. d.n d L i .:..to i 1 t :: .. ' • En91 et .. ·.)ood C1 i ffs: Pr'ent i ce-H.:..l1. Inc., 1';;:'::::0. pp. 1-456.
1.. •.. 1 i n t e r' .::.. A 1 .:.. n ,J. " A I.", 0 i din.;j t·l:.. 1 p r' .:.. c tic eLi B. t. i 1 i t;:.-· '=; u it·::. . II
} ou r' n ·~l_ of_.B.C c ou n t ·;:'.n c.:··, Au 9u s· t 1 ':;:':;:: 1. P p. .::.9-74.