auditing: the art and science of assurance engagements chapter 4: legal liability copyright © 2011...

Auditing: The Art and Science of Assurance Engagements

Chapter 4: Legal Liability

Copyright © 2011 Pearson Canada Inc.

Auditing, Canadian Eleventh Edition

Chapter 4 Learning Objectives

1. Identify the public accountant’s sources of legal liability.

2. Explain why the accountant does not have the right of privileged communication.

3. Describe the groups of individuals or organizations, in addition to the client, who can sue the auditor.

4. Examine conditions where the auditor may consider disclosure of confidential information.

5. Identify the actions that accountants should take to determine which legislation has an impact on their work.

4-2Copyright © 2011 Pearson Canada Inc.


Sources of Auditor’s Legal Liability



Business and Audit Failure

• Business failure: when a business cannot repay its debts, perhaps due to poor management, a shift in demand, or economic factors

• Audit failure: when the auditor issues an incorrect audit opinion (e.g. an unqualified opinion when it should be qualified)



Think of an example …

• Think of a recent business failure that was publicized in your area.

• Were the auditors sued?• If so, do you think that it was a business failure, or an

audit failure, or both?• Was fraud involved?



Role of Audit Risk

• The auditor uses audit risk to help decide how much evidence to collect.

• Audit risk is the risk that the auditor will conclude that the financial statements are fairly stated, when they are not (For example, if the auditor chooses audit risk of 3%, there is a 3% risk of material error in the financial statements).



Practice Problem 4-20, p. 104

• How does management integrity affect the audit process?

• Is the auditor responsible to consider organized criminal activity?



Expectation Gap

• There is an expectation gap when two different groups expect different outcomes in a particular situation.

• Here, we use the term ‘expectation gap’ to refer to the difference between what users actually expect and what the audit report actually provides.



What do Users Expect?

• Think about the different users of financial statements.

• What might the difference in expectations be among these users with respect to the auditor’s report?



Terminology and Context

• Before moving on, take a look at some of the legal terms covered on pages 81 to 82

• We will focus on three of these:– Prudent person– Joint and several liability– Lack of privileged communication



Discussion Problem 4-14, p. 102

• Clarifying terminology• Use this question with a series of true and false

questions to test your understanding of key legal terms



Prudent Person

• The auditor is not expected to be perfect.• How is the standard of performance set?• According to the courts it is based upon “reasonable

care and diligence in the performance of obligations” – this means that the auditor does his/her best given the training and experience required.



Joint and Several Liability

• The partner in charge of an audit engagement is responsible for his/her employees, other partners on the engagement, as well as work performed by other audit firms, internal auditors or specialists.

• Limited liability could be present if the firm formed a limited liability partnership.



Lack of Privileged Communication

• Lawyers may refuse to provide information to the courts that was given to them by their clients (called privileged communication).

• Accountants do not have this right.• They must provide information to the courts when

subpoenaed.



Review Question 4-4, p. 101

• Think about the typical accounting firm.• Think of as many specific examples as you can –

who would the partner in the public accounting firm be held liable for?



Who can Sue the Auditor?

• Clients (the business entity or organization that hired the auditor)

• Third parties:– Owners or shareholders (existing or potential)– Vendors– Bankers, Canada Revenue Agency or other

creditors – Customers– Employees, etc.



Six Possible Defences againstThird-Party Suits



Lack of Duty of Care

• The auditor claims that there was no duty to the party that is suing.

• Also called “lack of duty to perform”.• There is a duty of reasonable care to the client.• An engagement letter helps identify that there is no

duty of care to find fraud.




• The bank lent some more money• After relying upon the financial statements• Lo, and behold, the company went bankrupt• And the bank sued the auditors (of course?)• So are the auditors liable?



Absence of Misstatement

• The statements were in accordance with GAAP.• There were no material errors in the financial

statements.• The financial statements accurately portray the

financial statements of the organization.



Non-negligent Performance

• The audit was done in accordance with generally accepted auditing standards.

• The auditors are not responsible for undiscovered errors or fraud because their audit was done appropriately.

• CICA Assurance Handbook or expert witness used to support this defence.



Absence of Causal Connection

• This defence claims that there is no connection between the auditor’s breach (i.e. an audit failure) and the client’s loss.

• For example, the client relied upon others (such as a banker) or upon their own expertise when deciding to invest or lend money.



Contributory Negligence

• The auditor accepts partial blame, i.e. accepts that the audit was not conducted in accordance with GAAS.

• However, the auditor also places blame on the party that is suing the auditor, e.g. management did not correct internal control weaknesses.



No Damages

• There is one additional defence that arises from the definition of a tort action for negligence , and it is simply: “No damages”

• This defence is simply the fact that the plaintiff did not lose any money by relying upon the financial statements.



Practice Problem 4-18, p. 103

• Deliberate fraud on the part of the client• Overstatement of accounts receivable and inventory• Is the auditor liable?• Why or why not?• What defence would be used?



Preventing Excess Legal Costs

• Both the accounting profession and the individual practitioner need to respond to the potential of legal liability.



The Profession’s Response to Legal Liability

• Conduct research in auditing• Set standards and rules• Set requirements to protect auditors• Establish practice inspection requirements• Defend unjustified lawsuits• Educate users• Sanction members for improper conduct or

performance• Lobby for changes in laws



The Individual Practitioner’s Response to Legal Liability

• Deal only with clients possessing integrity• Hire qualified personnel and train and supervise them

properly• Follow the standards of the profession• Maintain independence• Understand the client’s business• Perform quality audits

(Continued)



The Individual Practitioner’s Response to Legal Liability

(Continued)

• Document the work properly• Obtain an engagement letter and a management

representation letter• Maintain confidential relations• Carry adequate insurance• Seek legal counsel (when warranted)




• It is important to follow up all errors• This practice problem looks at a firm’s internal quality

control and supervision processes


auditing: the art and science of assurance engagements chapter 4: legal liability copyright © 2011...

Documents

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