Auditing: Legal Liability and Landmark Cases

Flashcards covering auditors' legal liability under common law and federal securities statutes (Securities Act of 1933 and Securities Exchange Act of 1934), key legal doctrines, and landmark court cases.

Which approach to auditors' third-party liability is considered least desirable from the CPA's perspective, and why?

The Rosenblum approach, because it allows all reasonably foreseeable third parties to recover damages from a CPA who performed an engagement with ordinary negligence.

From the perspective of a CPA, how do the Ultramares, Rosenblum, and Restatement approaches compare in desirability regarding liability?

The Ultramares approach is the most desirable, the Rosenblum approach is the least desirable, and the Restatement of Torts approach (Foreseen User approach) sits between the two extremes.

In cases of breach of contract brought against CPAs, which element is a plaintiff NOT required to prove?

The plaintiff does not need to prove that the CPAs made a false statement; it is sufficient to prove that the CPAs had a legal duty, breached that duty, and caused the client to incur related losses.

If a CPA provides negligent tax advice to a public company client, under what body of law would the client bring suit?

Common law (clients are not covered under the Securities Act of 1933 or the Securities Exchange Act of 1934 for negligent tax advice).

Which case reaffirmed the principles of the Ultramares case by clarifying the conditions necessary for third parties to be considered third-party beneficiaries?

Credit Alliance Corporation v. Arthur Andersen & Company.

Which element is most frequently necessary to hold a CPA liable to a client?

Failed to exercise due care.

Under the Securities Act of 1933, what represents a viable defense for an auditor sued by an investor over an unqualified opinion on misleading financial statements?

Proving that the false statement is immaterial in the overall context of the financial statements, demonstrating that auditor negligence was not the proximate cause of the loss.

What liability standard generally applies to auditors and other defendants under the Securities Exchange Act of 1934 as amended by the Private Securities Litigation Reform Act of 1995?

Proportionate liability.

Under common law, how may a negligent CPA mitigate or bar damage recovery by a client?

By proving contributory negligence on the part of the client (plaintiff).

Under the Securities Act of 1933, what must purchasers of registered securities prove to recover losses from auditors?

Purchasers need only prove that the financial statements were misleading; the burden of proof then shifts to the auditors to show the audit was performed with "due diligence."

What was the most significant legal result of the Continental Vending case (United States v. Simon)?

It created a more general awareness of the possibility of auditor criminal prosecution under statutory law (the Securities Exchange Act of 1934).

What was the landmark significance of the 1136 Tenants' Corp. case?

It emphasized the legal liability of CPAs when associated with unaudited financial statements.

In a civil liability suit, does the requirement to prove that material misstatements were included in a filed document apply to Section 11 of the 1933 Act, Section 10(b) of the 1934 Act, or both?

Applies to both acts.

Does a plaintiff security purchaser need to prove reliance on a misleading document under Section 11 of the 1933 Act, Section 10(b) of the 1934 Act, or both?

Only applies to Section 10(b) of the Securities Exchange Act of 1934.

Does a plaintiff security purchaser need to prove privity with the CPA under Section 11 of the 1933 Act, Section 10(b) of the 1934 Act, or both?

Applies to neither of the acts.

Does a plaintiff security purchaser have to prove lack of due diligence by the CPA under Section 11 of the 1933 Act, Section 10(b) of the 1934 Act, or both?

Applies to neither of the acts (due diligence is an affirmative defense proven by the auditor under Section 11, whereas the plaintiff must prove scienter under Section 10(b)).

Does a plaintiff security purchaser need to prove that a monetary loss occurred under Section 11 of the 1933 Act, Section 10(b) of the 1934 Act, or both?

Applies to both acts.

Does the requirement to prove scienter apply to Section 11 of the 1933 Securities Act or Section 10(b) of the 1934 Securities Exchange Act?

Only applies to Section 10(b) of the Securities Exchange Act of 1934.

What is the definition of proportionate liability in auditor litigation?

A method of allocating damages to each liable group according to that group's pro-rata share of damages (e.g., if total damages are $\$500{,}000$ and CPAs bear $30\%$ of the responsibility, the CPAs are assessed $\$150{,}000$).

What is proximate cause in auditor legal defense?

The requirement that damage to another is directly attributable to the wrongdoer's act, allowing the defense to argue that an outside factor caused the loss.

What constitutes constructive fraud by an auditor?

Performing duties with such recklessness that persons believing the duties to have been completed carefully are being misled, without actual knowledge of misrepresentations within the financial statements.

How is common law distinguished from statutory law?

Common law is unwritten law developed through court decisions representing judicial interpretation of fairness, whereas statutory law is written law created by state or federal legislative bodies.

Which landmark case held auditors liable under Section 11 of the Securities Act of 1933 for failing to perform adequate due diligence?

Escott v. BarChris Construction Corporation.

Which case established that auditors cannot be held liable under the Securities Exchange Act of 1934 without scienter (intent to deceive)?

Ernst & Ernst v. Hochfelder.

Which case established that auditors can be held liable under common law for ordinary negligence to all foreseeable third parties?

Rosenblum v. Adler.

Under common law, to which third parties are CPAs liable for either ordinary or gross negligence?

Identified third parties for whose benefit the audit was performed.

Under the Second Restatement of the Law of Torts, for what level of culpability are auditors liable to a limited class of foreseen third parties?

Either ordinary or gross negligence.

If Company A engages a CPA firm to audit Company B for a merger and the CPA fails to detect fraud due to substandard work, what minimum culpability must Company A prove to hold the CPA liable under common law?

Ordinary negligence (Company A was in privity of contract with the CPA firm who was engaged by Company A).

In a common law action against an accountant, when is lack of privity an effective, viable defense?

When the plaintiff is a client's creditor suing the accountant for ordinary negligence.

Under the Ultramares rule, to which parties is an accountant liable for ordinary negligence?

To parties in privity: Yes; to foreseen parties: No.

Whom may the Public Company Accounting Oversight Board (PCAOB) investigate and discipline?

Both registered public accounting firms and registered public accounting firm employees.