Chapter 4

Legal Liability Review Questions 4-1 Several factors that have changed the legal environment in which public accountants in Canada operate are: 1. 2. 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 various securities commissions regarding their responsibility for protecting investors' interests. The greater complexities of auditing and accountancy due to the increasing size of businesses, the existence of the computer, and the intricacies of business operations. Society's increasing acceptance of lawsuits. The willingness of public accounting firms to settle their legal problems out of court. The many alternative accounting principles from which clients can elect to present their financial statements, and the lack of clear-cut criteria for the auditor to evaluate whether the proper alternative was selected.

3.

4. 5. 6.

4-2 Business risk, in this context, 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 unqualified 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 business risk in an engagement in determining the appropriate audit risk.

4-3 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.

4-4 A partner in a public accounting firm is liable for errors in the work of (the question asks for two):

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Employees of the firm. The employees are agents of the partner who is a principal in law and therefore liable for the acts of his or her agents. Fellow partners in the firm even if they work in an office that is geographically separate. Partners are jointly and severally liable for the acts of the other partners in the partnership. Other auditing firms (Section 6930) or specialists (Section 5360 and 5365) such as actuaries on whom the partner relies in obtaining sufficient appropriate audit evidence to arrive at his or her opinion on the financial statements. Dupuis v. Pan American Mines is an example; Thorne were liable for negligence by Seidman & Seidman on whom they relied.

2.

3.

4-5 A criminal action is one brought under the provisions of criminal statute law such as the Criminal Code of Canada. An example might be theft of inventory from the audit client; the individual committing the theft would be prosecuted by the Crown under the appropriate section of the Criminal Code. A civil action is one brought by one individual (or company, etc.) against another because the former believes that the latter has wronged him or her. An example might be where an individual believes that another individual has breached a contract between the two and brings an action to have the contract completed or for damages.

4-6 The auditor is responsible for conducting an audit in accordance with generally accepted auditing standards. The auditor's responsibility for detecting defalcations is dependent on whether an audit done in accordance with GAAS would have detected such a defalcation. Section 5400.01 states that the auditor's report when performing an audit provides an opinion on the financial statements. Section 5200.06 states that among management's responsibilities is "preventing and detecting error and fraud." This position is supported by the courts in International Laboratories Limited v. Dewar et al. Section 5135.14 states "The auditor may encounter circumstances which make him or her suspect the financial statements are materially misstated. In that event, the auditor should perform procedures to confirm or dispel that suspicion." Section 5135.15 states that GAAS require the auditor to design tests and procedures to reduce the risk of not detecting a material error or fraud in the accounts to an appropriately low level. 4-7 Contributory negligence used in legal liability of auditors is a defense used by the auditor when he or she claims the client or user also had a responsibility in the legal case. An example is the claim by the auditor that management knew of the potential for fraud because of weaknesses in internal control but refused to correct them. The auditor thereby claims that the client contributed to the fraud by not correcting material weaknesses of internal control. Kane Agencies v. Coopers & Lybrand is an example.

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4-8 In recent years the auditor's liability to a third party has become affected by whether the party is known or unknown. A known third party, under common law (for example, Haig v. Bamford and Toromont v. Thorne, usually has similar rights as a party that is privy to the contract. Caparo and related cases such as Dixon v. Deacon, Morgan, McEwan, Easson et al. is an example of that. It presently seems as if auditors may be liable for negligence to shareholders at the time the financial statements are issued; there does not appear to be a similar liability to third parties who rely on the financial statements to make decisions (for example, the limited class who will rely on the financial statements in Haig v. Bamford) after they have been issued.

4-9 The auditor's legal liability to the client can result from the auditor's failure to properly fulfill his or her contract for services. The lawsuit can be for breach of contract, which is a claim that the contract was not performed in the manner agreed upon, or it can be a tort action for negligence. An example would be the client's detection of an error in the financial statements, which would have been discovered if the auditor had performed all audit procedures required in the circumstances (e.g., misstatement of inventory account resulting from an inaccurate physical inventory not properly observed by the auditor). The auditor's liability to third parties under common law results from any loss incurred by the claimant due to reliance upon misleading financial statements. An example would be a bank which has loans outstanding to an audited company. If the audit report did not disclose that the company had contingent liabilities which subsequently became real liabilities and forced the company into bankruptcy, the bank would proceed with legal action against the auditors for the material omission. Criminal liability of the auditor may result from federal or provincial laws if the auditor defrauds another person through knowingly being involved with false financial statements. An example of an act which could result in criminal liability would be an auditor's providing a standard audit opinion on financial statements which he or she knows overstate income for the year and the financial position of the company at the audit date.

4-10 Some of the ways in which the profession can positively respond and reduce liability in auditing are: 1. 2. Continued research in auditing. Standards must be revised to meet the changed need of auditing.

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3.

4. 5. 6. 7.

The CICA through the Auditing Standards Board can establish requirements that the better practitioners always follow in an effort to increase the overall quality of auditing. Establish practice inspection requirements. Public accounting firms should defend unjustified lawsuits rather than settling out of court. Users of financial statements need to be better educated regarding the attest function. Improper conduct and performance by members must be sanctioned.

4-11 Some of the ways in which an individual public accountant can positively respond and reduce liability in auditing are: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 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. Document the work properly. Obtain an engagement letter and a letter of representation. Maintain confidential relations. Carry adequate insurance. Seek legal counsel.

Multiple Choice Questions 4-12 4-13 a. a. (1) (3) b. b. (3) (2) c. (4)

Discussion Questions and Problems 4-14 The president of Mountain told Frost that the Bank of Trail was prepared to increase their loan to Mountain based on the financial statements for the year ended December 31, 2001. Therefor while the Bank of Trail was not in privity, they were a member of a limited class of users of which the auditor had actual knowledge at the time of the audit. Insofar as the actual negligence by Frost, and thus Helmut & Co., is concerned, the matter is not clear-cut. Frost, although experienced, is new to Helmut & Co., who did not seem to provide much supervision. Frost was assisted by two juniors who were also probably not too familiar with Helmut & Co.'s practices. Mountain was a new client to Helmut & Co. so Frost would not have the prior year's working papers to rely on.

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In addition, Frost gave the two juniors the most important parts of the financial statements (for this client at least) and he does not seem to have done much supervision. The question says that Helmut provided a "cursory review." Mountain was in a hurry to get the statements and Helmut seems to have obliged the client. Independence can be affected by time pressures (i.e. inadequate time); that seems to have been the case in this audit. In summary, Helmut & Co. seems to owe a duty of care to the Bank of Trail and both Helmut & Co. and Frost seem to have been negligent the liability would be that of Helmut & Co. since they were the principal. There seems to be no doubt that the Bank of Trail relied on the financial statements to make their decision, and therefore it is probably that the Bank of Trail would succeed.

4-15 a. Brown, Cosden and Co. should use the defenses of meeting generally accepted auditing standards and contributory negligence. The fraud perpetuated by Joslin Supply Inc. was a reasonably complex one and difficult to uncover except by the procedures suggested by Cosden. In most circumstances it would not be necessary to physically count all inventory at different locations on the same day. Furthermore the president of the company contributed to the failure of finding the irregularity by refusing to follow Cosden's suggestion. There is evidence of that through his signed statement. b. There are two defenses Brown, Cosden and Co. should use in a suit by Maritimes Eastern Bank. First there is a lack of privity of contract. Even though this was a known third party, it does not necessarily mean that there is any duty to that party in this situation. That defense is unlikely to be successful in most jurisdictions today. The second defense which Cosden is more likely to be successful with is that the firm followed generally accepted auditing standards in the audit of inventory, including the employment of due care. Ordinarily it is unreasonable to expect a public accounting firm to find such an unusual problem in the course of an ordinary audit. Because the public accounting firm did not uncover the fraud does not mean it has responsibility for it. c. The firm is likely to be successful in their defense against the client because of the contributory negligence. The company has responsibility for instituting adequate internal control. The president's statement that it was impractical to count all inventory on the same day because of personnel shortages and customer preferences puts considerable burden on the company for its own loss.

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It is also unlikely that Maritimes Eastern Bank will be successful in a suit. The court is likely to conclude that Cosden followed due care in the performance of her work. The fact that there was not a count of all inventory on the same date is unlikely to be sufficient for a successful suit. Note: Caparo and related cases in the U.K. and Canada may have some impact here in determining whether or not Brown, Cosden & Co. owed a duty of care to Maritimes Eastern Bank. Failing that defense, but it is fairly clear that Brown, Cosden & Co. followed GAAS in conducting the audit and was not negligent. d. The issues and outcomes should be essentially the same whether Joslin Supply Inc. is a public company or a private company.

4-16 Yes. Normally a public accounting firm will not be liable to third parties with whom it has neither dealt with nor for whose benefit its work was performed. One notable exception to this rule is fraud. When the financial statements were fraudulently prepared, liability runs to all third parties who relied upon the false information contained in them. Fraud can be either actual or constructive. Here, there was no actual fraud on the part of Small or the firm in that there was no deliberate falsehood made with the requisite intent to deceive. However, it would appear that constructive fraud may be present. Constructive fraud is found where the auditor's performance is found to be grossly negligent. That is, the auditor really had either no basis or so flimsy a basis for his or her opinion that he or she has manifested a reckless disregard for the truth. Small's disregard for standard auditing procedures would seem to indicate such gross negligence and, therefore, the firm is liable to third parties who relied on the financial statements and suffered a loss as a result.

4-17 The accounting firm, Spark, Watt, and Wilcox, is potentially liable to its client because of the possible negligence of its agent, the in-charge accountant on the audit, in carrying out duties that were within the scope of his employment. Should there be a finding of negligence, liability would be limited to those losses that would have been avoided had reasonable care been exercised. Since all but $20,000 was recovered, the liability would likely be limited to $20,000 plus costs. There being no evidence of the assumption of a greater responsibility, the in-charge accountant's conduct is governed by the usual standard; i.e., that the accountant perform his duties with the profession's standards of conduct prevailing. The question arises as to whether the duty of reasonable care was breached when the in-charge accountant failed to make further investigation after being apprised by a competent subordinate of exceptions to six percent of the vouchers payable examined. Moreover, a question of causation arises; i.e., whether further actions by the in-charge accountant

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would have disclosed the fraud. If both lack of due care and causation are established, recovery for negligence will be available.

4-18 a. The legal issues involved in this case revolve around the auditor's compliance with generally accepted auditing standards and contributory negligence. Section 5303.28 of the CICA Handbook states that accounts receivable be confirmed by the auditor except under specific circumstances. This procedure was employed in the case, and the legal issue is whether or not the auditor used due care in following up the confirmation replies received. As a defense in the lawsuit, the auditor would claim to have followed generally accepted auditing standards by properly confirming accounts receivable. In addition, the auditor may defend him or herself by testifying that the company controller was responsible for investigating the reason for the differences reported on the confirmation replies. The auditor may state that he or she had a right to conclude that the controller had reviewed the explanations provided by the bookkeeper, and concluded they were correct. The auditor might also use the defense that there was contributory negligence. The controller should not have delegated the work to the bookkeeper and should have recognized the potential for intentional wrong-doing by the bookkeeper. b. The public accountant's deficiency in conducting the audit of accounts receivable was his or her failure to investigate and obtain evidence to substantiate the explanations provided by the bookkeeper. The auditor should have investigated each of the timing differences, through which he or she may have discovered that no sales allowance had been granted to the customer, but in fact, the customer had mailed payment for the merchandise which the bookkeeper had stolen.

4-19 Baerg & Vetzel would probably use International Laboratories v. Dewar et al. as their defense. Management has the principal responsibility for the prevention and detection of fraud. The case does not mention engagement letters or management letters but they both might be evidence to support Baerg & Vetzel's case. This would be especially true if they had written a letter to South-western Development pointing out weaknesses in internal control flowing from the decentralized management Southwestern uses. Baerg & Vetzel's strongest defense would be that they had exercised due care in performing the audit and that they had adhered to generally accepted auditing standards. The fact that Jasper & Co. later found fraud should not significantly affect the case in as much as they were specifically engaged to determine the existence of fraud, not to do an ordinary audit. Baerg & Vetzel are likely to have to demonstrate that the audit was adequately planned and sufficient appropriate audit evidence was accumulated and properly evaluated. For

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example, the case states that the managers who were defrauding the company negotiated lower than normal rents in return for the kickbacks. It is possible that analytical procedures or other audit tests might have revealed that some rents were abnormally low. The auditor may have to prove that such procedures were not necessary in the circumstances or would not have uncovered the fraud. Similarly, the decentralization of lease negotiation may also be cited by the plaintiff that internal control was inadequate and additional testing was necessary and would have uncovered the fraud. Baerg & Vetzel may have to prove that the understanding of internal control they obtained was adequate and the audit evidence they accumulated was appropriate, given the decentralized lease negotiations.

4-20 a. Being both the auditor for Lively Plays and personal tax advisor to the senior management representative of the firm leaves Parely & Karson in a conflict of interest between the confidentiality owed to Drewerson and the responsibility to supply the forensic report to the board of directors The role of the auditor is to be objective and carry out the engagement with due care and to act in accordance with the prudent person concept. b. By being associated with financial statements known to be materially misstated or false could lead to the auditor being found guilty of criminal fraud.

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a. 1. 2. 3. 4.

The lenders on the private placement might succeed if they could prove: Rossi owed a duty of care to the lenders. Rossi was negligent in the performance of his duties on the engagement. The lenders suffered a loss. There was a connection between Rossi's negligence and the loss suffered by the lenders.

The plaintiffs (the lenders) might be able to prove that Rossi owed a duty of care to them using Haig v. Bamford. Proving that Rossi had been negligent would be far more difficult. The case seems to suggest that Rossi had not been negligent in fact. The plaintiff must prove all four points outlined above to succeed. b. Rossi's lawyers would probably respond with the Caparo related cases that no duty of care was owing. Their strongest defence however would be that Rossi was not negligent; management perpetuated a fraud and that caused the financial statements to be misstated.

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The 1136 Tenants case is an excellent example of the problems that lack of an engagement letter and failure to follow up unexplained and unusual items case for an auditor. An engagement letter (also discussed in Chapter 7) is a signed agreement between the public accounting firm and the client identifying the work being done and the responsibility being undertaken by the auditor. It usually will state that the auditor is not responsible for the detection of fraud. In short, an engagement letter is a written understanding between the auditor and the client.

A public accountant acting as auditor or accountant has a responsibility to follow up unusual and unexplained items because of what they might indicate. For example, a missing invoice in a sample may be part of a much larger problem and a large number of missing invoices. Only by the following up of unusual or unexplained items can the auditor determine the magnitude and kind of problem (if any) that the item is indicative of.

Cases 4-23 a. Assessing managements integrity should be considered before accepting the audit engagement. Some considerations are: Check references from other professionals Does the client deal ethically with outside parties b. If during the assessment of management it is suspected that integrity is lacking the auditor would not put much reliance on managements assertions but would increase the amount of evidence and collect more from external sources. c. The normal responsibility is to carry out the audit with professional skepticism. It is not the auditors job to find criminal activity. The auditor will carry out procedures necessary to support his work and at the same time if anything comes to his attention that needs further investigation, will pursue it to its conclusion. d. When management or directors are involved in criminal activity their creditably is minimal at best. This indicates a larger audit risk. e. If it were found that a prudent person (other auditors) would have gathered more evidence that would have led to the discovery of the fictitious sales then it would be considered negligence.

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