Ch 5 Solutions.doc - Chapter 5 Legal Liability Concept...

Chapter 5
Legal Liability

Concept Checks
P. 124
1. Several factors that have affected the increased number of lawsuits against
CPAs are:
 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 SEC regarding its
responsibility for protecting investors’ interests.
 The greater complexities of auditing and accounting due to the
increasing size of businesses, the globalization of business, and the
intricacies of business operations.
 Society’s increasing acceptance of lawsuits.
 Large civil court judgments against CPA firms, which have
encouraged attorneys to provide legal services on a contingent fee
basis.
 The willingness of many CPA firms to settle their legal problems out
of court.
 The difficulty courts have in understanding and interpreting technical
accounting and auditing matters.
2. Business failure 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 unmodified
opinion can therefore be issued when, in fact, the financial statements 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 potential for business failure in an engagement in determining the
appropriate audit risk.
3. The difference between fraud and constructive fraud is that in fraud the
wrongdoer intends to deceive another party whereas in constructive fraud there
is a lack of intent to deceive or defraud. Constructive fraud is highly negligent
performance.
5-1

P. 134
1. The four major sources of auditor legal liability are:
 Liability to clients.
 Liability to third parties under common law.
 Civil liability under federal securities laws.
 Criminal liability.
2. Liability to clients under common law has remained relatively unchanged
for many years. If a CPA firm breaches an implied or expressed contract with a
client, there is a legal responsibility to pay damages. Traditionally the distinction
between privity of contract with clients and lack of privity of contract with third
parties was essential in common law. The lack of privity of contract with third
parties meant that third parties would have no rights with respect to auditors
except in the case of gross negligence.
That precedent was established by the Ultramares case. In subsequent
years, some courts have interpreted Ultramares more broadly to allow recovery
by third parties if those third parties were known and recognized to be relying
upon the work of the professional at the time that the professional performed
the services ( foreseen users ). A few jurisdictions have rejected the Ultramares