Exam 5: Legal Liability

A CPA firm notifies their audit client of a material weakness in internal controls in the warehouse storing inventories. Subsequently, the client discovers a large theft of inventory in the warehouse. In this case, the CPA firm would have the defense of contributor negligence.

In audits, failure of the auditor to meet auditing standards are not, by themselves, conclusive evidence of negligence.

CPAs can be held liable for criminal activity under both state and federal laws. Infamous cases include United States vs. Natelli and ESM Government Securities v. Alexander Grant & Co. Discuss what occurred in each case.

Under the Securities Act of 1933, a third-party plaintiff does not have the burden of proof that he or she relied on the financial statements or that the auditor was negligent or fraudulent in doing the audit. Rather, the plaintiff need only prove that the audited financial statements contained a material misrepresentation or omission.

When an audit has failed to uncover material misstatements and the wrong type of audit opinion is issued, it is not appropriate to question whether the auditor exercised due professional care in the performance of the audit.

An individual who is not party to the contract between a CPA and the client, but who is known by both and is intended to receive certain benefits from the contract is known as

The defense of contributory negligence by a third party is often used by auditors if charged with a violation of the 1934 Securities Act.

Under Federal statutes, the amount of damages under separate and proportionate liability can be increased to 200 percent of the amount determined to be proportionate to the CPA's degree of fault when the main defendant is insolvent.

Under common law, an individual or company that (1) does not have a contract with an auditor, (2) is known by the auditor in advance of the audit, and (3) will use the auditor's report to make decisions about the client company has:

Since the Sarbanes-Oxley Act of 2002, both the number of lawsuits and the sizes of awards to plaintiffs in the courts have been reduced against auditors.

The principal issue to be resolved in cases involving alleged negligence is usually

The term "expectation gap" refers to the difference in the results of an audit between what an auditor expects and what users of the financial statements audited by the auditor expect.

As a consequence of his failure to adhere to generally accepted auditing standards in the course of his examination of the Lamp Corp., Harrison, CPA, did not detect the embezzlement of a material amount of funds by the company's controller. As a matter of common law, to what extent would Harrison be liable to the Lamp Corp. for losses attributable to the theft?

With regards to the three major criminal cases (United States v. Natelli (1985); United States v. Weiner (1975); and ESM Government Securities v. Alexander Grant & Co. (1986)), which of the following is not a critical lesson learned from these cases?

The question of level of care is similar where the auditor is involved in a compilation or a review of financial statements.

The Securities and Exchange Commission can impose all but which of the following sanctions?

The expectation gap

Discuss at least three specific actions which practicing auditors can take to minimize their legal liability.

A CPA firm is sued after performing a review of a client's financial statements for not uncovering a material misstatement. The CPA firm in this situation can claim lack of duty as a legal defense.

An example of a third-party beneficiary under contract law includes a bank having a large loan with a client which requires an audit as part of the loan agreement. In these cases, though the contract for the audit engagement is between the auditor and the client, both the auditor and the client are aware that the bank will be relying on the audited financial statements.