Solution manual auditing theory by cabrera chapter 08

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CHAPTER AUDITOR’S LEGAL LIABILITY I Review Questions Examples of typical lawsuits against CPAs are a) Alleged misstatements that the auditor did not detect in the financial statements involving 1) improper or inadequate disclosure 2) inappropriate valuations b) Alleged failure to detect defalcation as a result of negligence in the conduct of the audit c) Alleged failure to complete the audit on the agreed-on date d) Alleged inappropriate withdrawal from an audit Refer to page 324, st paragraph of the textbook Refer to page 329 of the textbook Refer to page 341 of the textbook The increase in litigation against auditors seems to be happening for two reasons: a general increase in litigation in society, and the fact that investors and creditors who suffer losses will look for “deep pockets” to pay for those losses Most accounting firms appear to have “deep pockets.” Due (professional) care is the standard by which the courts and the profession expect a CPA to practice A CPA who is found to have exercised due professional care in an engagement should not have any liability to others The four gradations are none, negligence, gross negligence (sometimes referred to as constructive fraud), and fraud At one extreme is the auditor who performs an appropriate audit and issues an appropriate report This auditor’s degree of wrongdoing is “none.” An auditor who commits fraud is at the other extreme, since he or she knows that the financial statements are misstated and yet issues an unqualified opinion An auditor is negligent if he or she does not what a reasonably prudent auditor should in the circumstances An auditor is grossly negligent if he or she consistently fails to follow the standards of the profession on an engagement Auditors are responsible to clients for negligence, gross negligence, or fraud Refer to page 334 8-2 Solutions Manual - Principles of Auditing and Other Assurance Services 10 In some jurisdictions, auditors can use contributory negligence as a defense when a client is suing for a tort 11 Most courts have held that an auditor has a higher responsibility to communicate information beyond that required by generally accepted accounting principles and generally accepted auditing standards Courts have held that compliance with generally accepted accounting principles is persuasive but not conclusive evidence 12 An auditor should (a) follow the Philippine Standards on Auditing, the Code of Ethics for Professional Accountants in the Philippines, and where appropriate, generally accepted accounting principles; (b) establish and follow appropriate quality control procedures; (c) evaluate whether a client has the necessary integrity and appropriate reputation in the community; (d) evaluate carefully why a client wants an audit; (e) conduct the audit with appropriate professional skepticism; (f) provide for appropriate levels of consultation for issues; and (g) provide for appropriate review of the audit 13 The prudent man concept states that a man 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 14 Many CPA firms willingly settle lawsuits out of court in an attempt to minimize legal costs and avoid adverse publicity This has a negative effect on the profession when a CPA firm agrees to settlements even though it believes that the firm is not liable to the plaintiffs This encourages others to sue CPA firms where they probably would not to such an extent if the firms had the reputation of contesting the litigation Therefore, out-of-court settlements encourage more lawsuits and, in essence, increase the auditor’s liability because many firms will pay even though they not believe they are liable 15 Five general ways public accountants can get into legal difficulty: Misinterpretation or ignorance of accounting principles The accountant may not have observed the letter and spirit of PSAs, thus not insisting on completely adequate disclosure of information later determined to be important Misinterpretation or ignorance of auditing standards The accountant may not know to some important part of the audit (e.g., obtain client representations and lawyers’ letters.) Failure to implement audit procedures properly perform an audit in a negligent or worse manner The accountant may Auditor’s Legal Liability 8-3 Failure to discover client fraud The auditor may fail to be observant or properly skeptical 5A Commission of fraud or actual participation The accountant may commit an illegal act such as actively conspiring with the client to publish misleading financial statements Accountants have also done such things as offer bribes, fail to file tax returns and commit securities fraud 5B Misunderstandings of the nature of the engagement Particularly in compilation or review engagements, clients might expect more than the accountant thought he agreed to deliver and might claim damages from the accountant 16 Errors – basically defined as unintentional mistakes, including mathematical or clerical mistakes in the accounting records, mistakes in the application of accounting principles, and oversight or misinterpretation of facts that existed at the time the financial statements were prepared Irregularities – refers to intentional distortion of financial statements, including deliberate misrepresentations by management (sometimes referred to as management fraud), or misappropriations of assets (sometimes referred to as defalcations) Irregularities may result from misrepresentation or omission of the effects of events or transactions; manipulations, falsification or alteration of records or documents; omission of significant information from records or documents; recording of transactions without substance; intentional misapplications of accounting principles; or misappropriation of assets for the benefit of management, employees or third parties Clients’ Illegal Acts – are defined in auditing standards as violations of laws or government regulations, not including personal misconduct by client personnel unrelated to their business activities 17 Audit risk is the risk that the auditor will conclude that the financial statements are fairly stated and issue an unqualified repot when, in fact, the financial statements are materially misstated An audit failure occurs when the auditor, as a result of his or her failure to follow PSAs, issues an erroneous audit report 18 There are many steps individual practitioners can take to minimize legal liability including: • • • • • • 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 8-4 Solutions Manual - Principles of Auditing and Other Assurance Services • • • • • • Document the work properly Obtain an engagement letter and a representation letter Maintain confidential relations Carry adequate insurance Seek legal counsel Choose a form of organization with limited liability 19 The expectation gap refers to the difference in the beliefs of auditors and users of financial statements concerning the role of the auditor Most auditors believe that the conduct of the audit in accordance with GAAS is all that can be expected of them, whereas many users of financial statements believe that the auditor guarantees the financial viability of the company II Multiple Choice Questions b c a b a c 10 11 12 a c a b a d 13 14 15 16 17 18 c d c a a d 19 20 21 22 23 24 b d b c a a 25 26 27 28 29 30 a c c a a c 31 b 32 b III Comprehensive Cases Case The answers provided in this section are based on the assumption that the traditional legal relationship exists between the CPA firm and the third party user That is, there is no privity of contract, the known versus unknown third party user is not a significant issue, and high levels of negligence are required before there is liability a False There was no privity of contract between Tan and Cañada, therefore, ordinary negligence will usually not be sufficient for a recovery b True If gross negligence is proven, the CPA firm can and probably will be held liable for losses to third parties c True See a d False Gross negligence (constructive fraud) is treated as actual fraud in determining who may recover from the CPA e False JC is an unknown third party and will probably be able to recover damages only in the case of gross negligence or fraud Auditor’s Legal Liability 8-5 Assuming a liberal interpretation of the legal relationship between auditors and third parties, the answers to a and d would probably both be true The other answers would remain the same Case Yes Normally a CPA firm will not be liable to third parties with whom it has neither dealt 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 Dantes 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 Dantes’ 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 Case a Yes Carlos was a party to the issuance of false financial statements and as such is a joint tortfeasor The elements necessary to establish an action for common law fraud are present There was a material misstatement of fact, knowledge of falsity (scienter), intent that the plaintiff bank rely on the false statement, actual reliance, and damage to the bank as a result thereof If the action is based upon fraud there is no requirement that the bank establish privity of contract with the CPA Moreover, if the action by the bank is based upon ordinary negligence, which does not require a showing of scienter, the bank may recover as a third-party beneficiary (an exception to the strict privity requirement) Thus, the bank will be able to recover its loss from Carlos under either theory b No The lessor was a party to the secret agreement As such, the lessor cannot claim reliance on the financial statements and cannot recover uncollected rents Even if he or she was damaged indirectly, his or her own fraudulent actions led to his or her loss, and the equitable principle of “unclean hands” precludes him or her from obtaining relief c Yes Carlos had knowledge that the financial statements did not follow generally accepted accounting principles and willingly prepared an unqualified opinion The financial statements were not in accordance with generally accepted accounting principles That is a criminal act because there was an intent to deceive Case a Base, Umapas & Cañada is potentially liable to its client because of the possible negligence of its agent, the in-charge accountant on audit, in carrying out duties that were within the scope of his or her employment Should there be a finding of negligence, liability would be limited to 8-6 Solutions Manual - Principles of Auditing and Other Assurance Services those losses that would have been avoided had reasonable care been exercised There being no evidence of the assumption of a greater responsibility, the in-charge accountant’s conduct is governed by the usual standard; that is, that the accountant perform his or her duties with the profession’s standards of competence and care A question of fact arises as to whether the duty of reasonable care was breached when the in-charge accountant failed to investigate further after being apprised by a competent subordinate of exceptions to percent of the vouchers payable examined Moreover, a question of causation arises as to whether further actions by the in-charge accountant would have disclosed the fraud If both lack of due care and causation are established, recovery for negligence will be available to the client b In a properly organized liability partnership, the partner(s) and staff responsible for the engagement and the firm would be liable, as discussed in part a However, other partners would not be liable Case Ordinarily, users of financial statements, other than those who contracted for the audit and those known in advance to the auditor, may not recover for ordinary negligence by the auditor in the performance of an audit Recovery of damages by third parties must usually be based on fraud Actual knowledge of falsity (scienter) is also generally required for an action based on fraud; however, this requirement may be satisfied by the auditor’s reckless disregard for the truth or gross negligence It appears that the three deficiencies in the audit by Gonzales & Esteban might be sufficient to satisfy either approach Failure to check the existence of certain receivables, collectibility of other receivables, and existence of security investments, taken collectively if not individually, appear to show a reckless disregard for the truth by the auditor In fact, the audit probably lacks sufficient competent evidential matter as a reasonable basis for an opinion regarding the financial statements under examination The audit appears to have been conducted in a woefully inadequate fashion, without regard to the usual auditing standards and procedures necessary to exercise due professional care Therefore, the auditors were grossly negligent in the performance of their duties Case Corpuz has stated that the CPA firm has “reviewed the books and records of Flores Ventures,” when in fact no such “review” has occurred A “review” of financial statements consists of limited investigatory procedures designed to provide statement users with a limited degree of assurance that the financial statements are in conformity with generally accepted accounting principles Corpuz’s actions are similar to issuing an auditors’ report without first performing an audit Such an action may well be considered an act of Auditor’s Legal Liability 8-7 criminal fraud, intended to mislead users of the financial statements If the financial statements of Flores Ventures turn out to be misleading, there is little doubt that any court would find the CPA firm guilty of at least constructive fraud and liable to any third party who sustains a loss as a result of reliance upon the statements The fact that Corpuz violated Vasquez’s policy of submitting all reports for Vasquez’s review would not lessen the CPA firm’s liability The concept of mutual agency allows Corpuz, as a partner, to commit the firm to contracts, including auditors’ reports and accountants’ reports The fact that this report was not submitted for Vasquez’s review might be introduced as evidence against Corpuz in the event he is accused of criminal fraud Case (1) Yes, but only to the extent of P70,000 Beta is a third-party beneficiary of the contract between Mega and its auditors, and may therefore recover from the auditors losses caused by the CPAs’ ordinary negligence However, the original P50,000 loan was made prior to Beta’s reliance upon the negligently audited financial statements Thus, the auditors’ negligence was not the proximate cause of this portion of Beta’s loss The auditors’ negligence may, however, be considered the proximate cause of the P70,000 loss incurred as a result of reliance upon the misleading statements (2) The prospects for Manila’s recovery of its P30,000 loss are substantially less than those of Beta Manila was not a third-party beneficiary to the contract Thus, in many jurisdictions following Ultramares, Manila cannot recover losses attributable to the CPAs’ ordinary negligence Similarly, it is doubtful that Manila would qualify as a foreseen third party as necessary under the Restatement approach Even in a jurisdiction accepting the Rosenblum precedent, which allows third parties to recover losses caused by the auditors’ ordinary negligence, Manila would have to prove that it was a “foreseeable third party relying upon the financial statements for routine business purposes.” It is questionable whether the loan by Manila was either “reasonably foreseeable” or “routine,” as Manila was a customer of Mega, not a lender ...8-2 Solutions Manual - Principles of Auditing and Other Assurance Services 10 In some jurisdictions, auditors can use... Maintain independence Understand the client’s business Perform quality audits 8-4 Solutions Manual - Principles of Auditing and Other Assurance Services • • • • • • Document the work properly Obtain... employment Should there be a finding of negligence, liability would be limited to 8-6 Solutions Manual - Principles of Auditing and Other Assurance Services those losses that would have been avoided
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