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Chapter 4

LEGAL RESPONSIBILITIES OF THE INDEPENDENT AUDITOR

Statutory Law

A. Securities Act of 1933 B. Securities Exchange Act of 1934 C. RICO Act D. Private Securities Reform Act of 1995

I. Common Law

A. Clients B. Third Parties C. Burden of Proof D. 1136 Tenants Case

II. Terms

A. Ordinary Negligence B. Gross Negligence C. Fraud D. Joint and Several Liability E. Proportionate Liability

III. Limited Liability Partnerships vs. Limited Liability Corporations

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Legal Responsibilities of the Independent Auditor

I. Statutory Laws - Potential legal liability as defined by the Securities Act of 1933, the Securities Exchange Act of 1934, the Rico Act of 1970, and the Private Securities Litigation Reform Act of 1995.
Questions concerning the Securities Acts of 1933 and 1934.

1. Describe the general purpose of each Act.

2. How does the auditor become subjected or exposed to each Act?

3. What are the specific provisions of each Act? Include in your discussion: -Who is the plaintiff? -Who has the burden of proof? -What civil or criminal penalties are provided by the Acts?

A. Securities Act of 1933

1. Regulates the initial sale of securities in interstate commerce.

2. Auditor becomes subjected to the Act when he/she audits the financial statements that must be submitted with the registration statement to the SEC in order to sell securities to the public.

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3. Provisions of the 1933 Act: a. Plaintiff may sue the auditor for ordinary or gross negligence or fraud. b. Plaintiff must show that loss was incurred and that the financial statements and audit report are misleading. Does not have to prove reliance on the financial statements as a cause for the loss. Plaintiffs are the persons or parties who buys securities described in the registration statement. c. The burden of proof is on the auditor. Auditor must prove "Due Diligence" (not negligent). The plaintiff does not have to prove that the auditor is guilty of negligence. d. Auditors are subjected to both civil and criminal liability under the 1933 and 1934 Acts. Auditor may be sued by shareholders and fined by the federal government up to $5 million or imprisoned for not more than 20 years or both.

B. Securities Exchange Act of 1934

1. Regulates the sale of securities after their initial issuance.

2. Auditors become subjected to the 1934 Act by auditing the financial statements which accompany the annual 10-K report, submitted by publicly held companies to SEC.

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3. Provisions of the 1934 Act: a. Buyers and sellers of stock after initial issuance may sue auditor for misleading report. b. Burden of proof is on the plaintiff (shareholders). Plaintiff must prove reliance on misleading statements and audit report as the caused of the loss. c. Plaintiff must base suit on gross negligence or fraud. d. Accountant is given "statutory defense" - must only prove acted in "good faith" (not grossly negligent). e. Civil and criminal penalties are the same as under the 1933 Act.

C. RICO ACT (Racketeer Influenced and Corruption Organization Act)(Slide 4-5)

1. Nature - The independent auditor may be subjected to provisions of the RICO Act in that racketeering activities are defined to include mail fraud and fraud in the sale of securities. 2. Although RICO is a federal criminal stature, Congress added a provision that allows triple damages in civil cases brought under the Act. In 1993, a favorable ruling by the U.S. Supreme Court relieved much of the concern about auditor’s liability under RICO. The court decided that the accountants couldn’t be held liable under the RICA Act unless they actually participated in the operation or management of the organization. Also, the Private Securities Litigation Reform Act of 1995 eliminated securities fraud as an offense in a civil RICO action. However, a number of states have their own version of RICO.

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D. Private Securities Reform Act of 1995

1. Provides for proportionate liability so that peripheral defendants -like the independent auditor- pay only their share of a judgment. If one or more of the defendants are not able to pay their share of the losses, the auditors will have unlimited joint and several liability only to certain small investors. a. Auditors have joint and several liability to small investors with a net worth of less than $200,000 and recoverable damages that exceed 10 percent of their net worth. b. Auditors have joint and several liability to other investors with a limit 50 percent of the auditors proportionate share.

2. Bill ensures that any CPA engaged in knowing fraud is still subject to the full force of joint and several liability.

3. Bill requires rapid notification to the SEC by auditors of illegal acts that have not been properly addressed by management. See page 4-5.

4. Requires plaintiffs to allege that defendant was at least "reckless" for a case to proceed to trial.

5. Mandates auditor to use procedures to identify client's related-party transactions.

6. Requires audit firm to design audits to provide reasonable assurance of detecting illegal acts that have a material and direct effect on a client's financial statements.

7. Requires auditor to assess client's ability to remain a going concern.

8. Permits federal judges to fine plaintiff's attorney's who file frivolous securities lawsuits.

4-5

Reporting Illegal Acts

Should auditors be required to report illegal acts by clients to regulatory agencies? Rule 301 of the Code of Conduct prohibits CPAs from directly disclosing such information to outside parties, unless the auditors have a legal duty to do so. A recent amendment of the Securities Exchange Act of 1934, the Private Securities Reform Act of 1995, includes a requirement for fraud reporting, or whistleblowing by the auditors. The requirements of this law apply when the client has committed an illegal act and (a) it has a material effect on the financial statements, (b) senior management and the board of directors have not taken appropriate remedial action, and (c) the failure to take remedial action is reasonably expected to warrant a departure from a standard audit report or resignation by the auditors. In these circumstances, the auditors must, as soon as practicable, communicate their conclusions directly to the board of directors. Within one day, the management of the client must send a notification to the Securities and Exchange Commission (SEC) of having received such a communication from the auditors, and a copy of the notification should be sent to the auditors. If the auditors do not receive the copy within a one-day period, they have one day to directly communicate the matter to the SEC.

Auditors are required to communicate illegal acts in other situations. When illegal activities cause the auditors of a public company to lose faith in the integrity of senior management, they will resign and a Form 8-K will be filed with SEC by management that discloses the reasons for the auditor’ resignation. The auditors must file a response to the filing indicating whether or not they agree with management’s reasons, and providing the details when they disagree. In addition, when the auditors are performing an audit in accordance with the Single Audit Act, they may be required to disclose illegal acts by the client to an agency that provides federal financial assistance to the client.

4-6

II. Common Law – Unwritten legal principles developed through court decisions.(Slides 4, 8-9)

A. Liability to Clients- 1. Liability based on a contractual agreement. Failure to comply with express terms of the contract subjects accountant to civil liability imposed by client. 2. Accountant may be sued by client for ordinary negligence, gross negligence or fraud. 3. Thus, auditor may be sued on basis of breach of contract or negligence.

B. Liability to third parties (Slides 11-12)

1. Liability for negligence is governed by accountant’s knowledge of use of work by third parties. 2. Accountant is not liable for ordinary negligence if third parties are unknown as users or beneficiaries of accountant’s work. If third parties are known as users or beneficiaries, then they may sue accountant for ordinary negligence. 3. All third parties may sue the accountant for gross negligence or fraud.

C. Plaintiff bears most of the burden of proof.

1. Prove loss was sustained. 2. Prove reliance upon misleading financial statements and audit report. 3. Prove reliance caused the loss. 4. Prove that auditor was guilty of certain degree of negligence.

D. 1136 Tenants Case (Slides 27-28), p.121
E. Preventing Litigation (Slide 30), p.123

4-7

III. Terms

A. Ordinary Negligence - Lack of reasonable care. Failure to perform engagement in accordance with applicable professional standards. Failure to exercise due professional care.

B. Gross Negligence - Lack of even the slightest care. Subtantial failure to comply with Generally Accepted Auditing Standards (GAAS).

C. Fraud - Misrepresentation of a material fact. Intent to deceive.

D. Joint and Several Liability - Defendant may be required to pay the losses attributed to the actions of other defendants who do not have the financial resources to pay. See text P. 112.

E. Proportionate Liability – provides that defendant is responsible for only the losses caused by that defendant’s negligence. See text P. 112.

4-8

IV. Limited Liability Partnerships (LLP) and Limited Liability Corporations (LLC)

A. LIMITED LIABILITY PARTNERSHIP (LLP)Most large public accounting firms have recently selected this form of business. Reasons:

1. The potential liability of each partner is similar to the liability of a shareholder in a corporation. The potential loss of any partner is limited to his or her capital in the partnership (except as noted in 2.).

2. General Partners who are directly involved in negligent activities may also lose personal assets. Otherwords, partners are still liable (of losing personal assets) for their own acts but their personal assets are not at risks for acts of other partners. However, partnership assets are at risk for the negligent act of all partners.

B. Limited Liability Corporations (LLC)

1. Members of LLC enjoy limited liability regardless of their participation in the corporation. The personal assets of members are protected. However, the assets of the corporations and the investments of its members are at risk.

2. This form of organization is not available in all states. Not only must LLC's be recognized in a state, but the state legislature and state board of accountancy must approve the form of organization for CPA firms.

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Hello

...Hello world Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to you Hello to...

Words: 275 - Pages: 2