Legal Liability of Cpas

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CHAPTER 4

Legal Liability
Of CPAs

Review Questions

4-1There are several reasons why the potential legal liability of CPAs for professional "malpractice" exceeds that of physicians and other professionals. One reason is the vast number of people who may sustain damages. If a physician or attorney commits a serious error, the number of injured parties generally is limited to one individual patient or client. When a CPA's report is in error, literally millions of investors may sustain losses. Second, the federal Securities Acts regarding CPAs' liability are unique in that much of the burden of proof is shifted to the defendant. Normally, defendants are "presumed innocent until proven guilty." Under the federal Securities Acts, however, CPAs charged with "malpractice" must prove their innocence. Finally, when investors sustain losses in the many millions of dollars, the economics of the situation dictates bringing suit against the CPAs even if the prospects for recovery appear remote. When the possible dollar recovery is smaller, which usually is the case in other professional malpractice suits, the plaintiffs are more likely to be deterred from filing suit simply by the costs of litigation.

4-2Ordinary negligence means lack of reasonable care. Gross negligence means lack of even slight care, indicative of reckless disregard for duty. An oversight by a CPA resulting in a misstatement in a financial statement might be considered ordinary negligence, whereas if a CPA failed substantially to comply with generally accepted auditing standards the charge might be gross negligence.

4-3Privity is the relationship between parties to a contract. A CPA firm is in privity with the client which it is serving, as well as with any third party beneficiary, such as a creditor bank named in the engagement letter (the contract between the CPA firm and its client). Under common law, if the auditors do not comply with their obligations to the client, resulting in damages, the client may sue and recover its losses by proving that the auditors were negligent in performing their duties under the contract.

4-4A third-party beneficiary is a person other than the contracting parties who is named in the contract or intended by the contracting parties to have definite rights and benefits under the contract. For example, a bank would be a third party beneficiary if the auditors and the client agreed that the purpose of the audit was to provide the bank with an audit report to make a bank loan to the client.

4-5Common law is unwritten law that has developed through court decisions; it represents judicial interpretation of a society's concept of fairness. Statutory law is law that has been adopted by a governmental unit, such as the federal government.

4-6The primary difference between the Ultramares and the Restatement approaches relates to whether the CPA has liability for ordinary negligence to third parties not specifically identified as users of the CPA's report. Under the Ultramares approach a CPA may be held liable for ordinary negligence to a third party only when that CPA (1) was aware that the financial statements were to be used for a particular purpose by a known party or parties, and (2) some action of the CPA indicates such knowledge. Under the Restatement approach the specific identity of the third parties need not be known to the CPA to establish liability for ordinary negligence. However, such liability for ordinary negligence is only to a limited class of known or intended users of the audited financial statements.

4-7In Ultramares v. Touche, the New York Court of Appeals ruled that auditors could be held liable to third parties (not in privity of contract) for gross negligence or fraud, but not for acts of ordinary negligence. In Rosenblum v. Adler, the New Jersey Supreme Court ruled that auditors could be held liable for ordinary negligence to any...
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