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Transcript of Legal Liability
Carefully assess the risk of errors and irregularities, including those indicated by weaknesses in internal control
Exercise extreme care in audits of clients that have a high degree of business risk, as indicated by such factors as financial difficulties
Carefully prepare and review working papers Preventing Litigation Compilation of financial statements
Preparation of financial statements based upon information provided to CPAs by client
Not intended to lend any assurance as to statements’ reliability
Review of financial statements
Consists of limited verification procedures, substantially less in scope than an audit
Provides limited assurance as to statements’ reliability Unaudited Financial Statements of Nonpublic Companies: What are they? May conduct investigations and disciplinary proceedings on registered CPA firm and professional employee
Sanctions can include:
Suspension of firms and accountants from engagements for publicly traded companies
Referral of criminal cases to the Justice Department PCAOB United States v. Arthur Andersen (2002)—Arthur Andersen was accused of the wholesale destruction of documents relating to the Enron Corporation collapse. The jury found, based primarily on an email message that an Arthur Andersen attorney advised a partner to revise a memo to omit certain information, including a comment that an Enron press release that included an earnings announcement was misleading. Loss of this case effectively put Arthur Andersen out of business. The conviction was overturned by the U.S. Supreme Court Criminal Liability Selected Court Cases Establishing Precedents Under Statutory Law Liability to Third Parties under Statutory Laws Must establish that losses resulted from CPAs’ performance
CPA breached a duty of due professional care
Third party seeks to establish that it sustained a loss caused by relying on misleading financial statements which included an audit report that was inadequate
Gross negligence will establish liability
Ordinary negligence depends on jurisdiction Third Parties Duty
Defined by GAAS, the engagement letter and legal considerations
Breach of duty
Auditor did not perform obligations listed in the engagement letter or
Performance did not meet professional standards
Does not imply auditors were negligent whenever misstatements due to errors or fraud are later found Elements of Duty and
Breach of Duty Criminal statutes
Most lawsuits allege violations of federal securities acts
Usually class action lawsuits by investors
Racketeer Influenced Corruption Organizations Act Other Sources of CPA Liability 3. Fraud
Misrepresentation by a person of a material fact, known by that person to be untrue or made with reckless indifference as to whether the fact is true, with the intention of deceiving the other party and with the result that the other party is injured
Constructive fraud – does not involve a misrepresentation with intent to deceive (gross negligence)
Securities Act of 1933
Securities Exchange Act of 1934 1. Breach of Contract
2. Negligence - tort
Ordinary – violation of legal duty to exercise a degree of care that an ordinary prudent person would exercise under similar circumstances
Gross – lack of even slight care, indicative of a reckless disregard for one’s professional responsibilities Primary Sources of CPA Liability Common Law
Develops through case decision
Breach of contract
Develops when governmental unit passes laws and regulations imposing liability on CPAs CPA Liability Some cases are obviously a result of less than adequate audit performance
In many cases, some of the many estimates made in the preparation of financial statements are, in hindsight, proven wrong
A case often argues, in hindsight, that the amounts were unreasonable
Other cases may be due to other factors such as the ability of the CPA firm to pay (“deep pockets”) Litigation Perspective Potential liability may exceed that of other professions (such as physicians) because:
Number of parties suffering significant losses.
Possibly millions of investors as well as firm creditors.
Amounts can be excessive in some cases exceeding the limits of professional liability insurance Scope of CPA Liability Place emphasis within the firm on complying with GAAS and professional ethics
Retain legal counsel that is familiar with CPA’s legal liability
Maintain adequate professional liability insurance
Investigate prospective clients thoroughly
Obtain a thorough knowledge of the client’s business Preventing Litigation CPAs who prepare unaudited financial statements should
adhere closely to Rules of Conduct 102 and 202 of AICPA Code of Professional Conduct
Engagements letters are essential
Should still be alert for and follow up on unusual items such as missing invoices
Report clearly and concisely using standardized language Lessons from 1136 Tenants’ Corp. Case Has power to prohibit CPAs from reporting on SEC registrants’ financial statements.
Can take punitive action against public accounting firms
Consent decrees which can enforce certain penalties or restrictions
Auditors are forced to report illegal acts by clients to SEC if the client fails to report them SEC Among the activities included as "racketeering activities" are mail fraud and fraud in the sale of securities
Used against CPAs who knew or should have known of material misstatements of financial statements
Allows triple damages in civil cases
1993 – Reves v. Ernst & Young
Court decided accountants cannot be held liable under RICO act unless they actually participated in the operation or management of the organization RICO Act Private Securities Litigation Reform Act of 1995
Placed limits on amount of auditors’ liability by establishing proportionate liability
If one of more defendants are not able to pay their share of losses,
to certain small investors only, auditors have unlimited joint and several liability
To other investors, auditors liability limited to an amount not to exceed 50% of the auditors’ proportionate share of the losses Proportionate Liability under 1934 Act Rosenblum Approach to Auditor Liability Selected Case
Rusch Factors, Inc. v. Levin (1986)--A common-law decision in which the auditors were found liable for ordinary negligence to a third party not specifically identified to the auditors, although the auditors were aware of the intended use of the financial statements.
To be held liable for ordinary negligence, the auditors must have been aware that the financial statements were to be used for a particular purpose, although the identity of the third party need not necessarily be known. Restatement of Torts Approach to Auditor Liability Selected Case
Rosenblum v. Adler (1983)--Established that the auditors could be held liable for ordinary negligence to all third parties that the CPAs could reasonably foresee as users of the financial statements for routine business purposes.
Opens the door to liability for ordinary negligence to virtually all third parties who rely on the financial statements. Approaches to Auditor Common Law Liability to Third Parties Losses
Damages to the plaintiff
Depend on the nature of the engagement
Negligence not proximate cause
Joint and several Elements of
Losses and Causation Duty—CPAs accepted a duty of due professional care
Breach of duty—CPAs breached that duty
Losses—Suffered by plaintiff
Causation (proximate cause)—Losses were caused by CPAs’ performance Elements of Proof by Client Under Common Law Selected Cases
Ultramares Corporation v. Touche (1931)--A landmark case under common law in that it established that auditors could be held liable to third-party beneficiaries for ordinary negligence and to other third parties for gross negligence.
Credit Alliance Corp. v. Arthur Andersen & Co. (1985)--A common-law decision establishing that auditors must demonstrate knowledge of reliance on the financial statements by a third party for a particular purpose to be held liable for ordinary negligence to that party.
Auditors must have been aware that the financial statements were to be used for a particular purpose by a known third party to be liable to that party for ordinary negligence. Ultramares Approach to Auditor Liability Keystone Computers & Networks
Issue #1 Problem #1
KCN AUDIT PLAN Rackspace Summary:
- Ringo Pistachio Company owes KCN $77,000 for computer equipment.
- Sam (president) and Steele (controller) worked a repayment schedule; $11,000 per month.
- First payment was made, but nothing after.
- Possible bankruptcy for Ringo:
Legal counsel says creditors expects to receive ~40 cents per dollar
Steele says ~60 cents per dollar
Analysis of audited statements says ~50 to 60 cents per dollar
- Equipment can possibly be sold for $25,000 to $35,000.
- No allowance for the this account is currently included in the allowance for doubtful accounts.
- What, if any, loss reserve (and/or note disclosure) should be reflected in the financial statement? General Accounting Requirements. FASB ASC 450-20 requires accrual of a loss when it is probable that an asset has been impaired at the date of the financial statements and the amount of the loss can be reasonably estimated. Collectibility of receivables is included in ASC 450-20 as an explicit example of a loss contingency. When the amount of the loss is estimated as a range and no point within that range is a better estimate than any other amount, accounting standards require accrual of the minimum amount in the range. In addition, disclosure of the nature of the contingency and the additional exposure to loss is required when there is at least a reasonable possibility of loss in excess of the amount accrued. When some amount within the range appears to be a better estimate than any other amount within the range, that amount shall be accrued. Expected Recovery Expected Loss(1 - Expected Recovery) Dollars of Expected Loss*
Legal counsel (40%) 60% $46,200
Steele and Best (60%) 40% $30,800
Our analysis (50%-60%) 40%-50% $30,800-$38,500
Repossession $25,000-$35,000 $42,000-$52,000
*$77,000 outstanding receivable x expected loss Bad Debt Expense $30,800
Allowance for Doubtful accounts $30,800 Journal Entry https://login.uiwtx.idm.oclc.org/login?qurl=http%3a%2f%2fcheckpoint.riag.com%2flogin%3fiploc%3dunivoftheincar FASB Codification Link: OBJECTIVES OF THE ENGAGEMENT
BUSINESS AND INDUSTRY CONDITIONS
OWNERSHIP AND MANAGEMENT
OBJECTIVES, STRATEGIES AND BUSINESS RISKS
MEASUREMENT AND REVIEW OF FINANCIAL PERFORMANCE
PROCEDURES TO OBTAIN AN UNDERSTANDING OF THE CLIENT AND ITS ENVIRONMENT
SIGNIFICANT ACCOUNTING AND AUDITING MATTERS
SCHEDULING AND STAFFING PLAN SECTION PURPOSE CONTENT To describe the services that are to be rendered to the client.
To describe the nature of KCN's business and industry.
To indicate meetings held with client and with CPA
To describe the owners and management of the company.
To describe KCN’s business objectives, major strategies and the risks related to achieving its objectives.
Describes the methods used by management to monitor performance.
Describes the procedures used by the auditors to obtain an understanding of the client and its environment.
To describe the significant risks identified by the auditors.
To describe particular accounting and auditing matters of concern.
To identify an amount to be used as a measure for planning materiality.
To provide the schedule for major portions of the audit, and the staffing requirements for the engagement. The objectives are (1) audit of KCN's financial statements for the year ended 12/31/X5, and (2) issuance of a letter on compliance with covenants of the client's letter of credit agreement.
KCN sells and services micro-computers, networking hardware and software to business customers. The industry is sensitive to economic conditions and very competitive, with KCN competing with companies much larger than itself. KCN’s long-term success depends on its ability to attract and retain qualified information technology personnel. The annual growth in spending for information technology products and services is expected to be 3% per year for the next three years. The section includes major dates beginning with interim audit work through the issuance of an updated management letter. A total of 195 hours are budgeted for the audit. Based on an analysis of sales, total assets, and pretax net income, an amount of $300,000 will be used as a measure of planning materiality. Three particular concerns exist: (1) proper accounting for extended warranties, (2) capitalization of software costs, and (3) possible impairment of software. Two significant risks were identified: (1) KCN has engaged in a strategy to sell to customers with higher credit risk, and (2) the officers of the company receive significant bonuses based on quarterly results. The procedures used include (1) review of information from the prior-year’s audit, (2) Inquiries of management, (3) reading board minutes, (4) review of monthly performance reports, (5) review of industry reports, review of the company’s website, and (6) review of articles in the Wall Street Journal. Measures used to monitor performance include: (1) inventory and receivables turnover, (2) aging of accounts receivable, (3) sales and gross margins by type of revenue, (4) net income, and the total inventory balance. The major objective of KNC is to increase revenues by 6% and increase net income by 8% for each of the next 3 years. Major strategies include: (1) aggressive advertising, (2) sales to customers with higher risk profiles, and (3) new software development. The primary risks include (1) advertising may not create the desired results, (2) credit losses may exceed benefits of increased sales, and (3) software development activities may not produce products. KCN is privately owned by Terry Keystone, Mark Keystone, John Keystone, Keith Young, and Rita Young. Terry and Mark Keystone participate in management. At this point, one meeting has been held with client personnel and one with the engagement team. Criminal Liability Accounts Receivable, Net
We classify as trade accounts receivable amounts due within twelve months, arising from the provision of services in the normal course of business. We assess collectability based on a number of factors, including customer payment history and creditworthiness. When evaluating the adequacy of allowances, we analyze accounts receivable, current economic conditions and trends, historical bad debt write-offs, customer creditworthiness, and changes in customer payment terms. We write off customer accounts receivable balances to the allowance for doubtful accounts when it becomes likely that we will not collect from the customer. Our provision for bad debts and customer credits increased from $4.3 million in 2010 to $5.9 million in 2011 due to the increases in net revenue and accounts receivable.
We accrue for contingent obligations. As facts concerning contingencies become known, we reassess our position and make appropriate adjustments to the financial statements. Is an IT hosting company based in San Antonio, Texas, USA. Transparency: Regular "Open Book" meetings are held where the top level leaders share in-depth financial information with all employees. Valuation of Accounts Receivable and Service Credits
Estimates that further impact revenue recognition relate primarily to the allowance for doubtful accounts and customer service credits. Both estimates are relatively predictable based on historical experience.
All of their customer agreements provide that they will achieve certain service levels. To the extent that such service levels are not achieved, they record service credits, which are a reduction to revenue, and a corresponding increase in the allowance for customer credits to provide for estimated adjustments to receivables.
We make judgments as to our ability to collect outstanding receivables and provide allowances when collection becomes doubtful. Judgment is required to assess the likelihood of ultimate realization of recorded accounts receivable. If the financial condition of our customers were to deteriorate, resulting in an impairment of either their ability or willingness to make payments, an increase in the allowance for doubtful accounts would be required. Similarly, a change in the payment behavior of customers generally may require an adjustment in the calculation of the appropriate allowance. Service interruptions or significant equipment damage in our data centers, whether or not within our control, could result in us not achieving service level commitments to these customers, resulting in an obligation to pay a service level credit. Our liability insurance does not cover ordinary service interruptions. This Issue. Since recovery is estimated as a range, with no point within the range being a better estimate than any other, the minimum within that range should be accrued. There is a question in this issue as to the proper range to consider as follows: CPAs not liable KPMG: Unmodified blue sky law