Foreseeable third parties are best described as

Explain why the potential liability of auditors for professional "malpractice" exceeds that of physicians or other professionals.

There 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.

Distinguish between ordinary negligence and gross negligence within the context of the CPAs' work.

Ordinary 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

What is meant by the word privity? How does privity affect the auditor's liability under common law?

Privity 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

Define the term third-party beneficiary.

A 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

Distinguish between common law and statutory law.

Common 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

Briefly describe the differences in liability to third parties under the known user, foreseen user, and foreseeable user approaches to CPA liability.

The 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

Briefly describe the different common law precedents set by the Ultramares v. Touche & Co. case and the Rosenblum v. Adler case.

In 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 "foreseeable" third parties who utilize the financial statements for "routine business purposes."

What landmark case was embraced by the court in the case of Credit Alliance Corp. v. Arthur Andersen & Co.? Identify the two factors that the court stated must be proved for the auditors to be held liable for ordinary negligence to a third party.

The Credit Alliance Corp. case embraced the landmark Ultramares v. Touche & Co. precedent. The court stated that before the auditors may be held liable for ordinary negligence to a third party (1) the auditors must have knowledge of reliance on the financial statements by that party for a particular purpose, and (2) some action by the auditors must indicate that knowledge

Compare auditors' common law liability to clients and third-party beneficiaries with their common law liability to other third parties.

Under common law, auditors are liable to their clients for ordinary negligence as well as for fraud and breach of contract. Auditors are liable to third party beneficiaries (and in some jurisdictions to foreseen or foreseeable third parties) for fraud and for ordinary negligence. Auditors are liable for gross negligence and fraud to other third parties

Contrast joint and several liability with proportionate liability.

Under joint and several liability one defendant may be required to pay the losses attributed to the actions of other defendants who do not have the financial resources to pay. Thus, if two parties were negligent and found to each be 50% liable, if one was unable to pay, the other party could be required to pay the entire 100%. Under proportionate liability a defendant is liable only for his or her proportion of fault. Using the previous example, neither defendant could be required to pay more than 50% of the damages

Compare the rights of plaintiffs under common law with the rights of persons who purchase securities registered under the Securities Act of 1933 and sustain losses. In your answer, emphasize the issue of who must bear the burden of proof.

Legal actions under common law require the plaintiffs to bear most of the burden of affirmative proof. The plaintiffs must prove they sustained losses, that they relied upon financial statements that were misleading, that this reliance caused their losses, and that the auditors were guilty of a certain degree of negligence. In legal actions brought under the Securities Act of 1933, the burden of proof is shifted to the auditors, who must show that they were not negligent (the due diligence defense) or that misleading financial statements were not the proximate cause of the plaintiffs' losses

State briefly a major distinction between the Securities Act of 1933 and the Securities Exchange Act of 1934 with respect to the type of transactions regulated.

The Securities Act of 1933 regulates the initial sale of securities in interstate commerce (new issues), and the Securities Exchange Act of 1934 regulates trading of securities after initial distribution

Why was the Ernst & Ernst v, Hochfelder decision considered a "victory" for the accounting profession?

The Hochfelder v. Ernst decision is regarded as a "victory" for the accounting profession because it is one of the few decisions to limit, rather than expand, auditors' legal liability to third parties. In this decision the U.S. Supreme Court ruled that ordinary negligence was not a sufficient degree of misconduct for auditors to be held liable to third parties under Rule 10b-5 of the Securities Exchange Act of 1934

How was the Continental Vending case unusual with respect to penalties levied against auditors?

The Continental Vending case was unusual in that it involved criminal charges against the CPAs for violating provisions of the Securities Acts. Although there was no intent to defraud on the part of the CPAs, they were convicted of criminal fraud on the basis of gross negligence. The three CPAs were later pardoned by the president of the United States

Why did Congress enact the Racketeer Influenced and Corrupt Organizations Act? Why has it been of concern to auditors? What subsequent developments have reduced this concern?

The Racketeer Influenced and Corrupt Organizations Act was passed by Congress to prosecute mobsters and racketeers who influence legitimate businesses. It has been of concern to CPAs because the act broadly defines the term "racketeering activities" to include fraud in the sale of securities. Therefore, the act was used successfully in a small number of cases against CPAs. Of particular concern is the Act's provision that allows treble damages to be awarded. Concern about the RICO Act has been reduced based on the United States Supreme Court ruling in Reves v. Ernst & Young. In that case, the court decided accountants could not be held liable unless it can be proven that they actually participated in the operation or management of the organization

How does the SEC regulate auditors who appear and practice before the commission?

The SEC has issued Rules of Practice to govern the appearance and practice before the commission of CPAs, attorneys, and others. Rule of Practice 2(e) gives the power of suspension or disbarment to the SEC. In addition, the Public Company Accounting Oversight Board (under the authority of the SEC) may conduct investigations and disciplinary proceedings regarding both registered public accounting firms, and professional employees (including owners). Board sanctions include monetary damages, suspension of firms and accountants from working on engagements for publicly traded companies, and referral of criminal cases to the Justice Department

In the 1136 Tenants ' Corporation case, what was the essential difference in the way the client and the CPAs viewed the work to be done in the engagement?

In the 1136 Tenants' Corporation case, the client contended that the auditors had been retained to perform all necessary accounting and auditing services. The CPAs argued that they had been retained to do "write-up" work only, consisting of maintaining accounting records and preparing financial statements and tax returns. This difference was critical because the client contended the CPAs had been negligent in not discovering a defalcation. The case illustrated the importance of an engagement letter to define the services to be performed

Comment on the following statement: While engagements letters are useful for audit engage­ments, they are not necessary for compilation and review engagements.

Engagement letters are important both for audits and for accounting and review services performed by CPAs. Oral arrangements are unsatisfactory when a dispute arises as to the services to be rendered by the CPAs

Rogers and Green, CPAs, admit they failed substantially to follow generally accepted auditing standards in their audit of Martin Corporation. "We were overworked and understaffed and never should have accepted the engagement," said Rogers. Does this situation constitute fraud on the part of the public accounting firm? Explain.

No. Rogers and Green appear to be guilty of gross negligence, which often is considered tantamount to constructive fraud. However, actual fraud involves knowledge of misrepresentation within the financial statements and an intention to deceive users of those statements. Although Rogers and Green failed substantially to comply with generally accepted auditing standards, there is no indication that they knew of misrepresentation in the statements or intended to deceive third parties. Gross negligence may be considered constructive fraud, because the auditors are misleading the public as to the degree of credibility that they are able to add to the statements. While such conduct is highly unprofessional, it is still quite different from attesting to the "fairness" of financial statements known by the auditors to be misleading