Chapter 6 starts with an Ethical Reflection of the case of Cenco, Inc. v. Seidman which deals with common-law legal standards for auditors who fail to detect fraud. In this case, managers were inflating inventory. Cenco, in turn, sued Seidman, the audit firm for not detecting the fraud. The court ruled in favor of Seidman because Cenco's management was just as complicit as Seidman and would not receive damages from their own audit firm.
Later, in an answer to the onslaught of audit liability cases, the AICPA pushed Congress to pass the PSLRA in 1995. The act establishes proportionate liability meaning audit forms can only be liable for the proportion of damages connected with the portion of what was actual audited. There is argument that this may have helped auditors veer away from the due care standard. One wonders if this was a pre-curser to later cases such as Enron and MCI.
The chapter outlines the duties of officers and directors and the loyalty, liability and the Business Judgement Rule. The Business Judgement Rule limits the liability of officers and directors to losses as a result of fraud...and not simply a poor business decision such as marketing or M&A.
The Chancery Court as outlined in Chapter 6, is a forum used to resolve commercial business litigation matters.
Common-Law liability has to do with the performance of due care by the auditor. The second paragraph of the audit statement is meant to emphasis and hold the auditor accountable for due care in performing the audit using GAAS.
Privity relationships exist between the auditor and client due to auditor's contractual obligation to the client. Therefore, a client sue an accountant for failing to live up the terms of the contract. The 1933 Ultramares decision set the precedent that third parties without privity could sue if the negligence was so great that it could be called constructive fraud. By 1985, the decisions started coming back in favor of the auditors. A 1985 case established tests that must be passed before holding an auditor liable for negligence to third parties. 1) knowledge by the accountant that the financial statements are to be used for a particular purpose, 2) the intention of the third party to rely on those statements, and 3) some action by the accountant linking them to the third party that provides evidence of the accountant's understanding of intended reliance. So, there is liability to clients, liability to third parties, and also foreseen third parties. Section 552 of the Law of Torts, limits loss to those whom the auditor knew would rely on the financial statements for a specific transaction.
In common-law liability for fraud is available to third parties as long as they can prove 1) a false representation by the accountant, 2) knowledge or belief by the accountant that the representation was false, 3) the accountant intended to get the third party to rely on false statements, 4) the third party relied on the false representation, and the third party suffered damages.
Statutory laws are those laws, which if violated, can result in a prison sentence. The Securities Act of 1933, and later the Securities Exchange Act of 1934 established regulations for publicly traded companies to follow. Violations of these acts can result in steep fines and even prison sentences. Ask Martha Stewart.
The Foreign Corrupt Practices Act establishes standards for payments made by U.S. entities to foreign governments. The act makes it a crime to offer or provide payments to officials or foreign governments, political candidates , or political parties for the purpose of obtaining or retaining business. Recently Johnson and Johnson was brought up on these very charges.
Finally, the RICO act, in the case of Reves v. Ernst & Young, established that the plaintiff prove the accounting firm participated in the operation of management of the client's business.
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