Solution Manual Of Ethical Obligations And Decision Making in Accounting Text And Cases, 4th Edition By Steven M Mintz
Chapter 6 Discussion Questions
Suggested Discussion and Solutions
1. As discussed in the opening reflection, MF Global filed a complaint charging PwC with professional malpractice, breach of contract, and unjust enrichment in connection with its advice concerning, and approval of, the company’s off-balance-sheet accounting for its investments. The court’s decision points out that absent PwC’s advice, MF Global Holdings would not have invested heavily in European sovereign debt to generate immediate revenues and would not have suffered the massive damages that befell the company in 2011. Do you believe that auditors should be held legally liable when they advise clients on matters related to the company’s finances that turn out to be wrong? Explain with reference to legal and professional standards.
In the MF Global case, PricewaterhouseCoopers (PwC) advised MF Global to invest in European sovereign debt to generate immediate revenues that turned out to be risky investments that lost money. MF Global also recorded the transactions as sales and not financings, which wasn’t in accordance with generally accepted accounting principles (GAAP). Thus, PwC was sued for failing to detect problems with MF Global’s financial statements. The audits conducted by PwC gave MF Global a clean bill of health.
Auditors’ legal liability is typically established by demonstrating a lack of due care, which is a lack of reasonable care that would be expected under the circumstances, and failure to exercise the degree of professional skepticism warranted under the circumstances. A critical issue for auditors is to demonstrate they followed generally accepted auditing standards (GAAS) in conducting the audit including gathering sufficient competent evidential matter to warrant the expression of the opinion. Auditors also need to show they assessed the likelihood of fraud and reviewed management’s report on internal controls. If auditors can demonstrate meeting these standards, then auditors’ will not generally be held liable for fraud at their clients. From a legal standard perspective, auditors must protect against conducting an audit with negligence, gross negligence and fraud. It appears that PwC was negligent at a minimum because its audit did not identify the riskiness of the MF Global investments and allowed the improper accounting.
Auditors should not be held liable simply because their advice turns out to be wrong. However, it appears from the facts of the case that PwC did not exercise due diligence in making its investment recommendation. MF Global relied on that advice. Shareholders were harmed when it turned out the advice was faulty.
2. Distinguish between common-law liability and statutory liability for auditors. What is the basis for the difference in liability?
Common law liability arises from legal opinions issued by judges in deciding cases. These opinions become legal precedents and guide other judges in deciding on similar cases in the future. Common law cases are civil suits. Statutory liability reflects legislation passed at the state or federal level; the legislation establishes certain courses of conduct. Statutory law can either result in civil liability or criminal liability. A good example of statutory law is the SEC securities acts that establish liabilities for auditors in conducting an audit in accordance with GAAS and responsibilities with respect to material misstatements in the financial statements. Auditors have liabilities for ordinary negligence; gross negligence (constructive fraud); and fraud. Many times statutory law can be interpreted differently by different people. This is why making rulings based on precedent in common law systems can be beneficial when the meaning of a law is disputed.
3. Is there a conceptual difference between an error and negligence from a reasonable care perspective? Give examples of each of your response.
Errors are unintentional mistakes or omissions. Errors may involve mistakes in gathering or processing data or testing, misinterpretation of facts, mistakes in the application of GAAP or GAAS. A simple error is transposing numbers when entered into the data-base system (i.e., $492 recorded as $429). There can be errors in math, disclosure, and even in interpreting GAAP. In the latter case, an error is distinguished from fraud by intent. If the intent of the “error” was to deceive another party, it is fraud not an error.
Negligence is a violation of a legal duty to exercise a degree of care that an ordinarily prudent person would exercise under similar circumstances. Negligence would be deciding that the accounts receivable confirmations are unnecessary since they take too much time and normally do not change the balance sheet accounts in a significant amount.
4. Distinguish between the legal concepts of actually foreseen third-party users and reasonably foreseeable third-party users. How does each concept establish a basis for an auditor’s legal liability to third parties?
Actually foreseen third party users are a limited range of individuals or organizations that the client intends the information to benefit. The auditor need not know the exact identity of the third party. However, it owes a duty to persons who the professional knows will rely on the information. The auditor would be liable to any plaintiff that justifiably relied on the information and suffered a loss from that reliance. An example would be if the client informs the auditor that it will be using the audited financial statements to obtain a bank loan, without naming any specific bank. Under the (actually) foreseen third party doctrine, any bank would have relied on the audited financial statements in making lending decisions and may have a legal right to sue.