Auditor's Professional Liability under Common Law | Auditing & Attestation Course | CPA Exam AUD

This session focuses on auditors' professional liability under common law, a topic relevant for auditing and attestation courses and the CPA exam. Common law is defined as law passed and upheld by court decisions, making it subject to change based on new rulings. Each state in the US has its own court system, leading to significant differences in common law across jurisdictions. This variability is crucial because the specific state where a lawsuit is filed can determine the legal precedent applied.

For a plaintiff to successfully sue an auditor under common law, they must demonstrate four key things: 1) The financial statements were materially misstated, which is often proven by restatements. 2) The existence of damages, easily quantifiable in cases involving stock price drops after restatements. 3) Causality, proving that the damages resulted from reliance on the misstated financial statements, often linked to market efficiency. 4) Auditor misconduct, with the type and degree of misconduct (negligence, gross negligence, or fraud) required depending on the plaintiff's relationship to the audit and the jurisdiction.

Besides the client, third parties reasonably expected to rely on the audited financial statements can also sue. These third parties are categorized into three groups: identified users (specifically known to the auditor, e.g., a named bank for a loan), foreseen users (a group of potential users known to the auditor, e.g., banks in a certain area), and foreseeable users (a general class of users whose members may or may not rely on the statements, e.g., public shareholders or creditors).

State courts follow one of three main precedents: Credit Alliance, Restatement (or Rusch Factors), or Citizen Bank Rosenblum (or H. Rosenblum). The ability of a plaintiff to sue for negligence versus gross negligence depends on which of these precedents the state follows and which type of user the plaintiff is. Identified users can sue for negligence across all three precedents. Foreseen users can sue for negligence under Restatement and Rosenblum but only for gross negligence under Credit Alliance. Foreseeable users can sue for negligence only under Rosenblum, while under Credit Alliance and Restatement, they can only sue for gross negligence. The Rosenblum precedent is the least auditor-friendly because it allows foreseeable users to sue for negligence, lowering the burden of proof.

The evolution of common law and auditor liability is illustrated by the Ultramares case (Fred Stern & Company). Initially, before this case, foreseen or foreseeable users could only sue auditors for fraud, which is difficult to prove due to the requirement of intent. In the Ultramares case, a bank (Ultramares), not named in the engagement letter, lent money based on misstated financial statements audited by Touche. When Fred Stern went out of business, Ultramares sued Touche. Although the fraud claim was dismissed, a jury found the auditor negligent. Judge Cardozo, in the New York Court of Appeal, lowered the standard of proof, allowing third parties (primary beneficiaries specifically mentioned) to sue for negligence and others for gross negligence. This landmark decision significantly increased the auditor's legal exposure by expanding who could sue and for what level of misconduct, demonstrating how common law evolves through judicial decisions.