4 questions

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Accounting ethical:

for #1-2: answer the questions (read the power point as needed, around 100 words per question)

for #3-4: read the cases first, then answer the questions. (read the power point as needed, around 150 words per question)

Auditors’ Legal Liabilities and Defenses

Chapter 08

© 2023 McGraw Hill, LLC. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw Hill, LLC.

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Learning Objectives

L O 8-1: Describe common-law rulings and auditors’ legal liabilities to clients and third parties.

L O 8-2: Explain auditors’ defenses to negligence, negligent misrepresentation, and fraud.

L O 8-3: Explain the basis for auditors’ statutory legal liability.

L O 8-4: Explain the provisions of the P S L R A.

L O 8-5: Discuss auditors’ legal liabilities under S O X.

L O 8-6: Explain the provisions of the F C P A.


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Questions to Consider

What are the professional and ethical requirements for auditors to avoid legal liability to clients and third parties?

What legal actions can be taken against auditors?

What are auditor defenses to fraud?

What are additional legal obligations under S O X, the Private Securities Litigation Reform Act, and the Foreign Corrupt Practices Act?


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Legal Liability of Auditors: An Overview

Zoe-Vonna Palmrose identifies the 4 general stages in audit-related disputes:

Events that result in losses for users of the financial statements.

Investigation by plaintiff attorneys to link the user losses with allegations of material omissions or misstatements of financial statements.

Filing of the lawsuit.

Final resolution of the dispute.

Auditors can be sued by clients, investors, creditors, and the government.

Auditors can be held liable under common and statutory law.


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Common and Statutory Law

Common law:

Evolves from legal opinions issued by judges in deciding a case.

Statutory law:

Legislation passed at state or federal level that establishes certain courses of conduct that must be adhered to by parties.

Breach of contract is a claim that accounting or auditing services were not performed in a manner proscribed in the contract (brought by clients)

Tort actions cover other civil complaints (brought by clients and users of financial statements)





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Common Law Liability

Auditor must perform professional services with due care.

Evidenced by having exercised same degree of skill and judgment possessed by others in the profession.

Adherence to generally accepted auditing standards can provide evidence of having exercised due care in the audit.

Due care includes exercising the degree of professional skepticism expected in the audit of financial statements.

Audit failures – all possible causes – breach of contract, tort, deceit, and fraud.


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Liability to Clients – Privity

A contractual obligation to the client that creates a privity relationship.

A client can bring a lawsuit against an accountant for failing to live up to terms of the contract; plaintiff must demonstrate:

Economic loss.

Auditors breached contract.

Auditors failed to exercise appropriate level of professional care.

Auditors breach or failure of care caused the loss.

Fraud includes gross negligence or constructive fraud that represents an extreme or reckless departure from professional standards of care.

Ultramares v. Touche, 1933.

Third party not in contractual privity cannot sue based on negligence.

Left open possibility for gross negligence and fraud.


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Professional Negligence

Professional negligence is the liability theory most often referred to as an “accounting malpractice” claim. The elements of a professional negligence action against an accountant are similar to those present in any other type of negligence lawsuit.

Duty — the accountant must have owed the plaintiff a duty to use reasonable care in delivering accounting services.

Breach of Duty — the plaintiff must show that the accountant failed to use that degree of skill and learning normally possessed and used by public accountants in a similar situation.

Damage — the plaintiff must show that he or she suffered damage as a direct result of the accountant’s breach of duty.

Causation — a causal nexus between the asserted breach and damages, such as a business driven into bankruptcy because it went into debt in reliance on overstated financial statements.


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Defending Audit-Malpractice Cases

Contributory negligence of the client can be regarded as a defense to the liability of the accountant for malpractice.

It has to be proved that the negligence of the client has proximately contributed to the accountant’s failure to perform.

The client’s negligence is a defense only when it has contributed to the accountant’s failure to perform his contract and to report the truth.


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Comparative Negligence

The comparative negligence rule replaced the harsh all-or-nothing approach of contributory negligence with a formula based upon allocation of fault.

The change from contributory negligence to comparative fault did not totally immunize defendants from liability if the plaintiff was the slightest bit negligent.

Courts now allow accountants to assert a comparative negligence defense and have affirmed the jury’s apportionment of damages between the accountants and the corporation.


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Recklessness involves conduct that is short of actual intent to cause harm, but greater than simple negligence.

Unlike negligence, which occurs when a person unknowingly takes a risk that they should have been aware of, recklessness means to knowingly take a risk.

Recklessness is a state of mind that is determined both subjectively and objectively.

What the actor knew or is believed to have been thinking when the act occurred (subjective test)

What a reasonable person would have thought in the defendant’s position (objective test)


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Negligent Misrepresentation

Negligent misrepresentation occurs when an accountant gives false information to a third party with respect to financial statement information.

A liability exists when the accountant knows the person who will rely on the statement and knows the purpose of relying.

Auditor liability for negligent misrepresentation does not require proof of the audit that was intended to influence the particular plaintiff.

A complaint for negligent misrepresentation is sufficient if it alleges the audit was intended to influence the particular classes of person to which the plaintiff belongs.


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Exhibit 8.3 Accountants’ Liability for Negligence and Recklessness

Negligence refers to the failure to take proper and reasonable care, causing injury or loss to another person
Recklessness is the state of mind where a person deliberately pursues a course of action while consciously disregarding any risks stemming from such action
An individual not aware of the risk involved, but should have known what risks are
An individual is aware of the risk involved
Carries a lesser liability than recklessness
Carries a greater liability than negligence


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Common Law Liability to Third Parties
Near-Privity Relationship

Near privity relationship established in Credit Alliance v. Arthur Andersen & Co.

Case establishes tests for holding auditors liable for negligence to third parties.

Knowledge that financial statements to be used for a particular purpose.

Intention of third party to rely on financial statements.

Action linking the accountant and the third party.

Security Pacific Business Credit, Inc. v. Peat Marwick Main & Co.

Sharpened last criteria of near privity test:

The auditor must directly convey the audited report to the third party, OR.

The auditor acts to induce reliance on the audit report.


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Plaintiff Claims Under Common Law

Common-law liability for fraud is available to third parties in any jurisdiction. The plaintiff must prove:

A false representation by the accountant.

Knowledge or belief by the accountant that the representation was false.

The accountant had fraudulent intent or scienter (established by proof that accountant acted with knowledge of the false representation)

The third party relied on the false representation.

The third party suffered damages.


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Actually Foreseen Third Parties

“Middle ground” approach followed by most states expands class of third parties that can successfully sue auditor for negligence beyond near-privity to limited group whose reliance is (actually) foreseen, but not necessarily known to the auditor.

Rusch Factors, Inc. v. Levin, 19 68.

Rhode Island federal court held an accountant liable for negligence to a third party not in privity of contract.

Restatement (Second) of Torts.

Expands an accountant’s legal liability for negligence to any third parties (foreseen third party) identified as intended recipients of the work…should be foreseen as a relying on financial information.

Blue Bell, Inc. v. Peat, Marwick, Mitchell & Co., 19 86.

Texas Court of Appeals held that if an accountant preparing audited statements knows or should know…the accountant may be held liable for negligent misrepresentation.


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Reasonably Foreseeable Third Parties 1

H. Rosenblum v. Adler, 19 83.

New Jersey Supreme Court ruled that auditors should be liable to all reasonably foreseeable third parties who rely on the financial statements.

“Independent auditors have a duty of care to all persons whom the auditor should reasonably foresee as recipients of the statements from the company for proper business purposes, provided the recipients rely on those … statements”.

Citizens State Bank v. Timm, Schmidt & Company.

Wisconsin Court ruled the cost of credit to lenders would be prohibitive if foreseeable third parties could not sue auditors.


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Gross Negligence and Fraud

Gross negligence may be interpreted as fraud.

Gross negligence, or constructive fraud, occurs when the auditor acts so carelessly in the application of professional standards that it implies a reckless disregard for the standards of due care.

Fraudulent intent or scienter must exist.

Scienter is the intent to deceive, manipulate, or defraud.


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Statutory Liability for Fraud 1

To establish liability for fraud under Section 10(b) of the Securities Act, a plaintiff must show that:

The defendant made a material misstatement or omission;

The misstatement or omission was made with an intent to deceive, manipulate or defraud (i.e., scienter);

There is a connection between the misrepresentation or omission and the plaintiff’s purchase or sale of a security;

The plaintiff relied on the misstatement or omission;

The plaintiff suffered economic loss; and,

There is a casual connection between the material misrepresentation or omission and the plaintiff’s loss.


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Common Law Liability for Fraud

Common-law liability for fraud is available to third parties in any jurisdiction. The plaintiff (third party) must prove

a false representation by the accountant,

knowledge or belief by the accountant that the representation was false,

that the accountant intended to induce the third party to rely on false representation,

that the third party relied on the false representation, and,

that the third party suffered damages.


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Liability for Fraudulent Misrepresentation

General Rule

One who makes a fraudulent misrepresentation is subject to liability to the persons or class of persons whom he intends or has reason to expect to act or to refrain from action in reliance upon the misrepresentation, for pecuniary loss suffered by them through their justifiable reliance in the type of transaction in which he intends or has reason to expect their conduct to be influenced.


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Income Tax Fraud versus Tax Negligence

Accountants’ legal liability extends to actions of personal tax fraud and negligence as well as permitting and/or enabling the tax fraud of a client.

Income tax fraud is the willful attempt to evade tax law or defraud the I R S including when a client.

Intentionally fails to file a income tax return,

Willfully fails to pay taxes due,

Intentionally fails to report all income received,

Makes fraudulent or false claims in preparing the tax return,

Prepares and files a false return.


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Holding Accountants Liable for Fraud

To hold accountants liable under common law, third parties must prove.

That the accountant made a false representation,

The accountant had knowledge or believed that the representation was false,

The accountant intended to induce the third party to rely on false representation,

The third party relied on the false representation, and,

The third party suffered damages.


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Auditor Defenses for Negligence

The due care defense is based on the prudent person concept. This defense implies four things:

The auditor possessed the requisite skills to evaluate accounting entries.

The auditor employed such skill with reasonable care and diligence.

The auditor undertook his task(s) with good faith and integrity.

While the auditor may be liable for negligence, the auditor is not liable for errors in judgment.


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Auditor Defenses to Fraud

The auditor should be liable only if inadequacies in their audit resulted in failure to detect the fraud.

Fraud requires an intent to deceive another part or scienter. In such cases, the auditor acted with knowledge of a false representation.

Unlike negligence where the auditor might have made a careless statement, fraud requires the belief that representation was false.

Fraudulent intent means a representation was made with reckless indifference to the truth or falsity.


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Auditor Requirements to Protect Themselves Against Fraud

Auditor must prove:

Auditor didn’t have duty to the third party.

The third party was negligent.

Auditor’s work was performed in accordance with professional standards.

The third party did not suffer loss.

Any loss to the third party was caused by other events.

The claim is invalid because the statute of limitations has expired.


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Requirements For Auditors’ Defense Against Fraud

The representation in question in was not false,

The representation in question was not material,

The auditor did not know the representation was untrue,

There was no intent to deceive,

The third party did not rely on the representation,

The third party did not suffer any damages.


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Consideration of Fraud in a Financial Statement Audit

In order to avoid statutory liability for fraud, the auditor must demonstrate that he carefully considered fraud risks in the financial statement audit.

In addition to exercising due care, the auditor should evaluate the conditions for fraud depicted in the fraud triangle.


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Statutory Liability for Fraud 2

Auditors may have legal liability under the Securities Act of 1933 and the Securities Exchange Act of 1934. These statutory liabilities may lead to convictions for crimes, provided their conduct was “willful”.

The term “willful” often is influenced by the context of the situation.

Section 32(a) of the Securities Exchange Act of 19 34 provides that any person who “willfully” violates any provision of the Act can be charged with a crime.

Section 15(b)(4) authorizes the S E C to seek civil administrative penalties against any person who “willfully” violates certain provisions of the securities laws.


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Securities Act of 19 33

Regulates the initial offering of securities through the mails or interstate commerce.

Companies must file registration statements, (S-1, S-2, and S-3 forms) and prospectuses which contain financial statements that have been audited by an independent C P A.

Accountants who assist in the preparation of the registration statement are civilly liable if the registration statement:

Contains untrue statements of material facts.

Omits material facts required by statute or regulation.

Omits information that if not given makes the facts stated misleading.


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Materiality Defense

The term material describes the kind of information that an average prudent investor would want to have to make an intelligent, informed decision whether to buy the security.

A material fact is one that, if correctly stated or disclosed, would have deterred or tended to deter the average prudent investor from purchasing the securities in question.

Facts that tend to deter a person from purchasing a security are those that have an important bearing upon the nature or condition of the issuing corporation or its business.


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Section 11 of the 1933 Securities Act

A major opinion of the U.S. Supreme Court on March 24, 2015, in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund changes the legal landscape with respect to when an issuer of financial statements may be held liable under Section 11 of the Securities Act of 1933 for statements of opinion made in a registration statement.

The Court vacated and remanded the Sixth Circuit’s 2013 decision holding that a Section 11 plaintiff need only allege that an opinion in a registration statement was “objectively false,” notwithstanding the company’s understanding when the statement was made.

The Supreme Court ruled a statement of opinion in a registration statement may not support Section 11 liability merely because it is “ultimately found incorrect”.


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Material Omission

A material omission claim would require the plaintiff “to identify actual and material steps taken or not taken by [the defendant auditor] in its audit or knowledge it did or did not have in the formation of the opinion” rather than simply “claiming that any reasonable audit would have uncovered a material fact whose omission renders the opinion misleading to a reasonable person reading the statement fairly and in context”.


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Securities Exchange Act of 19 34

Regulates subsequent trading and ongoing reporting of securities sold on U.S. stock exchanges.

Entities having total assets of $10 million or more and 500 or more stockholders are required to register under the Securities Exchange Act.

Requires ongoing filing:

Reviewed quarterly filing (10-Q)

Audited annual reports (10-K)

Form 8-K whenever a significant event takes place affecting the entity.

Authoritative literature for information filed with the S E C.

Financial Reporting Releases (F R Rs)

Staff Accounting Bulletins (S A Bs)

Interpretations of Regulations S-X and S-K.


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Section 18 of the Securities Exchange Act of 19 34

Imposes liability on any person who makes a material false or misleading statement in documents filed with the S E C.

The auditor’s liability can be limited if the auditor can show that she “acted in good faith and had no knowledge that such statement was false or misleading”

Number of court cases have limited the auditor’s good-faith defense when the auditor’s action has been judged to be grossly negligent.


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Section 10 and Rule 10b-5 Securities Exchange Act of 19 34

Unlawful for a C P A to:

Employ any device, scheme, or artifice to defraud.

Make an untrue statement of material fact or omit a material fact.

Engage in any act, practice, or course of business to commit fraud or deceit in connection with the trading of the stock.

Rule 10b-5 of the Securities Exchange Act of 19 34.

Plaintiff must prove:

A material, factual misrepresentation or omission.

Reliance by plaintiff on the financial statement.

Maxwell v. K P M G L L P : Maxwell’s harm wasn’t caused by K P M G’s audit.

Damages suffered as a result of reliance on the financial statements.

Intent to deceive, manipulate or defraud (scienter)


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Private Securities Litigation Reform Act (P S L R A)

Amends the Securities Exchange Act of 19 34 by adding Section 10A, “Audit Requirements”

Auditor must include “Procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts”

Auditor’s responsibility to detect fraud and requires auditors to promptly notify the audit committee and board of directors of illegal acts.

Particularity Standard.

Goal to harmonize holdings of courts that led to varying standards of auditor legal liability.

Allows scienter to be pled through “particularized” allegations establishing either.

Strong circumstantial evidence of conscious misbehavior or recklessness, or.

Facts showing that the defendant had both the motive and opportunity to commit securities fraud.

Defined the concept of “motive”.

Allege facts demonstrating a “concrete and personal benefit” that would be realized from the fraud.

Keeping the stock prices high or other motives possessed by most corporate insiders are insufficient evidence.


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Proportionate Liability – P S L R A

Attempts to reform auditor liability because tort liability was out of control.

Drops legal standards of joint-and-several liability and adopts proportionate liability for all non-knowing securities violations under the Exchange Acts.

A party is liable only for that proportion of damages for which she is responsible.

Only those who committed “knowing” securities fraud will suffer joint and several liability.

Telltabs, Inc. v. Makor Issues and Rights, plaintiffs did not meet the “strong inference” standard, and were too vague to establish a “strong inference” of scienter.


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S O X and Auditor Legal Liabilities Section 404 Internal Control over Financial Reporting

S O X passed to increase the transparency of financial reporting by enhancing corporate disclosure and to foster an ethical climate.

S O X increases auditor liability to third parties by specifying or expanding the scope of third parties to whom an auditor owes a duty of care.

S O X requires accounting firms to review and assess management’s report on internal controls and issue its own report.

Failing to disclose detected material weaknesses exposes auditors to Section 11 liability.

P C A O B inspections to date have shown that auditors’ opinions on internal controls are inadequate in many cases.


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S O X and Auditor Legal Liabilities Section 302
Corporate Responsibility over Financial Reporting

Section 302 requires the certification of periodic reports filed with the S E C by the C E O and C F O that the report does not contain any untrue statement of a material fact or omit a material fact necessary to make the statements not misleading.

Higginbotham v. Baxter Int’l, the court ruled that claims of scienter require more than just an assertion; specific proof of such knowledge must exist.

In re Lattice Semiconductor Corp, the court ruled that 302 certifications did give rise to inference of scienter due to either knowing about improper journal entries and misstating financial statements or knowing that controls were inadequate.

In re WatchGuard Secs Litig., the court held that the individual defendants’ 302 certifications were, by themselves, inadequate to support a strong inference of scienter.


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Establishes standards of acceptability of payments (facilitating/bribes) made by U. S. multinational entities to foreign government officials.

Lockheed made a 1.7M payment to Japanese Premier Tanaka.

Applies to:

All U. S. firms, public or private.

Foreign companies filing with S E C.

Department of Justice oversees criminal and civil enforcement while the S E C oversees civil enforcement with respect to registrants.

Corporation may be fined up to $1M and cannot indemnify officers.

Officers may be fined up to $10,000, imprisoned up to 5 years or both.

S E C Charges Pfizer with F C P A Violations.

Pfizer paid over $26M in disgorgement and prejudgment interest.


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Difference between Facilitating Payments and Bribe

Under the Foreign Corrupt Practices Act (F C P A)

a bribe is money or a gift given to someone to change their behavior and perform an act or service that is not part of their legal or authorized activities.

a facilitation fee is a payment made to speed up (or queue jump) the process of a task that is within a person’s normal range of authorized activities.

These payments may still be illegal for the person to receive even though they may be an acceptable part of the culture in the country.

The facilitating payments are like tipping a maître d to get a better table at a restaurant.


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Internal Accounting Control Requirements

F C P A makes all S E C registrants maintain adequate books and to have controls to ensure all transactions are approved by management and recorded properly.

In 2017, the S E C charged Halliburton for violating F C P A provisions related to internal control failures and making payments to a company in Angola in exchange for lucrative oilfield service contracts.

Haliburton paid $14M in disengagement, $1.2M in prejudgment interest, and a $14M penalty.


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Section 13(b)(2)(B) Internal Control Requirements

Requires issuers to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that:

Transactions are executed in accordance with management’s general or specific authorization;

Transactions are recorded as necessary;

to permit preparation of financial statements in conformity with generally accepted accounting principles or any other criteria applicable to such statements, and,

to maintain accountability for assets.

Access to assets is permitted only in accordance with management’s general or specific authorization; and,

The recorded accountability for assets is compared with the existing assets at reasonable intervals and appropriate action is taken with respect to any differences.


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Internal Control and Reasonable Assurance

Under section 13(b)(2)(B) of the Securities Exchange Act of 19 34, registrants must devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in conformity with G A A P or any other criteria applicable to such statements.

To meet these standards the following needs to be demonstrated:

Transactions are executed in accordance with management’s general or specific authorization;

Transactions are recorded as necessary (1) to permit preparation of financial statements in conformity with generally accepted accounting principles or any other criteria applicable to such statements, and (2) to maintain accountability for assets;

Access to assets is permitted only in accordance with management’s general or specific authorization; and,

The recorded accountability for assets is compared with the existing assets at reasonable intervals and appropriate action is taken with respect to any differences.


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Concluding Thoughts 1

Auditors are liable to clients and third parties for failing to conduct an audit in accordance with generally accepted auditing standards, S O X requirements under 302 and 404, and the rules of conduct under the A I C P A Code, and S E C regulations.

Auditors are liable for fraud when:

they make misrepresentations in the financial statements;

the misrepresentations are made to induce third parties to rely on those statements;

the third parties did rely on the misrepresentations; and,

such reliance was the proximate cause of suffering a loss. The key element in fraud is the intent to deceive another party; fraud does not occur by accident.


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Concluding Thoughts 2

The most important standards to protect auditors from legal liability are:

exercising due care in the performance of professional services, including professional skepticism;

properly assessing whether the internal controls are operating as intended; and,

conducting an audit in accordance with generally accepted auditing standards.

These requirements are necessary to determine whether material misstatements of the financial statements are present thereby making it impossible for auditors to provide reasonable assurance that the financial statements are free of fraud.


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Consequences of Earnings Management: The Need for Ethical Leadership in Accounting

Chapter 07

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Learning Objectives

L O 7-1: Describe the characteristics of financial statement restatements.

L O 7-2: Explain how errors in accounting and reporting can trigger restatements.

L O 7-3: Explain how restatements due to operational issues occur.

L O 7-4: Explain how corporate governance systems influence earnings management.

L O 7-5: Describe the characteristics of ethical leadership.

L O 7-6: Discuss how various leader types influence earnings management.

L O 7-7: Explain how ethical leadership in accounting might positively influence whether earnings management occurs.


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Questions for Consideration

What is the difference between reissuance restatements and revision restatements of the financial statements?

How can earnings management lead to regulatory actions and why?

How can corporate governance reduce or even eliminate earnings management?

What is the role of ethical leadership and ethical leaders in keeping earnings management in check?


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Ethical Reflection

Earnings management reduces the usefulness of reported results and has consequences for the company, top management, and the shareholders whose interests they are supposed to protect.

Audit Analytics describes the differences when financial statements are restated because of improper financial reporting by revising or reissuing the financial statements effected.

The S E C reported a total of 484 restatements in 2019 the lowest in 19 years analyzed.

However, the percentage of revision restatements is high: 79% of the total.

Revision restatements do not appear to the public to be as severe as reissuance restatements where the public is told not to rely on the original financial statements.

Earnings management is oftentimes the motivation for fraudulent financial reporting and has implications for the internal controls.

Earnings management often leads to S E C investigations for violations of regulatory requirements.

Earnings management has implications for ethical leadership that is often missing causing gaps in corporate governance and an environment that condones, it not directs, earnings management.


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Characteristics of Financial Statement Restatements

Revision of financial statements that was previously publicly reported may be one of two types.

Reissuance restatements are the more serious, as past or previous financial statements cannot be relied upon.

Revision restatements do not undermine reliance on past financials.

“Stealth Restatements”

A restatement disclosed only in periodic reports and not in the 8-K, or amended periodic report such as a 10-K/A or 10-Q/A.

The S E C requires companies to disclose within four business days that past financial statements should no longer be relied on.

The 8-K form is designed to be an early warning system so that the public knows immediately about the financial statement restatements and does not have to wait until the statements are filed with the S E C.


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Hertz Accounting Restatements

Hertz Global Holdings, Inc., filed its 2014 Form 10-K with restated results for 2012 and 2013 as well as selected unaudited restated financial information for 2011.

Hertz addresses the issue of non-G A A P financial measures including EBITDA, Corporate EBITDA, and how these amounts were calculated.

By comparing the validity of these amounts to pretax G A A P income, Hertz mislead readers into thinking that non-G A A P measures of earnings may be as reliable as G A A P amounts.


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Restatements Due to Errors in Accounting and Reporting

Exhibit 7.3 Accounting Errors that Trigger Financial Statement Restatements

Category Cause of Restatements
Revenue recognition Improper revenue recognition, including questionable items and misreported revenue
Expense recognition Improper expense recognition, including period of recognition, incorrect amounts; includes improper lease accounting
Misclassification Improper classification on income statement, balance sheet, or cash flow statement; includes non-operating revenue in the operating category; cash outflow from operating activities in investment activities
Equity Improper accounting for E P S; stock-based compensation plans, options, warrants, and convertibles
Other comprehensive income (O C I) Improper accounting for O C I transactions, including unrealized gains and losses on investments in debt and equity securities, derivatives, and pension-liability adjustments
Capital assets Improper accounting for asset impairments; asset-placed-in-service dates and depreciation
Inventory Improper accounting for valuation of inventory, including market adjustments and obsolescence
Reserves/allowances Improper accounting for bad debt reserves on accounts receivable, reserves for inventory, and provision for loan losses
Liabilities/contingencies Improper estimation of liability claims, loss contingencies, litigation matters, commitments, and certain accruals


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Cubic Corporation

Cubic Corporation restated financial statements due to errors in calculating revenues on certain long-term development contracts and on long-term service contracts with non-U.S. Government customers.

Cubic historically recognized sales and profits for development contracts using the cost-to-cost percentage-of-completion method of accounting, modified by a formulary adjustment which had the effect of deferring a portion of revenue and profits until later in the contract performance period.

Cubic also used the cost-to-cost percentage-of completion to revenues for its service contracts, which is only acceptable for U.S. Government contracts.


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Restatements Due to Operational Issues

On May 6, 2019, Kraft Heinz Co. disclosed that it would restate its financial statements due to faulty procurement practices. This is an example where the timing of expense recognition triggered the restatement rather than error corrections in the accounting and reporting.

In a regulatory filing, Kraft said the investigation showed “several employees in the procurement area engaged in misconduct” that qualitatively affected its financial reporting for 2016, 2017, and the first three quarters of 2018.

According to Kraft, the misstatements “principally relate to the incorrect timing of when certain cost and rebate elements associated with complex supplier contracts and arrangements were initially recognized, and once corrected for, the company expects to recognize corresponding decreases to costs of products sold in future financial periods”

The adjustments to financial statements totaled about $208 million, of which approximately $27 million was recorded in the fourth quarter 2018 cost of products sold, leaving a cumulative net misstatement of $181 million.

Kraft said that “The findings from the investigation did not identify any misconduct by any member of the senior management team.” However, the facts indicate otherwise.


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MagnaChip Semiconductor, Ltd

MagnaChip managed earnings using revenue techniques such channel stuffing and delaying write-offs of inventory.

Employees engaged in a “pull-in” sales practice whereby they offered distributors undisclosed concessions via side agreements to incentivize them to order products earlier than wanted or needed so that MagnaChip would hit revenue targets.

MagnaChip also improperly recognized revenue on “sales” of non-existent or unfinished products in order to meet revenue targets.

The company also recognized revenue on unfinished production of products.

MagnaChip violated G A A P because it recognized revenue on purported sales of products that had not yet completed manufacturing and therefore had not yet shipped or been delivered, and the risk of loss had not transferred to the purchaser.


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S E C Clawback for Accounting Violations

Firms with clawback provisions are over 2.5 times more likely to report material misstatements as revisions compared with firms without clawback provisions (70.1 percent and 26.8 percent respectively)

Managers are more likely to use discretion afforded by the materiality rules to correct misstatements through revisions instead of restatements.

It was “an unintended consequence of clawbacks, namely that clawback provisions deter the filing of restatements upon a misstatement discovery”


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Corporate Governance and Earnings Management

Companies that engage in earnings management raise questions about the role of corporate governance and consequences of earnings management.

How is it that managers, the board of directors, and audit committee failed to identify and stop earnings management?

What was management’s role in choosing to use various financial shenanigan techniques to make the company look better than it really is?

What role did the internal controls over financial reporting play in keeping earnings management at bay?

These are a few of the questions to be asked when evaluating the consequences of earnings management.


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What is Ethical Leadership?

The Ethical Leader:

Understands that positive relationships are built on respect, openness, and trust.

Portrays the underlying principles of integrity, honesty, fairness, justice, responsibility, accountability, and empathy.

Aligns external actions with one’s internal values.

Strives to honor and respect others in the organizations.

Seeks to empower others to achieve success by focusing on right action.

Leads by example.

Has a vision of the future that entails some notion of the good.


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Values-Driven Leadership

A leader needs to connect with organizational values.

Leaders must ask what they stand for and why.

Leaders must consider why others would want to follow them. The goal is to get in touch with what motivates one’s actions and how best to motivate those in the organization who look to the leader for direction.

Kouzes and Posner suggest that “Clearly articulating and, more importantly, demonstrating one’s values, forms the basis of a leader’s credibility—and credibility in leadership is character-based”.


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Ethical Leadership Competence

Refers to the ability to handle all kinds of moral problems that may arise in an organization.

Requires developing the competency to reason through ethical conflicts in a systematic way, judgment and reflection on what the right thing to do is.

Thornton identifies five levels of ethical competence.

Personal and Professional – accounting professionals should internalize the values of the profession, including objectivity, integrity, diligence, and duty to society.

Interpersonal – working in teams requires respect of others and fair-mindedness.

Organizational and Societal – auditors should follow the ethics codes and expectations of their organization, but they should never compromise their professional identify.


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Authentic Leaders & Followers

Authentic leaders are,

Focused on building long-term shareholder value, not in just beating quarterly estimates.

Individuals who are deeply aware of how they think and behave and are perceived by others as being aware of their own and others’ values/moral perspectives, knowledge, and strengths; aware of the context in which they operate; and confident, optimistic, resilient, courageous, and of high moral character.

Acknowledging the ethical responsibilities of their roles, authentic leaders can recognize and evaluate ethical issues and take moral actions that are thoroughly grounded in their beliefs and values.

Followers are,

Likely to emulate the example of authentic leaders who set a high ethical standard.

Empowered to make ethical choices on their own without the input of the leader.

Becoming moral agents of the organization.


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Transformational Leadership

Transformational leadership is defined as a leadership approach that causes change in individuals and social systems.

It creates valuable and positive change in followers with the end goal of developing followers into leaders.

It enhances the motivation, morale, and performance of followers through a variety of mechanisms and includes:

Connecting the follower’s sense of identity and self to the mission and the collective identity of the organization.

Being a role model for followers that inspires them.

Challenging followers to take greater ownership for their work.

Understanding the strengths and weaknesses of followers.

Transformational leadership is more effective than transactional leadership, where the appeal is to more selfish concerns.

Transformational leaders raise the bar by appealing to higher ideals and values of followers.


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Followership & Leadership

The flip side of leadership is followership.

Introduced by Hollander and Webb, the term followership is characterized as an independent relationship in which the leader’s perceived legitimacy can affect the degree to which followers allow themselves to be influenced.

Followership, servant leaders (next slide), and authenticity all share one common characteristic: Leader ethicality.

De Cremer and Tenbrunsel define leader ethicality as the intention to demonstrate normatively appropriate conduct and to create an environment within which others will be encouraged to act ethically and discouraged from acting unethically.

The social perception of a leader’s legitimacy may play an important role in determining how the leader’s morally relevant actions are interpreted and the influence leaders have on followers.

Leadership and followership are reciprocal relationships with one influencing the other.


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Servant Leadership

Servant leadership advocates a perspective that leaders have a responsibility to serve their followers by helping them achieve and improve by modeling leaders’ ethical values, attitudes, and behaviors that influence organization outcomes through the fulfillment of followers’ needs.

Leaders should put the needs of the followers before their own needs.

Servant leaders use collaboration and persuasion to influence followers rather than coercion and control; they understand their stewardship role and are accountable for their actions.


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Social Learning Theory

Social learning theory holds that individuals look to role models in the work context, and model or imitate their behavior.

Modeling is acknowledged to be one of the most powerful means for transmitting values, attitudes, and behaviors.

Leaders who engage in unethical behaviors create a context supporting what Kemper calls “parallel deviance,” meaning that employees observe and are likely to imitate the inappropriate conduct, especially if leaders are rewarded for the unethical conduct.

The social learning approach argues that because of leaders’ authority role and the power to reward and punish, employees will pay attention and mimic leaders’ behavior, and they will do what is rewarded and avoid doing what is punished in the organization.


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Ethical Skills of Leaders in Accounting Firms

Defined as the capacity to rigorously apply rules and procedures.

Independence – keeping a professional distance from the client.

Confidentiality – keeping confidential information confidential.

Having integrity, perseverance, humility, objectivity and acting on your values.


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Ethical Leadership and Audit Firms

The promotion of responsible leadership is seen within audit firms as a way to improve audit quality.

Responsible leadership is a critical component of setting the proper tone and encouraging members of the organization to ask probing questions when management’s representations are unclear or unsubstantiated.

Authentic partner leaders gain the confidence of audit staff and managers and create a foundation for ethical decision making.

Ponemon found that leaders of accounting firms set the tone of their organizations, promoting those whose personal attributes more closely reflected the leaders’ perceptions and moral reasoning development.

Ponemon hypothesized a correlation between the organizational culture created by leaders of the accounting firms and the subordinates’ personal characteristics and decision-making styles.


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Ethical Leadership and the Internal Audit Function

Chambers identifies attributes of internal audit leadership behavior including honesty, courageousness, accountability, empathy, trustworthiness, respect, and proactiveness.

Internal auditors can sometimes be bullied by C F Os which makes it more difficult for them to carry out their ethical obligations.

Auditors may take their cue from executive management’s behavior, especially if such behavior is the social norm and has been rewarded in the past.

A high quality internal audit function can reinforce the tone at the top and provide guidance for decision makers by monitoring internal control and management’s actions.


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Culture and Ethical Leadership in Accounting

Accountants and auditors are less likely to report financial wrongdoing if they perceive that past attempts by others in the organization to blow the whistle internally lead to retaliation.

Having an ethics hotline enhances reportability and ethical leaders should support such efforts.

Brennan and Kelly studied the propensity or willingness to blow the whistle among trainee auditors.

The factors studied included audit firm organizational structures, personal characteristics of whistleblowers, and situational variables.

The authors found that formal structures for whistleblowing and internal (versus external) reporting channels increase the likelihood of the subjects’ reporting of an ethical violation by an audit partner.


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Aaron Beam & HealthSouth

The $2.8 billion HealthSouth fraud involved recording fake revenues on the company’s books from 1996 through 2012 and correspondingly adjusting the balance sheets and paper trails.

Aaron Beam, a former C F O, allowed the C E O, Richard Scrushy, to bully him into manipulating financial reports to reflect the numbers Scrushy promised investors.

“I should have had the courage to stand up and say, ‘No, we can’t cross this line,’” Beam said.


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Health South

Beam was not alone to fall prey to Scrushy.

Four other C F Os all failed in their duties.

Once in, they could not get out – Scrushy even stated to one C F O, if you quit you will be the fall guy.

Their head of internal audit did not even try to do their job appropriately.

None of them displayed the courage needed to be an effective leader in the accounting profession.


© McGraw Hill, LLC

When Are Auditors More Likely to Report Wrongdoing?

The following points highlight when auditors are more likely to report wrongdoing:

superiors and top management do not place obstacles in their way;

the reporter has a high commitment to the organization and/or colleagues;

the issue has high moral intensity;

ethical dissonance is not present; and,

the reporter perceives the organization provides reliable outlets (i.e., hotline) to report wrongdoing and retaliation will not occur.


© McGraw Hill, LLC

Concluding Thoughts

Financial Statement Restatements occur because of the use of aggressive accounting techniques (i.e., financial shenanigans)

These techniques are used to manage earnings and make the company look better from quarter to quarter and year to year.

In order to avoid S E C lawsuits for improper financial reporting, companies must tighten their corporate governance system and build ethical leaders.

Ethical leaders can set the tone for subordinates who then become followers in the organization. To build ethical leaders, the organization must commit to doing the right thing at every turn.


© McGraw Hill, LLC


Discuss the role of ethical leadership behavior in public accounting firms and how ethical leadership influences the internal communication and employee outcomes in the organization. [100 words]

What is the role of moral intensity, organizational culture, and ethical leadership in promoting ethical behavior? [100 words]


Case 7-6 New Leadership at General Electric

On June 12, 2017, GE announced that 30-year GE veteran and current President and CEO of GE Healthcare John Flannery would be replacing Jeff Immelt as CEO of the company as of August 1, 2017. Immelt had been the CEO for 16 years, taking over that role from the iconic Jack Welch. GE stated that the announcement was the culmination of a six-year succession planning process for the company’s top spot. Flannery started at GE in 1987 fresh out of Wharton Business School’s MBA program and has worked in many positions, including successfully turning around the failing health care division of the company. The Company’s CFO Jeff Bornstein was named Vice Chairman. Bornstein was one of three other final candidates considered for the CEO position. Barclays’ analyst, Scott Davis, observed that Jeff Immelt has been criticized for his inability to connect with investors, and now many are expecting “fairly dramatic changes” under Flannery.

In a statement from the company, Immelt was quoted as saying he was supportive of his successor: “John is the right person to lead GE today. He has broad experience across multiple businesses, cycles, and geographies. He has a track record of success and led one of our most essential businesses,” Immelt said. “Most important are his strong leadership traits-good judgment, resilience, a learner, team builder, and a tough-minded individual and competitor. He will be trusted by investors, our customers and the GE team.”

GE’s Market Cap at $153.6 Billion, while greater than 93 percent of the rest of the companies in the S&P 500, has dropped $240 billion in the last 10 years. Analysts at Seeking Alpha issued a statement saying that: “General Electric has gotten absolutely crushed over the last two days, falling 15 percent from $20.50 down to $17.50. GE’s peak of the current bull market for the S&P 500 came on July 20th of last year (2016), but since then it’s down 47 percent. Even more shocking is that at $17.50, GE’s share price is trading at the same level it was at 20 years ago in early 1997. Of course, there have been dividends paid, but it’s not a good look for a company when share price is unchanged on a 20-year basis.”

On the GE July 21, 2017, second-quarter earnings call with financial analysts and investors, Flannery stated that, while he does not officially start his new role as CEO until August 1, he was already underway conducting a “deep dive” into all the business areas within GE.$ He stated, “In addition to the business reviews, I want to repeat the process I used in healthcare to really get out and listen to what people are thinking, good and bad about the Company. I always start with customers and employees, but it’s also important to get the view of our government partners and especially our investors.” His plan was to take his first 90 days in his role to develop a new strategic plan for the company with the intent to report back to the investors in regard to that plan in November. The rest of this earnings call was handled by the current CEO Immelt and CFO Bornstein and was relatively optimistic as to earnings for the year and into the future.

On the October 20, 2017, third-quarter earnings call with investors, Flannery led the call with Bornstein as CFO and Bornstein’s successor Jamie Miller who would be taking over as CFO on November 1. Flannery kicked off the call by stating, “While the company has many areas of strength, it’s also clear from our current results that we need to make some major changes with urgency and a depth of purpose.Our results are unacceptable, to say the least. He went on to say that his review of the company has been, and continues to be, exhaustive. The team and I have performed deep dives on all aspects of the Company,” and left no stone unturned. “We are evaluating our business [structure], corporate [systems], our culture, how decisions are made, how we think about goals and accountability, how we incentivize people, how we prioritize investments in the segments; and at the overall Company level, including global research, digital and additive. We have also reviewed our operating processes, our team, capital allocation and how we communicate to investors. Everything is on the table, and there have been no sacred cows.” One of those changes was that Jeff Bornstein would be leaving the company and not be the new vice chairman.

While stating he would give more details on the November call, he further stated that “We are driving sweeping change and moving with speed and purpose. I’m focusing on the culture of the Company. Our culture needs to be driven by mutual candor and intense execution, and the accountability that must come with that. We have announced changes in our team at the highest levels of the Company. In addition to changes in our culture and our team, I will also share more with you in November on our capital allocation methods, changes we are making to analytics and metrics, and process improvements. In particular, these changes will be focused on improving the cash generation of the Company. We have to manage the Company for cash and profitability in addition to growth.”

On the November 17, 2017 call, Flannery led an Investor Update to provide a detailed analysis of his “deep dive” into the business and his plans for the company. He reiterated, “that the current operating results were unacceptable” and “the management team is completely devoted to doing what it takes to correct that.” He went on to say, “going forward, we really just have to focus on how we can create the most value and portfolio of assets that we have for our owners and we’re going to do that with a very dispassionate eye, very critical analytical dispassionate eye. The GE of the future is going to be a more focused industrial company, it will leverage a lot of really game changing capabilities in digital in Additive in industrial research, culture of the company much more open, much more transparent, much more connected. And at the end of the day, we really exist to deliver outcomes for the customers, performance for the owners and have an environment where our employees are motivated by, excited by, rewarded for delivering on those two things.”

Only time will tell whether Flannery is able to turn GE around and deliver on these promises.

Describe the characteristics traits of leadership at GE. How would you describe Flannery’s leadership style? [150 words]


Case 8-2 Joker & Wild LLC

Joker & Wild LLC has just been sued by its audit client, Canasta, Inc., claiming the audit failed to be conducted in accordance with generally accepted auditing standards, lacked the requisite care expected in an audit, and failed to point out that internal controls were not working as intended. The facts of the case are that the auditors failed to find the accounting manager’s misappropriation of assets when he stole inventory and then improperly, knowingly, wrote down inventory for market declines.

Current market values of inventory were not provided to the auditors despite numerous requests for this information. The auditors relied on management’s representations about these values, which understated inventory by 10 percent. The plaintiff client brought the suit against the CPA firm claiming negligence, asserting the firm’s failure to find the vice president’s misappropriations of inventory and false valuations damaged the company by prematurely recognizing losses and then causing large reversals in the subsequent fiscal year when the inventory was sold for 15 percent above the original cost. The defendant CPA firm sought to blame the client, claiming Canasta did not cooperate on the audit and the vice president overrode internal controls.

Are the auditors guilty of malpractice? Explain. [150 words]


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