QUESTION 11.Explain why the "non-negligence" defense under common law is often the best one against a third-party lawsuit. Compare it with each of the other available defenses.

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Auditor's Defense Against lawsuits by clients under common law 1. lack of duty (engagement letter) 2. nonnegligent performance 3. contributory negligence (the client contributed to the failure of detecting the misstatement) 4. absence of causal connection Against lawsuits by 3rd parties for the auditor's ordinary negligence under common law: 1, 2, 4 -Court decisions: Ultramares (1931):\"known third party -foreseen users -foreseeable users Auditor's Defense Under Securities Acts 4933 (burden of proof on auditor): (1) GAAS audit, (2) no causal connection - 1934: plaintiff needs to prove that the auditor had intent to deceive (scienter) TABLE 5-3 Summary of Auditor Liability Liability to Third Liability to Third Liability to Third Parties Under Parties Under 1933 Parties Under 1934 Alleged Auditor Action Liability to Client Common Law Securities Act Securities Act Breach of contract Yes NIA N/A NIA Negligence Yes Primary Beneficiary - N/A No Yes Other third parties - depends on jurisdiction Gross Negligence Yes Yes N/A Yes - likely Constructive fraud/Recklessness Yes Yes NIA Yes - likely Fraud Yes Yes N/A Yes - likely "Yes" indicates that the auditor could be held liable to a client or third party for the alleged auditor action. "No" means the auditor would not be liable for the alleged action. "N/A" means that the alleged auditor action is not an available basis to seek liability from the auditor under common law or the securities acts. Material error or omission is required for liability under the 1933 act. to third parties under the 1933 and 1934 Securities acts. The table illustrates the strict burden on auditors to defend themselves under the 1933 act. Liability to third parties under common law and the 1934 act depends on the degree of negligence. Liability to third parties under common law also depends upon the jurisdiction and whether the third party is a primary beneficiary or known user of the financial statements. The defenses available to the auditor are summarized in Table 5-4. If the auditor is unable to prove a lack of duty to perform the service, the preferred defense is generally nonnegligent performance. CONCEPT CHECK 1. What are the four major sources of auditors' legal liability? 2. Compare and contrast traditional auditors' legal responsibilities to clients and third-party users under common law. How has that law changed in recent years? 3. What are the auditor's possible defenses against lawsuits filed under the Securities Exchange Act of 1934? Auditor Defenses Against Suits by Client, Third Parties Under Common TABLE 5-4 Law, and Under the 1933 and 1934 Securities Acts Third Parties 1933 1934 Available Auditor Defenses Client Suits Common Law Securities Act Securities Act Lack of duty to perform service NIA A Nonnegligent performance (audit in X X X accordance with audit standards) Contributory negligence by X N/A N/A N/A client or third party Absence of causal connection (no X X NIA? X reliance on financial statements "X" indicates the auditor defense would be available. "N/A" indicates the defense generally would not be applicable. Under the 1933 Securities Act, the auditor must prove due diligence in the performance of the audit. Auditor may prove that the loss was not attributable to the misleading financial statements Chapter 5 / LEGAL LIABILITY 129