 Welcome to this session. This is Professor Farhad. In this session, we would look at the auditor's professional liability specifically under common law. This topic is covered in auditing and attestation course as well as on the CPA exam. If you need additional lectures about this topic as well as auditing topic, please go to my website farhadlectures.com where I have additional topics. Now, in the prior session, we looked at contract law and what is the auditor's responsibility under contract law. In this session, we would look at common law. In the following session, we would look at the federal status specifically in 1933, 1934. The first thing we want to know is what is common law because it's very important that you understand the idea of common law. Common law is a law that passed by a court and it's upheld by the court. It's shaped by court precedence. What is a precedent? It's basically a prior court decision. To be more specific, each court in a state system is separate from the other court in the other state system. In the United States, we have many states. Each state will have its own court system. Whatever that court decides the law to be, the law will be in that state as the court decided. That will be that law until a new judge or a new jury decides that the law need to be changed. It's prior court decision. Simply put, if a case land in front of a judge, the judge would look at how did the prior judge ruled given the circumstances. The current judge, if they agree with the prior judge, then the law will stand as what the prior judge decided it to be. But if the new judge decided or the new jury decided that how the law was applied prior to this case is not valid, then the law becomes the new judgment of that court. It's obviously the common law subject to change over time as a result of a judge's and jury's decision. And it evolves over time. At the end of this session, I will show you a quick case of how it evolves. But basically, the idea is it evolves. Why? Because it's a judge-based. It's a court-based. One single judge in a state can change the law. Okay, that's how it works. So there could be significant differences in common law across different jurisdictions. Each state has its own court system. Therefore, we could have different laws among different states. The reason why we're talking about, you're going to see why common law is important to understand what common law is. Because depending where the suit is filed against the auditor, the law will differ. So the precedent could be different. So if they file in Pennsylvania versus New Jersey, Pennsylvania law is different than New Jersey law. So that's why it depends on where the suit is filed. And we would have 53 different states. You could have 50 different jurisdiction with 50 different laws. Think about marijuana. For example, marijuana is legal in Colorado. It's not legal in any other state. Why? Because the state decides it's legal there. Therefore, the court decides it's legal there. Therefore, it's legal in that state until a new judge comes and said, no, it's not legal. Then it's not legal anymore. But as far as auditors' liability are concerned, we're going to look at three different precedents. So again, we have many jurisdictions that basically all these jurisdiction, all these state courts, they follow three different precedents. They're not the same. They're three different precedents in how they look, how they approach auditor's liability. And that's why we're talking about common law, because we're concerned about auditor's liability. We're not legal students. And hopefully you learn about common law when you took your business law course or when you're taking your business law course. But for my purpose, you are only concerned with the three different precedents that I will discuss later on. Okay? So who the plaintiff is and the degree of auditor misconduct, it's going to depend on the jurisdiction. So in one jurisdiction, you might be able to sue the auditor for negligence. In other jurisdiction, you may not be able to sue the auditor for negligence, depending who you are and the degree of auditor misconduct. And we'll talk about much more details in this session. But the point is common law is different among different jurisdictions. What's a civil liability requirement in one state could be another in another state. Okay? But let's talk about what the plaintiff, because remember, the plaintiff is going to sue the auditor. The plaintiff will sue the auditor. Why? Because of the auditor misconduct. The auditor may be issued an unqualified financial statement and missed something. So the plaintiff must show four things to succeed under common law. And what are those four things? First, the plaintiff will have to show that the financial statements were materially misstated. And that's not hard to prove. If the auditor issue a unqualified opinion, then they went back and they revised earnings per share or they find a mistake. Well, the statements were materially misstated. So that's easy to prove as far as the plaintiff is concerned, because once we found the mistake, well, the prior financial statements were materially misstated. That's the first thing they have to show. The second thing is damages, the existing amount of damages. So how much did they lose? What are the damages? That's easy also to prove, especially if it's a publicly traded company. If you bought a stock for a $100 and after the restatement, the stock dropped to $70, well, guess what? There was a $30 decrease in the stock times, you know, you have 10,000 stocks or whatever, how many stocks you have. So that's also easy to show. The third, you have to show causality. You have to show that the damages result from relying on the statement. So simply put, when the auditor said EPS was $2, you bought the stock, then we find out that the now EPS should be $1.20. So earnings per share went down as a result, the stock price went down as a result, you lost that $30 per stock. But you have to show the damages are coming from the actual fault of the auditor. So you have to show that the auditor caused the damage. Now how can you link because of the auditor? The auditor's mistake, you suffer the damages. It's a little bit more difficult than the other two, but it's doable. Based on the market efficiency theory, assuming you are dealing with a publicly traded company, for a publicly traded company, the assumption is the stock price reflect information about the company. So all the information about the stock, which is earnings per share when you issue the financial statement is embedded. So when I bought the stock, I assumed that I bought a stock with $2 earnings per share. Now you're telling me otherwise. Why you're telling me otherwise? Because you made a mistake. And because you made a mistake, you're telling me otherwise EPS went down, my stock price went down. And here's the causality because the stock price is reflecting the new information. It's embedded in the stock price. And you don't have to look at the financial statement. You don't have to show that, well, I look at the financial statements, EPS was $2 when I bought it. You don't have to show this. As long as you say I relied on the market, the market is supposed to determine the stock price. When I bought the stock price at $100, that was the market price. And that market price reflected all information, which is part of it, the $2 earnings per share that was misstated. So those three, you still have one more. And the fourth one is you have to show the auditor misconduct. That's important. What type of misconduct? And that depends on who you are as a plaintiff and the jurisdiction in which you filed the lawsuit. And this is what we have to kind of differentiate between who you are as a plaintiff and which jurisdiction you are going to show that the plaintiff messed up. So I'm sorry, the defendant, you have to show that the auditor messed up and how at what level? Was it negligence, gross negligence, and who you are and in which jurisdiction? So simply put, what's going to happen is this. So who can file? Simply put, who can file? Obviously, the client can always file. And under common law, third party reasonably expected to rely on the audited financial statements. So notice, third party reasonably expected is way more than the contractor. Remember, the contract law, you have to be part of the engagement letter mentioned in the engagement letter. Okay. Here, if you are reasonably expected to rely on the audited financial statements, then you are potentially, you potentially can sue the auditor for misconduct. But who are those third party reasonably, reasonably expected? Well, the common law breaks them into three groups. So you could have three groups of third party who are reasonably expected that could rely on the audited financial statement. The first group is called identified users and you need to differentiate between those groups for the CTA exam. Okay. So who are the unidentified users? Well, the identified user, let's assume a client came to you as the auditor and he told you, I'm going to go to the bank of Philadelphia. I want to get a loan. I want you to audit my financial statements. Guess what? The client obviously is the client. Then the bank of the first bank of Philadelphia becomes an identified users. Why? Because you told me, you mentioned that you're going to go get a loan after issuing those financial statements. So users that the auditor know would rely on the financial statement. For example, the first bank of Philadelphia, you told me and it doesn't have to be written orderly. Orderly is good enough. Okay. Or you could say maybe two banks and the just you could need two, three banks. Okay. Those are identified users. In other words, you identify them. You told me who they are. Now I know they are going to be using the financial statement. Another group called foreseen users. Okay. Those foreseen users, they're not identified individually known. So you did not specifically mention their name that they're going to be relying on the financial statements, but you said it's a group of people. For example, you could say, I'm going to after you audit the financial statements, I'm going to take them to the five banks in the Philadelphia area. Who are those five banks? Well, well, basically any bank in the Philadelphia area and in a sense becomes a foreseen user. Okay. And those are still small number. Okay. But larger than identified because identified, they have to name them specifically orderly or in writing foreseen users. You did not name which five banks, but now you have more banks, or you could say banks in the Philadelphia area, potentially every bank in the Philadelphia area becomes a foreseen user. Okay. And the third group is for foreseeable users. And this is where this group is very large. The foreseeable users is a general class of users whose members may or may not rely on the financial statements. Okay. This is a large group. Once again, what are we discussing here? We're discussing who can sue the auditor. Well, the client obviously can sue the auditor and third party reasonably expected to rely on the financial statements. Those third parties, they can be identified users, foreseen users, and foreseeable users. Why am I specifying this? Because you're going to see on the next slide, depending who you are in the lawsuit would allow you to sue the auditor under various under various claims. Okay. So let's take a look at this at this slide. Okay. And remember, the users are you could, we could have three type of users. We have the identified users and remember those are specifically identified. We have the foreseen users and we have the foreseeable users. We have three users. So now who are you depending on who you are identified foreseen or foreseeable. And when you go to when you go to sue the auditor, well, you're going to go to your state court to sue the auditor. Now, depending on your on your jurisdiction, we have three types of jurisdiction, credit alliance, restatement, torche, rush factor, which is those are two cases. Basically, but two cases, but basically they came up with the same decision. That's why there's a two name and citizen bank, Rosenblum or, you know, Tim Schmidt case, Tim with two M's. Okay. So those are the three different jurisdiction. So all the state courts in the United States, when you go to sue the when you go to sue the auditor, they're going to follow one of these three cases. Okay. So let's start with identified user. Okay. If you are an identified user, what can you do? Well, if you're filing under a credit alliance jurisdiction, you could sue for negligence. So as long as you are identified user, you could sue for negligence. As long as you can show that the that the auditor was careless, you can you can sue them under restatement, torche, rush factor, you could also sue for negligence. Under the citizen state, Rosenblum, you could sue for negligence. So as identified users, you're very close. You are very close to the case because you are identified in the contract. You have the right to sue the auditor for negligence. Now, if you are a foreseen user, you are a foreseen user, and you happen to file the file the case in a credit alliance state. So I'm going to tell you this to make it easier for you. For example, in Pennsylvania, PA uses the credit alliance as well as New York. New York and PA use the they follow the credit alliance precedent. Okay. Remember Kamala precedent, they filed this precedent. So if you are a foreseen user and you file a case in that state under the credit alliance, if you are a foreseen user, you can you have you have you can you can sue for gross negligence. So a foreseen user cannot sue for negligence. A foreseen user, they have to sue for gross negligence. And remember gross negligence, you have to show that they were really careless. So your standard of proof is a little bit higher. Okay. If you are a foreseen user and in a place where it's they use restatement or trash factor, even a foreseen user can sue for negligence. Also, if you are in a state where they follow the citizen bank Rosenblum case, like in New Jersey, New Jersey, follow this, you can sue even though you're a foreseen user, you can sue for negligence. Again, it's easier to sue when you can sue for negligence. It's easier to prove negligence. If you're a foreseeable user, now you're far away from the case, you're a foreseeable future foreseeable user, your shareholder creditor under credit alliance, you could sue for gross negligence under restatement or you could also sue the auditor for gross negligence, not negligence, gross negligence. But notice under the citizen bank Rosenblum case, you can sue for negligence. So even though you're a foreseeable user in New Jersey or in any state that followed the citizen bank Rosenblum precedent, you can sue the auditor for negligence. It means the lower of proof is much lower for you if you sue the auditor in those states. So notice courts that follow the citizen bank Rosenblum, they allow you to sue the auditor wherever your position is for negligence, whether you're identified user, foreseen user, or foreseeable user. So notice here credit alliance is the most the friendliest to the auditor because only as an identified user you could sue for negligence. For foreseen and foreseeable, you have to have, you have to, you can only sue under gross negligence case. Okay. Why am I talking about this? Because look, under credit alliance, the negligence is a small group of individuals, a small group of people who are identified users. They are either mentioned orally or mentioned and written in the contract versus foreseeable users. They could be a bunch, a lot of, for a publicly traded company, basically everyone can sue the company in New Jersey, sue the auditor in New Jersey because they are foreseeable user, also for negligence. So the lower of proof is much, much smaller. Okay. So this, this belong, this is a large group of people. It could be hundreds of thousands, okay, for, for publicly traded company. And all you need is one person in New Jersey, okay, that file a lawsuit and everybody else can jump on the board in a class action lawsuit with them. Okay. So let's talk a little bit about, since we talked about common law, let's talk about a little bit how that common law evolved over the years, just to give you an idea how it evolved. So, so this identified foreseen and foreseeable started with a case called Fred Stern and company case. I believe it's in the 20s. You can Google it, but it's, it started in the 20s. Basically, prior to the Fred Stern and company case, if you are a foreseen or foreseeable user, okay, you could only sue under fraud. And remember fraud is very hard to prove fraud. Why? Because you have to show intent and it's not easy to show intent that the auditor committed fraud. Okay. Remember, we talked about negligence, gross negligence and fraud. So prior to this case, as a foreseen or foreseeable user, you could only sue under fraud. So here's the company called Fred Stern and company. They borrowed money from a bank called ultra meris, ultra meris bank. The case is called ultra meris. Okay. That's what it's called ultra meris case or the Fred Stern and company case. And Fred Stern hire to Shayne Irvine to audit their financial statement, specifically the auditor balance sheet, but they missed something in the balance sheet and the balance sheet was inflated by $700,000. So they went to the bank, the auditor missed the mistake and the bank gave them the loan. Now, obviously ultra meris went out of business. I'm not not ultra meris. Fred Stern went out of business. So ultra meris the bank, they wanted to recover their money because they lend money to Fred Stern. So they went after the auditor. Okay. Now, ultra meris was not named in the engagement letter. So it was not named at that point. So the only option for ultra meris at that point is to sue the auditor for fraud because that's the only thing that was available. You want to sue the auditor, you're not named as part of the engagement letter. You can sue them for fraud. Well, guess what? The case was dismissed for fraud. But what the jury find determined is that the auditor was negligent and ultra meris should be able to recover under losses. Now, obviously, now that the law is changing. So what did to Shayne did? They appealed it. They appealed the case. They said, no, well, obviously, they're not going to, you know, they're not going to just pay out. They're going to appeal the case. Okay. So after various appeals, the case landed, the case landed with judge Cordosa and the New York court of appeal, which is the highest court in the state of New York and based and by the way, judge Cordosa became a Supreme Court later on. But the point is now it's in the hands of the highest court in the state. So what did judge Cordosa determine? Okay. What he said is third parties specifically mentioned in the engagement letter, the primary beneficiary, now they can sue for negligence. Okay. But also third parties should be able to recover from gross negligence. So what they did before it used to be only fraud. So before the ultra mayor's case, before the judge Cordosa decided on this case, basically judge Cordosa opened the door and lowered the standard of proof for the users. Okay. And he said, now we have identified users for seen and foreseeable. And what he's saying is third party now, they could sue the auditor under gross negligence. And basically, this is an example of how common law evolves. Okay. So simply put now the auditor after this case start to face increased low legal exposure because a third party foreseen can even sue you for gross negligence. And anyone mentioned in the engagement letter, what's called primary beneficiary, which is even mentioned. That's a primary beneficiary can also sue you for negligence because those parties prior to the ultra mayor's case, they could only sue you for fraud and fraud has a high standard. So fully this case just gave you an idea about common law, how common law works, because it's a little bit, if you're not familiar with it, it's not complicated, but it's not straightforward. If you're studying for your CPA exam, they all mean study hard. If you want more lectures about auditing, please go to my website for headlectures.com. If you do visit, please consider donating or contributing money. And if you're studying for your CPA study hard, it's worth it.