Accountant Liability and Accountability
Medgar Evers College
Professionals may be liable to clients for breach of contract, negligence, or fraud.
When a professional has breached a contract, damages include expenses incurred by the client to hire another part and any other reasonable and foreseeable losses that arise from the professional’s breach.
Negligence involves the proof of duty, breach, causation, and damages. Professional standards, state statutes, and judicial decisions bind professional conduct.
Accountants have the necessary expertise and experience in establishing and maintaining accurate financial records to design, control, and audit record-keeping systems; to prepare reliable statements that reflect an individual’s or a business’s financial status; and to give tax advice and prepare tax returns.
Professional standards usually include generally accepted accounting principles (GAAP) developed by the Financial Accounting Standards Board (FASB) and generally accepted auditing standards (GAAS) developed by the American Institute of Certified Public Accountants. A violation of these standards is prima facie evidence of negligence.
An accountant is not required to discover every impropriety, defalcation (embezzlement), or fraud.
An accountant who uncovers suspicious financial transactions and fails to investigate the matter fully or to inform the client of the discover can be held liable to the client for the resulting loss.
Audit — a systematic inspection by analysis and tests, of a business’s financial records in order to provide the auditor with evidence to support an opinion on the reliability of the business’s financial statements.
Attorneys have a duty to provide competent and diligent research. State and American Bar Association rules of professional conduct discipline attorneys.
Malpractice occurs when attorneys fail to exercise reasonable care and professional judgment.
Fraud or misrepresentation involves proof that 1) A misrepresentation of a material fact has occurred. 2) There is an intent to deceive 3) The innocent party has justifiably relied on the misrepresentation. 4) For damages, the innocent party must have been injured.
Actual fraud involves intent. Constructive fraud may be found when an accountant is grossly negligent in performing his or her duties.
Potential Liability to Third Parties
Traditionally, an accountant or other professional owed a duty only to those with whom she or he had a direct contractual relationship (privity of contract).
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Many people, though, now rely on auditors’ opinions. (Investors, shareholders, creditors, corporate managers, directors, regulatory agencies, etc.)
New York and the Ultramares Rule
— Accountants owe a duty of care only to those persons for whose “primary benefit” the statements were intended.
Ultramares Corp. V. Touche (1931) written by Chief Judge Benjamin Cardozo; Ultramares loaned substantial money to Stern and Company. Ultramares relied on certified balance sheets that Stern & Company hired the public accounting firm of Touche, Niven & Company to prepare. According to the certified balanced sheet, Stern had a net worth of $1,070715.26. But in reality, because Stern insiders falsified records, Stern & Company had more liabilities than assets. Ultramares sued Touche for negligence.
“Near privity rule” — Credit Alliance Corp. v. Arthur Anderson & Co. 65 N.Y.2d 536, 483 N.E.2d 110 (1985) — “a relationship sufficiently intimate to be equated with privity” is enough for a third party to sue another’s accountant for negligence.
The Restatement Rule — Accountants are liable for negligence not only to their clients but also to foreseen, or known, users - and users within a foreseen class of users - of their reports or financial statements.
Under Section 552(2) of the Restatement (Second) of Torts, an accountant’s liability extends to: 1) persons for whose benefit and guidance the accountant intends to supply the information or knows that the recipient intends to supply it, and
2) Persons whom the accountant intends the information to influence or knows that the recipient so intends.
The Restatement Rule still allows accountants to knowledgeably control their liability when they publish an audit or financial opinion.
Reasonable foreseeability rule — an accountant is liable to any users whose reliance on an accountant’s statement or reports was reasonably foreseeable. This standard has been criticized as extending liability too far because it means that accountants can be liable even in circumstances in which they are unaware of how their opinions will be used.
The Sarbanes Oxley Act of 2002 —
The Act imposes requirements on both domestic and foreign public accounting firms that provide auditing services to companies (“issuers”) whose securities are sold to public investors.
See p. 1057 for the Key Provisions of the Sarbanes-Oxley Act of 2002 relating to public accounting firms.
Potential Liability of Accountants under Securities Laws
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The Securities Act of 1933 requires registration statements to be filed with the Securities and Exchange Commission (SEC) prior to an offering of securities. Accountants often prepare and certify financial statements that are included in the registration statement.
Section 11 of the Securities Act of 1933 — imposes civil liability on accountants for misstatements and omissions of material facts in registration.
The accountant may be liable if he or she prepared any financial statements that “contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading.” There is no requirement of privity with the security purchaser nor any need for proof of reliance. All the purchaser of the security has to show is that he suffered a loss on the security.
After the purchaser has proved a loss on the security, the accountant has the burden of showing that he or she exercised due diligence in preparing the financial statements. Due diligence is proof of no negligence or fraud; that the accountant had “after reasonable investigation, reasonable grounds to believe, and did believe, at the time such part of the registration statement became effective that the statements therein were true and that there was no omission of a material fact required to be stated therein or necessary to make the statements therein not misleading.” Failure to follow GAAP and GAAS is proof of a lack of due diligence. Accountants must verify information furnished by a corporation’s officers and directors. Just asking questions is not always enough.
Besides proving that he or she acted with due diligence, an accountant may raise the following defenses to Section 11 liability: 1) There were no misstatements or omissions. 2) The misstatements or omissions were not of material facts. 3) The misstatements or omissions had no causal connection to the plaintiff’s loss. 4) The plaintiff-purchaser invested in the securities knowing of the misstatements or omissions.
Section 12(2) of the Securities Act of 1933 imposes civil liability for fraud in relation to offerings or sales of securities.
Purchasers of securities may bring suit in federal court and the Justice Department may bring criminal action against willful violations for punishments up to $10,000 in fine and/or five years in prison. The SEC can seek injunctions or other financial remedies.
Liability under the Securities Exchange Act of 1934
This is liability for fraud. There is no requirement of due diligence and the accountant just has to have acted in good faith.
Liability under Section 18 — falls on an accountant who makes or causes to be made in any application, report, or document a statement that at the time and in light of the circumstances was false or misleading with respect to any material fact. It applies only to documents filed with the SEC and only to sellers and purchasers. The seller or purchaser must prove one of the following: 1) the false or misleading statement affected the price of the security OR 2) the purchaser or seller relied on the false or misleading statement in making the purchase or sale and was not aware of the inaccuracy of the statement.
Good faith is a defense — showing that she had no knowledge that the financial statement was false or misleading and that he or she lacked an intent to deceive, manipulate, defraud, or seek unfair advantage over another party. MERE NEGLIGENCE IS NOT ENOUGH.
Another defense is proof that the buyer or seller of the security in question knew the financial statement was false and misleading.
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Sellers and purchasers must bring a cause of action within one year of the discovery of the facts and within three years of accrual.
Liability under Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 — broad anti-fraud provisions.
Section 10(b) — makes it unlawful for any person, including accountants to use, in connection with the purchase or sale of an security, any manipulative or deceptive device or plan that is counter to SEC rules and regulations.
Rule 10b-5 — makes it unlawful for any person, by use of any means or instrumentality of interstate commerce to do the following:
1) employ any device, scheme, or strategy to defraud, 2) make any untrue statement of a material fact or omit to state a material fact necessary to make the statements made in light of the circumstances, not misleading. 3) Engage in any act, practice, or course of business that operates or would operate as a fraud or deceit on any person, in connection with the purchase or sale of any security.
There is only liability to sellers and purchasers of securities.
The plaintiffs must prove intent (SCIENTER) to commit the fraudulent or deceptive act. Ordinary negligence is not enough.
Important changes from the Private Securities Litigation Reform Act of 1995
1) An auditor must use adequate procedures in an audit to detect any illegal acts of the company being audited. If there is something illegal, the auditor must disclose it to the company’s board of directors, the audit committee, or the SEC.
2) A party is liable only for the proportion of damages for which he or she is responsible, rather than joint and several liability.
3) Aiding and abetting a violation of the Securities Exchange Act of 1934 is a violation in itself. Accountants aid and abet when they are generally aware that they are participating in an activity that is improper and knowingly assist the activity. Silence may constitute aiding.
Accountant Liability and Accountability Classroom Exercises
Medgar Evers College
1. Under the Securities Exchange Act of 1934, which of the following penalties could be assessed against a CPA who intentionally violated the provisions of Section 10(b), Rule 10b-5 of the Act?
Civil liability of monetary damages Criminal liability of a fine
a. Yes Yes
b. Yes No
c. No Yes
d. No No
2. An accounting firm was hired by a company to perform an audit. The company needed the audit report in order to obtain a loan from a bank. The bank lent $500,000 to the company based on the auditor’s report. Fifteen months later, the company declared bankruptcy and was unable to repay the loan. The bank discovered that the accounting firm failed to discover a material overstatement of assets of the company. Which of the following statements is correct regarding a suit by the bank against the accounting firm? The bank
a. Cannot sue the accounting firm because of the statute of limitations.
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b. Can sue the accounting firm for the loss of the loan because of negligence.
c. Cannot sue the accounting firm because there was no privity of contract.
d. Can sue the accounting firm for the loss of the loan because of the rule of privilege.
3. At a confidential meeting, an audit client informed a CPA about the client’s illegal insider-trading actions. A year later, the CPA was subpoenaed to appear in federal court to testify in a criminal trial against the client. The CPA was asked to testify to the meeting between the CPA and the client. After receiving immunity, the CPA should do which of the following?
a. Take the Fifth Amendment and not discuss the meeting.
b. Cite the privileged communications aspect of being a CPA.
c. Discuss the entire conversation including the illegal acts.
d. Discuss only the items that have a direct connection to those items the CPA worked on for the client in the past.
4. Page, CPA, has T Corp, and W Corp, as audit clients. T Corp. is a significant supplier of raw materials to W Corp. Page also prepares individual tax returns for Time, the owner of T Corp. and West, the owner of W Corp. When preparing West’s return, Page finds information that raises going-concern issues with respect to W Corp. May Page disclose this information to Time?
a. Yes, because Page has a fiduciary relationship with Time.
b. Yes, because there is no accountant-client privilege between Page and West.
c. No, because the information is confidential and may not be disclosed without West’s consent.
d. No, because the information should only be disclosed in Page’s audit report on W Corp.’s financial statements.
5. To exercise due professional care an auditor should
a. Critically review the judgment exercised by those assisting in the audit.
b. Examine all available corroborating evidence supporting management assertions.
c. Design the audit to detect all instances of illegal acts.
d. Attain the proper balance of professional experience and formal education.
6. Cable Corp. orally engaged Drake & Co., CPAs to audit its financial statements. Cable’s management informed Drake that it suspected the accounts receivable were materially overstated. Though the financial statements Drake audited included a materially overstated accounts receivable balance, Drake issued an unqualified opinion. Cable used the financial statements to obtain a loan to expand its operations. Cable defaulted on the loan and incurred a substantial loss.
If Cable sues Drake for negligence in failing to discover the overstatement, Drake’s best defense would be that Drake did not
a. Have privity of contract with Cable.
b. Sign an engagement letter.
c. Perform the audit recklessly or with an intent to deceive.
d. Violate generally accepted auditing standards in performing the audit.
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1. A
2. B
3. C
4. C
5. B
6. D
Accountant Liability and Accountability Homework Exercises