Accountant Liability and Accountability
Fall, 2009 at 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.
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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).
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.
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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
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.
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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.
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.
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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.
Note the criminal violations of securities laws and tax laws on p. 1062.
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Accountant Liability and Accountability Classroom
Exercises
Fall, 2009 at 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
a.
b.
c.
d.
Yes
Yes
No
No
Criminal liability of a fine
Yes
No
Yes
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.
b.
c.
d.
Cannot sue the accounting firm because of the statute of limitations.
Can sue the accounting firm for the loss of the loan because of negligence.
Cannot sue the accounting firm because there was no privity of contract.
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.
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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.
b.
c.
d.
Critically review the judgment exercised by those assisting in the audit.
Examine all available corroborating evidence supporting management assertions.
Design the audit to detect all instances of illegal acts.
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.
b.
c.
d.
Have privity of contract with Cable.
Sign an engagement letter.
Perform the audit recklessly or with an intent to deceive.
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
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Accountant Liability and Accountability Homework
Exercises
Business Law II at Medgar Evers College
1. A CPA audited the financial statements of Shelly Company. The CPA was negligent in the
audit. Sanco, a supplier of Shelly, is upset because Sanco had extended Shelly a high credit limit
based on the financial statements which were incorrect?
a. In most states, both Shelly and Sanco can recover from the CPA for damages due to the
negligence.
b. States that use the Ultramares decision will allow both Shelly and Sanco to recover.
c. In most states, Sanco cannot recover as a mere foreseeable third party.
d. Generally, Sanco can recover but Shelly cannot.
2. Quincy bought Teal Corp. Common stock in an offering registered under the Securities Act of
1933. Worth and Co., CPAs gave an unqualified opinion on Teal’s financial statements that were
included in the registration statement filed with the SEC. Quincy sued Worth under the
provisions of the 1933 Act that deal with omission of facts required to be in the registration
statement. Quincy must prove that:
a.
b.
c.
d.
There was fraudulent activity by Worth.
There was a material misstatement in the financial statements.
Quincy relied on Worth’s opinion.
Quincy was in privity with Worth.
3. Beckler & Associates, CPAs, audited and gave an unqualified opinion on the financial
statements of Queen Co. The financial statements contained misstatements that resulted in a
material overstatement of Queen’s net worth. Queen provided the audited financial statements to
Mac Bank in connection with a loan made by Mac to Queen. Beckler knew that the financial
statements would be provided to mac. Queen defaulted on the loan. Mac sued Beckler to
recover for its losses associated with Queen’s default. Which of the following must Mac prove in
order to recover?
I. Beckler was negligent in conducting the audit.
II. Mac relied on the financial statements.
a.
b.
c.
d.
I only.
II only.
Both I and II.
Neither I nor II.
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For questions 4 and 5 — Under the liability provisions of Section 11 of the Securities Act of 1933,
a CPA may be liable to an purchaser of a security for certifying materially misstated financial
statements that are included in the security’s registration statement.
4. Under Section 11, a CPA usually will not be liable to the purchaser
a.
b.
c.
d.
If the purchaser is contributorily negligent.
If the CPA can prove due diligence.
Unless the purchaser can prove privity with the CPA.
Unless the purchaser can prove scienter on the part of the CPA.
5. Under Section 11, which of the following must be proven by a purchaser of the security?
Reliance on the financial statements
a.
b.
c.
d.
Yes
Yes
No
No
Fraud by the CPA
Yes
No
Yes
No
6. Dart Corp. Engaged Jay Associates, CPAs, to assist in a public stock offering. Jay audited
Dart’s financial statements and gave an unqualified opinion, despite knowing that the financial
statements contained misstatements. Jay’s opinion was included in Dart’s registration statement.
Larson purchased shares in the offering and suffered a loss when the stock declined in value after
the misstatements became known.
In a suit against Jay under the antifraud provisions of Section 10(b) and Rule 10b-5 of the
Securities Exchange Act of 1934, Larson must prove all of the following except:
a.
b.
c.
d.
Larson was an intended user of the false registration statement.
Larson relied on the false registration statement.
The transaction involved some form of interstate commerce.
Jay acted with intentional disregard of the truth.
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7. Ocean and Associates, CPAs, audited the financial statements of Drain Corporation. As a
result of Ocean’s negligence in conducting the audit, the financial statements included material
misstatements. Ocean was unaware of this fact. The financial statements and Ocean’s
unqualified opinion were included in a registration statement and prospectus for an original public
offering of stock by Drain. Sharp purchased shares in the offering. Sharp received a copy of the
prospectus prior to the purchase but did not read it. The shares declined in value as a result of the
misstatements in Drain’s financial statements becoming known. Under which of the following
Acts is Sharp most likely to prevail in a lawsuit against Ocean?
Securities Exchange Act of 1934, Section 10(b), Rule 10b-5
a,
b.
c.
d.
Yes
Yes
No
No
Securities Act of 1933
Section 11
Yes
No
Yes
No
8. (problem 51-5, p. 1065) In 1995, JTD Health Systems, Inc., hired Tammy Heiby as accounting
coordinator. Apparently overwhelmed by the duties of the position, Heiby failed to make
payroll tax payments to the Internal Revenue Service (IRS) in 1995 and 1996. Heiby tried to
hide this omission by falsifying journal entries and manually writing three checks out of
sequence, totaling $1.7 million and payable to a bank, from JTD’s cash account (to dispose of
excess funds that should have been paid in taxes). JTD hired Pricewaterhouse Coopers, LLP, to
review JTD’s internal accounting procedures and audit its financial statements for
1995. Coopers’ inexperienced auditor was aware that the cash account had not been balanced
in months and knew about the checks but never questioned them. The auditor instead
mistakenly explained that the unbalanced account was due to changes in Medicaid/Medicare
procedures and recommended no further investigation. In 1996, the IRS asked JTD to remit
the unpaid taxes, plus interest and penalties. JTD filed a suit in an Ohio state court against
Coopers, alleging common law negligence and breach of contract. Should Coopers be held
liable to JTD on these grounds? Why or why not? [JTD Health Systems, Inc. v.
Pricewaterhouse Coopers, LLP, 141 Ohio App.3d 280, 750 N.E.2d 1177 (Ohio App. 3 Dist. 2001)]
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9. (problem 51-6, p. 1065) Solucorp Industries, Ltd., a corporation headquartered in New York,
develops and markets products for use in environmental clean-ups. Solucorp’s financial
statements for the six months ending December 31, 1997, recognized $1.09 million in license
fees payable by Smart International, Ltd. The fees comprised about 50 percent of Solucorp’s
revenue for the period. At the time, however, the parties had a license agreement only “in
principle,” and Smart had made only one payment of $150,000. Glenn Ohlhauser, an
accountant asked to audit the statements, objected to the inclusion of the fees. In February
1998, Solucorp showed Ohlhauser a license agreement backdated to September 1997 but
refused to provide any financial information about Smart. Ohlhauser issued an unqualified
opinion on the 1997 statements, which were included with forms filed with the Securities and
Exchange Commission (SEC). The SEC filed a suit in a federal district court against Ohlhauser
and others. What might be the basis in the Private Securities Litigation Reform Act for the
SEC’s suit against Ohlhauser? What might be Ohlhauser’s defense? Discuss. [Securities and
Exchange Commission v. Solucorp industries, Ltd., 197 F.Supp.2d 4 (S.D.N.Y. 2002)]
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