Legal Liabilities of CPAs
Under Common Law
Chapter 43
Accountants'
Legal Liability
Introduction
• An accountant is subject to potential
civil liability arising from the
professional services they provide to
their clients and third parties.
• This legal liability is imposed both by
the common law at the state level and
by securities laws at the federal level.
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Accounting Law touches on a number of Common Law
subjects, including your favorite:
CONTRACTS
CPA + Client are in
Privity of Contract
That is, they can sue one another
for breach of the contract
between them
contracts
A legally-binding
AGREEMENT
What’s the contract in
a relationship between
CPA + client?
Explicit duties are found in engagement
letter: the contract between a client and a
professional that defines the scope of work (e.g.,
returns to be prepared) and the responsibilities and
obligations of each of the respective parties.
What have you agreed to?
Also Implicit Duties – the
accountant impliedly agrees to
perform the contract in a
competent and professional
manner.
Must exercise the care of a
reasonably skilled professional
accountant.
GAAP*
+
GAAS**
*Generally Accepted Accounting Principles, created by the FASB
(Financial Accounting Standards Board)
**Generally Accepted Auditing Standards, created by the AICPA
What have you agreed to do?
• Express an opinion on the fairness of
financial statements
• Provide reasonable assurance of
detecting material errors and fraud
• Detect only those problems that a
“normal” audit or review would
• Anything else you included in the
contract
What haven’t you agreed to do?
• Uncover all fraud, shortages or
defalcations
• Guarantee against losses from error or
fraud
• Go beyond a “normal” audit or review
and expressly examine the records for
evidence of fraud or other obvious
misconduct (unless you said you would)
Clients (and third-party
beneficiaries) can sue CPAs
for Breach of Contract (and
vice versa)
Damages for (Material)
Breach of Contract
Contract – Actual =
A CPA was hired to complete an audit by
an agreed deadline, and the contract
stipulated that time was of the essence
(that is, it was absolutely necessary the
audit was completed then, or it would be
useless to the client). They missed the
deadline.
Breach of contract?
Result?
Breach of contract? Yes. The CPA didn’t
do what they’d agreed to do, and all
benefit the client was to receive was lost.
Result? No compensation to CPA, and
damages to client, if applicable.
Damages for (Material)
Breach of Contract
Contract – Actual =
$ client
promised to
pay CPA for
work
$ CPA’s
services were
actually worth,
considering
the errors
$ deducted from
CPAs actual pay
(and damages
assessed, if
applicable)
A CPA was hired to complete an audit by
an agreed deadline and they missed it—
just like above. Except that this time, they
missed it entirely because the client failed
to provide necessary information in a
timely way.
Breach of contract? By whom?
Result?
Breach of contract? Not by the CPA: they
did what they were supposed to do. This
time, the client breached the contract.
Result? CPA is entitled to full fee, and any
additional damages must be covered by
the client.
Obviously, the client can’t interfere with the
CPA’s work, then hold them liable.
The CPA made some errors that resulted
in the client losing some money. Result?
A CPA has been hired by a client to
perform an audit. A standard engagement
letter is used. During the course of the
audit, the CPA fails to uncover a clever
embezzlement scheme by one of the
client’s employees.
Breach of contract?
Would a normal audit have
uncovered the scheme?
torts
Negligence
“the mother of all torts”
Negligence
You didn’t mean to do it
BUT
Did something wrong
that
A reasonable person
wouldn’t have done
and
It hurt somebody
4 elements of negligence:
X
DUTY
BREACH
CAUSATION
HARM
Accountant’s Duty:
An accountant is expected to perform with the
same degree of skill and judgment possessed
by the average, reasonable accountant.
4 elements of negligence:
X
DUTY
X
BREACH
CAUSATION
HARM
Accountant’s Duty of Care
indicated by compliance with
GAAP or GAAS (or IFRS*–international equivalent used
abroad and by the SEC)
Contract between client + CPA
Law (all of it: state/federal, legislative/common law)
Custom
*International Financial Reporting Standards, created by the International Accounting
Standards Board (IASB)
4 elements of negligence:
X
DUTY
X
BREACH
X
CAUSATION
HARM
Causation must be proximate
sufficiently related to a legally recognizable injury to
be held to be the cause of that injury.
“But/For” (sine qua non)
4 elements of negligence:
X
DUTY
X
BREACH
X
CAUSATION
X
HARM
Goal of tort lawsuit?
Compensate (pay back)
the Victim
“Compensatory Damages”
Torts decisions (typically) deal
in MONEY
How much money does the plaintiff
need to be “whole again”?
Goal of tort lawsuit?
To put the plaintiff in the
same position they would
have been had the tort
never occurred
No privity
Ultramares decision said accountants could
only be held liable for ordinary negligence
when there was privity.
(In other words, CPA only liable to Client for
breach of duty of care)
No privity
Ultramares decision said accountants could
only be held liable for ordinary negligence
when there was privity.
Lots of others (besides Client)
rely on CPA’s opinion when
making decisions:
Lots of others (besides Client)
rely on CPA’s opinion when
making decisions:
Investors
Shareholders
Creditors
Corporate managers + directors
Regulatory agencies
Shouldn’t CPAs be legally
accountable to them, too?
Who can successfully sue?
majority rule: Foreseen Parties
can sue CPAs for negligence
Third parties whom the CPA knew
would rely on or be influenced by
financial statements
wrongful or criminal deception
intended to result in financial or
personal gain
Elements of fraud:
X
X
X
X
“Punitive Damages” are
allowed
How do you protect yourself
against common law liability?
CY(personal and firm)A with insurance
(independent contractors are responsible for
themselves)
Draft an excellent Engagement Letter, in
writing, which lays out what you will do and
how you will do it, includes disclaimers about
what you will not necessarily be doing, and is
signed by both parties.
Then avoid making any implied promises and
do what you said you were going to do.
Do your duty by complying with:
GAAP or GAAS (or IFRS*–international equivalent used
abroad and by the SEC)
Contract between client + CPA
Law (all of it: state/federal, legislative/common law)
Custom
*International Financial Reporting Standards, created by the International Accounting
Standards Board (IASB)
Fulfill your
duty to investigate
anything that seems suspicious.
Be clear in audit letters
I do not have sufficient
information to issue an
opinion.
My approval of these
financial statements is
qualified by the
uncertainty of an
outstanding lawsuit
currently unresolved.
Consider your duty to
Foreseen Parties
Those who you CPA know will rely
on financial statements
Don’t be negligent
NEVER lie
• And be careful with Client
Information:
– Working Papers – an accountant is
considered the owner of his working
papers but may not disclose their contents
unless the clients agrees or a court orders
the disclosure.
– Accountant-Client Privilege is not
recognized generally by the common law,
but some states grant some form of
privilege.
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Securities Law: Designed
to protect investors
1st piece of federal securities
regulation?
Securities Act of 1933: Covers
regulation of IPOs
When you are doing an IPO,
you must file a registration
statement (“Form S-1”)
• Provides investors with an understanding of
the securities offered and the profitability of
the company.
• Includes details of the investment offered,
how the business operates, its history,
management, financial condition, and
insight into any risk.
Rules about financials in S-1
statements
• The financial forms included, such as an income
statement, must be audited by an independent
certified public accountant.
• Must not contain untrue material facts
• Must not omit material facts
• Section 11 imposes express civil liability upon
accountants if the financial statements they prepare
or certify for a registration statement contain any
untrue statement or omit any material fact.
Section 11 imposes express civil liability upon accountants
if the financial statements they prepare or certify for a
registration statement contain any untrue statement or omit
any material fact.
Account can defend with due diligence, which requires that
the accountant had, after reasonable investigation,
reasonable grounds to believe and did believe that the
financial statements were true, complete, and accurate.
A willful violator of Section 11 is subject of fines not more
than $10,000 and/or imprisonment of not more than five
years.
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So…
Since 1933, CPAs have been statutorily
liable to investors who rely on the
information they provide at IPOs.
Securities Exchange Act of
1934
• Regulates securities sold on national stock
exchanges
• Applies to securities issued by
corporations with more than $10 million in
total assets and securities held by 500+
investors.
• Requires each company to furnish SEC
with annual report (Form 10-K), which
includes financial statements to be audited
in accordance with PCAOB standards by a
registered firm.
• Requires each company to file quarterly
reports (Form 10-Qs), which include
quarterly financial statements to be
reviewed by a registered firm.
Section 18 – imposes express civil liability on an
accountant who knowingly makes any false or
misleading statement about any material fact in any
report, document, or registration filed with the
Securities and Exchange Commission.
Rule 10b-5 – an accountant is civilly liable under this
rule if he acts with scienter in making oral or written
misstatements or omissions of material fact in
connection with the purchase or sale of a security.
Criminal Liability – a willful violator of either Section
18 or Rule 10B-5 is subject to fines or not more than
$5 million and/or imprisonment of not more than
twenty years.
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Sarbanes-Oxley
Following ENRON
– Establishes a new regulatory body to oversee public
company auditors, makes auditors more independent from
their clients and places direct responsibility for the audit
relationship on audit committees.
– Audit Requirements – auditors must establish procedures
capable of detecting material illegal acts, identifying material
related to party transactions, and evaluating whether there is
a substantial doubt about the issuer’s ability to continue as a
going concern during the next fiscal year.
How does the SEC enforce
fraud actions?
• SEC has a fraud task force: 12 staffers
(lawyers & accountants)
• objective: to improve our ability to detect
and prevent financial statement and other
accounting fraud
• developing state-of-the-art methodologies
that better uncover accounting fraud
• renewed commitment to prosecuting those
who betray the trust of the public markets
What tools do they use?
• Analyze performance trends by industry
• Pay attention to private suits
• Initiate "street sweeps" in particular
areas
• “Claw back" bonus money received or
the proceeds of stock sales that
occurred during a period when the
company's financials were misstated.
What tools do they use?
Use data analytics to assess the degree to
which a company's financial statement
appears anomalous (compare
performance across industries & detect
outliers that suggest possible fraud)
Criminal Liabilities of CPAs
Under Statutory Law
In real life!
CPA Charged With Bank Fraud For Providing Inflated Tax Returns To Client To Use To
Defraud Lenders
Information was unsealed today charging Barry Horrow, 68, of Glenn Mills with 4 counts of bank
fraud, announced United States Attorney Zane David Memeger.
The information alleges that Horrow, a Certified Public Accountant who owned and operated his own
accounting company, Horrow and Associates, which operated in both Delaware and West Chester Counties,
committed bank fraud by helping one of his clients, George Barnard of Newtown Square (who owned Capital
Financial Mortgage Corporation (“CFMC”) and who was charged previously in an indictment with various offenses
stemming from a $13 million fraud scheme who owned) to defraud lenders into issuing mortgages for 3 multimillion dollar New Jersey Shore beach mansions and a yacht based on false information. Specifically, the
information alleges that Horrow repeatedly provided false tax returns for Barnard to submit to lenders on which
Horrow inflated Barnard’s income by hundreds of thousands of dollars, when Horrow knew that the lenders were
going to be relying upon the inflated income figures in approving Barnard’s loan requests. The information also
alleges that Horrow purported to conduct audits of CFMC, when in reality Horrow did not conduct any audits, and
that he issued false audit reports that he knew were being submitted to lenders to help secure loans for both
CMFC and Barnard.
Horrow faces a maximum sentence of 120 years’ imprisonment, a five-year period of supervised
release, a $4,000,000 fine, a $400 special assessment, and a likely advisory sentencing guideline range of 51 – 63
months’ imprisonment. The information also seeks the forfeiture of over $2,965,000.The case was investigated by
the Federal Bureau of Investigation, the Department of Housing and Urban Development, Office of Inspector
General, and the Internal Revenue Service, Criminal Investigative Division, and is being prosecuted by Assistant
United States Attorney Michael S. Lowe.
In real life!
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Enron Scandal (2001)
Company: Houston-based commodities, energy and service
corporation
What happened: Shareholders lost $74 billion, thousands of employees
and investors lost their retirement accounts, and many employees lost
their jobs.
Main players: CEO Jeff Skilling and former CEO Ken Lay.
How they did it: Kept huge debts off balance sheets.
How they got caught: Turned in by internal whistleblower Sherron
Watkins; high stock prices fueled external suspicions.
Penalties: Lay died before serving time; Skilling got 24 years in prison.
The company filed for bankruptcy. Arthur Andersen was found guilty of
fudging Enron's accounts.
Fun fact: Fortune Magazine named Enron "America's Most Innovative
Company" 6 years in a row prior to the scandal.
IRS
• Perjury (willfully preparing false tax
returns)
• Tax evasion (willfully assisting others to
evade taxes)
• The maximum statutory penalty for each
count of aiding and assisting the
preparation of false tax returns is three
years in prison and a fine of $250,000.
In real life!
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Larry Couchot, a CPA from Dayton, OH, admitted that for tax years 2006 through 2010, he
assisted in the preparation of false individual income tax returns for a group of individuals
associated with the Cadillac Ranch restaurants, which caused a tax loss of over $191,000 to the
IRS.
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Couchot was aware that these individuals used a substantial amount of company funds to pay
for personal expenses, including payments for their personal cars, car insurance, country club
dues, personal credit card charges and their individual income tax liabilities. Couchot also
admitted that he was aware that one individual used company funds to pay for other personal
expenses, including lawn services, repairs and maintenance to personal residences, granite
counter tops and TV and audio systems.
Couchot admitted that he prepared false federal income tax returns that failed to report these
items as income on two individuals’ income tax returns. Couchot pleaded guilty to aiding and
assisting in the preparation of a false income tax return for the year 2009 for Jon Field and to
preparing a false income tax return for Eric Schilder for the year 2007, which reported only
$68,000 of income. In contrast, the business records of the company indicated Schilder earned
over $129,000 in income in that year. Couchot admitted that after the false return was filed with
the IRS on behalf of Schilder, he created a false summary that he retained in his records to
support the false income reported on that return.
At sentencing, Couchot faces a statutory maximum sentence of three years in prison, a $250,000
fine and one year of supervised release for each of the two charges.
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Again with the real life!
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Certified Public Accountant Convicted of Preparing False Returns
A federal jury convicted certified public accountant Jeffery Deshon Applewhite, aka Jeffrey Donald Mason, a resident of Los
Angeles County, California, of 20 counts of aiding and assisting the preparation and presentation of false tax returns late yesterday,
announced Assistant Attorney General Kathryn Keneally of the Justice Department’s Tax Division, U.S. Attorney Melinda Haag for
the Northern District of California and Internal Revenue Service (IRS)-Criminal Investigation Special Agent in Charge José M.
Martinez. Applewhite was not convicted on five charges of identity fraud.
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The evidence presented during the five day trial before U.S. District Court Judge Jeffrey S. White showed that Applewhite, who
owned and operated tax preparation businesses in Los Angeles and Oakland, California, prepared false and fraudulent income tax
returns for clients during the years 2006 through 2011 on which he fabricated deductible expenses, including gifts to charity, and
other expenses. Applewhite also fraudulently included residential energy credits and education credits to which his clients were not
entitled on tax returns he prepared. Applewhite prepared and filed false returns using the names Jeffery Deshon Applewhite and
Jeffrey Donald Mason, and used the name and tax preparer identification number of another tax return preparer.
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Applewhite’s sentencing hearing is scheduled for Aug. 5, 2014, before Judge White in Oakland. The maximum statutory penalty for
each count of aiding and assisting the preparation of false tax returns is three years in prison and a fine of $250,000.
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The case was investigated by Special Agents from IRS - Criminal Investigation . Assistant U.S. Attorney Cynthia Stier and Trial
Attorney Sonia Owens of the Tax Division are prosecuting the case.
What do these 3 have in
common?
Frank Tieri (mobster)
Michael Milken (crooked financier)
They’re all RICO criminals
Found guilty of a “pattern of racketeering”
under the RICO statute
What’s RICO again?
Federal law (enacted in 1970) to crack down on acts performed as part of
an ongoing criminal organization
What does that mean?
Anyone affiliated with businesses or groups involved in a “pattern of
racketeering”
Obviously organized crime qualifies, but so can some kinds of fraud under
securities laws
What happens if you’re convicted for racketeering under RICO?
You can be fined up to $25,000 and sentenced to 20 years in prison per
count
You also have to forfeit all ill-gotten gains and interest in any business
gained through the illegal behavior
In real life!
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Bernie Madoff Scandal (2008)
Company: Bernard L. Madoff Investment Securities LLC was a Wall
Street investment firm founded by Madoff.
What happened: Tricked investors out of $64.8 billion through the
largest Ponzi scheme in history.
Main players: Bernie Madoff, his accountant, David Friehling, and
Frank DiPascalli.
How they did it: Investors were paid returns out of their own money or
that of other investors rather than from profits.
How they got caught: Madoff told his sons about his scheme and they
reported him to the SEC. He was arrested the next day.
Penalties: 150 years in prison for Madoff + $170 billion restitution.
Prison time for Friehling and DiPascalli.
Fun fact: Madoff's fraud was revealed just months after the 2008 U.S.
financial collapse.
Gramm-Leach Bliley Act
(1999)
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Repealed the Glass–Steagall Act— a 1933 federal regulation separating commercial
and investment banking
Removed barriers between industries, making it possible for a single institution to act
as any combination of an investment bank, a commercial bank, and an insurance
company
With the bipartisan passage of the Act, commercial banks, investment banks, securities
firms, and insurance companies were allowed to consolidate
Furthermore, it failed to give to the SEC or any other financial regulatory agency the
authority to regulate large investment bank holding companies
During debate in the House of Representatives, Rep. John Dingell (Democrat of MI)
argued that the bill would result in banks becoming "too big to fail." Dingell further
argued that this would necessarily result in a bailout by the Federal Government.
YIKES