Business Law for the Entrepreneur
and Manager
Chapter 14 – Liability of Accountants and
Other Professionals
Frank Cavico and Bahaudin G. Mujtaba
© Cavico & Mujtaba, 2008
Chapter Topics
• Common Law Liability
– Breach of Contract
– Negligence
– Fraud
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•
•
•
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Liability to Third Parties
Statutory Liability
Criminal Liability
State Laws
Confidentiality and Privilege
– Summary
© Cavico & Mujtaba, 2008
Accountants and the Profession
•
•
Accountants are members of a profession who provide a variety of
professional services: for example, tax, consulting, bookkeeping
(compilations), and various assurance services. Assurance services provide
information enhancement and include audits and reviews of financial
statements. An audit is the examination of financial statements performed by a
certified public accountant in accordance with specific professional standards.
The product of this work is the auditor’s opinion which, according to the
Public Company Accounting Oversight Board’s (PCAOB) standard auditor’s
report, gives the users of financial statements reasonable assurance that the
entity’s statements are free from material misstatement and “…present fairly,
in all material respects, the financial position,…results of…operations,
and…cash flows…in conformity with accounting principles accepted in the
United States of America.” A certified public accountant, known as a CPA, is
an accountant who has attained certain educational requirements, typically five
years of college study, and who has passed the rigorous Uniform CPA Exam
administered in 55 U.S. jurisdictions.
© Cavico & Mujtaba, 2008
Accountants and Services
• In the performance of their professional services,
accountants, like members of the legal and
medical profession, are exposed to legal liability.
Legal liability against accountants is based on both
the common law and statutory law. In the former
category, the accountant can be sued for breach of
contract, negligence, and fraud. In the statutory
category, the accountant faces legal liability based
on a variety of federal and state statutes, especially
federal securities laws. Moreover, accountants
may confront legal liability not only from their
clients but also third parties.
© Cavico & Mujtaba, 2008
Common Law Liability
• As previously discussed in the first chapter of this
book, common law is derived from case law. That
is, it is based on prior adjudicated precedent
(which is the legal opinion of judges). Pursuant to
the common law, accountants are exposed to legal
liability from their clients and potentially third
parties based on three doctrines:
– 1) breach of contract,
– 2) negligence, and
– 3) fraud.
© Cavico & Mujtaba, 2008
Breach of Contract
• Accountants are retained by their clients to
perform a variety of professional accounting
services; as such, accountants regularly enter into
contracts with their clients; these contracts are at
times called “engagements” or engagement letters.
• The standards of the accounting profession require
an engagement letter for each audit and review.
The failure of the accountant to perform or to
substantially perform his or her contract duties
subjects the accountant to a lawsuit for breach of
contract premised on common law contract
principles.
© Cavico & Mujtaba, 2008
Negligence
• Accountants, as members of a profession, like lawyers, are
under a legal duty to perform their professional accounting
and auditing services in a careful, reasonable, and prudent
manner. They must exercise the degree of care and skill
and possess the requisite knowledge of the ordinary,
reasonable, and prudent member of their profession.
Accountants are thus held to the old common law
negligence standard of the “reasonably prudent person,”
but in the specific, reasonably prudent, accountant
professional context. The failure to adhere to this legal
duty, referred to as due care, subjects the accountant to
legal liability for negligence, which on the professional
level is deemed “malpractice,” and thereby accounting
malpractice.
© Cavico & Mujtaba, 2008
Fraud
• An accountant may be liable for fraud, which (as explained
in the Contracts and Tort chapters), is a very broad term
encompassing liability for intentional misrepresentation,
called deceit in the old common law, and negligent
misrepresentation. In the former more serious formulation
of fraud, the accountant could be subject to punitive
damage liability. Also, accountants are regarded as
fiduciaries; and thus are in a relationship of trust and
confidence with their clients; consequently, the breach of
this fiduciary relationship, for example, by purposefully
omitting a material fact which is relied on by the client, is
regarded in the law as the equivalent of fraud, thereby
subjecting the accountant to punitive damage liability.
© Cavico & Mujtaba, 2008
Liability to Third Parties
• Most negligence lawsuits instituted against accountants are
brought by their clients who contend that the accountants’
carelessness has caused them some harm. However, it is
possible that another party also suffered harm and thus
seeks to sue the accountant. This party is characteristically
a third party, such as a corporate shareholder or financial
institution, who relied on the information supplied (or not
supplied) by the accountant. This area of the accountant’s
negligence liability to third parties is a very difficult one in
the law because there are three competing legal principles:
1) the Ultramares rule, 2) the Restatement (Second) of
Torts rule, and 3) the negligence “foreseeability” rule.
© Cavico & Mujtaba, 2008
Statutory Liability
• There are several statutes, both federal and
state, that impact the liability of the
accountant. First, the civil liability of the
accountant under major statutes will be
addressed; and then in the next statutory
section, the criminal liability of the
accountant will be examined.
© Cavico & Mujtaba, 2008
Sarbanes-Oxley Act (SOX)
• The Sarbanes-Oxley Act (SOX) of 2002 was a
Congressional response to the spate of corporate
scandals as exemplified by the famous (infamous)
Enron collapse. SOX emerged as one of the most
important modifications of federal securities laws
since the enactment of the 1933 and 1934 acts.
The main purposes of SOX are to protect investors
by improving the accuracy and reliability of
corporate disclosure and to increase and improve
corporate accountability and governance.
© Cavico & Mujtaba, 2008
The Securities Act of 1933
• The Securities Act of 1933 is a disclosure type of
statute. It is designed to promote fairness and
stability in the securities markets by requiring that
certain essential information concerning the
issuance of stocks and the principals behind the
issuance are made available to the investing
public. There are two major sections of the Act:
Section 5, which details the requirements for a
registration statement as well as a prospectus; and
Section 11, which sets forth the penalties for noncompliance with Section 5 requirements.
© Cavico & Mujtaba, 2008
The Securities and Exchange Act of 1934
• The Securities and Exchange Act of 1934 has
several purposes. It provides for the registration
and regulation of security exchanges, securities
brokers and dealers, and national security
associations. It also provides for the regulation of
proxy solicitations for voting. Most importantly,
the 1934 Act is a very broad anti-fraud statute,
which applies to all purchase and sales of
securities, and which seeks to police, punish, and
deter fraudulent, deceptive, and manipulative
practices in the securities marketplace.
© Cavico & Mujtaba, 2008
The Securities and Exchange Act of
1994
• The Securities and Exchange Act of 1994, as amended by
the U.S. Congress in 1995, in Section 10A imposed
significant new duties on auditors to investigate, detect,
and report illegal acts committed by their clients.
Specifically, unless the illegality is clearly inconsequential,
the auditor is required to disclose to the client’s
management and audit committee the illegal act. Moreover,
if the management of the firm fails to take timely and
proper remedial action to correct the illegal activity, the
auditor must report the illegal act to the firm’s board of
directors; but only if the illegal conduct would have a
material effect on the client’s financial statements and the
auditor intends to issue a non-standard audit report or
intends to resign for the audit engagement.
© Cavico & Mujtaba, 2008
Criminal Liability
• Accountants as well as other professionals and
members of the public can be held criminally
liable under federal and state laws, especially
securities laws. Section 24 of the 1933 Act makes
it a crime for any person to make an intentional
false statement of material fact in a registration
statement filed with the SEC. It is also a crime for
any person to purposefully omit any material fact
that would be necessary to ensure that the
registration statement is not misleading.
© Cavico & Mujtaba, 2008
Confidentiality and Privilege
• Accountants and attorneys are regarded as
members of a profession in a fiduciary
relationship with their clients. One of the
characteristics of this professional
relationship is a duty of confidentiality. The
legal system also recognizes this duty of
confidentiality as a legal privilege, but to a
much greater degree for lawyers than
accountants.
© Cavico & Mujtaba, 2008
Attorney-Client Relationship
• The attorney-client privilege is the privilege a client has to
reveal information given to his or her attorney in
confidence without fear of disclosure. The common law
has long recognized such a privilege. The privilege is also
constitutionally protected on the federal and state levels by
the right against self-incrimination and the right to legal
counsel. In order for a person to secure effective legal
representation, and particularly to obtain a viable defense
to criminal prosecution, the client must feel confident that
he or she can fully tell the attorney the facts of the case
without any apprehension that the attorney will be called as
a witness against the client.
© Cavico & Mujtaba, 2008
Summary
• This chapter has examined the legal liability of the
accountant as well as other professionals under a
variety of laws – federal and state, statutory and
common law, civil and criminal.
– This chapter underscored the very important SarbanesOxley Act of 2002, and discussed how it impacted
corporate governance, the securities laws, and the
accounting profession.
– This chapter compared and contrasted the privilege of
confidentiality and non-disclosure between lawyers and
their clients and accountants and their clients.
– Finally, this chapter provided certain practical
recommendations for the accountant to avoid legal
liability.
© Cavico & Mujtaba, 2008
Reference
1.
2.
Cavico, F. & Mujtaba, B. G., (2008). Business Law for the Entrepreneur
and Manager. ILEAD Academy Publications; Davie, Florida, USA. ISBN:
978-0-9774-2115-2.
Cavico, F. and Mujtaba, B. G. (2008). Legal Challenges for the Global
Manager and Entrepreneur. Kendal Hunt Publishing; United States.
© Cavico & Mujtaba, 2008