978-0134004006 Chapter 51 Lecture Note

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subject Authors Henry R. Cheeseman

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“In our complex society the accountant’s certificate and the lawyer’s opinion can
be instruments for inflicting pecuniary loss more potent than the chisel or the crowbar.
Justice Blackmun
I. Teacher to Teacher Dialogue
Much has been written about the dramatic changes in the legal environment in which
accountants and professionals find themselves working today. The proverbial pot of gold known
bottom line be all that bad? CPA’s like every other professional, need to work harder and be more
disciplined than ever before. The special status accorded in the past through cases like
Ultramares simply can no longer provide safe harbors from liability. It is a tough lesson to learn,
but a very necessary one indeed.
business, the accounting profession has also become one of the prime targets of change. Albeit
still a very highly respected profession, it has not been “business as usual” for accountants in
recent history. The profession’s future has become more uncertain than ever because of the
increased scope of an accountant’s legal liabilities.
the wayside. The work product of accountants is simply too important to be expected to be kept in
the four walls of the client’s office. Today’s “glass jar” world of information technology transfer
makes it not only foreseeable but probable that information used to establish financial credibility
will in fact be used by many third parties, ranging from governmental entities to investors and
ACCOUNTANTS’ DUTIES AND
LIABILITY
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Accountants’ Duties and Liability
more accountable than ever.
Another factor that has led to so many suits being filed against accountants today is that the
profession has not really decided how it will ultimately react to these drastic changes. It continues
to seek the public’s confidence in its work and reliance on its work products. In many ways
certain elements of its work are not even optional but rather held to a captive audience. Can you
this thinking, ultimate reliance on the work product of the accounting profession will be restored
on the basis that what users really wanted all along is comfort in knowing that they can “bank” on
what the financial statements are really saying. This sort of change will probably happen only
when the government is willing to step in to provide financial assurances to the accounting
profession will be transmogrified from the practice of this profession as we know it today.
II. Chapter Objectives
1. Describe an accountant’s liability to his or her client for breach of contract and fraud.
2. Describe an accountant’s liability to third parties under the Ultramares doctrine.
the foreseeability standard.
4. Describe an accountant’s civil liability and criminal liability under federal securities laws.
5. Describe the duties of accountants under the Sarbanes-Oxley Act.
III. Key Question Checklist
What functions are included in the practice of accountancy?
What are the contact theories of liability?
What are the common law tort theories of liability?
IV. Text Materials
Introduction to Accountants’ Duties and Liability
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The primary functions of accountants are to audit financial statements and render opinions about
Public Accounting
A Certified Public Accountant (CPA) meets certain educational standards and passes the CPA
Limited Liability Partnership In this form of partnership, all the partners are limited partners
Accounting Standards and Principles
Generally Accepted Accounting Principles (GAAPs) These are the standards for the
Generally Accepted Auditing Standards (GAASs) These specify the methods and procedures
Audit Audits are a verification of a company’s books and records that must be performed by an
Auditor’s Opinions After completing the audit, auditors render an opinion about how fairly the
Unqualified Opinions Unqualified opinions are the most favorable opinion, and represent that
Qualified Opinions Qualified opinions state that the financial statements are fairly represented
Adverse Opinions An adverse opinion is one that says the statements do not represent the
Disclaimer of Opinion Disclaimer of opinions express that the auditor cannot draw a
conclusion as to the accuracy.
Accountants Liability to Their Clients
Accountants may be found liable under common law theories like breach of contract, fraud, and
negligence.
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Accountants’ Duties and Liability
Liability to Clients: Breach of Contract Terms of engagement are specified when an
Liability to Clients: Fraud The client is allowed recovery if the accountant is liable for either
actual or constructive fraud. Actual fraud is an intentional misrepresentation or omission of a
Liability to Clients: Accounting Malpractice (Negligence) Accountants owe a duty to use the
reasonable care, knowledge, skill, and judgment expected from the profession. Failure to perform
evidence of negligence.
Accountants Liability to Third Parties
Liability to Third Parties: Ultramares Doctrine In Ultramares Corp v. Touche, et. al., based
Case 51.1 Ultramares Doctrine: Credit Alliance Corporation v. Arthur Andersen & Company
65 N.Y.2d 536, 493 N.Y.S.2d 435, 1985 N.Y. Lexis 15157, Court of Appeals of New York
Facts: Arthur Andersen & Co., CPAs, prepared audited financial statements of L.B. Smith, Inc.,
for the years 1977 to 1979. An unqualified opinion was given for all years. These financial
negligence?
Decision: No. The court reaffirms Ultramares. For an accountant to be liable in negligence to
noncontracting parties, the following must occur: 1) the accountant must have been aware that the
financial statements were to be used for a particular purpose; 2) in furtherance of that purpose a
Andersen is not liable to them.
Ethics Questions: Ultramares held that an accountant could not be held liable for negligence
unless the plaintiff was in either in privity of contract or a privity-like relationship with the
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Liability to Third Parties: Foreseeability Standard Some states have broadened the
Ultramares Rule to apply to any foreseeable third parties that may see the statements. The
ultimately, the company failed. Cast sued KPMG for its negligence in auditing Papel.
Issue: Is KPMG liable to third parties for accounting malpractice?
Decision: KPMG was not liable. The court contended that KPMG could not have known at the
time of its audit that its audit work would be depended upon during the course of a future merger.
Liability to Third Parties: Fraud A third party that relies on an accountant’s actual or
constructive fraudulent activities and is injured, may bring an action in torts.
Liability to Third Parties: Breach of Contract Third parties are usually excluded from
Securities Law Violations
Section 11(a) of the Securities Act of 1933 Civil liability is imposed upon accountants who
fraudulently or negligently issue financial statements that are included with registration
preparation and certification.
Section 10(b) of the Securities Exchange Act of 1934 This prohibits any manipulative or
deceptive practice in connection with the sale or purchase of any security. The Supreme Court has
ruled that only intentional and reckless behavior can be considered under these sections.
purchased or sold.
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Accountants’ Duties and Liability
Criminal Liability of Accountants
Criminal Liability: Section 24 of the Securities Act of 1933 It is a criminal offense for any
person to make untrue statements or omit any material fact in SEC filings or to willfully violate
Criminal Liability: Section 32(a) of the Securities Exchange Act of 1934 This makes it a
criminal offense to willfully and knowingly make or cause to be made false or misleading
statements in any SEC filings. Fines may reach up to $1 million for an individual, with
Criminal Liability: Tax Preparation The 1976 Tax Reform Act imposes a fine of up to
Criminal Liability: State Securities Laws Most states have enacted the Uniform Securities
Act, patterned after federal laws and establishing criminal liabilities.
Ethics: Accountants’ Duty to Report a Client’s Illegal Activity
committed material violations of law.
Sarbanes-Oxley Act
SOX establishes a Public Company Accounting Oversight board and requires that public
Public Company Accounting Oversight Board (PCAOB) The act creates the PCAOB, which
has the authority to adopt rules concerning auditing, accounting quality control, independence,
and ethics of public companies and public accountants.
activities, and assessing civil money penalties.
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the board determines.
Audit Report Sign-Off The act requires that a second partner of the accounting firm review
and approve audit reports prepared by the firm.
one year following the audit.
Audit Committee The committee must be composed of outside board members who are not
employed by the corporation and do not receive compensation other than for directors’ duties
Accountants’ Privilege and Work Papers
Accountant-Client Privilege About 20 states have enacted statutes creating an accountant-
client privilege.
V. Key Terms and Concepts
AccountantThe term accountant applies to persons who perform a variety of services,
including bookkeepers, tax preparers, and so on.
other accounting services to the client.
Accountant’s work papers—These papers often include plans for conducting audits, work
assignments, notes regarding the collection of data, evidence about the testing of accounts,
notes concerning the client’s internal controls, notes reconciling the accountant’s report and
the client’s records, research, comments, memorandums, explanations, opinions, information
flows in conformity with GAAPs.
American Institute of Certified Public AccountantsThe GAASs are set by the American
Institute of Certified Public Accountants (AICPA).
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in cash flows.
Constructive fraud—Constructive fraud occurs when an accountant acts with “reckless
disregard” for the truth or the consequences of his or her actions.
Disclaimer of opinionAn auditor’s opinion that expresses the auditor’s inability to draw a
conclusion about the accuracy of the company’s financial records.
under Section 11(a).
EngagementA formal entrance into a contract between a client and an accountant.
Expertised portionAccountants are considered experts, and the financial statements they
prepare are considered an expertised portion of the registration statement.
Foreseeability standardA rule that an accountant is liable for negligence to third parties
disregard of the law occurs.
Generally accepted accounting principles (GAAPs)Standards for the preparation and
presentation of financial statements.
Generally accepted auditing standards (GAASs)Standards for the methods and procedures
that must be used to conduct audits.
International Accounting Standards Board (IASB).
International Financial Reporting StandardsMost companies in other counties abide by
Joint and several liabilityOne party of several at-fault parties could be made to pay all of a
judgment.
partners.
Private Securities Litigation Reform Act of 1995The Private Securities Litigation Reform
Act of 1995, a federal statute, changed the liability of accountants and other securities
professionals.
Privity of contractThe state of two specified parties being in a contract.
accountant.
Proportionate liability—A rule that limits a defendant’s liability to his or her proportionate
degree of fault.
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accountant.
Public Company Accounting Oversight BoardThe board has the authority to adopt rules
Qualified opinion—An auditor’s opinion that states that the financial statements are fairly
Racketeer Influenced and Corrupt Organizations Act (RICO)An act that provides for both
Registration statementThe Securities Act of 1933 requires that before a corporation or
another business sells securities to the public, the issuer must file a registration statement with
the Securities and Exchange Commission (SEC).
accountants.
Section 10A of the Securities Exchange Act of 1934Section 10A imposes duties on
auditors to detect and report illegal acts committed by their clients.
Section 10(b) of the Securities Exchange Act of 1934A section of the Securities Exchange
Act of 1934 that prohibits any manipulative or deceptive practice in connection with the
purchase or sale of any security.
omissions.
Section 18(a) of the Securities Exchange Act of 1934A section of the Securities Exchange
Act of 1934 that imposes civil liability on any person who makes false or misleading
statements in any application, report, or document filed with the SEC.
Section 24 of the Securities Act of 1933A section of the Securities Act of 1933 that makes
thereunder.
Section 32(a) of the Securities Exchange Act of 1934A section of the Securities Exchange
Act of 1934 that makes it a criminal offense for any person to willfully and knowingly make
or cause to be made any false or misleading statement in any application, report, or other
document required to be filed with the SEC pursuant to the Securities Exchange Act of 1934
or any rule or regulation adopted thereunder.
other reports.
Section 552 of the Restatement (Second) of TortsA rule that an accountant is liable only
for negligence to third parties who are members of a limited class of intended users of the
client’s financial statements. Provides a broader standard for holding accountants liable to
third parties for negligence than the Ultramares doctrine.
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return.
Uniform Securities ActA model act promulgated by the National Conference of
Ultramares Corporation v. ToucheThe landmark case that initially defined the liability of
accountants to third parties.
statements.
Unqualified opinion—An auditor’s opinion that the company’s financial statements fairly
represent the company’s financial position, the results of its operations, and the change in
cash flows for the period under audit, in conformity with generally accepted accounting
principles (GAAPs).

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