978-0134004006 Chapter 51 Lecture Note

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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

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.

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.

Accountant’s 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.

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

 Accountant—The 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 Accountants—The GAASs are set by the American

Institute of Certified Public Accountants (AICPA).

Accountants’ Duties and Liability

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 opinion—An 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).

 Engagement—A formal entrance into a contract between a client and an accountant.

 Expertised portion—Accountants are considered experts, and the financial statements they

prepare are considered an expertised portion of the registration statement.

 Foreseeability standard—A 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 Standards—Most companies in other counties abide by

 Joint and several liability—One party of several at-fault parties could be made to pay all of a

judgment.

partners.

 Private Securities Litigation Reform Act of 1995—The Private Securities Litigation Reform

Act of 1995, a federal statute, changed the liability of accountants and other securities

professionals.

 Privity of contract—The 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 Board—The 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 statement—The 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 1934—Section 10A imposes duties on

auditors to detect and report illegal acts committed by their clients.

 Section 10(b) of the Securities Exchange Act of 1934—A 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 1934—A 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 1933—A section of the Securities Act of 1933 that makes

thereunder.

 Section 32(a) of the Securities Exchange Act of 1934—A 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 Torts—A 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.

Accountants’ Duties and Liability

return.

 Uniform Securities Act—A model act promulgated by the National Conference of

 Ultramares Corporation v. Touche—The 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).