978-1285860381 Chapter 27 Solution Manual Part 1

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Suggested Additional Assignments

Interview

Ask students to interview a certified public accountant who audits companies (as opposed to one who

specializes in taxation). Students should ask the following:

Is the accountant concerned about increased liability?

Has she made any changes in the way she practices her profession as a result of concerns

about liability?

What kind of liability insurance does she have?

Has she ever had an issue over the accountant-client privilege?

Research: GAAP & GAAS

Ask students to research and prepare a one-page report summarizing some recent changes or updates to

generally accepted accounting principles (GAAP) or generally accepted auditing standards (GAAS)

issued by the Financial Accounting Standards Board (FASB). They may want to start their research at the

FASB website: http://www.fasb.org.

Research: U.S. Accounting Standards v. International Accounting

Standards

Ask students to research the differences between U.S. accounting standards and International accounting

standards. Have students include in the research the recent proposal by the Securities and Exchange

Commission (SEC) to shift from US standards to international standards for many large multinational

companies.

Research: Sarbanes-Oxley

Have students research the passage and implementation of the Sarbanes-Oxley Act of 2002 and address

the following questions in a brief report:

What problems does the act address?

What must businesses and accounting firms do to comply with its requirements?

What are the costs of complying with Sarbanes-Oxley?

Can they find studies or commentary on whether Sarbanes-Oxley has been effective in

achieving its goals?

Chapter Overview

Chapter Theme

Accountants serve many masters and, therefore, face numerous potential conflicts. After the Arthur

Andersen disaster, accountants, regulators and the public have begun to re-think the role of the accounting

profession. Shareholders expected accountants to be more careful watchdogs than, in many cases, they

were. How will accountants handle the inherent conflict of interest between shareholders and the

managers who pay the bills?

Quote of the Day

“You can’t blame money for what it does to people. The evil is in the people, and money is the peg they

hang it on. They go wild for money when they’ve lost their other values.” –Ross MacDonald

(1915-1983), American novelist, in The Moving Target.

Introduction

Audits

To verify transactions, accountants use two mirror image processes—vouching and tracing. In vouching,

they choose a transaction listed in the company’s books and check backwards to make sure that there are

original data to support it. In tracing, the accountant begins with an item of original data and traces it

forward to ensure that it has been properly recorded throughout the bookkeeping process.

GAAP is the acronym for generally accepted accounting principles, the rules for preparing financial

statements. GAAS is the acronym for generally accepted auditing standards, the rules for conducting

audits. The SEC has proposed a set of rules that would ultimately require U.S. companies to use

international financial reporting standards (IFRS) instead of GAAP. Students who completed the

GAAP assignment should present their results.

Question: What is the advantage of using GAAP?

Answer: If everyone follows the same careful rules, investors have a better understanding of what

Question: Is GAAP enough to protect investors?

General Question: Is there a solution to this problem?

General Question: Would such a system work?

Opinions

An auditor can issue one of four opinions to accompany audited financial statements:

Unqualified Opinion: Also known as a clean opinion, it indicates that company’s

financial statements fairly present its financial opinion in accordance with GAAP.

Qualified Opinion: This indicates that although the financial statements are generally

accurate, there is an outstanding, unresolved issue. The issue may involve a violation of GAAP

or something else whose resolution is uncertain.

Adverse Opinion: This states that, in the auditor’s view, the company’s financial

statements do not accurately reflect its financial position.

Disclaimer of Opinion: An auditor issues this when it does not have enough information

to form an opinion.

Example: What Does “Material” Mean?

W. R. Grace had an unusual problem–earnings in one of its units were too high. Grace executives knew

that if they reported these numbers accurately, their bosses would set targets for the following year even

higher. They feared they could not even match the current numbers, never mind an increase the next year.

Their solution? They “parked” the excess earnings in a reserve account, intending to withdraw them

when needed. Their accountant at PricewaterhouseCoopers LLP discovered the ploy but still issued a

clean opinion, stating that the financials were “accurate in all material respects.”

PricewaterhouseCoopers issued this opinion because the fake reserves were not material as part of the

larger company; if this unit of Grace were stand-alone, the reserves would have been material. A

PricewaterhouseCoopers spokesperson said that a clean opinion “doesn’t mean that the financial

statements are free from error or that the auditor agrees with everything.”1

Question: What does “material” mean?

Question: What else could PricewaterhouseCoopers have done?

Answer: It could have reported this issue to Grace’s audit committee, although one of the in-house

1Ann Davis, “SEC Case Claims Profit ‘Management’ by Grace,” Wall Street Journal, April 7, 1999, p. C1.

Question: What is the problem with this kind of manipulation?

General Question: Should PricewaterhouseCoopers have refused to issue a clean opinion?

Congress Responds to Enron: Sarbanes-Oxley

The Public Company Accounting Oversight Board (PCAOB)

The PCAOB was established by Sarbanes-Oxley to ensure that investors receive accurate and complete

financial information. It has the authority to regulate public accounting firms and enforce its rules

through its power to revoke an accounting firm’s registration or prohibit it from auditing public

companies.

Sarbanes-Oxley contains other provisions that affect auditors:

Reports to Audit Committee: Auditors must report to the audit committee of the

client’s board of directors, not to senior management

Limits on Consulting: Accounting firms that audit public companies are prohibited

from providing consulting services to those clients on certain topics. Other consulting

agreements must be approved by a client’s audit committee.

Conflicts of Interest: An accounting firm cannot audit a company if one of the client’s

top officers worked for the accounting firm within the prior year and was involved in the

company’s audit.

Term Limits: After five years, the lead audit partner must rotate off a client’s account

for at least five years.

Consolidation: A GAO study required by Sarbanes-Oxley warned against further

consolidation in the accounting industry.

If students did the research project on Sarbanes-Oxley, this would be an appropriate time for them to

report their results.

Liability to Clients

Contract

Contracts between accountants and their clients are either written or oral. A written contract is often called

an engagement letter.

Negligence

An accountant is liable for negligence to a client who can prove that:

The accountant breached his duty to the client by failing to exercise the degree of skill and

competence that an ordinarily prudent accountant would under the circumstances, and

The accountant’s violation of duty caused harm to the client.

Case: Oregon Steel Mills, Inc. v. Coopers & Lybrand, LLP2

Facts: Oregon Steel Mills, Inc. was a publicly-traded company whose financial statements were audited

by Coopers & Lybrand, LLP for many years. When Oregon sold the stock in one of its subsidiaries,

Coopers advised Oregon—incorrectly and negligently, as it turned out—that the transaction should be

reported as a $ 12.3 million gain.

Two years later, Oregon began a public offering of additional shares of stock for a May 2 sale.

Shortly before Oregon filed the stock offering with the SEC, it found out from Coopers that the sale of its

subsidiary had been misreported and that it would have to revise its financial statements. As a result, the

2 336 Ore. 329; 83 P.3d 322; 2004 Ore. LEXIS 55 Supreme Court of Oregon, 2004

offering was delayed from May 2 to June 13. During this period of delay, the price of the stock fell from

$16 to $13.50.

Oregon sued Coopers for $35 million, the difference between what Oregon actually received for its

stock and what it would have received if the offering had occurred on May 2. The trial court granted

Coopers motion for summary judgment but the court of appeals reversed. Coopers appealed.

Issue: Did Coopers’ negligence cause the loss to Oregon?

Holding: Judgment for Coopers affirmed. The court concluded that the risk of a decline in Oregon’s

stock price in June was not a reasonably foreseeable consequence of Coopers’ negligent acts. It is of

course foreseeable that stock prices will fluctuate, and that an accounting firm’s negligence may harm a

client by delaying its ability to raise capital, but Coopers did not cause the decline in Oregon’s stock price.

Coopers knew that Oregon intended to enter the market and sell its securities, but at the time of Coopers’

wrongful conduct the schedule for that offering was known only in the most general sense. Also, there is

no evidence in the record that Oregon expected market forces to be particularly favorable on May 2.

Question: Was Coopers negligent in advising Oregon on the gain from the sale of its subsidiary?

Question: Did this negligence cause a delay in Oregon’s public offering?

Question: Did Oregon receive less money in the public offering because of the delay?

Question: Is Coopers liable for this harm that resulted from its negligence?

Question: What did cause Oregon’s harm?

Question: What caused this decline?

Question: I’m still confused. Could you give another example?

Answer: If a professor lets class out late and one of the students is then hit by a falling brick as she

Common Law Fraud

An accountant is liable for fraud if (1) she makes a false statement of a material fact, (2) she either knows

it is not true or recklessly disregards the truth, (3) the client justifiably relies on the statement and (4) the

reliance resulted in damages.

For example, William deliberately inflated numbers in the financial statements he prepared for Tess so

that she would not discover that he had made some disastrous investments for her. Because of these

distortions, Tess did not realize her true financial position for some years. William committed fraud.

A fraud claim is an important weapon because it permits the client to ask for punitive damages. In

negligence or contract cases, a client is typically entitled only to compensatory damages. Punitive

damages can be several times higher than a compensatory claim.

Breach of Trust

Accountants occupy a position of enormous trust because financial information is often sensitive and

confidential. Clients may put as much trust in their accountants as they do in their lawyers, clergy, or

psychiatrists. Accountants have a legal obligation to (1) keep all client information confidential and (2)

use client information only for the benefit of the client.

Alexander Grant & Co. did accounting work for Consolidata Services, Inc. (CDS), a company that

provided payroll services. The two firms had a number of clients in common. When Alexander Grant

discovered discrepancies in CDS’s client funds accounts, it notified those companies that were clients of

both firms. Not surprisingly, these mutual clients fired CDS, which then went out of business. The court

held that Alexander Grant had violated its duty of trust to CDS.

Fiduciary Duty

In a fiduciary relationship, one party has an obligation (1) to act in a trustworthy fashion for the benefit of

the other person and (2) to put that person’s interests first. As a general rule, accountants do not have a

fiduciary duty to their clients. However, clients often do put great faith in their accountants and,

sometimes accountants take on responsibilities that extend beyond the typical scope of an

accountant-client relationship. As the following case illustrates, in such situations, accountants may be

deemed a fiduciary and held to a high standard of accountability.

Case: Leber v. Konigsberg3

Facts: Steven Leber (Leber) was the trustee of the Steven E. Leber Charitable Remainder Unitrust

(“Trust”) which, at its peak, had assets of $4 million. The Defendant, Paul Konigsberg (Konigsberg), was

a certified public accountant and the named partner of Konigsberg Wolf & Co., P.C. (the firm).

Leber invested all of the Trust’s assets with Bernard Madoff (“Madoff”) who, it turns out, was running a

$65 billion Ponzi scheme.4 Ultimately, Madoff’s sons revealed the fraud and investors around the world

learned that all of their investments were gone. [A trustee has been appointed to recover assets, but that

process will be long and the results uncertain.]

Leber alleges that he made this disastrous investment on the advice of Konisberg, who not only

recommended Madoff, but promised that he would personally supervise, monitor and provide due

diligence for the Trust’s account with Madoff.

Leber filed suit against Konigsberg and the firm, on the grounds that they breached their fiduciary duty to

him and the Trust. He sought payment of $4 million. Defendants filed a motion for summary judgment

alleging that accountants do not owe their clients a fiduciary duty.

Issue: Do accountants owe a fiduciary duty to their clients?

Excerpts from Judge Marra’s Decision: Defendants assert that under New York law, accountants do not

owe fiduciary duties to their clients. Defendants’ contention is generally true (“general rule”).

A fiduciary relationship arises when one has reposed trust or confidence in the integrity or fidelity of

another who thereby gains a resulting superiority of influence over the first, or when one assumes control

and responsibility over another.

Leber avers [that] Konigsberg talked about how he and his firm provided financial advisory services and

helped place clients in certain investments. Konigsberg advised that he thought that as a result of his role

as a financial advisor to the [Trust] that it was expected that the [Trust] would retain Konigsberg Wolf as

its tax accountants as well. Konigsberg indicated that [Leber] must hire Konigsberg Wolf in order to get

the proper analysis of the Madoff account of the [Trust] and that if this was done [their] relationship could

3 2010 U.S. Dist. LEXIS 128910,United States District Court For The Southern District Of Florida, 2010

4 In a Ponzi scheme, the fraudster uses money from prior investors to pay out large returns to new

victims. The scheme can be very profitable for all involved until the fraudster runs out of new “investors”.

Indeed, investors often attract new victims for the fraudster by bragging about their incredible returns

(which are, indeed, incredible). For years, Madoff had been well-known in the investment community as

someone who earned implausibly steady returns, no matter what market conditions were.

continue. It was clear that if [Leber] didn’t hire Konigsberg Wolf, that Konigsberg would no longer be the

[Trust’s] financial advisor and that the [Trust’s] account at Madoff would be jeopardized. [Konigsberg’s

bills indicated] that he was charging not only for “tax analysis” but also for analysis of the monthly

reports of Madoff for the [Trust].

Under circumstances such as those listed above, a breach of fiduciary duty claim against an accountant

pursuant to New York law may proceed. [An accountant] may be found to have assumed additional duties

of care when acting as a financial advisor. [In a prior case,] the plaintiff sufficiently stated a cause of

action for breach of fiduciary duty where it was alleged that plaintiff had placed total trust and reliance

upon an accountant’s investment advice, and that the accountant concealed pertinent information about

those investments, such as the nature of the risk involved.

As a result, summary judgment on Leber’s claims against Defendants for breach of fiduciary duty cannot

be granted.

Question: What actions by the accountant did the court say created a breach of fiduciary duty?

Liability to Third Parties

When conducting an audit, accountants serve three masters: the company’s officers, its board of directors,

and its investors.

Question: Who hires the accounting firm and pays its bill?

Question: What incentive does that create for the auditors?

Question: Who, besides company officers, is concerned about the company’s financial health?

Answer: The board of directors, investors, creditors, and suppliers. Investors, creditors, and

Question: What duty do the auditors owe to the board of directors?

Answer: The board of directors, more than company officers, is really their client. Indeed, under

Furthermore, under the Private Securities Litigation Reform Act, which Congress passed in 1995,

Must ensure that the client’s board of directors is notified.

Question: What about the auditors’ liability to third parties such as investors and suppliers?

Ultramares Doctrine, Foreseeable Doctrine, and Restatement Doctrine

Under the Ultramares doctrine, accountants who fail to exercise due care are liable to a third party only if

they know the identity of the third party who:

will see their work product, and

will rely on the work product for a particular, known purpose.

Under the foreseeable doctrine, accountants who fail to exercise due care are liable to a third party if:

it was foreseeable that the third party would receive financial statements from the

accountant’s client, and

the third party relied on these statements.

Under the Restatement doctrine, accountants who fail to exercise due care are liable to:

a third party they knew would rely on the information, or

any third party in the same class as someone who the accountant knew would rely on the

information.

You Be the Judge: – Ellis v. Grant Thornton5

Facts: The First National Bank of Keystone could do nothing right, For five years, it issued risky

mortgage loans on which borrowers defaulted. Keystone Management lied about the value of the loans.

When the Office of the Comptroller of the Currency (OCC) began to smell trouble, it required Keystone

to hire a nationally recognized independent accounting form to audit its books. Keystone hired Grant

Thornton. Stan Quay was the lead partner on the account. Quay was negligent in conducting the audit

and failed to notice a discrepancy of $515 million between reported and actual value of the loans.

As Quay was finishing up his audit, the board began talking with Gary Ellis about becoming president

of the bank. Ellis was already employed, and was reluctant to move to a bank that the OCC was

investigating. To reassure him, the Keystone board suggested he talk with Quay and look at the bank’s

financials. Quay told Ellis that Keystone would receive a clean, unqualified opinion. Ellis attended a

shareholder meeting at which Quay announced that his opinion would be unqualified. He did ultimately

issue a clean opinion reporting shareholder’s equity of $184 million, when in fact the bank was insolvent.

The first page of the report stated: “This report is intended for the information and use of the Board of

Directors and Management of the First National Bank of Keystone and its regulatory agencies and should

not be used by third parties for any other purpose.” A week later, the Board voted to hire Ellis, who quit

his job to come on board. Five months later, the OCC declared Keystone insolvent and shut it down.

Ellis filed suit against GT, seeking compensation for his lost wages. The district court ruled in favor of

Ellis and granted him $2.5 million in damages. GT appealed.

You Be the Judge: Was Grant Thornton liable to Ellis for its negligence in preparing keystone’s financial

statements?

Arguments for Ellis: Stan Quay was negligent in preparing Keystone’s financial statements. He

reassured Ellis that the statements were accurate. Ellis reasonably relied on both Quay’s written financial

statements and oral assurances. As a result, Ellis suffered grave harm. It is only reasonable to hold GT

liable to Ellis for a harm that was completely foreseeable.

Arguments for Grant Thornton: Under the Restatement doctrine, accountants who fail to exercise due

care are liable to (1) anyone they knew would rely on the information and (2) anyone else in the same

class. Keystone’s financial statements very clearly stated that they were designed for the benefit of

Keystone’s board of directors and regulatory agencies. Ellis is in neither class. Therefore, he cannot

recover from GT for any harm he may have suffered.

Moreover, Keystone did not pay GT to discuss the financial statements with existing or potential

employees. Indeed, GT was unaware that Ellis might be hired until after it had reached a decision to give

a clean opinion. It is unreasonable to hold GT liable for a risk of which it was unaware.

Holding: In favor of GT. The judgment of the district court was reversed.

Question: How is an accountant’s liability to third parties determined under the Restatement doctrine?

5 2008 U.S. App. LEXIS 13379, United States Court of Appeals for the Fourth Circuit.

Question: How is an accountant’s liability to third parties determined under the Ultramares doctrine?

Answer: Accountants who fail to exercise due care are liable to a third party only if they know that the

Question: How is an accountant’s liability to third parties determined under the Forseeable doctrine?

Answer: An accountant who fails to exercise due care is liable to a third party if (1) it was forseeable that

–

Securities Act of 1933

Under §11 of the 1933 Act, auditors are liable for any material misstatement or omission in the financial

statements that they prepare for a registration statement.

Holding: The court held for EY. It held that Amorosa suffered no loss that could be connected to the

flawed financial statements because the stock price went up after the WP article. As the second

Discussion Question at the end of the chapter notes, it seems that the court is imposing a causality

requirement. The author discussed this issue with an SEC staff lawyer who said that the courts are

straining to rein in potential liability against peripheral players, such as auditors. This case is on the

forefront of that trend.

Securities Exchange Act of 1934

A company that is subject to the 1934 Act must file with the SEC an annual report containing audited

financial statements and quarterly reports with unaudited financials.

Liability for Inaccurate Disclosure in a Required Filing

Under §18 of the 1934 Act, an auditor who makes a false or misleading statement in a required

filing is liable to any buyer or seller of the stock who has acted in reliance on the statement. The

auditors can avoid liability by showing that they acted in good faith and did not know the information was

misleading.