Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
Chapter 46
ACCOUNTANTS’ LIABILITY AND MALPRACTICE
RESTATEMENT
Malpractice is the name given to work by a professional that falls below the level of skill and care common for that
profession. When malpractice occurs, the professional’s or accountant’s client has the choice of remedies in the form
of action for tort (negligence) or an action for breach of contract. Third parties using or affected by the accountant’s
work may also have a tort action. Accountants today play an integral role in business transactions because their
audit work is used in decisions to extend loans to a company or invest in it through the purchase of shares. In some
circumstances accountants may limit their liability for financial statements, but they would not be permitted to
exculpate themselves from any harm caused by them.
The parties entitled to collect damages from accountants for malpractice include those in privity of contract and those
who rely (forseeably) on the accountant’s financial statements. There are conflicting rules among courts and states
on accountants’ liability to third parties. The rules followed by the courts to determine liability include: the privity rule
(largely eliminated as a requirement for recovery), the contact rule, the known-user rule, the foreseeable user rule
and the flexible rule. There is ongoing judicial activity on the scope and extent of accountants’ liability to third parties
for the work on financial statements.
Liability of accountants to third parties for their work in relation to matters related to securities governed by federal law
is clearly established by statute. Accountants can have liability to purchasers of shares if the financial statements
furnished for the share offering were materially false or incorrect. Following the collapse of several large corporations
that had inaccurate financial statements, Congress passed the Sarbanes-Oxley Act that imposes new responsibilities
on auditors and audit committees. Criminal penalties are increased and auditors must work diligently to uncover poor
internal controls and then report them to the audit committee.
STUDENT LEARNING OUTCOMES
LO.1: Define "malpractice".
LO.2: Distinguish malpractice liability from breach of contract liability.
LO.3: List which third parties may recover for the malpractice liability of accountants and when they may do so.
LO.4: Discuss the difference between accounting malpractice and fraud.
LO.5: Explain how Sarbanes-Oxley and Dodd-Frank have affected the accounting profession and accountants'
liability.
INSTRUCTOR’S INSIGHTS
Break the chapter down into three components – related Learning Outcomes are indicated in ( ):
1. What are the general principles of law in accountants’ malpractice and liability?
Describe what constitutes accountant malpractice (LO.1)
Explain the remedies available for accountant malpractice
2. What is the accountants’ liability to third parties given privity issues?
Describe the status of an accountant
Explain the various theories on accountants’ liability to third parties (LO.3)
3. What are accountants' liabilities and duties under Sarbanes-Oxley?
a. Explain the new responsibilities of auditors (LO.5)
CHAPTER OUTLINE
I. What are the General Principles of Law in Accountants’ Malpractice and Liability?
A. What constitutes malpractice
1. There is a duty of professionals to exercise such skill and care as is common within the community or
by persons performing similar services
CASE BRIEF: Dale K. Barker Co., P.C. v. Valley Plaza
541 Fed. Appx. 810 (10th Cir. 2013)
FACTS: We can't say exactly when the trouble started for Larry and Patricia Sumrall, but it had to be by the
time they hired Dale K. Barker, Jr. and his accounting firm. The Sumralls needed professional help
with past-due tax returns and other amounts they owed the IRS, and they turned to Mr. Barker. At
the end of the day, though, the Sumralls found themselves having to pay the IRS over $222,000 in
taxes, penalties, and interest.
Mr. Barker then filed suit against the Sumralls for failure to pay their bills in full. By this time,
however, the Sumralls were convinced that Mr. Barker had contributed to their problems with the
IRS. So they replied with counterclaims of their own − for breach of contract, negligence, and
breach of fiduciary duty, among other things.
After a bench trial, the district court concluded that Mr. Barker's services had been deficient and
cost the Sumralls dearly. The court held that Mr. Barker's bills were unjustified; that he was entitled
to no fees beyond those he'd already been paid; and that the Sumralls were entitled to
compensation from Mr. Barker for their counterclaims.
ISSUE: Were the Sumralls entitled to damages for deficiencies in Mr. Barker’s work? What are his
damages?
HOLDING: Yes, the Sumralls were entitled to damages because Mr. Barker could have and should have
REASONING: The district court awarded $70,296.91, and Mr. Barker says this award was speculative. In fact,
however, the Sumralls ultimately paid the IRS $222,001.27 in taxes, interest, and penalties. Relying
on the Sumralls' expert's testimony, the district court found that, but for Mr. Barker's misconduct, the
Sumralls could have settled the claim with the IRS for $151,704.36, meaning they needlessly
incurred $70,296.91.
The Sumralls' experts testified that Mr. Barker owed the Sumralls a duty to complete their civil
matter “promptly after 1996,” and that a resolution at that time “should have been vigorously
pursued ... and [the matter] settled fairly quickly.” The Sumralls' experts also provided at least two
estimates they believed were reasonable “starting point[s]” for use as a “frame of reference” in
calculating the cost to the Sumralls of not settling earlier. Although Mr. Barker disputes the best
method of estimating damages, there is no question that evidence exists in the record to support
the positions the district court took. It is settled, too, that a “precise” amount of damages need not
be proven; a district court may estimate damages “based upon approximations, ... reasonable
assumptions[,] or projections.”
The court also held that the Sumralls were entitled to their attorneys’ fees for bringing the
counterclaims against Mr. Barker in his suit for payment.
The judgment is affirmed.
DISCUSSION POINTS: Ethics & The Law
The Feeder Fund and the Auditor
The court held that they had a duty to ask and a duty to follow up if there was just a refusal to provide documentation,
as Madoff often did. Below is an excerpt from the court’s opinion in the case.
Accounting malpractice contemplates a failure to exercise due care and proof of a material deviation from
the recognized and accepted professional standards for accountants and auditors, generally measured by
generally accepted accounting principles and auditing standards promulgated by the American Institute of
Certified Public Accountants, which proximately causes damage to plaintiff (Cumis Ins. Soc. v. Tooke, 293
A.D. 2d 794, 797-98, 739 N.Y. S. 2d 489 [3d Dept. 2002]).
Section 330 of the American Institute's Professional Standards deals with the Confirmation Process (Deft's
ex Y). In general “confirmation” is the process of obtaining and evaluating a direct communication from a
third party in response to a request for information about a particular item affecting financial statement
assertions (Sec. 330.04). The auditor is responsible for selecting the items for which confirmations are to be
requested and designing the confirmation request (Id). Confirmation is undertaken to obtain evidence from
third parties about financial statement assertions made by management (Sec. 330.06). It is presumed that
audit evidence is more reliable when it is obtained from knowledgeable independent sources outside the
entity being audited (Id.).
[2] It may be presumed that Madoff would not have responded truthfully, had defendant inquired of Madoff to
confirm the existence of specific securities transactions. However, the obligation to design the confirmation
may have required defendant to request sufficient documentation to substantiate the transaction. Had
defendant requested documentation on a large enough sample of transactions, it may have been more
difficult for Madoff to cover up its fraud. Moreover, a reasonably prudent audit may have required bypassing
Madoff and requesting supporting documentation from the market maker or the other party to the securities
transaction. In any event, defendant has not established prima that it was not negligent in failing to obtain
any confirmations of the existence of the securities which Madoff purportedly held, or the transactions which
it purportedly executed, on Andover's behalf. Nor has defendant established prima facie that Andover would
have lost its investment even if defendant had obtained such confirmations in the course of its audit process
(Electrical Contractors Health & Welfare Fund v. D'Arcangelo & Co., — A.D. 3d — 2015 N.Y. Slip Op 00113,
2015 N.Y. App. Div. LEXIS 184 [4th Dept 2015]).
Defendant's argument addressed to the sufficiency of plaintiff's claim based upon Andover's holding the
investment with Madoff is misplaced. The case cited by defendant concerns a fraud action against an issuer
of securities rather than an action for accounting malpractice (Starr Foundation v. AIG, 76 A.D. 3d 25, 901
N.Y. S. 2d 246 [1st Dept 2010]). Any other arguments not addressed herein are deemed to be without merit.
Accordingly, defendants' motion for summary judgment dismissing the complaint is denied.
Professional responsibility requires that auditors ask and follow up if there are suspicions.
The fact that the audit firm missed some red flags does not result in scienter, or the standard needed to hold an audit
firm liable for the actions of another in losing an investor’s money. GAAS violations are not enough to hold the auditor
liable to third parties for losses resulting from another company’s actions.
And only in a select few cases have courts in this Circuit found that, “because the red flags would be clearly evident
to any auditor performing its duties, one could reasonably conclude that [the auditor] must have noticed the red flags,
but deliberately chose to disregard them....” In re Philip Serv. Corp. Sec. Litig., 383 F. Supp. 2d 463, 475 (S.D.
N.Y.2004) (quotation marks omitted). See also In re Complete Mgmt. Inc. Sec. Litig., 153 F. Supp. 2d 314, 334 (S.D.
N.Y. 2001) (“Here, plaintiffs make the critical allegation that if Andersen were conducting any kind of audit at all, they
would have seen the potential problems with the [audited company's] receivables and the need to investigate
further.”); In re Oxford Health Plans, Inc. Sec. Litig., 51 F. Supp. 2d 290, 295 (S.D. N.Y. 1999) (denying motion to
dismiss where complaint alleged that, based on investigatory finding that a company's “computer accounting system
was unable to keep track of basic information”, state regulatory agency had mandated that “the leaders of the KPMG
auditing team be removed” and yet KPMG reaffirmed the accuracy of its audit).
Nor is it enough to “merely alleg[e] that the auditor had access to the information by which it could have discovered
the fraud....” In re Tremont, 703 F. Supp. 2d at 370; see also Rothman, 220 F. 3d at 98; In re IMAX, 587 F. Supp. 2d at
484. Thus, the Second Circuit has affirmed the dismissal of a complaint “replete with allegations that [a firm] ‘would’
have learned the truth as to those aspects of the [fraudulent] funds if [it] had performed the ‘due diligence’ it
promised” and that “[i]f [the firm] had asked various questions earlier, it would have further questioned the [fraudulent
fund's] financial records or recognized the need to ask further questions.” South Cherry Street, LLC v. Hennessee
Group LLC, 573 F. 3d 98, 112 (2d Cir. 2009). See also Massey–Ferguson Ltd., 681 F. 2d at 120 (“Plaintiff's allegation
that [an accounting firm] reviewed or recklessly failed to review data and documents relating in part to ... the
adequacy of [a company's] internal controls and accounting ... when properly parsed, contains no allegation of
actionable fraudulent conduct.”) (internal quotation marks omitted); In re Refco, 503 F. Supp. 2d at 663 (dismissing
claim where “plaintiffs have made no allegations whatsoever as to how the [defendants] unfettered access would
have led them across particular documents in which the red flags would have been apparent”). Judge Lynch's
formulation is as apt here as it was in the Court's prior order: even if “there was certainly a monster under the bed”,
for the Court “the question is whether anyone had a reason to look there.” Id. at 649.
A defendant has reason to look where it is aware of red flags, but flags are not red merely because the plaintiff calls
them red. See In re Marsh & Mclennan Cos., Inc. Sec. Litig., 501 F. Supp. 2d 452, 487 (S.D. N.Y. 2006) (“Merely
labeling allegations as red flags ... is insufficient to make those allegations relevant to a defendant's scienter.”)
Indeed, “plaintiffs must allege that facts which come to a defendant's attention would place a reasonable party in
defendant's position on notice of wrongdoing.” In re Refco, 503 F. Supp. 2d at 649 (quotation marks omitted). Where
plaintiffs have alleged that a defendant was aware of such facts, courts in this Circuit have allowed such actions to
proceed. See, e.g., In re Complete Mgmt., 153 F. Supp. 2d at 334-35; Varghese v. China Shenghuo Pharm. Holdings,
Inc., 672 F. Supp. 2d 596, 610 (S.D. N.Y. 2009) (“Plaintiffs do not merely allege that HB & M should have discovered
errors in [the audited company's] financial reporting, but that they were aware, based on [the audited company's]
filings, that there were ongoing serious problems with the [the audited company's] financial reporting.”); In re Winstar
Commc'ns, Nos. 01-CV-3014, 01-CV-11522, 2006 WL 473885 (S.D. N.Y. Feb. 27, 2006) (holding that allegations that
an audited company provided auditor “with all the paperwork associated with the claimed bogus transactions .... also
gives rise to a strong inference that [the auditor] acted recklessly in conducting the [company's] audit”).
In order to survive a motion to dismiss, the SAC must “allege facts that give rise to a strong inference of fraudulent
intent.” Acito, 47 F. 3d at 52. A strong inference would arise if the SAC alleges either that PWC had a motive and
opportunity to commit fraud or otherwise “alleg[es] facts that constitute strong circumstantial evidence of conscious
misbehavior or recklessness.” Shields, 25 F. 3d at 1128. Since the SAC does not identify any motive that the Court
has not already identified as insufficient in its prior order, see Stephenson I, 700 F. Supp. 2d at 620-21, the question
is whether the SAC “alleg[es] facts that constitute strong circumstantial evidence of conscious misbehavior or
recklessness.” Id.
The five GAAS violations alleged by the SAC are not such facts. It is well-established that “allegations of GAAP and
GAAS violations are not sufficient, on their own, to establish scienter.” In re AOL Time Warner, 381 F. Supp. 2d at
239; see also Anwar, 728 F. Supp. 2d at 450. Nor are the allegations that PWC ignored a lack of controls at
Greenwich Sentry and BMIS sufficient to establish scienter. See Doral Fin. Corp., 344 Fed. Appx. at 720. The SAC's
conclusory allegations that the failures were reckless do not make them so. Rather, “these allegations must be
coupled with evidence of ‘corresponding fraudulent intent.’” Doral Fin. Corp., 344 Fed. Appx. at 720 (quoting Novak,
216 F. 3d at 309). Indeed, Stephenson seems to concede as much. (See Pl.'s Opp'n at 2 (“[A]llegations of GAAS
violations, coupled with wil[l]ful or reckless ignorance of red flags of misconduct, supply the requisite inference of
‘fraudulent intent’ for pleading purposes.”); see also id. at 3.)
However, none of the seven red flags alleged in the SAC supplies the required “strong inference” of fraudulent intent.
Most of these red flags allege no more than that PWC had access to information by which it could have discovered
warning signs of fraud or that PWC would have discovered these warnings signs if it had conducted an audit in
accordance with GAAS and its own policies. Perhaps that is true, though even that suggestion seems questionable
since numerous other entities had access to the same information and none of them discovered Madoff's fraud before
he revealed it. But, in any event, the SAC does not allege facts from which the court could infer that PWC actually
knew about and ignored most of these warning signs. And the two red flags which PWC did seem to know do not
appear to have put PWC on notice of a fraud. Therefore, like at least four other courts who have considered similar
suits against auditors of BMIS feeder funds, see In re Beacon Assoc., 745 F. Supp. 2d at 416-17, 2010 WL 3895582,
Anwar, 728 F. Supp. 2d at 453; In re Tremont, 703 F. Supp. 2d at 371, CRT Inv., Ltd. v. Merkin, 29 Misc. 3d 1218(A)
2010 WL 4340433 (N.Y. Sup. Ct. N.Y. County May 5, 2010), the Court concludes that Stephenson has not pleaded
facts suggesting “an actual intent to aid in the fraud being perpetrated by” BMIS. Rothman, 220 F.3d at 98. The Court
now assesses each red flag in more detail.
However, there is ethical accountability for companies that did not follow through enough when returns should have
raised questions about the viability of the investment model. In addition, Mr. Stephenson probably should have
questioned the ROI himself.
4. Liable negligence in failure to detect fraud
B. Choice of remedy
C. The environment of accountants’ malpractice liability
D. Limitation of liability
1. Disclaimers for negligence; clear and unambiguous; conspicuous
II. What is the Accountants’ Liability to Third Parties Given Privity Issues?
A. Status of the accountant
1. Full-time employee
2. Independent contractor – regular client
B. The conflicting theories of accountants’ third party liability (See Figure 46-1 in text)
1. The privity rule – accountant not liable unless there is a contract
3. The known user rule – accountant liable to those he knows will be using the accountant’s work
CASE BRIEF: Dewar v. Smith
342 P. 3d 328 (Wash. App. 2015)
FACTS: Bradley Beddall, a real estate developer, and Douglas Dewar began a condominium conversion
project for the Lea Hill Condominiums. When the local real estate market declined and the project
floundered, Beddall owed Dewar $3,900,000 and could no longer meet his obligations. Beddall told
Dewar that he wanted out of the project.
Beddall signed a quit claim deed conveying the Lea Hill property to Dewar. Dewar and Beddall
signed a settlement agreement, part of which was that Beddall could obtain a large tax refund
based upon his losses from the project and would turn that refund over to Dewar. The agreement
gave Dewar the right of “review, evaluation, and approval” of the tax return in his “sole and absolute
discretion.” Beddall signed an “irrevocable” power of attorney and appropriate IRS Form 2848
authorizing his attorney, Jonathan Hatch, to sign the tax return, receive and negotiate the refund
check, and deliver the funds to Dewar.
Kenneth Smith, a CPA, had an engagement letter with Beddall that did not mention Dewar. But
Smith knew the content of the settlement agreement and its purpose. During his preparation of
Beddall's tax return, Smith had a copy of the agreement. Consistent with the Hatch–Beddall power
of attorney and IRS forms, Smith prepared the return for Hatch's signature.
Hatch signed the completed tax return, which had Beddall's address on it. As the settlement
agreement required, Smith transmitted the return to Dewar for his review. The same day, Dewar
notified Smith that, “The only change I insist on is the address change.” After Smith changed the
address, Hatch signed the amended return, which Smith filed the same day.
Shortly after Smith filed the return, Beddall instructed him to stop discussing the matter with Hatch
and to communicate about the return only with Beddall. During a call with the IRS and Smith,
Beddall asked the IRS representative to change the address on his tax return from Hatch's address
to Smith's address.
Smith did not tell Dewar or Hatch that Beddall had amended the address on the return.
The IRS sent four refund checks totaling $1,206,703.32 to Smith's office. Smith notified Beddall,
who instructed him to deliver the checks to Beddall's son-in-law, Ron Rubin. Smith did so.
Beddall sent an e-mail to Dewar and Hatch to tell them that the tax refund money was in Thailand.
When Beddall forwarded this e-mail to Smith, Smith withdrew from his engagement with Beddall.
Dewar sued Kenneth Smith for conversion, civil conspiracy, tortious interference with contractual
relationship, breach of implied contract, breach of duty owed to third-party beneficiary, and breach
of fiduciary duties.
The trial court granted Dewar's motion for partial summary judgment to establish that Smith owed
Dewar a duty of care. The court also held that Smith committed negligent misrepresentation when
the address on the tax return was changed, he received the checks, and he gave them to Rubin
without disclosing these actions to Dewar and Hatch. Smith appealed.
ISSUES: Did Smith owe Dewar a duty of care? Is Smith liable to Dewar for the loss of the refund monies?
HOLDING AND
REASONING: Once Beddall revoked his consent, federal law prohibited Smith from disclosing confidential tax
information, including addresses. This federal prohibition preempts any state law tort duty to
disclose. But, when Dewar requested a copy of Beddall's return, Smith had choices besides
A tax preparer “may not, however, ignore the implications of information furnished to, or actually
known by, the practitioner, and must make reasonable inquiries if the information as furnished
These statutes, rules, and Washington cases involving a professional's duty support the trial court's
conclusion that Smith owed Dewar a duty of care. Smith had a statutory and common law duty of
Smith knew the agreement's material provisions. Thus, he knew that Dewar and Beddall intended
Note: The court remanded the case for trial because Dewar still had to prove that Smith’s actions
4. The foreseeable user rule
a. It is foreseeable that a particular class of unknown persons will rely on the work product
b. Lender needs financials
CASE BRIEF: Cast Art Industries, LLC v. KPMG LLP
36 A. 3d 1049 (N.J. 2012)
FACTS: Cast Art Industries (the individual plaintiffs, Scott Sherman, Gary Barsellotti, and Frank Colapinto,
were Cast Art's shareholders – because the claims of Cast Art and the individual plaintiffs are
inextricably intertwined, the court referred simply to Cast Art and plaintiff in the singular) produced
and sold collectible figurines and giftware. Papel Giftware was in the same line of business as Cast
Art, and in spring 2000 Cast Art explored acquiring Papel. Among the factors that made such Papel
attractive to Cast Art were Papel's large number of existing customer accounts, its existing sales
force, and its production facilities. Eventually, Cast Art decided on a merger, rather than an
acquisition. Cast Art negotiated a loan agreement with PNC Bank for $22 million to fund the
venture. PNC's conditions included that it receive audited financial statements and that Cast Art’s
CEO, Scott Sherman, personally guarantee $3.3 million of the loan.
KPMG (defendant) had audited Papel's financial statements since 1997. KPMG was already in the
process of auditing Papel's 1998 and 1999 financial statements when Cast Art and Papel began
their merger discussions. In its letter to the chairman of Papel's audit committee, dated November
17, 1999, in which it agreed to undertake these audits and report the results, KPMG noted the
parameters of its work:
An audit is planned and performed to obtain reasonable assurance about whether the
financial statements are free of material misstatement, whether caused by error or fraud.
Absolute assurance is not attainable because of the nature of audit evidence and the
characteristics of fraud. Therefore, there is a risk that material errors, fraud (including
fraud that may be an illegal act), and other illegal acts may exist and not be detected by
an audit performed in accordance with generally accepted auditing standards. Also, an
audit is not designed to detect matters that are immaterial to the financial statements.
The process of KPMG completing its audits of Papel's financial statements for the years 1998 and
1999 was protracted because of tensions between John Quinn, the KPMG partner responsible for
the audit, and Frederick Wasserman, Papel's chief financial officer resulting from slowness in
providing KPMG with records as well as disagreements over adjustments that KPMG concluded
had to be made to Papel's financial statements. Eventually, Wasserman agreed to certain of the
adjustments, and KPMG concluded that the remainder were immaterial, and waived their inclusion.
In September 2000, KPMG delivered to Papel the completed audits for the years 1998 and 1999.
KPMG included in its accompanying opinion letter, which again was addressed to the chairman of
Papel's audit committee that Papel “was not in compliance with certain financial covenants” with its
lenders, which KPMG characterized as raising “substantial doubt about the Company's ability to
continue as a going concern.”
Cast Art obtained copies of the completed 1998 and 1999 audits and provided copies to PNC.
Three months later, in December 2000, Cast Art and Papel consummated the merger. Shortly after
the merger was finalized, Cast Art began to experience difficulty in collecting some of the accounts
receivable that it had believed Papel had had outstanding prior to the merger. Cast Art began its
own investigation and learned that the 1998 and 1999 financial statements prepared by Papel were
inaccurate and that Papel had engaged regularly in accelerating revenue.
Papel's did not follow its stated policy to recognize revenue from sales when goods were shipped
and invoices sent. Papel routinely booked revenue from goods that had not yet been shipped. For
example, testimony at trial established that Papel would pack goods for shipment and book the
revenue, but then simply place the shipping cartons in trailers on its property and color code the
invoices to note when the goods were, in fact, to be shipped and billed. There was also testimony
that at certain points Papel would not close out its books at month's end. Rather, it would hold them
open and book in the improperly extended month revenue that was earned in the following period.
There was also testimony that at least one transaction, referred to at trial as the “Bookman”
transaction, was a fraudulent entry of a $121,244 sale that never occurred.
Although Cast Art knew at the time of the merger that Papel was carrying a significant amount of
debt, it was unaware of those accounting irregularities until after the merger was complete. The
surviving corporation was unable to generate sufficient revenue to carry its debt load and produce
new goods, and it eventually failed.
Following a lengthy trial for KPMG’s malpractice, a jury returned a verdict in favor of Cast Art and
awarded damages totaling $31.8 million, which was amended to $38,096,902 by the trial court
judge. The Appellate Division upheld the verdict on liability but vacated the damage award and
remanded for a new trial on damages. The case was certified to the New Jersey Supreme Court.
ISSUE: Could KPMG be held liable for the losses Cast Art experienced as a result of its acquisition?
REASONING: The court held that New Jersey was not a privity state, but it was also not a foreseeable user state,
that its statute was somewhere in between. The New Jersey standard is that the auditor must be
aware AT THE TIME OF THE ENGAGEMENT that a third party would be using the auditor’s work
for making decisions about loans, etc. Because KPMG had begun the work prior to the plans for
the merger, it could not be held liable to PNC for its audit work. Further, KPMG had issued
qualifications on its opinion that would cast doubt on the company as an ongoing entity. The court
held that it could not be held liable for the demise of the business. The New Jersey Supreme Court
reversed a $38,000,000 verdict and dismissed the case.
5. The intended user rule – knowledge that the client would transmit the information to the nonprivity
plaintiff
6. The flexible rule (you can sum up theories with Figure 46-1)
7. Unknown user – accountant not liable if there is no knowledge
C. Nonliability parties – parties to whom accountants have no liability
DISCUSSION POINTS: Thinking Things Through
How Many Plaintiffs Can There Be In a Class-Action Securities Litigation? How
Many Defendants?
Cover who is suing whom and for what. Classify privity relationships, etc. Emphasize the extent of the subprime
litigation. Use Figure 46-1.
D. Defenses to accountants’ liability
1. Contributory negligence – client ignored accountant’s advice or contributed to the mistake
E. Accountants’ fraud malpractice liability
CASE BRIEF: Carlson v. Xerox Corp.
392 F. Supp. 2d 267 (D. Conn. 2005)
FACTS: Throughout the early and mid-1990s, Xerox had a significant market share in the digital copying
products industry. Its financial reports reflected healthy, constant growth; operating income was
increasing in regular, quarterly increments, and revenues were rising at a double-digit rate. By the
late 1990s, however, Xerox faced increasing competition from Japanese competitors in the digital
copier market and it was able to meet Wall Street's earning expectations only by engaging in
massive accounting fraud.
The SEC findings in its investigation of Xerox and its accounting practices concluded that "Xerox
senior management was informed of the most material of these accounting actions and the fact that
they were taken for the purpose of what the [c]ompany called 'closing the gap' to meet performance
targets. These accounting actions were directed and approved by senior Xerox management,
sometimes over protests from managers in the field who knew the actions distorted their
operational results." The complaint alleged that Xerox reallocated revenues from service to the
equipment portion of sales-type leases by assuming an artificial gross margin differential between
the two lease components (or an assumed profit margin) that had no basis in economic reality.
Equipment margins were in fact falling. Xerox used this method to pull forward $617 million of
equipment revenues from 1997-2000. Internally, KPMG referred to this method as "half-baked
revenue recognition."
In certain contracts, Xerox negotiated or unilaterally imposed price increases and loan extensions
on existing lease customers. While Xerox immediately recognized revenues from these increases
and extensions, GAAP required Xerox to realize such revenues over the life of the lease. According
to the SEC, in 1999, KPMG informed Xerox that this practice violated GAAP, but Xerox refused to
follow this advice. Nevertheless, KPMG certified Xerox's 1999 and 2000 financial statements.
Xerox recorded adjustments of at least $95 million as a result of retroactive revisions to residual
values. GAAP prohibits increasing the estimated residual value of leased equipment for any reason
after it is first established. By relying on this methodology, from 1997 to 1999, Xerox inflated its
pre-tax earnings by a net of $43 million. According to the SEC, in 1996, KPMG objected to this
practice as violating GAAP but, after arguments with Xerox senior management, approved its
implementation in 1998, while continuing to criticize its use.
In November of 1999, Xerox senior managers discussed the fact that without their accounting
actions, Xerox had essentially no growth through the late 1990s. In 2001, Xerox began issuing a
series of earnings restatements that would total $11 billion. In late 2001, Xerox announced that
PriceWaterhouse Coopers, LLP ("PwC") was replacing KPMG as the company's new auditor for the
2001 fiscal year. Xerox paid a $10 million fine to the SEC to settle civil charges and also agreed to
complete it restatement of earnings for 1997 through 2001.
Investors such as the Florida State pension plan and other individual investors (plaintiffs) brought
suit against the executive officers of Xerox as well as Xerox’s external auditor, KPMG for fraud.
KPMG moved to have the complaint against it dismissed because it was not a party to the
accounting fraud.
ISSUE: Could auditors who did not make the accounting entries be held liable for fraud?
REASONING: The court held that the plaintiffs in the case had put forward enough facts to survive a motion to
dismiss. The court found that the facts showed that KPMG was aware of accounting issues, that it
raised the accounting issues and problems to managers, and that each time KPMG backed down
on its concerns. It replaced the lead auditor on the Xerox account when Xerox requested that he
be replaced. The court referred to the accounting firm as a “virtual pushover” for the client and that
its complicity in the continuing misstatements was enough to have a case of fraud brought to trial.
KPMG was aware of the accounting problems and allowed them to continue. Knowledge is the key
element in fraud and the plaintiffs had included enough facts to show that knowledge.
DISCUSSION POINTS: Have the students discuss the Carlson v. Xerox Corp. case in which auditors are held
liable for fraud because of their knowledge of the accounting issues.
III. What are Accountants’ Liabilities and Duties Under Sarbanes-Oxley?
A. Auditor independence
1. Audit firms must register with the Public Company Accounting Oversight Board (PCAOB or
“Peek-a-boo” as it is common called)
a. Board will certify firms
2. Audit firms must disclose violations
3. Auditor conflicts and independence
a. Restrictions on types of services – see list in text
b. Statutory list of prohibitions including bookkeeping, systems designs, actuarial service, legal
B. Audit committees of corporate boards
1. Must be independent – no director contracts with corporation; no former officers; no relatives
C. Records retention
D. Dodd-Frank and accountants as whistleblowers
DISCUSSION POINTS: E-Commerce & Cyberlaw
Emails: The Destruction of a Career, Destruction of a Firm
Convey the following principles:
1. All e-mails are admissible.
ANSWERS TO QUESTIONS AND CASE PROBLEMS
1. Accountants’ liability to third parties. The absence of privity or the lack of knowledge of the intended use did not
bar liability of an accountant for negligence to third persons sustaining loss by relying on the statements
3. Accountant liability for malpractice. Judgment for the Ronsons. The failure of the accountant to inform his clients
of the problems with interest accruing amounted to malpractice, and the accountant could be held liable for the
4. Accountants’ negligence malpractice liability to foreseeable user. No. The fact that Shatterproof was not the
client of the accountants did not bar Shatterproof from suing the accountants for malpractice. To the contrary, the
rule followed in some jurisdictions is that when an accountant fails to exercise ordinary care in the preparation of
5. Accountants' negligence malpractice liability to foreseeable user. Judgment for the investors. The court held that
there was privity of contract between Ernst & Young and the investors because their purchase was a private
placement, Ernst & Young knew who the investors were at the time it certified the financial statements for the
6. Accountant’s liability to nonprivity plaintiff; intended beneficiary rule. No. From the fact that the accountant
prepared the annual audit every year as a matter of routine, it was clear that the report shown to DDC was
7. Accountants’ liability for fraud. First Bank is an intended user, but Henry Hatfield may have the traditional auditor
8. Accountants' liability; accountant responsibility; statutory liability. The accountant may not be able to affirmatively
9. Privity and accountant’s liability. Lack of privity of contract between the plaintiff and the defendant’s accountant
is not a bar to suit. While there is a conflict of what will be required in place of privity, there is no reason to deny
recovery by a nonprivity plaintiff against a negligent accountant when the accountant made the audit with
10. Accountants' liability; lack of privity; issue of forseeability. The court also held that Citibank had made many
loans to SCA and that the $1.4 million loan was part of an entire package of lending agreements and that the jury
11. Accountant liability to third parties. Judgment for Stirtz. The accountant did not have a duty of care to the
stockbroker who was loaning margin credit. The accountant could not be held liable for misrepresentation to a
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning
management system for classroom use.
