Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
1
Chapter 47
Professional Liability and Accountability
INTRODUCTION
This chapter gives an overview of the standards imposed on accountants and auditors, as well as other
professionals, and should be of great interest to students planning to sit for the Certified Public Accountant (CPA)
exam. Professionals have found themselves increasingly subject to liability over the past decade. The legal
responsibility of auditors, in particular, has been a subject in recent cases and legislation, which this chapter
discusses, and any changes in this liability in your jurisdiction should be brought to the attention of those students
who may be preparing for a career in accounting. This chapter considers the potential common law liability of
professionals to clients and to third persons, the potential liability of accountants under securities laws and the
Internal Revenue Code, and the relationship of professionals with their clients.
CHAPTER OUTLINE
I. Potential Liability to Clients
Professionals may be liable for breach of contract, negligence, or fraud.
A. LIABILITY FOR BREACH OF CONTRACT
A professional owes a duty to his or her client to honor the terms of their contract and to perform the
contract within the stated time period. If the professional fails to perform, he or she may be held liable for
2 UNIT NINE: GOVERNMENT REGULATION
expenses incurred by the client to secure another professional to provide the services, for penalties
imposed on the client for failure to meet time deadlines, and so on.
B. LIABILITY FOR NEGLIGENCE
All professionals are subject to standards of conduct established by codes of professional ethics, by state
statutes, and by judicial decisions. In their performance of contracts, professionals must exercise the
established standard of care, knowledge, and judgment generally accepted by members of their
professional group.
1. Accountant’s Duty of Care
The text discusses accountants’ duty in the context of their role in business financial systems.
a. GAAP and GAAS
• An accountant who complies with generally accepted accounting principles (GAAP) and
generally accepted auditing standards (GAAS) will not be liable to a client for incorrect
judgment. A violation of GAAP and GAAS is prima facie evidence of negligence.
• But compliance does not necessarily relieve an accountant of liability—he or she may be held
to a higher standard established by state statute and by judicial decisions.
b. Global Accounting Rules
• The Securities and Exchange Commission requires U.S. companies to replace GAAP rules
with the International Financial Reporting Standards (IFRS) established by the International
Accounting Standards Board.
• The IFRS are simpler, broader, and more straightforward. Many countries already use the
IFRS, which thus makes financial reporting standards more uniform.
c. Discovering Improprieties
An accountant who uncovers suspicious financial transactions and fails to investigate the matter
fully or to inform his or her client of the discovery can be held liable to the client for the resulting
loss.
d. Audits
An accountant may be liable for failing to detect misconduct that a normal audit would have
revealed.
e. Qualified Opinions and Disclaimers
An auditor is not liable for damages resulting from whatever is specifically qualified or disclaimed.
f. Unaudited Financial Statements
A lesser standard of care is typically required for an unaudited financial statement. An
accountant may be subject to liability, however, for failing, in accordance with standard
accounting procedures, to delineate a balance sheet as “unaudited.” An accountant will also be
held liable for failing to disclose facts or circumstances that give reason to believe misstatements
have been made or fraud has been committed.
g. Defenses to Negligence
Possible defenses include—
• The accountant was not negligent.
• The accountant’s negligence, if any, was not the proximate cause of the client’s loss.
• The client was also negligent (depending on whether state law allows contributory negligence
as a defense).
2. Attorney’s Duty of Care
The conduct of attorneys is governed by rules established by each state and by the American Bar
Association’s Code of Professional Responsibility and Model Rules of Professional Conduct.
a. Standard of Care
In judging an attorney’s performance, the standard used is normally that of a reasonably
competent general practitioner of ordinary skill, experience, and capacity.
b. Misconduct
A criminal act that reflects adversely on a person’s “honesty or trustworthiness, or fitness as a
lawyer” is professional misconduct.
c. Liability for Malpractice
When an attorney fails to exercise reasonable care and professional judgment, he or she
breaches the duty of care and may be liable for malpractice.
ADDITIONAL BACKGROUND—
Attorney’s Duty of Care
The conduct of attorneys is governed by state law and, where adopted, by American Bar Association
rules relating to professional responsibility. The following is selected from the preamble to the American Bar
Association Model Rules of Professional Conduct.
PREAMBLE: A LAWYER’S RESPONSIBILITIES
A lawyer is a representative of clients, an officer of the legal system and a public citizen having special
responsibility for the quality of justice.
As a representative of clients, a lawyer performs various functions. As advisor, a lawyer provides a client
with an informed understanding of the client’s legal rights and obligations and explains their practical
implications. As advocate, a lawyer zealously asserts the client’s position under the rules of the adversary
system. As negotiator, a lawyer seeks a result advantageous to the client but consistent with requirements of
honest dealing with others. As intermediary between clients a lawyer seeks to reconcile their divergent
interests as an advisor and, to a limited extent, as a spokesman for each client. A lawyer acts as evaluator by
examining a client’s legal affairs and reporting about them to the client or to others.
In all professional functions a lawyer should be competent, prompt and diligent. A lawyer should maintain
4 UNIT NINE: GOVERNMENT REGULATION
communication with a client concerning the representation. A lawyer should keep in confidence information
relating to representation of a client except so far as disclosure is required or permitted by the Rules of
Professional Conduct or other law.
C. LIABILITY FOR FRAUD
1. Actual Fraud
A professional may be held liable for actual fraud when he or she intentionally misstates a material
fact to mislead his or her client and the client justifiably relies on the misstated fact to his or her injury.
2. Constructive Fraud
In contrast, a professional may be held liable for constructive fraud whether or not he or she acted
with fraudulent intent. The intentional failure to perform a duty in reckless disregard of the
consequences would constitute gross negligence on the part of a professional.
II. Potential Liability to Third Parties
• Many third parties (investors, shareholders, creditors, managers, directors, regulatory agencies, and
others) rely on professional opinions, such as those of auditors. In this light, many courts have all but
abandoned the privity requirement in regard to accountants’ liability to third parties.
CHAPTER 47: PROFESSIONAL LIABILITY AND ACCOUNTABILITY 5
• When a business fails, its independent auditor may be one of the few potentially solvent defendants.
Most courts hold auditors liable to third parties for negligence, but the standard for imposing this liability
varies.
A. THE ULTRAMARES RULE
In Ultramares Corp. v. Touche, the New York Court of Appeals concluded that accountants owe a duty of
care only to those persons for whose “primary benefit” financial statements are intended.
1. The Requirement of Privity
Under the Ultramares rule, in the absence of privity or a relationship “so close as to approach that of
privity,” a party cannot recover from an accountant.
2. Modifications to Allow Near Privity
The rule was modified in Credit Alliance Corp. v. Arthur Andersen & Co., in which the New York Court
of Appeals held that if a third party has a sufficiently close relationship or nexus (link or connection)
with an accountant, then the Ultramares privity requirement may be satisfied without establishing an
accountant-client relationship. This is a minority rule.
B. THE RESTATEMENT RULE
Most courts have adopted the position of the Restatement (Second) of Torts, Section 552(2)—
accountants are subject to liability for negligence not only to their clients but also to foreseen, or known,
users or classes of users of their reports or financial statements. Liability extends to—
• Those persons for whose benefit and guidance an accountant “intends to supply the information or
knows that the recipient intends to supply it.”
• Those persons whom an accountant “intends the information to influence or knows that the recipient
so intends.”
C. THE “REASONABLY FORESEEABLE USERS” RULE
A few courts hold accountants liable to any users whose reliance on an accountant’s statements or
reports was reasonably foreseeable. Criticism of this view and support for the view of the majority of the
courts is that the Restatement’s approach is more reasonable because it allows accountants to control
their exposure to liability.
D. LIABILITY OF ATTORNEYS TO THIRD PARTIES
Like accountants, attorneys may also be held liable under the common law to third parties who rely on
legal opinions to their detriment. The principles stated in Section 552 of the Restatement (Second) of
Torts may apply to attorneys just as they may apply to accountants.
CASE SYNOPSIS—
Case 47.1: Perez v. Stern
Domingo Martinez died in a hit-and-run accident. Reyna Guido—the mother of Martinez’s two children,
including Esteban Perez, the named plaintiff—filed a wrongful death suit in a Nebraska state court through
attorney Sandra Stern. Stern neglected to perfect service within the required time, however, and the suit was
dismissed. Guido filed malpractice claims on behalf of herself, the children, and Martinez’s estate in a
Nebraska state court against Stern. The court issued a judgment in Stern’s favor on the ground that the
6 UNIT NINE: GOVERNMENT REGULATION
claims were time barred. Guido appealed.
..................................................................................................................................................
Notes and Questions
How might Stern, or anyone in a similar position, have avoided the negative result in this case?
The circumstances here give support to the warning that an attorney—or any professional—should take steps
The standards for defining professional misconduct appear to focus on an act’s impact on third
Should a professional’s misbehavior be considered a violation of the rules of professional
ADDITIONAL CASES ADDRESSING THIS ISSUE —
Potential Liability to Third Parties
Cases considering professionals’ liability to foreseen or known users include the following.
• NationsBank, N.A. v. KPMG Peat Marwick LLP, 813 So.2d 964 (Fla.App. 4 Dist., 2002) (a borrower's
accounting firm could be liable to the lenders on a theory of negligent misrepresentation following the
CHAPTER 47: PROFESSIONAL LIABILITY AND ACCOUNTABILITY 7
borrower’s default, when the firm knew that the annual financial statements prepared for the borrower were
relied on by the lenders in making their decisions concerning the borrower's credit).
• North American Specialty Insurance Co. v. Lapalme, 258 F.3d 35 (1st Cir. 2001) (a negligent-
misrepresentation claim against an accounting firm failed because there was no evidence that the firm had
any actual knowledge that the plaintiff would rely on financial statements in undertaking future transactions
that were substantially similar to ongoing transactions known to the defendants).
• Glenn K. Jackson, Inc. v. Roe, 273 F.3d 1192 (9th Cir. 2001) (a law firm was not a third-party beneficiary
of an agreement between the firm’s client and its accountants and thus could not recover from the
accountants under a theory of negligent misrepresentation).
• Reisman v. KPMG Peat Marwick LLP, 57 Mass.App.Ct. 100, 781 N.E.2d 821 (2000) (an accounting firm
was not liable to shareholders, who acquired their stock in pooling-of-interests transactions, for negligent
misrepresentations in the corporation's Securities and Exchange Commission report, when the report
contained no signature, opinion, representation, or statement of the accounting firm, even though the firm
instructed the corporation on how to report financial transactions and reviewed, edited, and helped prepare
the information reported).
III. The Sarbanes-Oxley Act of 2002
This act imposes requirements on a public accounting firm that provides auditing services to an issuer (a
company that has securities registered under Section 12 of the Securities Exchange Act of 1934; that is
required to file reports under Section 15(d) of the 1934 act; or that files, or has filed, a registration statement
not yet effective under the Securities Act of 1933).
A. THE PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD
This board, which reports to the Securities and Exchange Commission, oversees the audit of public
companies subject to securities laws to protect public investors and ensure that public accounting firms
comply with the provisions of the Act.
B. KEY PROVISIONS OF THE SARBANES-OXLEY ACT RELATING TO PUBLIC ACCOUNTING FIRMS
Public accounting firms are firms and associated persons that are “engaged in the practice of public
accounting or preparing or issuing audit reports.”
1. Auditor Independence
• It is unlawful to perform for an issuer both audit and nonaudit services, which include
bookkeeping for an audit client, financial systems design and implementation, appraisal
services, fairness opinions, management functions, and investment services.
• A public accounting firm cannot provide audit services to an issuer if the lead audit partner or
the reviewing partner provided those services to the issuer in each of the prior five years.
• Reports to an issuer’s audit committee must be timely and indicate critical accounting policies
and practices, as well as alternatives discussed, and other communications, with the issuer’s
management.
8 UNIT NINE: GOVERNMENT REGULATION
• A public accounting firm cannot provide audit services to an issuer if the issuer’s chief
executive officer, chief financial officer, chief accounting officer, or controller worked for the
auditor and participated in an audit of the issuer within the preceding year.
2. Document Destruction
The act prohibits destroying or falsifying records to obstruct or influence a federal investigation or in
relation to a bankruptcy. Penalties include fines and imprisonment up to twenty years.
3. Document Retention
Accountants who audit or review publicly traded companies must retain the working papers related
to the audit or review for seven years . Penalties include fines and imprisonment up to ten years.
C. REQUIREMENTS FOR MAINTAINING WORKING PAPERS
Under the common law (codified in a number of states), working papers remain the accountant’s
property. It is important to retain them in the event of a suit for negligence or other action in which the
accountant’s competence is challenged.
• The client has a right of access to the papers and must give permission before they can be
transferred to another accountant. Also, without the client’s permission or a valid court order,
disclosure of their contents would breach the accountant’s fiduciary duty to the client.
• Accountants must keep working papers for as long as five years from the end of the fiscal period to
which the papers applied, subject to a possible fine and imprisonment.
IV. Potential Liability of Accountants under Securities Laws
A. LIABILITY UNDER THE SECURITIES ACT OF 1933
Accountants often prepare and certify an issuer’s financial statements that are included in a registration
statement under the Securities Act of 1933 (discussed in Chapter 42).
1. Liability under Section 11
• An accountant may be held civilly liable if he or she prepared any financial statements in-
cluded in a registration statement that “contained an untrue statement of a material fact or
omitted to state a material fact required to be stated therein or necessary to make the
statements therein not misleading” [15 U.S.C. Section 77k(a)].
• Liability extends to anyone who acquires a security covered by the registration statement. No
proof of reliance or privity is required.
a. The Due Diligence Standard
• If a purchaser proves a loss on a security, to avoid liability an accountant must show that
he or she exercised due diligence in preparing the financial statements.
• Due diligence means an accountant had, “after reasonable investigation, reasonable
grounds to believe and did believe, at the time such part of the registration statement
became effective, that the statements therein were true and that there was no omission
of a material fact required to be stated therein or necessary to make the statements
therein not misleading” [15 U.S.C. Section 77k(b)(3)].
CHAPTER 47: PROFESSIONAL LIABILITY AND ACCOUNTABILITY 9
• Proof of following generally accepted standards is proof of due diligence.
10 UNIT NINE: GOVERNMENT REGULATION
b. Defenses to Liability
Besides proving that he or she has acted with due diligence, an accountant may raise the
following defenses to Section 11 liability—
• There were no misstatements or omissions.
2. Liability under Section 12(2)
Civil liability for fraud may be based on a communication to an investor (orally or in a pro-
spectus, of an untrue statement or omission of a material fact.
• Some courts have applied Section 12(2) to accountants who aided and abetted the seller or
B. LIABILITY UNDER THE SECURITIES EXCHANGE ACT OF 1934
Under Sections 18 and 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 of the Securities
and Exchange Commission, an accountant may be held liable for fraud. Here, however, an accountant
need not prove due diligence to escape liability.
1. Liability under Section 18
An accountant who makes or causes to be made in any application, report, or document a
statement that, at the time and in light of the circumstances, was false or misleading with respect to
any material fact may be civilly liable [15 U.S.C. Section 78r(a)]. Liability extends only to sellers or
purchasers who must prove—
• The statement affected the price of the security.
• He or she relied on the statement in making the purchase or sale and was not aware of its
inaccuracy.
a. Good Faith Defense
An accountant can be exonerated on proof of good faith in the preparation of a financial
statement.
b. Other Defenses
In addition to a good faith defense, accountants can claim the buyer or seller knew the
statement was false and misleading.
2. Liability under Section 10(b) and Rule 10b-5
a. Prohibited Conduct
Section 10(b) makes it unlawful for a person to use, in connection with the purchase or sale of
a security, a manipulative or deceptive device or contrivance in contravention of SEC rules.
CHAPTER 47: PROFESSIONAL LIABILITY AND ACCOUNTABILITY 11
Rule 10b-5 makes it unlawful for a person to, by use of a means or instrumentality of interstate
commerce, to—
b. Extent of Liability
• Accountants may be liable only to sellers or purchasers under Section 10(b) and Rule
CASE SYNOPSIS—
Case 47.2: Overton v. Todman & Co., CPAs, P.C.
Todman & Co., CPAs, P.C., audited the financial statements of Direct Brokerage, Inc. (DBI), issuing
unqualified opinions that the statements were accurate. Despite the certifications, Todman made significant
errors that concealed DBI's largest liability—its payroll taxes—in two audits. The errors came to light when it
..................................................................................................................................................
Notes and Questions
Does an accountant have a duty not only to correct prior certified statements, but also a duty to
update those statements? The court explained, “The duty to correct requires only that the accountant
12 UNIT NINE: GOVERNMENT REGULATION
Does an accountant have a duty to correct more than those statements on which it certified an
opinion? No, held the court in this case. “[A]n accountant need correct only those particular statements set
Apart from issuing a certified opinion, are there other ways in which an accountant creates a duty
C. THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
This act (the PSLRA) changed the potential liability of accountants and other professionals in securities
fraud cases.
1. Proportionate Liability
A party is now liable only for that proportion of damages for which he or she is responsible (thus, if
an accountant was not aware of any fraud, his or her liability could be proportionately less than if he
or she actively participated in it.
2. Aiding and Abetting
One provision of the PSLRA made aiding and abetting certain securities a crime.
D. POTENTIAL CRIMINAL LIABILITY OF ACCOUNTANTS
An accountant may be found criminally liable for violations of the securities laws, the tax laws, and state
and federal criminal codes.
1. Criminal Violations of Securities Laws
2. Criminal Violations of Tax Laws
There is specific liability under the Internal Revenue Code—aiding or assisting in the preparation of
V. Confidentiality and Privilege
A. ATTORNEY-CLIENT RELATIONSHIPS
CHAPTER 47: PROFESSIONAL LIABILITY AND ACCOUNTABILITY 13
The confidentiality of attorney-client communications is protected by law, which confers a privilege on
such communications. An attorney may not discuss a client’s case with anyone—even under court
order—without the client’s permission.
CASE SYNOPSIS—
Case 47.3: Commonwealth of Pennsylvania v. Schultz
An investigation into allegations of sexual misconduct involving Jerry Sandusky, former defensive
coordinator for the Penn State football team, led a grand jury to subpoena Gary Schultz, a retired vice
president of the university. Schultz had overseen the campus police at the time of the alleged events. Before
testifying, Schultz met with Cynthia Baldwin, counsel for Penn State. He told her that he did not have any
documents relating to the alleged incidents, believing this disclosure to be in the strictest confidence between
an attorney and her client. Baldwin, however, saw her role only as counsel for Penn State, representing
..................................................................................................................................................
Notes and Questions
Should lawyers be subject to higher legal and ethical standards than other professionals? Yes,
ADDITIONAL BACKGROUND—
Attorney-Client Relationships
The conduct of attorneys is governed by state law and, where adopted, by American Bar Association
rules pertaining to professional responsibility. These tenets include attorney-client confidentiality—keeping
the communications of clients confidential. The following is the text of Rule 1.6 of the American Bar
14 UNIT NINE: GOVERNMENT REGULATION
Association Model Rules of Professional Conduct, which expresses this tenet, with selected comments.
Rule 1.6 Confidentiality of Information
CHAPTER 47: PROFESSIONAL LIABILITY AND ACCOUNTABILITY 15
(a) A lawyer shall not reveal information relating to representation of a client unless the client consents after
COMMENT:
The lawyer is part of a judicial system charged with upholding the law. One of the lawyer’s functions is to
advise clients so that they avoid any violation of the law in the proper exercise of their rights.
The observance of the ethical obligation of a lawyer to hold inviolate confidential information of the client
not only facilitates the full development of facts essential to proper representation of the client but also
encourages people to seek early legal assistance.
B. ACCOUNTANT-CLIENT RELATIONSHIPS
As for accountant-client communications, most states and the federal courts abide by the common law,
which provides that an accountant must disclose information about his or her client under a court order.
Other professionals may also be compelled to disclose information provided in confidence by clients.
16 UNIT NINE: GOVERNMENT REGULATION
TEACHING SUGGESTIONS
1. Impress on accounting students that criminal and civil liability has been imposed on auditors since the
early 1960s—merely complying with GAAS no longer guarantees protection. Those who choose to be ac-
countants must practice the profession with skill.
2. It might be pointed out that in a capitalist system it is essential that accurate information be disseminated
to avoid any wasting of assets. Partly for this reason, an independent check on an enterprise’s management
by auditors benefits everyone with an interest in the business.
Cyberlaw Link
What effect might the availability of financial documents on the Web have on the liability of
auditors for the contents of those documents? Does the existence of the Internet change the
definition of “foreseeable third party”?
DISCUSSION QUESTIONS
1. Identify the broad areas of a professional’s potential common law liability to clients. Professionals
may be liable to clients for breach of contract, negligence, or fraud. A professional’s failure to perform according to
the terms of a contract may constitute a breach for which a client may recover damages for expenses to secure the
2. What is the accountant’s duty of care? Accountants must comply with generally accepted accounting
principles (GAAP) and generally accepted auditing standards (GAAS). GAAP consist of conventions, rules, and
3. How can a professional limit his or her liability? Professionals can limit their liability to some extent by
4. An accountant’s potential common law liability for negligence may extend to what third persons?
Most courts hold that accountants may be liable to third parties for negligence. The majority view is that an
5. What alternatives does a client have when he or she is dissatisfied with an attorney? The client has
several alternatives. For example, if a client believes that, in regard to his or her case, the attorney is acting
6. How can an accountant avoid liability under the Securities Act of 1933? An accountant must
demonstrate that he or she exercised due diligence in preparing the statements (failure to follow GAAP and GAAS
7. How might an accountant be liable under the Securities Exchange Act of 1934? An accountant may be
liable for fraud under Sections 18 or 10(b) of the Securities Exchange Act of 1934 or SEC Rule 10b-5. (An ac-
countant does not need to prove due diligence to escape liability under these provisions.) Section 18. Section 18
imposes civil liability on an accountant who makes or causes to be made in any application, report, or document a
statement filed with the SEC that at the time, in light of the circumstances, was false or misleading as to any material
fact. This liability extends only to sellers and buyers, who must prove that the statement affected the price of the
8. What are working papers? Working papers are documents used and developed during an audit—including
10. What is the difference between the attorney-client privilege and the accountant-client privilege?
Professional ethical tenets require professionals generally to keep communications with their clients confidential. The
CHAPTER 47: PROFESSIONAL LIABILITY AND ACCOUNTABILITY 19
ACTIVITY AND RESEARCH ASSIGNMENT
Among topics in this chapter that lend themselves to research in state codes and case law are (1) whether
EXPLANATION OF A SELECTED FOOTNOTE IN THE TEXT
Footnote 8: Credit Alliance Corp. is a major financial service company engaged primarily in financing the
purchase of capital equipment through installment sales and leasing agreements. As a condition of extending
additional major financing to L.B. Smith, Credit Alliance required an audited financial statement. Smith provided Credit
In Credit Alliance Corp. v. Arthur Andersen & Co., the court had to choose between the Ultramares rule
and the Restatement (Second) of Torts in dealing with the rights of third parties against accountants when there is no
privity of contract. Under the Restatement, the third party becomes an “intended beneficiary” when the accountant
knows or should have known that the work done by the accountant was being performed for the benefit of a third
If Credit Alliance had been Andersen’s client, and the accounting firm had been held liable for
negligence, what damages might the plaintiff have recovered? With appropriate proof, the client of a negligent
