1163
Chapter 48
Professional Liability
and Accountability
See separate Lecture Outline System
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
ADDITIONAL RESOURCES—
VIDEO SUPPLEMENTS
1164 INSTRUCTOR’S MANUAL TO ACCOMPANY BUSINESS LAW, TWELFTH EDITION
The following video supplements relate to topics discussed in this chapter—
PowerPoint Slides
To highlight some of this chapter’s key points, you might use the Lecture Review PowerPoint slides compiled for
Chapter 48.
Business Law Digital Video Library
The Business Law Digital Video Library at www.cengage.com/blaw/dvl offers a variety of videos for group or
individual review. Clips on topics covered in this chapter include the following.
• Legal Conflicts in Business
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 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, and a violation of
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The Securities and Exchange Commission requires U.S. companies to begin to use the International
Financial Reporting Standards (IFRS) established by the International Accounting Standards Board. GAAP
are to be phased out by 2016.
c. Audits, Qualified Opinions, and Disclaimers
An auditor is not liable for damages resulting from whatever is specifically qualified or disclaimed.
d. 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.
e. Defenses to Negligence
Possible defenses include that the accountant was not negligent; if the accountant was negligent, this was
not the proximate cause of the client’s losses; or the client was 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.
ADDITIONAL BACKGROUND—
American Bar Association Model Rules of Professional Conduct
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.
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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
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
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.
A lawyer’s conduct should conform to the requirements of the law, both in professional service to clients and in
the lawyer’s business and personal affairs. A lawyer should use the law’s procedures only for legitimate purposes and
not to harass or intimidate others. A lawyer should demonstrate respect for the legal system and for those who serve
it, including judges, other lawyers and public officials. While it is a lawyer’s duty, when necessary, to challenge the
rectitude of official action, it is also a lawyer’s duty to uphold legal process.
As a public citizen, a lawyer should seek improvement of the law, the administration of justice and the quality of
civic influence in their behalf. A lawyer should aid the legal profession in pursuing these objectives and should help the
bar regulate itself in the public interest.
Many of a lawyer’s professional responsibilities are prescribed in the Rules of Professional Conduct, as well as
substantive and procedural law. However, a lawyer is also guided by personal conscience and the approbation of
professional peers. A lawyer should strive to attain the highest level of skill, to improve the law and the legal
profession and to exemplify the legal profession’s ideals of public service.
* * * *
Lawyers play a vital role in the preservation of society. The fulfillment of this role requires an understanding by
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CASE SYNOPSIS—
Case 48.1: Walsh v. Skate
Stephen Teiper wrote to the Nebraska Board of Public Accountancy to accuse his brother–in-law, Michael Walsh, a
certified public accountant (CPA), of impersonating Teiper to obtain financial information from Teiper’s insurance
company. The board filed a complaint against Walsh for a violation of its rules. Walsh admitted that he had
impersonated Teiper, but argued that Teiper had provided his personal information to Walsh for this purpose. The
board found that Walsh committed a “discreditable act,” and concluded that his conduct was reprehensible and
reflected adversely on his fitness to engage in the practice of public accountancy. The board reprimanded Walsh,
placed him on probation for three months, and ordered him to attend four hours of continuing education in ethics. The
board also ordered him to pay the costs of the hearing. Walsh petitioned a Nebraska state court, which affirmed the
orders. Walsh appealed.
…………………………………………………………..……………………………………………………………………
Notes and Questions
The Nebraska Board of Public Accountancy (www.nbpa.ne.gov) was established in 1957 by the Nebraska Public
Accountancy Act. The board’s “vision” is “to protect the welfare of the citizens of the State of Nebraska by assuring the
competency of persons licensed as Certified Public Accountants (CPAs).” The board assures the competency of CPAs
through examination, certification, licensure, registration, continuing professional education, and “quality review.”
Among other responsibilities, the board investigates and disciplines licensees who fail to comply with the board’s
requirements and standards, and the profession’s ethical principles. The board’s activities are self-supported through
licensing fees.
1168 INSTRUCTOR’S MANUAL TO ACCOMPANY BUSINESS LAW, TWELFTH EDITION
the protection of the public is the purpose of, and the reason for, the rules of professional conduct. No, this is not the
right focus, although innocent third parties should be made “whole” if possible, because wrongdoers must also be
transformed to conduct themselves properly for their own “good.”
ANSWER TO “WHAT IF THE FACTS WERE DIFFERENT” IN CASE 48.1
ANSWER TO “THE ETHICAL DIMENSION” QUESTION IN CASE 48.1
Was the specific purpose for Walsh’s impersonation significant to the result in this case? Why or why not? No. The
misrepresentation could have been for almost any purpose. It was the ethical breach consisting of falsity and its “taint”
on the accountancy profession that resulted in the imposition of sanctions on Walsh.
D. LIMITING PROFESSIONALS’ LIABILITY
Professionals can limit their liability to some extent by disclaiming it, though not all disclaimers are effective in all
circumstances. Professionals may be able to limit their liability for the misconduct of other professionals with
whom they work by organizing their business as a professional corporation (PC) or a limited liability partnership
(LLP).
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
A. THE ULTRAMARES RULE
1. The Requirement of Privity
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., 65 N.Y.2d 536, 483 N.E.2d 110 (1985),
in which the court 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 “near privity” rule is a minority rule.
ANSWER TO VIDEO QUESTION LTR. A
Should Ray prepare a financial statement that values a list of assets provided by the advertising firm without
verifying that the firm actually owns these assets? The circumstances in the video indicate that the client is pressuring
Ray to value the assets listed without verifying that the firm actually owns these assets—because “time is of the
essence.” Laura also tells Ray that the financial statement will be given to a company interested in purchasing Onyx
Advertising. Although courts apply different standards to determine when an accountant can be held liable by third
parties, the majority of courts now hold that accountants can be held liable by third parties whom they know will be
ANSWER TO VIDEO QUESTION LTR. B
Discuss whether Ray is “in privity” with the company interested in buying Laura’s advertising firm. Privity of
contract refers to the relationship that exists between the promisor and the promisee in a contract. Traditionally, an
accountant owed no duty to a third party with whom the accountant was not in privity. Here, Ray is clearly in privity
with Laura at Onyx Advertising and not with the potential acquiror. Although Ray knows that this other company will
be getting a copy of the financial statement, he has no contractual relationship with this company and does not even
know the company’s name.
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ANSWER TO VIDEO QUESTION LTR. C
Under the Ultramares rule, to whom does Ray owe a duty? Under the Ultramares rule, an accountant owes a duty
of care only to those persons for whose “primary benefit” the statements were intended. Thus, the key issue is
whether the financial statement that Ray was asked to prepare was intended for the “primary benefit” of the company
interested in buying Laura’s advertising firm or for the primary benefit of Onyx. Laura will claim that she contracted
with Ray to prepare the report for her company (Onyx Advertising) and that the statement was intended for her
primary benefit. The facts of the video, however, are different from the facts in the Ultramares case. It is evident from
the outset of the video that Laura intends to give the report to the company interested in buying Onyx Advertising. Ray
were intended (regardless of whether Ray knew the company by name). Note that since the Ultramares case, a
minority of courts have modified the rule somewhat to include third parties that have a sufficiently close relationship
or nexus (the “near privity” rule). Under the near privity rule, a third party can hold the accountant liable if the
accountant was aware that the third party was going to receive and rely on the accountant’s statements.
B. THE RESTATEMENT RULE
Most courts have adopted the position of the Restatement (Second) of Torts, Section 552(2), which states that
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. An accountant’s liability extends to those persons for
whose benefit and guidance the accountant “intends to supply the information or knows that the recipient intends
to supply it” and to those persons whom the accountant “intends the information to influence or knows that the
recipient so intends.”
C. 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 48.2: 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 claims were time barred. Guido appealed.
The Nebraska Supreme Court affirmed the dismissal of Guido’s and the estate’s claims—they were time barred—
but reversed and remanded with respect to the children. “A lawyer owes a duty to his or her client to use reasonable
care and skill in the discharge of his or her duties, but ordinarily this duty does not extend to third parties, absent facts
CHAPTER 48: PROFESSIONAL LIABILITY AND ACCOUNTABILITY 1171
establishing a duty to them.” Here, the facts established that “Stern owed a duty to the children, as direct and intended
beneficiaries of her services, to competently represent their interests. . . . Therefore, they have standing to sue Stern
for neglecting that duty and their claims against Stern were tolled by their minority.”
…………………………………………………………..…………………………………………….……………………..
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 to be reminded of deadlines
ANSWERS TO QUESTIONS AT THE END OF CASE 48.2
1. If the children had suffered no harm as a result of the attorney’s malpractice, would the outcome of this case have
been different? Why or why not? Yes. In fact, very likely there would not be a case, because Guido sought to recover
damages only for the children (realizing that she had no chance of recovering because the Statute of Limitations had
expired). Because of the attorney’s malpractice, Guido was unable to proceed with the wrongful death suit against the
hit-and-run driver who was responsible for the death of the children’s father. It is possible that she could have won a
significant amount of damages in that lawsuit for the children’s sake. Because of the attorney’s malpractice, the
children were deprived of these potential damages. If, however, it would have been impossible to obtain damages for
2. Why did the court affirm the dismissal of Guido’s individual claim but not the claims that she had brought on
behalf of the children? Guido’s claim was dismissed because she had not filed the malpractice suit against the
attorney until after the Statute of Limitations had expired. The claims she had brought on behalf of the children,
however, were not dismissed. This was because the court held that the Statute of Limitations was “tolled,” or
suspended, during their minority, meaning that they were still entitled to bring suit against the attorney (through
Guido).
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ADDITIONAL CASES ADDRESSING THIS ISSUE —
Recent 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 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).
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
B. APPLICABILITY 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
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• It is unlawful to perform for an issuer both audit and nonaudit services, which include bookkeeping for
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.
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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.
IV. Potential Liability of Accountants under Securities Laws
The text discusses liability under the Securities Act of 1933 and the Securities Exchange Act of 1934.
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 41).
1. Liability under Section 11
An accountant may be held civilly liable if he or she prepared any financial statements included 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)].
a. Extent of Liability
This liability extends to anyone who acquires a security covered by the registration statement. No
proof of reliance or privity is required.
b. The Due Diligence Standard
c. 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.
• Any misstatements or omissions were not of material facts.
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2. Liability under Section 12(2)
Civil liability for fraud may be based on a communication to an investor (orally or in a prospectus, of an
3. Penalties and Sanctions for Violations
Penalties and sanctions include fines up to $10,000, imprisonment up to five years, injunctions, and orders
to refund profits.
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
2. Liability under Section 10(b) and Rule 10b-5
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. Rule 10b-5 makes it unlawful
for a person to, by use of a means or instrumentality of interstate commerce, to—