Business Law Chapter 48 Homework Sec That The Time Light The Circumstances

CHAPTER 48: PROFESSIONAL LIABILITY AND ACCOUNTABILITY 1177

b. Requirements for Recovering Damages

Ordinary negligence is not enough. A plaintiff must prove scienter—intent to commit fraud.

CASE SYNOPSIS—

Case 48.3 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 became clear that the company

had not filed or paid its payroll taxes for those two years. Owing more than $3 million in unpaid taxes, interest, and

penalties, DBI sought outside investors, including David Overton, who relied on DBI’s statements and Todman’s

opinions to invest. When DBI collapsed, Overton and others filed a suit in a federal district court against Todman,

asserting fraud under Section 10(b) and Rule 10b-5. The court dismissed the complaint. The plaintiffs appealed.

…………………………………………………………..……………………………………………………………………

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 correct statements that were

false when made. In contrast, the duty to update requires an accountant to correct a statement made misleading by

intervening events, even if the statement was true when made.” In at least one case, it has been noted that in some

circumstances, “an issuer may have a duty to update opinions and projections . . . if the original opinions or

projections have become misleading as the result of intervening events.” The court here commented, however, that

“[o]n the facts of this case, we need not, and do not, reach the issue of whether an accountant has a duty to update.”

Does an accountant have a duty to correct more than those statements on which it certified an opinion? No, held

certified financial statements. . . . [A]n accountant is under no duty to divulge information collateral to the statements

1178 INSTRUCTOR’S MANUAL TO ACCOMPANY BUSINESS LAW, TWELFTH EDITION

ANSWER TO “WHAT IF THE FACTS WERE DIFFERENT?” IN CASE 48.3

If Todman had conducted an audit for DBI but had not issued a certified opinion about DBI’s financial statements,

would the result in this case have been the same? Explain. The court noted in this case that “if an accountant does not

issue a public opinion about a company, although it may have conducted internal audits or reviews for portions of the

company, the accountant cannot subsequently be held responsible for the company’s public statements issued later

merely because the accountant may know those statements are likely untrue.”

ANSWER TO “THE LEGAL ENVIRONMENT DIMENSION”

QUESTION IN CASE 48.3

Did Overton have a valid reason to sue DBI’s auditors? Why or why not? Yes, the investors were dissatisfied with

the result of their investment and looked for the most likely scapegoat, which here was the accountant. Sometimes,

one must simply suffer the consequence of a bad turn o fate. No, because for economic and other progress, there must

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

2. Aiding and Abetting

One provision of the PSLRA made aiding and abetting certain securities a crime.

V. Potential Criminal Liability of Accountants

An accountant may be found criminally liable for violations of the Securities Act of 1933, the Securities Exchange Act of

1934, the Internal Revenue (IR) Code, and both state and federal criminal codes.

A. CRIMINAL VIOLATIONS OF SECURITIES LAWS

CHAPTER 48: PROFESSIONAL LIABILITY AND ACCOUNTABILITY 1179

VI. Confidentiality and Privilege

A. ATTORNEY-CLIENT RELATIONSHIPS

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.

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 similarly be compelled to disclose information given to them in confidence by clients.

ADDITIONAL BACKGROUND—

Attorney-Client Confidentiality

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 Association Model

Rules of Professional Conduct, which expresses this tenet, with selected comments.

Rule 1.6 Confidentiality of Information

(a) A lawyer shall not reveal information relating to representation of a client unless the client consents after

consultation, except for disclosures that are impliedly authorized in order to carry out the representation, and except

(2) To establish a claim or defense on behalf of the lawyer in controversy between the lawyer and the client, to

establish a defense to a criminal charge or civil claim against the lawyer based upon conduct in which the client was

involved, or to respond to allegations in any proceeding concerning the lawyer’s representation of the client.

COMMENT:

The lawyer is part of a judicial system charged with upholding the law. One of the lawyer’s functions is to advise

CHAPTER 48: PROFESSIONAL LIABILITY AND ACCOUNTABILITY 1181

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.

Almost without exception, clients come to lawyers in order to determine what their rights are and what is, in the

maze of laws and regulations, deemed to be legal and correct. The common law recognizes that the client’s

confidences must be protected from disclosure. Based upon experience, lawyers know that almost all clients follow

the advice given, and the law is upheld.

A fundamental principle in the client-lawyer relationship is that the lawyer maintain confidentiality of information

relating to the representation. * * *

* * * *

A lawyer is impliedly authorized to make disclosures about a client when appropriate on carrying out the

* * * *

The duty of confidentiality continues after the client-lawyer relationship has terminated.

TEACHING SUGGESTIONS

1. Impress on accounting students that criminal and civil liability has been imposed on auditors since the early

2. It might be pointed out that in a capitalist system it is essential that accurate information be disseminated to avoid

3. Emphasize that investors and others rely on accountants’ reports and statements, and that is why accuracy in

those reports and statements is essential. Public policy demands it—it is the cornerstone of an analytical process. It

4. Since at least the movie “2001: A Space Odyssey” in 1968, it has been surmised that one day (possibly within

twenty years) computers will replace human intelligence. Today, however, a computer can only retrieve, analyze, and

report the data that is entered into it. When people enter the data, mistakes are sometimes made. Because of the

widely held notion that computers are infallible, however, whatever a computer does with data is generally accepted.

1182 INSTRUCTOR’S MANUAL TO ACCOMPANY BUSINESS LAW, TWELFTH EDITION

This can turn what may have been a small error into a major blunder. How might the losses in such cases be avoided?

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 services elsewhere, for penalties

2. What is the accountant’s duty of care? Accountants must comply with generally accepted accounting principles

3. How can a professional limit his or her liability? Professionals can limit their liability to some extent by disclaiming it,

4. An accountant’s potential common law liability for negligence may extend to what third persons? Most courts hold

5. What alternatives does a client have when he or she is dissatisfied with an attorney? The client has several

6. How can an accountant avoid liability under the Securities Act of 1933? An accountant must demonstrate that he or

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 accountant 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 security, or the seller or buyer relied on the statement in buying or selling

and was not aware of its inaccuracy. A seller or buyer may bring an action within a year after discovering the facts that

constitute the cause of action and within three years after the cause accrued. An accountant may avoid liability on proof of

good faith in a statement’s preparation (showing that he or she did not know that the statement was false or misleading, that

8. What are working papers? Working papers are documents used and developed during an audit—including notes,

memoranda, copies, and other papers that make up the work product of an accountant’s services. Whose property are they?

9. What are a client’s rights in regard to working papers? A client has a right of access to working papers and must give

permission before they can be transferred to another accountant. Without the client’s permission or a valid court order, their

contents are not to be disclosed. Unauthorized disclosure could result in a malpractice suit.

ACTIVITY AND RESEARCH ASSIGNMENT

Among topics in this chapter that lend themselves to research in state codes and case law are (1) whether the

students’ state is one of the few in which accountant-client communications are privileged, and if they are not privileged, the

extent to which accountant-client confidentiality is protected; (2) crimes for which accountants may be particularly liable, and

criminal penalties; and (3) the common law liability of accountants—that is, cases in which they have been charged with neg-

ligence, breach of contract, or fraud.

EXPLANATIONS OF SELECTED FOOTNOTES IN THE TEXT

Footnote 3: Oregon Steel Mills, Inc. (OSM), hired Coopers & Lybrand, LLP. On Coopers’ advice, OSM reported a stock

sale as a $12.3 million gain on its 1994 financial statements. The next year, OSM planned a public offering of its own stock,

expecting to file the necessary documents with the Securities and Exchange Commission (SEC) in February 1996 and sell the

stock on May 2. The SEC required OSM to restate its 1994 statements. This delayed the public offering until June 13, when, due

to unrelated factors, the stock price was lower than it had been on May 2. OSM filed a suit in an Oregon state court against

Coopers, claiming that its advice regarding the 1994 transaction was negligent and caused the delay. The court issued, in

Coopers’ favor, a summary judgment, which a state intermediate appellate court reversed. Coopers appealed. In Oregon Steel

Mills, Inc. v. Coopers & Lybrand, LLP, the Oregon Supreme Court reversed. “[D]efendant’s conduct caused the delay in the

offering that led to an unintended adverse result. However, the intervening action of market forces on the price of plaintiff’s

CHAPTER 48: PROFESSIONAL LIABILITY AND ACCOUNTABILITY 1185

Based on the court’s reasoning in this case, what damages might OSM recover for Coopers’ negligence? As the court

stated, “[w]ith appropriate proof, the client of a negligent accounting firm may recover damages for lost profits or lost business

opportunities that result from the accounting firm’s negligent acts.” For example, OSM “should be able to recover all the out–of–

pocket expenses it incurred because of defendant’s accounting errors—and perhaps other identifiable damages.”

A rule of professional conduct bars a lawyer from having “sexual relations” with a current client. During Inglimo’s

representation of L.K., Inglimo had sexual relations with L.K.’s girl friend in L.K.’s presence and with L.K. also engaging in sexual

relations with his girl friend during the encounter. Did this conduct violate the rule? No, at least not according to the authorities

in the Inglimo case. The referee interpreted the rule to require that an attorney have intimate contact with the client, and

concluded that because L.K.’s girl friend was not Inglimo’s client, and Inglimo and L.K. did not have sexual contact, there was no

violation. The state supreme court agreed.

Should lawyers be subject to higher legal and ethical standards than other professionals? Yes, because the impact that

a lawyer (or a judge) may have in a particular case can exceed the impact that other professionals might have—there can be a

far-reaching permanence in a legal matter that may not exist in the work of other professionals—and because attorneys often

deal with many aspects of individuals’ lives. No, because all professionals should be subject to the same high standards.

The standards for defining professional misconduct appear to focus on an act’s impact on third parties rather than its

effect on the professional. Is this the appropriate focus? Why or why not? Yes, this is the appropriate focus because 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.”

Should an attorney’s misbehavior be considered a violation of the rules of professional conduct even if he or she is not

convicted of a crime? Discuss. Yes, and it generally does. In this case, the court held that an attorney’s criminal act can support a

violation of rule of professional conduct prohibiting a lawyer from committing a criminal act that reflects adversely on the

lawyer’s honesty, trustworthiness or fitness as a lawyer, even if the attorney is never charged or convicted. The court also held

ANSWERS TO ESSAY QUESTIONS IN

STUDY GUIDE TO ACCOMPANY BUSINESS LAW, TWELFTH EDITION

1186 INSTRUCTOR’S MANUAL TO ACCOMPANY BUSINESS LAW, TWELFTH EDITION

BY HOLLOWELL & MILLER

1. Contrast an accountant’s past and present potential common law liability to third persons. At one time, a professional

owed no duty to a person with whom he or she had no contractual relationship (for example, in Ultramares Corp. v. Touche, in

which a lender’s alleged reliance on accountants’ negligently prepared statements caused it to lose money on loans, the court

2. 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 confidentiality of attorney-

client communications is also protected by law, which confers a privilege on the communications. An attorney and his or her

employees may not discuss a client’s case with anyone, even under court order, without the client’s permission. (This privilege

REVIEWING—

PROFESSIONAL LIABILITY AND ACCOUNTABILITY 

Superior Wholesale Corporation planned to purchase Regal Furniture, Inc. and wished to determine Regal’s net

worth. Superior hired Lynette Shuebke, of the accounting firm Shuebke Delgado, to review an audit that had been

prepared by Norman Chase, the accountant for Regal. Shuebke advised Superior that Chase had performed a high-

quality audit and that Regal’s inventory on the audit dates was stated on the fairly general ledger. As a result of these

representations, Superior went forward with its purchase of Regal. After the purchase, Superior discovered that the

1. If Shuebke’s review was conducted in good faith and conformed to generally accepted accounting principles, could

Superior hold Shuebke Delgado liable for negligently failing to detect material omissions in Chase’s audit? Why or why

CHAPTER 48: PROFESSIONAL LIABILITY AND ACCOUNTABILITY 1187

not? What constitutes negligence may vary according to judicial decision and state statutes, but complying with GAAP

2. According to the rule adopted by the majority of courts to determine accountants’ liability to third parties, could

Chase have been liable to Superior? The majority of courts apply the principles set out in the Restatement (Second) of

3. Generally, what requirements must be met before Superior can recover damages under Section 10(b) of the

Securities and Exchange Act of 1934 and SEC Rule 10b-5? Could Superior meet these requirements? To be liable for

4. Suppose that a court determined that Chase had aided Regal in willfully understating its tax liability. What is the

maximum penalty that could be imposed on Chase? Aiding or assisting in the preparation of a false tax return is a

felony punishable by a fine of up to $100,000 in the case of an individual ($500,000 in the case of a corporation) and

imprisonment of up to three years. A penalty of $250 per return may be assessed for negligent understatement of tax

liability. For a willful understatement, the penalty may be $1,000. Additional penalties of up to $10,000 may apply for

aiding and abetting an understatement.

 DEBATE THIS: 

Only the largest publicly held companies should be subject to the Sarbanes-Oxley Act. All U.S. publicly held

companies, other than the very largest, are at a competitive advantage compared to similar countries in Europe and

Asia. Why? Because they have to spend, in total, billions a year satisfying Sarbanes-Oxley reporting requirements. The

U.S. used to be the preferred country to list a foreign company on one of the stock exchanges. Today, we are no

longer in this formerly enviable position because foreign companies don’t want to pay the huge cost of complying

with the Sarbanes-Oxley Act.

1188 INSTRUCTOR’S MANUAL TO ACCOMPANY BUSINESS LAW, TWELFTH EDITION

