Chapter 51 Liability of Accountants Business Law Legal

Certified Public Accountant (CPA) • CPA – an accountant who has: – met certain educational requirements – passed the CPA examination – had a certain number of years of audit experience • Public Accountant – a person who is not certified. © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman 19 - 2

Primary Functions of Accountants • Primary functions: – Auditing financial statements – Rendering opinions about those audits • Other functions: – Rendering tax advice and tax preparation – Preparing unaudited financial statements – Consulting services © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman 19 - 3

Accounting Standards and Principles • Generally Accepted Accounting Principles (GAAP) – Standards for the preparation and presentation of financial statements. • Generally Accepted Auditing Standards (GAAS) – Standards for the methods and procedures that must be used to conduct audits. © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman 19 - 4

Audits • The verification of a company’s books and records pursuant to: – Federal securities laws – State laws – Stock exchange rules • The audit must be performed by an independent CPA. – Must conduct sampling – Verify information from third parties © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman 19 - 5

Auditor’s Opinions • After the audit is complete, the auditor must render an opinion about how fairly the financial statements present: – the company’s financial position, – result of operations, and – change in financial position © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman 19 - 6

Auditor’s Opinions (continued) • The auditor’s opinion may be: – Unqualified – Qualified – Adverse • Disclaimer of Opinion expresses the auditor’s inability to draw a conclusion as to the accuracy of the company’s financial records. © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman 19 - 7

Limited Liability Partnership (LLP) • A special for of partnership where all partners are limited partners. • Only loss incurred is capital contributions. • Most public accounting firms operate as an LLP. © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman 19 - 8

Liability of Accountants to Their Clients Breach of Contract Fraud Negligence © 2007 Prentice

Breach of Contract • Terms of engagement are specified when accountant and client enter into contract. • If accountant fails to perform, he is liable for breach. • Damages include: – Expenses incurred in securing new accountant – Fines and penalties owed because of delay © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman 19 - 10

Fraud • When accountant is liable for actual or constructive fraud, client can recover proximate damages. • Punitive damages may be awarded in cases of actual fraud. © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman 19 - 11

Negligence • Accountants owe duty to use reasonable care, knowledge, skill, and judgment. • Measured against those actions of a reasonable accountant. • May be sued for damages if fails to meet standards. © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman 19 - 12

• Liability of Accountants to Third Parties There are three major rules of liability that a state may adopt in determining whether an accountant is liable in negligence to third parties: 1. The Ultramares Doctrine 2. Section 552 of the Restatement (Second) of Torts 3. The foreseeability standard © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman 19 - 13

Ultramares Doctrine • A rule that an accountant is liable only for negligence to third parties who are in privity of contract or a privity-like relationship with the accountant. • Provides the narrowest standard for holding accountants liable to third parties for negligence. © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman 19 - 14

Section 552 of the Restatement (Second) of Torts • A rule that an accountant is liable only for negligence to third parties who are members of a limited class of intended users of the client’s financial statements. • Provides a broader standard for holding accountants liable to third parties for negligence than the Ultramares doctrine. © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman 19 - 15

The Foreseeability Standard • A rule that an accountant is liable for negligence to third parties who are foreseeable users of the client’s financial statements. • Provides the broadest standard for holding accountants liable to third parties for negligence. © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman 19 - 16

Fraud • If an accountant engages in actual or constructive fraud, a third party who relies on the accountant’s fraud and is injured may bring tort action to recover damages. © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman 19 - 17

Breach of Contract • Third parties usually cannot sue accountants for breach of contract. – Third parties are merely incidental beneficiaries who do not acquire any rights under the accountantclient contract. – They are not in privity of contract with the accountants. © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman 19 - 18

Statutory Liability of Accountants • The Securities Act of 1933 – Section 11(a) • The Securities Exchange Act of 1934 – Section 10(b) and Rule 10 b-5 – Section 18(a) • Private Securities Litigation Reform Act of 1995 © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman 19 - 19

Criminal Liability of Accountants • Criminal Violations of the Securities Act of 1933 – Section 24 • Criminal Violations of the Securities Exchange Act of 1934 – Section 32(a) • 1976 Tax Reform Act • Racketeer Influenced and Corrupt Organizations Act © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman 19 - 20

Accountant-Client Privilege • Accountant cannot be called as a witness against a client in a court action. • An accountant can be a plaintiff in a lawsuit. © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman 19 - 21

Sarbanes-Oxley Act of 2002 Major Provisions: • Establishment of the Public Company Accounting Oversight Board. • Public accounting firms must register with the board. • Separation of audit and nonaudit services. • Audit reports sign-offs • Prohibited employment. © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman 19 - 22