Liability of Accountants and Other Professionals
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• LO11-1: Under common law, what is the duty of an accountant to his or her clients?
• LO11-2: Under common law, what is the duty of an accountant to third parties?
• LO11-3: What is the impact of federal securities law on accountant liability?
• LO11-4: What is the extent of liability of professionals other than accountants?
Chapter 11 Hypothetical Case 1
As Chapter 11 indicates, Ultramares v. Touche is the most famous case of accountant legal liability to third parties. In this case,
Justice Benjamin Cardozo, writing for the highest state court in New York, took a narrow view of which third parties were
permissible plaintiffs in civil causes of action against accountants. Concerned that a more liberal rule would subject accountants to
a liability of "an indeterminate amount, for an indeterminate time, to an indeterminate class," Cardozo held an accountant liable in
negligence only to those with whom he or she had privity of contract. This decision is now known as the Ultramares Rule, and
according to this rule, an accountant will be held liable for negligence only to the client and anyone for whose "primary benefit"
the accounting statements were prepared.
In your reasoned opinion, is the Ultramares Rule sound law? Is it ethical?
Chapter 11 Hypothetical Case 2
As Chapter 11 indicates, The Sarbanes-Oxley Act of 2002 prohibits registered public accounting firms (RPAFs) from engaging in the
following non-auditing acts for their auditing clients:
2. Financial information systems design and implementation;
3. Appraisal or valuation services;
4. Actuarial services;
5. Internal-audit outsourcing services;
6. Management functions or human resources;
7. Broker or dealer, investment adviser, or investment banking services;
8. Legal or expert services unrelated to the audit; or
9. Any additional service the board of directors of the client company deems impermissible.
Is this provision of Sarbanes-Oxley good law, or does it represent over-regulation by the government?
Accountant's Duty to Clients: Overview
• Three primary types of liability to accountants under common law:
• Breach of contract
Accountant's Duty to Clients: Negligence
• Liable to client for negligence if he/she fails to exercise care of competent,
reasonable professional, and that failure causes loss/injury to client
Duty to client to perform his/her responsibilities according to generally accepted
accounting principles (GAAP) and generally accepted auditing standards (GAAS)
Accountant's Duty to Clients:
Breach of Contract
• Whenever accountant hired to perform specific task, he/she enters into contract
Explicitly, accountant agrees to perform contractual tasks
Implicitly, accountant agrees to complete work in a competent and professional
manner, according to professional standards (GAAP and GAAS)
Accountant may be liable for violating explicit and/or implicit agreements
Accountant's Duty to Clients: Fraud
Accountants who commit fraud liable to those parties accountant reasonably should have
foreseen as being injured through justifiable reliance on fraudulent information
Accountants may be liable for actual or constructive fraud
Actual fraud: Accountant's actions meet criteria necessary to prove fraud
Constructive fraud: No fraudulent intent, but accountant grossly negligent in performing his/her duties
Accountant's Liability to
Privity or near-privity (Ultramares rule):
Requires that third party be in privity of contract with accountant, or be close enough to accountant to
Foreseen users and class of users (Restatement rule):
Requires that third party be known recipient, or be from a class of known recipients, of accountant's
Reasonably foreseeable users test:
Allows any third party that should have been reasonably foreseen as using product of accountant's
work to bring suit
• Working papers: Various documents used and developed during audit
Accountant is legal owner of working papers, but client may access at any time upon request
Does not exist under federal law, but some states have granted this right in a limited way
When granted, client has right to privilege, but accountant has fewer protections
• Accountant-client privilege
Federal Securities Law and Accountant Liability: Overview
• Securities Act of 1933
• Securities Exchange Act of 1934
• Private Securities Litigation Reform Act of 1995
• Sarbanes-Oxley Act of 2002
• Racketeer Influenced and Corrupt Organization (RICO) Act
Securities Act of 1933
• Section 11—Accountants civilly liable for misstatements and omissions of
material facts made in registration statements filed with the Securities and
Exchange Commission (SEC)
Section 15—Applies liability to controlling persons when Section 11
Securities Exchange Act of 1934
• Section 18: Accountants liable for fraudulent statements made to SEC
• Section 10(b) and SEC Rule 10b-5: Unlawful for accountants to use "any manipulative
or deceptive device/contrivance" in contravention of SEC rules and regulations
Section 20(a): Person who controls liable violator of act may also be liable
Private Securities Litigation
Reform Act (PSLRA) of 1995
• Requires that accountants use adequate procedures when performing
audit, so they can detect any illegal acts of company being audited
Includes specific actions/guidelines accountant must follow after
identifying potentially illegal activity when conducting audit
Sarbanes-Oxley Act of 2002
• Consists of new rules/regulations for public accounting firms in order to
reduce fraud in accounting practices
Created Public Company Accounting Oversight Board
Titles I and II outline duties of board and establish new requirements for
public accounting firms
Liability of Other Professionals
• Many professionals who provide services are professionally liable under
theories similar to accountants' liability
• Real estate brokers
• Other professionals
Chapter 11 Hypothetical Case 3
Evan McGill is a prominent member of the community. His entrepreneurial rise to wealth and power is known throughout Madison County, where he was born and
continues to live and operate his business, McGill Construction Company. McGill is an active member of the community, and is proud of his service as a deacon at the
local Baptist church.
Gordon Linder has been McGill's personal and business accountant for the past twenty years. McGill pays Linder generously for his accounting services, and Linder's
professional relationship with the businessman has generated him scores of other clients. In fact, it could be said that Linder owes his professional success, and the
health of his accounting practice, to McGill.
During tax season, McGill arrives at Linder's office for preparation of his personal and business tax returns. When Linder asks McGill about his deductible business
expenses, McGill quotes a figure of $148,000; however, he is only able to provide documentation for $120,000 of the expenses.
When Linder asks McGill for documentation of the additional $28,000, McGill states, "You know I don't have the time or inclination to keep every receipt, and you also
know I have a photographic memory. I can tell you where I ate lunch on November 7, 1990, and I can tell you that I had exactly $148,000 in business expenses last year.
Besides, if I get audited, that's my problem, not yours."
From an ethical standpoint, is it permissible for Linder to take McGill's word for it with regard to the non-documented $28,000 in business deductions? From a
professional and legal standpoint, are there risks inherent in Linder's acceptance of McGill's assertion without documentation?
Chapter 11 Hypothetical Case 4
San Francisco made major changes to the city tax code last year, making sure that big companies headquartered there paid taxes at a fair
and equal rate to its residents. One month after the hike in taxes, San Francisco-based social media startup Samovar held an IPO, releasing
the shares of common stock at $54. As part of the paperwork for filing the IPO, Samovar's accounting firm, Reed Fortier Rockwell, had to
release a Registration Statement that listed any "any known events or uncertainties" that could affect its future operating results. Reed
Fortier's Registration Statement failed to note the fact that Samovar's effective tax rate was rising from 34% to 41%.
The tax reforms hit Samovar hard, and it was forced to reduce its next earnings guidance. Its stock took a dive, and now hovers around $14
A group of shareholders have filed a class-action lawsuit against Samovar and Reed Fortier, claiming that their actions violate the Securities
Act of 1933. Do you agree or disagree that their actions intentionally misled stockholders?