Chapter 04 - Legal Liability of CPAs
CHAPTER 4
Legal Liability of CPAs
Review Questions
4-1
There There are sever several al reasons reasons why why the the poten potentia tiall legal legal liabi liability lity of CPA CPAs for professi professiona onall "malpract "malpractice" ice" excees that of physicians an other professionals! ne reason is the vast n#mber of people who who may s#stain amages! $f a physician or attorney commits commits a serio#s error% the n#mber of in&#re parties generally generally is is limite limite to to one iniv inivi#al i#al patient patient or client! client! 'hen 'hen a CPA(s CPA(s report is in error% error% literally millions of investors may s#stain losses! )econ% the feeral )ec#rities Acts regaring CPAs( liability are #ni*#e in that m#ch of the b#ren of of proof is shifte shifte to to the efen efenant! ant! +ormally% +ormally% efenan efenants ts are "pres#me "pres#me innocen innocentt #ntil #ntil proven g#ilty!" g#ilty!" ,ner ,ner the feeral )ec#rities Acts% Acts% however% however% CPAs CPAs charge charge with "malpractice "malpractice"" m#st prove their their innocen innocence! ce! inally% when investors s#stain losses in the many millions of ollars% the economics of the sit#ation ictates bringing s#it against the CPAs even if the prospects for recovery appear remote! 'hen the possible ollar recovery is smaller% which #s#ally is the case in other professional malpractice s#its% the plaintiffs are more li.ely to be eterre from filing s#it simply by the costs of litigation!
4-/
rinary rinary neglig negligenc encee means means lac. of reason reasonabl ablee care! care! ross ross negl neglig igenc encee means means lac. of even even slight slight care% inicative of rec.less isregar for #ty! #t y! An oversight oversight by a CPA res#lting in a misstatement in a financial statement might be consiere orinary negligence% whereas if a CPA faile s#bstantially to comply with generally accepte a#iting stanars the charge might be gross negligence!
4-
Privity Privity is is the relation relationshi ship p betwe between en parties parties to a contract! contract! A CPA CPA firm is in in privity privity with with the the clien clientt which it is serving% as well as with any thir party beneficiary% s#ch as a creitor ban. name in the engagement letter 2the contract between the CPA CPA firm an its client3! ,ner common common law% if the a#itors o not comply with their obligations to the client% res#lting in amages% the client may s#e an recover its losses by proving that the a#itors were negligent in performing their #ties #ner the contract!
4-1
Chapter 04 - Legal Liability of CPAs
4-4
A thir-party beneficiary is a person other than the contracting parties who is name in the contract or intene by the contracting parties to have efinite rights an benefits #ner the contract! or example% a ban. wo#l be a thir party beneficiary if the a#itors an the client agree that the p#rpose of the a#it was to provie the ban. with an a#it report to ma.e a ban. loan to the client!
4-
Common law is #nwritten law that has evelope thro#gh co#rt ecisions5 it represents &#icial interpretation of a society(s concept of fairness! )tat#tory law is law that has been aopte by a governmental #nit% s#ch as the feeral government!
4-6
The primary ifference between the ,ltramares an the 7estatement approaches relates to whether the CPA has liability for orinary negligence to thir parties not specifically ientifie as #sers of the CPA(s report! ,ner the Ultramares approach a CPA may be hel liable for orinary negligence to a thir party only when that CPA 213 was aware that the financial statements were to be #se for a partic#lar p#rpose by a .nown party or parties% an 2/3 some action of the CPA inicates s#ch .nowlege! ,ner the Restatement approach the specific ientity of the thir parties nee not be .nown to the CPA to establish liability for orinary negligence! 8owever% s#ch liability for orinary negligence is only to a limite class of .nown or intene #sers of the a#ite financial statements!
4-9
$n Ultramares v. Touche % the +ew :or. Co#rt of Appeals r#le that a#itors co#l be hel liable to thir parties 2not in privity of contract3 for gross negligence or fra#% b#t not for acts of orinary negligence! $n Rosenblum v. Adler % the +ew ;ersey )#preme Co#rt r#le that a#itors co#l be hel liable for orinary negligence to any "foreseeable" thir parties who #tili
4-=
The Credit Alliance Corp. case embrace the lanmar. Ultramares v. Touche & Co. preceent! The co#rt state that before the a#itors may be hel liable for orinary negligence to a thir party 213 the a#itors m#st have .nowlege of reliance on the financial statements by that party for a partic#lar p#rpose% an 2/3 some action by the a#itors m#st inicate that .nowlege!
4->
,ner common law% a#itors are liable to their clients for orinary negligence as well as for fra# an breach of contract! A#itors are liable to thir party beneficiaries 2an in some &#risictions to foreseen or foreseeable thir parties3 for fra# an for orinary negligence! A#itors are liable for gross negligence an fra# to other thir parties!
4-10
,ner &oint an several liability one efenant may be re*#ire to pay the losses attrib#te to the actions of other efenants who o not have the financial reso#rces to pay! Th#s% if two parties were negligent an fo#n to each be 0? liable% if one was #nable to pay% the other party co#l be re*#ire to pay the entire 100?! ,ner proportionate liability a efenant is liable only for his or her proportion of fa#lt! ,sing the previo#s example% neither efenant co#l be re*#ire to pay more than 0? of the amages!
4-/
Chapter 04 - Legal Liability of CPAs
4-11
Legal actions #ner common law re*#ire the plaintiffs to bear most of the b#ren of affirmative proof! The plaintiffs m#st prove they s#staine losses% that they relie #pon financial statements that were misleaing% that this reliance ca#se their losses% an that the a#itors were g#ilty of a certain egree of negligence! $n legal actions bro#ght #ner the )ec#rities Act of 1>% the b#ren of proof is shifte to the a#itors% who m#st show that they were not negligent 2the #e iligence efense3 or that misleaing financial statements were not the proximate ca#se of the plaintiffs( losses!
4-1/
The )ec#rities Act of 1> reg#lates the initial sale of sec#rities in interstate commerce 2new iss#es3% an the )ec#rities @xchange Act of 1>4 reg#lates traing of sec#rities after initial istrib#tion!
4-1
The Hochfelder v. Ernst ecision is regare as a "victory" for the acco#nting profession beca#se it is one of the few ecisions to limit% rather than expan% a#itors( legal liability to thir parties! $n this ecision the ,!)! )#preme Co#rt r#le that orinary negligence was not a s#fficient egree of miscon#ct for a#itors to be hel liable to thir parties #ner 7#le 10b- of the )ec#rities @xchange Act of 1>4!
4-14
The Continental Vending case was #n#s#al in that it involve criminal charges against the CPAs for violating provisions of the )ec#rities Acts! Altho#gh there was no intent to efra# on the part of the CPAs% they were convicte of criminal fra# on the basis of gross negligence! The three CPAs were later parone by the presient of the ,nite )tates!
4-1
The 7ac.eteer $nfl#ence an Corr#pt rgani
4-16
The )@C has iss#e 7#les of Practice to govern the appearance an practice before the commission of CPAs% attorneys% an others! 7#le of Practice /2e3 gives the power of s#spension or isbarment to the )@C! $n aition% the P#blic Company Acco#nting versight Boar 2#ner the a#thority of the )@C3 may con#ct investigations an isciplinary proceeings regaring both registere p#blic acco#nting firms% an professional employees 2incl#ing owners3! Boar sanctions incl#e monetary amages% s#spension of firms an acco#ntants from wor.ing on engagements for p#blicly trae companies% an referral of criminal cases to the ;#stice epartment!
4-
Chapter 04 - Legal Liability of CPAs
4-19
$n the 11! Tenants" Corporation case% the client contene that the a#itors ha been retaine to perform all necessary acco#nting an a#iting services! The CPAs arg#e that they ha been retaine to o "write-#p" wor. only% consisting of maintaining acco#nting recors an preparing financial statements an tax ret#rns! This ifference was critical beca#se the client contene the CPAs ha been negligent in not iscovering a efalcation! The case ill#strate the importance of an engagement letter to efine the services to be performe!
4-1=
@ngagement letters are important both for a#its an for acco#nting an review services performe by CPAs! ral arrangements are #nsatisfactory when a isp#te arises as to the services to be renere by the CPAs!
4-1>
+o! 7ogers an reen appear to be g#ilty of gross negligence% which often is consiere tantamo#nt to constr#ctive fra#! 8owever% act#al fra# involves .nowlege of misrepresentation within the financial statements an an intention to eceive #sers of those statements! Altho#gh 7ogers an reen faile s#bstantially to comply with generally accepte a#iting stanars% there is no inication that they .new of misrepresentation in the statements or intene to eceive thir parties! ross negligence may be consiere constr#ctive fra#% beca#se the a#itors are misleaing the p#blic as to the egree of creibility that they are able to a to the statements! 'hile s#ch con#ct is highly #nprofessional% it is still *#ite ifferent from attesting to the "fairness" of financial statements .nown by the a#itors to be misleaing!
Questions Requiring Analysis
4-/0
CPA liability to clients may be base on 213 breach of contract% 2/3 a tort action for negligence% or 23 both! ,ner common law% in general% the client m#st prove the following to establish CPA liabilityD #tyEthe CPA accepte a #ty to exercise s.ill% pr#ence an iligence! Breach of #tyEthe CPA breache that #ty! LossEthe client s#ffere a loss! Ca#sationEthe loss res#lte from the CPA(s negligent performance! • • • •
$n this circ#mstance it wo#l seem that the above elements might be proven in a case against 8er $rwin! This seems partic#larly li.ely given the fact that inexperience staff assistants operate witho#t s#fficient s#pervision! 4-/1
A client has a vali claim to recover its losses from a CPA firm if it can prove the CPAs were negligent an this negligence was the proximate ca#se of the client(s loss! 8owever% in this case% ;ensen% $nc! may be hel g#ilty of contrib#tory negligence for not having followe the CPAs( recommenations for improving internal control! )#ch contrib#tory negligence might ca#se a co#rt to prohibit the client(s recovery from the CPA firm% or limit the losses recovere from the CPA firm thro#gh the concept of comparative negligence!
4-4
Chapter 04 - Legal Liability of CPAs
4-//
:es! Creitors #s#ally are thir parties not in privity of contract with the a#itors! ,ner common law% these "other" thir parties may recover from the a#itors any losses proximately ca#se by the a#itors( gross negligence% or% in some &#risictions% orinary negligence! $n this sit#ation% whether the co#rts ahere to the Ultramares % Restatement % or Rosenblum approach is not an iss#e5 the a#itors were g#ilty of gross negligence tantamo#nt to constr#ctive fra#! )mall exhibite a rec.less isregar for his professional responsibilities by falsifying the a#it wor.ing papers! As state in o#r isc#ssion of professional ethics% CPAs are responsible for the acts of their assistants5 th#s% the firm of 8anson an Brown is liable for )mall(s gross negligence!
4-/
The facts clearly inicate negligence by )cott reen! A#itors have a responsibility to esign their a#it to provie reasonable ass#rance of etecting material misstatements #e to errors an fra#! nce evience of even immaterial fra# is bro#ght to the a#itors( attention% they are obligate to isclose the sit#ation to the client! )cott reen co#l be hel liable for losses that res#lt from fail#re to isclose their s#spicions to the client!
4-/4
)par.s% 'atts% an 'ilcox% CPAs are liable to their client for amages ca#se by the negligence of the senior a#itor! The assistant a#itor selecte a sample of 60 transactions in her test of controls for hanling p#rchases% receiving% vo#chers payable% an cash isb#rsements! 'hen a#itors rely #pon a sample to form an opinion abo#t an entire pop#lation% they m#st examine each item in the sample caref#lly! $n this case% the assistant a#itor fo#n n#mero#s inications of fra# 2missing receiving reports3% b#t the in-charge a#itor too. no action! This con#ct by the senior a#itor clearly shows lac. of the "#e professional care" re*#ire by generally accepte a#iting stanars% an is th#s inicative of orinary negligence! The tests of controls mae by the a#itors are part of their f#rther a#it proce#res! 'hen the tests isclose wea.nesses in internal control that may allow material fra# to occ#r% the a#itors have two specific responsibilities! They sho#lD 213
Comm#nicate the sit#ation to the appropriate levels of the client(s management incl#ing the a#it committee of the client(s boar of irectors!
2/3
@xpan their a#it proce#res to etermine if material fra# act#ally has occ#rre an% if so% the effects of this fra# on the financial statements!
The ollar amo#nt of the CPAs( liability will epen #pon what portion of the client(s F900%000 loss was proximately ca#se by the a#itors( negligence! The a#itors almost certainly will be liable for the F00%000 loss occ#rring after the completion of the a#it! $n aition% they may be hel responsible for all or part of the F/00%000 loss occ#rring earlier% epening #pon whether this loss might have been prevente or recovere ha the a#itors ta.en prompt an appropriate action!
4-
Chapter 04 - Legal Liability of CPAs
4-/
4-/6
2a3 1>4!
The stoc.holers co#l initiate the laws#it #ner the )ec#rities @xchange Act of
2b3
The Private )ec#rities Litigation 7eform Act of 1>> establishes a form of proportionate liability #ner the 1>4 )ec#rities @xchange Act! 'hen all efenants are able to pay their share each party pays its pro-rate share! Accoringly% )awyer an )awyer wo#l be liable for F/0%000 2? G F%000%0003!
2c3
$f management 2or any other liable party3 is #nable to pay its share each other efenant may be re*#ire to pay 0? over its pro rata share! )awyer an )awyer wo#l be liable for a maxim#m of F9%000 2the original F/0%000 pl#s F1/%0003! Beca#se management is responsible for F%00%0000 of the total 290? G F%000%0003 an is #nable to pay% )awyer an )awyer will probably en #p paying the entire F9%000! Also% this amo#nt may increase somewhat #e to the ActHs re*#irements that the losses of certain small investors be entirely pai if possible!
2a3
The #ni*#e aspect of this case is that the CPA firm of Arth#r Anersen was fo#n g#ilty of of the felony of criminal estr#ction of oc#ments! The inictment name only the firm
an not any inivi#al partner or professional staff! The conviction ca#se the emise of this international acco#nting firm! 2b3 This case ill#strates how the actions of a few inivi#al partners an employees can lea to isastro#s res#lts for the firm! 8owever% it sho#l be note that the conviction was overt#rne by the ,!)! )#preme Co#rt base on the instr#ctions given to the &#rors! 4-/9
2a3 The case sho#l be ismisse! $n the Hochfelder case% the ,!)! )#preme Co#rt hel that action for amages #ner )ection 102b3 an 7#le 10b- was not warrante in the absence of intent to efra# 2scienter3 on the part of the CPA firm! Altho#gh oron Ioore was negligent in the performance of its a#its% the firm was #naware of the existence of the scheme% an therefore not g#ilty of fra# #ner )ection 102b3 of the )ec#rities @xchange Act of 1>4! 2b3
The plaintiffs might have file s#it #ner common law for negligence! Their prospects for s#ccess wo#l epen #pon two factorsD 213
'hether the &#risiction in which the s#it was bro#ght recogni
2/3
'hether the co#rt consiere these investors to be "reasonably foreseeable thir parties #sing the financial statements for ro#tine b#siness p#rposes!"
4-6
Chapter 04 - Legal Liability of CPAs
Objective Questions
4-/=
I#ltiple Choice 2a3 2/3 A CPA will be liable to thir parties who were #n.nown an not foreseeable for gross negligence! $t sho#l be pointe o#t that if the thir party ha been "foreseeable%" liability might be establishe for orinary negligence #ner a co#rt following the Rosenblum v. Adler ecision! 2b3 2/3 The 7osenbl#m Approach provies more thir parties the ability to recover amages from the CPA who has performe an engagement with orinary negligence% an accoringly% is least esirable from the perspective of the CPA! The ,ltramares Approach is most esirable% an the 7estatement Approach 2also .nown as the oreseen ,ser Approach3 is between the two extremes! 2c3 2/3 The plaintiffs nee not prove that the CPA mae a false statement% it is eno#gh to prove losses an breach of a #ty that the CPA ha! 23 243 +egligent tax avice wo#l orinarily res#lt in a s#it bro#ght #ner common law! +ote that the client is not covere #ner the )ec#rities Act of 1> or the )ec#rities @xchange Act of 1>4! 2e3 213 The Creit Alliance Corp! v! Arth#r Anersen Co! case reaffirme the principles in the ,ltramares case by clarifying the conitions necessary for parties to be consiere thir-party beneficiaries! 2f3 213 Contrib#tory negligence% negligence on the part of the plaintiff% may be #se as a efense an the co#rt may limit or bar recovery by a plaintiff whose own negligence contrib#te to the loss! 2g3 23 The #rivate $ecurities %itigation Reform Act of 1' amene the )ec#rities an @xchange Act of 1>4 to place limits on the amo#nt of the a#itorsH liability thro#gh establishing proportionate liability! 2h3
243 A CPA may avoi liability #ner the 1> Act by proving that their negligence was not the proximate ca#se of the plaintiff(s loss! Accoringly% a fining that the false statement is immaterial wo#l in all circ#mstances represent a viable efense!
2i3
23 A CPA may be fo#n liable to a client when #e care has not been exercise!
2&3
23 ,ner the )ec#rities Act of 1> p#rchasers of sec#rities who s#stain losses nee only prove that the financial statements containe in the registration statement were misleaing! Then the b#ren is shifte to the a#itors to prove that they performe the a#it with "#e iligence!"
4-9
Chapter 04 - Legal Liability of CPAs
2.3
213 The Continental Vending case was a lanmar. in establishing a#itors( potential criminal liability #ner the )ec#rities @xchange Act of 1>4! The case involve a#ite financial statements% was bro#ght #ner stat#tory law% an i not involve registration statements 2which are covere by the )ec#rities Act of 1>3!
2l3
2/3 The 11! Tenants case was a lanmar. case concerning a#itors( liability when they are associate with #na#ite financial statements!
4-/>
2a3 Tr#e! The )ec#rities Act of 1> reg#lates interstate offerings of sec#rities to the p#blic! 2b3
Tr#e! The effect of the )ec#rities Act of 1> is to give to thir parties who p#rchase registere sec#rities the same rights against the a#itor as are possesse by the client #ner common law!
2c3
alse! )ection 112a3 of the )ec#rities Act of 1> specifically bars recovery by anyone .nowing of an #ntr#th or omission in a registration statement!
23
Tr#e! The )ec#rities Act of 1> shifts the b#ren of proving that the a#it was con#cte properly to the efenant a#itors!
2e3
Tr#e! An acco#ntant s#ccessf#lly asserting the "#e iligence" efense can avoi liability!
2f3
Tr#e! The acco#ntants( efense will #s#ally incl#e efforts to establish that there were other ca#ses for the plaintiffs( losses!
2g3
alse! The )@C oes not pass on the merit of sec#rities% nor oes it efen acco#ntants!
4-0
2a3 2b3 2c3 23 2e3 2f3 2g3
Liable +ot liable Liable Liable Liable Liable +ot liable
4-1
2a3 2b3 2c3 23 2e3 2f3 2g3
23 23 293 213 263 2/3 243
4-=
Chapter 04 - Legal Liability of CPAs
4-/
4-
2a3 23 )ection 11 of the )ec#rities Act of 1> imposes liability on a#itors for misstatements or omissions of a material fact in certifie financial statements or other information provie in registration statements! )imilarly% #ner )ection 102b3% 7#le 10b of the )ec#rities @xchange Act of 1>4% the plaintiff m#st prove there was a material misstatement or omission in information release by the company% s#ch as a#ite financial statements! 2b3
23 ,ner both )ection 11 of the 1> Act an )ection 102b3 of the 1>4 Act% the plaintiff m#st allege or prove that sJhe inc#rre monetary amages!
2c3
213 ,ner )ection 11 of the 1> Act% the b#ren of proof is shifte to the efenant% acco#ntant! The acco#ntant may then efen himself or herself by establishing #e iligence! The plaintiff oes not have to show lac. of #e iligence by the CPA ,ner )ection 10% the plaintiff m#st prove scienter!
23
243 The plaintiff oes not have to prove that sJhe was in privity with the CPA #ner either section!
2e3
2/3 ,ner )ection 102b3% the plaintiff m#st prove &#stifiable reliance on the financial information! This is not tr#e #ner )ection 11 in which the plaintiff nee prove only the items in item 2a3 an 2b3 isc#sse above!
2f3
2/3 The plaintiff oes have to prove that the CPA ha scienter #ner )ection 102b3 of the 1>4 Act! )cienter is not neee #ner the 1> Act!
2a3 2b3 2c3 23 2e3 2f3 2g3 2h3 2i3 2&3
1/ 10 > 1 11 / 9 14
)ec#rities Act of 1> Proportionate liability Proximate ca#se Breach of contract )cienter ra# Constr#ctive fra# Common law +egligence )tat#tory law
4->
Chapter 04 - Legal Liability of CPAs
Probles
4-4
4-
)L,T$+D 'ilson an 'yatt 2@stimate timeD /0 min#tes3 2a3
The first basis for liability wo#l be to assert orinary negligence by 'ilson an 'yatt! The fail#re to meet the stanars of the profession wo#l be inicative of orinary negligence! )ince the p#rpose of the a#it was the p#rchase of the treas#ry stoc.% 7is. Capital is a thir-party beneficiary #ner the contract between 'ilson an 'yatt an loria )#nshine! Therefore% 'ilson an 'yatt wo#l be hel liable for orinary negligence to 7is. Capital! The secon basis for liability is constr#ctive fra#! 8ere 7is. Capital m#st show that the acco#ntants either .new the financial statements were incorrect or examine them witho#t regar for #e professional care5 that is% that their negligence was so great 2i!e!% grossly negligence3 as to constit#te constr#ctive fra#! $f fra# is proven% privity is not necessary for recovery by a thir party!
2b3
:es! $n this case 7is. Capital is clearly a thir-party beneficiary! Therefore% 7is. Capital co#l recover losses% if it can be establishe that the firm of 'ilson an 'yatt is g#ilty of orinary negligence!
)L,T$+D )eavers ean CPAs 2@stimate timeD /0 min#tes3 2a3
:es% b#t only to the extent of F90%000! B#sch is a thir-party beneficiary of the contract between Ieglow an its a#itors% an may therefore recover from the a#itors losses ca#se by the CPAs( orinary negligence! 8owever% the original F0%000 loan was mae prior to B#sch(s reliance #pon the negligently a#ite financial statements! Th#s% the a#itors( negligence was not the proximate ca#se of this portion of B#sch(s loss! The a#itors( negligence may% however% be consiere the proximate ca#se of the F90%000 loss inc#rre as a res#lt of reliance #pon the misleaing statements!
2b3
The prospects for Iaxwell(s recovery of its F0%000 loss are s#bstantially less than those of B#sch! Iaxwell was not a thir-party beneficiary to the contract! Th#s% in many &#risictions following Ultramares % Iaxwell cannot recover losses attrib#table to the CPAs( orinary negligence! )imilarly% it is o#btf#l that Iaxwell wo#l *#alify as a foreseen thir party as necessary #ner the Restatement approach! @ven in a &#risiction accepting the Rosenblum preceent% which allows thir parties to recover losses ca#se by the a#itors( orinary negligence% Iaxwell wo#l have to prove that it was a "foreseeable thir party relying #pon the financial statements for ro#tine b#siness p#rposes!" $t is *#estionable whether the loan by Iaxwell was either "reasonably foreseeable" or "ro#tine%" as Iaxwell was a c#stomer of Ieglow% not a lener!
4-10
Chapter 04 - Legal Liability of CPAs
4-6
)L,T$+D Thomas 7oss% CPAs 2@stimate timeD 1 min#tes3 2a3
213 ,ner common law in a &#risiction that aheres to the Ultramares octrine% the stoc.holers m#st show that they inc#rre losses% that the CPAs were grossly negligent% an that this gross negligence was the proximate ca#se of the stoc.holers( losses! 2/3
2b3
213 $n a s#it bro#ght #ner the )ec#rities Act of 1>% initial p#rchasers of the sec#rity m#st show only that they ha a loss an that the financial statements were misleaing! 2/3
2c3
The a#itors% in orer to avoi liability% m#st prove either that they performe their a#it with "#e iligence" 2that is% were not negligent3 or that their negligence was not the proximate ca#se of the plaintiffs( losses! 213 $n a s#it bro#ght #ner the )ec#rities @xchange Act of 1>4% the plaintiffs normally m#st prove reliance #pon the misleaing financial statements% as well as that they s#staine a loss an that the statements were misleaing!
2/3
4-9
,ner common law% the efenant is "pres#me innocent #ntil proven g#ilty%" an therefore bears no b#ren or affirmative proof! The a#itors will% however% intro#ce evience ref#ting the plaintiffs( allegations!
To avoi liability% the a#itors m#st prove either that they "acte in goo faith" 2were not grossly negligent3% an that their gross negligence was not the proximate ca#se of the plaintiffs( losses!
)L,T$+D Charles 'orthington% CPA 2@stimate timeD /0 min#tes3 Craft has state that the CPA firm has "reviewe the boo.s an recors of lac. Kent#res%" when in fact no s#ch "review" has occ#rre! A "review" of financial statements consists of limite investigatory proce#res esigne to provie statement #sers with a limite egree of ass#rance that the financial statements are in conformity with generally accepte acco#nting principles! Craft(s actions are similar to iss#ing an a#itors( report witho#t first performing an a#it! )#ch an action may well be consiere an act of criminal fra#% intene to mislea #sers of the financial statements! $n aition% Craft(s actions violate 7#les 10/% /0/% an 01 of the A$CPA Code of #rofessional Conduct ! $f the financial statements of lac. Kent#res t#rn o#t to be misleaing% there is little o#bt that any co#rt wo#l fin the CPA firm g#ilty of at least constr#ctive fra# an liable to any thir party who s#stains a loss as a res#lt of reliance #pon the statements! The fact that Craft violate 'orthington(s policy of s#bmitting all reports for 'orthington(s review wo#l not lessen the CPA firm(s liability! The concept of m#t#al agency allows Craft% as a partner% to commit the firm to contracts% incl#ing a#itors( reports an acco#ntants( reports! The fact that this report was not s#bmitte for 'orthington(s review might be intro#ce as evience against Craft in the event he is acc#se of criminal fra#!
4-11
Chapter 04 - Legal Liability of CPAs
4-=
4->
)L,T$+D ,na#ite )tatements 2@stimate timeD 0 min#tes3 2a3
The compilation 2preparation3 of financial statements is *#ite ifferent from an a#it% an it is important that the client #nerstan this! ral commitments% s#ch as telephone conversations% can often be mis#nerstoo an sho#l be followe #p by a written engagement letter spelling o#t the nat#re an limitations of the services to be performe!
2b3
@ven a reg#lar a#it cannot be relief #pon to isclose efalcations% an in an engagement involving the compilation of #na#ite financial statements% the CPAs o not even perform any a#it proce#res! The fact that the CPA intens to perform no investigative proce#res an will rely #pon the representations of the managing agent sho#l specifically be set forth in the written engagement letter! f co#rse% if the CPA has reason to s#spect that the representations of the managing agent are erroneo#s% the concept of #e professional care re*#ires that she inform her client of her reservations!
2c3
The wor "A#it" sho#l be avoie in referring to all engagements other than a#its! therwise% it may appear that the CPAs have le the client to believe that they were acting as a#itors% in which case they may be hel acco#ntable for con#cting their wor. in accorance with generally accepte a#iting stanars! The CPA sho#l explain this sit#ation to the client an pers#ae the client to change the acco#nt title to "Acco#nting ees!"
23
'hile ay oes not have a responsibility to perform a#it proce#res when compiling #na#ite financial statements% he oes have a responsibility to exercise #e professional care! This wo#l incl#e avising the client of any sit#ation that might s#ggest a problem for the client! The CPA sho#l alert his client to the missing invoices in writing an avise the client to follow #p on the matter% or% if the client wishes% the CPA co#l investigate the matter as an aitional acco#nting service! The .ey point is that the CPA m#st not fail to alert the client to the #nerlying potential for fra#!
)L,T$+D Iar. 'illiams% CPA 2@stimate timeD /0 min#tes3 2a3
CPAs as members of a profession are obligate to exercise #e professional care! Th#s% a CPA may be hel liable to the client for the amages res#lting from the CPA(s orinary negligence! )ince ;ac.son inancial was the client% ;ac.son can recover losses proximately ca#se by 'illiams( negligence! $t wo#l appear that ;ac.son inancial co#l also recover the a#it fee as amages beca#se of 'illiams( breach of contract!
4-1/
Chapter 04 - Legal Liability of CPAs
4-40
2b3
The first arg#ment which 'illiams( attorney wo#l ma.e is that Apex ha no rights #ner the contract between ;ac.son an 'illiams! $n most &#risictions% an "other" thir party is able to recover losses attrib#table to the a#itor(s gross negligence% b#t not orinary negligence! A secon arg#ment is that 'illiams( negligence was not the proximate ca#se of Apex(s loss! The loss apparently occ#rre prior to the a#it by 'illiams an co#l not have been prevente even if 'illiams ha iscovere the efalcations! inally% the attorney wo#l arg#e contrib#tory negligence on the part of Apex! +ormally losses are allocate between the parties when both parties are negligent! 'hether the first arg#ment that ;ac.son has no rights #ner the contract will prevail is an interesting *#estion! There is little a#thority on the precise sit#ation in the problem! Altho#gh Apex is not the client an is not mentione as a beneficiary in the engagement letter% it is the company whose financial statements were a#ite! 'hether this fact creates the #ty of care owe by 'illiams to ;ac.son inancial is% at present% #nclear!
2c3
+o! A CPA firm is not prevente from recovering against its ins#rer! This is precisely the p#rpose of this type of ins#rance5 it serves to protect the ins#re firm from its own negligence! CPAs may be barre from recovering from their ins#rers% however% if they are fo#n g#ilty of criminal fra#!
)L,T$+D Cragsmore Company% CPAs 2@stimate timeD /0 min#tes3 The legal problems for Cragsmore Company involve possible criminal liability% as well as civil liability% for fra#! The facts in the Iarlowe Ian#fact#ring% $nc! a#it bear mar.e similarities to the facts in the Continental Vending case! $n Continental Vending % the co#rt fo#n two partners an a manager of a CPA firm g#ilty of criminal fra# for failing to insist #pon ae*#ate isclos#re of the #ncollectibility of a s#bstantial receivable from an affiliate! Ir! Cragsmore(s con#ct has implications of a conspiracy with management an owners of Iarlowe to conceal the relate-party aspects of the lease between Iarlowe an Acme Leasing Company! Altho#gh the inae*#ate isclos#re of the facts of the lease is not the proximate ca#se of losses to Iarlowe(s creitors beca#se of the company(s ban.r#ptcy% it is conceivable that a fining of fra# against Cragsmore Company with respect to the lease isclos#re wo#l lea to recovery of amages against the CPA by the creitors of Iarlowe! enerally% there is no re*#irement that financial statements or notes isclose the lac. of fire ins#rance! Iany companies o not obtain ins#rance coverage by choice5 others cannot obtain coverage beca#se of the ha
4-1
Chapter 04 - Legal Liability of CPAs
!n"Class Tea Case
4-41
)L,T$+D eiger Co! 2@stimate timeD 0 min#tes3 2a3
213 :es! )ince 'illis is liable to a client for orinary negligence% it is li.ely that it will be fo#n liable to eiger! 2/3
,ncertain! Liability to the ban. involve is epenent #pon whether the ban. can establish itself as a thir-party beneficiary% an thereby recover for orinary negligence! To accomplish this the ban. will have to establish that the a#itors ha been aware that the financial statements were to be #se by that partic#lar ban. as a basis for granting the loan! $f it is #nable to accomplish this% it is #nli.ely that it will be able to recover since other thir parties m#st prove gross negligence!
23
+o! The shareholers are consiere thir parties who orinarily m#st establish that the a#it was performe with gross negligence!
243
Answer / is most li.ely to be affecte since the Restatement of Torts Approach expans thir party liability to a limite class of .nown or intene #sers whose specific ientity nee not be .nown by the CPA! Accoringly% a ban. that was #nable to establish itself as a thir party beneficiary #ner the Ultramares approach might be able to establish itself as a foreseen thir party #ner the Restatement of Torts approach an thereby recover for orinary negligence! ifferences between the Restatement of Torts an Ultramares approaches relate to common law liability to thir parties% an accoringly% liability to the company itself is #naffecte! )hareholers have not orinarily been able to establish themselves as foreseen thir parties #ner the Restatement of Torts Approach!
2b3
213 +o! The 1> )ec#rities Act offers protection only to a limite gro#p of investorsEthose who p#rchase a sec#rity offere or sale #ner the registration statement! Accoringly% the company itself will not orinarily be able to recover! 2/3
+o! The 1> )ec#rities Act offers protection only to a limite gro#p of investors Ethose who p#rchase a sec#rity offere or sale #ner the registration statement! Accoringly% the ban. will not orinarily be able to recover!
4-14
Chapter 04 - Legal Liability of CPAs
23 +o! The 1> )ec#rities Act offers protection only to a limite gro#p of investorsEthose who p#rchase a sec#rity offere or sale #ner the registration statement! )ince the shareholers here i not p#rchase sec#rities% they will not orinarily be able to recover! inally% the sec#rities ha been o#tstaning for 10 years which far excees the three year stat#te of limitations! Answer wo#l change as it is o#btf#l that the a#itors wo#l #43 be able to establish that the a#it ha been performe with #e iligence when orinary negligence is involve! Accoringly% the shareholers might well be able to recover their loses! 2c3
213 +o! The )ec#rities @xchange Act of 1>4 offers protection only to p#rchasers an sellers of sec#rities registere with the )@C! 2/3
+o! ,nless the loan was an )@C registere sec#rity 2or sho#l have been% which is #nli.ely here3 the ban. will not be able to recover #ner the )ec#rities @xchange Act of 1>4!
23
o#btf#l! 'hile these shareholers are offere some protection #ner the )ec#rities @xchange Act of 1>4% the orinary negligence of the CPA is #nli.ely to be s#fficient to warrant s#ch recovery as )ection 10 re*#ires the existence of scienter 2orinarily gross negligence or even fra#3 an )ection 1= allows the CPAs to avoi liability by proving that they perform with goo faith% which they probably will be able to o in the case!
Researc$ an% &iscussion Case
4-4/
)L,T$+D Io#ntain 7eso#rces an )#per#n 2@stimate timeD 40 min#tes3 This case is closely moele after the case of The (und of (unds) %td.) v. Arthur Andersen & Co. 'e i not s#ggest reference material relating to this case to the st#ents beca#se we have fo#n that it totally ominates their concl#sions5 they opt to avoi the F=0 million &#gment at all costs! There are several significant ifferences between o#r case an the (und of (unds case% which may well affect the ecision were o#r case bro#ght before the same co#rt! The most important ifference is that o#r client companies have not signe any agreement regaring the prospective sales price of the properties! 8ence% Io#ntain 7eso#rces cannot be eeme in violation of a contract! Also% the same .ey a#it personnel a#ite #n of #ns an ing 7eso#rces Company! $n o#r case% the two clients are a#ite by ifferent offices of the same firm an% therefore% by entirely ifferent personnel! inally% in o#r case the a#itors have previo#sly approve a write-own of the carrying val#e of the #nprove properties #ner (A$* A$C +,!-, '! ing 7eso#rces ha not recogni
4-1
Chapter 04 - Legal Liability of CPAs
2a3
The following arg#ments might be avance in favor of avising )#per#n as to o#r opinion of the val#e of the propertiesD •
•
•
Io#ntain 7eso#rces may be perpetrating a fra# #pon )#per#n! $f we say nothing% we may appear to be aiing an abetting that fra#! $f )#per#n pays an excessive price for the properties an s#bse*#ently m#st write them own to an estimate recoverable val#e% it will s#stain a large loss! 'e have information that may prevent o#r client 2)#per#n3 from inc#rring s#ch a loss! 7emaining silent wo#l constit#te a lac. of professional care with respect to )#per#n! )#per#n .nows that we% as a#itors for Io#ntain 7eso#rces% have information as to the fair val#e of these properties! #r silence may be viewe as tacit approval of the transaction! $n this sit#ation% we have consierable evience that the properties o not contain significant oil an gas reserves! This evience was s#fficient for #s to agree that Io#ntain 7eso#rces sho#l write these properties own to a carrying val#e of F> million to avoi overstatement of assets! As we have .nowlege of the impaire val#e of these properties% it wo#l be iffic#lt for #s to allow )#perf#n to not write the asset own to a similar amo#nt!
•
2b3
$f we insist that )#per#n write these properties own to% say% F> million% )#per#n will probably s#e #s an allege that o#r silence was the proximate ca#se of their loss! #r expos#re appears to be approximately F million 2F4/ million - F> million3!
The following arg#ments might be avance in favor of not offering avice to )#per#nD •
•
•
•
iving )#per#n any information abo#t these properties wo#l violate o#r ethical responsibilities to Io#ntain 7eso#rces for confientiality! The transaction price in the p#rchase or sale of assets is a managerial prerogative! $t is inconsistent with the role of the inepenent a#itors to intervene beca#se they believe one or the other of the transacting parties is receiving a ba eal! 'e are not experts in the val#e of oil an gas properties% which is highly spec#lative by any stanars! $t may t#rn o#t that these properties are a bargain at F4/ million! As far as we .now% Io#ntain 7eso#rces has not mae any misrepresentations of fact or violate any laws! 'e have no right to intervene in a transaction merely beca#se we believe that o#r client is abo#t to earn a s#rprisingly large profit!
4-16
Chapter 04 - Legal Liability of CPAs
•
•
2c3
$f we offer o#r opinion of the val#e of the properties to )#per#n% Io#ntain 7eso#rces will probably s#e #s for breach of confientiality! There is a certain a#tonomy between offices of a national firm! Io#ntain 7eso#rces is a client of the enver office% while )#per#n is not! $f )#per#n were the client of another CPA firm% it is o#btf#l that we wo#l even consier the possibility of alerting the other a#itors or their client as to o#r opinion of the economic val#e of the properties!
#r opinionD 'e consier it to be totally inconsistent with the role of an inepenent a#itor to intervene in a transaction between a company an its c#stomers on the premise that the a#itors have a "greater wisom" than the transacting parties! Io#ntain 7eso#rces is not% to the a#itors( .nowlege% oing anything illegal! #rthermore% all of the information at the a#itors( isposal is confiential! Barring a flagrant violation of the law by one of the transacting parties% we o not believe that a#itors have either the legal responsibility or the right to inter&ect their #nsolicite opinion into the b#siness transaction of a#it clients! $f the a#itors ha become aware that the client was fra##lently overcharging for the property 2as was the case in (unds of (unds3 o#r sol#tion wo#l of co#rse% be ifferent!
4-19
