FIU Sarbanes Oxley Act Debate Discussion Questions

Debate This:

Sarbanes-Oxley Act

• Debate This: Sarbanes-Oxley Act
• Chapter 40, P. 965

Superior Wholesale Corporation planned to purchase Regal Furniture, Inc., and wished to deter-mine 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 accurately on the general ledger. As a result of these representations, Superior went forward with its purchase of Regal.After the purchase, Superior discovered that the audit by Chase had been materially inaccurate and misleading, primarily because the inventory had been grossly overstated on the balance sheet. Later, a former Regal employee who had begun working for Superior exposed an e-mail exchange between Chase and former Regal chief executive officer Buddy Gantry. The exchange revealed that Chase had cooperated in overstating the inventory and understating Regal’s tax liability. Using the information presented in the chapter, answer the following questions.

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 not?
2. According to the rule adopted by the majority of courts to determine accountants’ liability to third parties, could Chase be liable to Superior? Explain.
3. Generally, what requirements must be met before Superior can recover damages under Sec-tion 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5? Can Superior meet these requirements?
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?

Debate This:

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

40
Learning Objectives
The five Learning Objectives below are designed to help improve your under- standing. After reading this chapter, you should be able to
answer the following questions:
1.
2.
3.
4.
5.
Under what common law theories may professionals be liable to clients?
What are the rules concerning an auditor’s liability to third parties?
How might an accountant violate the Securities Act?
What crimes might an accountant commit under the Internal Revenue Code?
What is protected by the attorney-client privilege?
Liability of Accountants and Other
Professionals
“A member should observe the profes- sion’s technical and ethical standards
… and discharge professional respon- sibility to the best of the member’s ability.”
Professionals, such as accountants, attorneys, physicians, and architects, are increasingly faced with the
threat of liability. In part, this is because the public has become more aware that professionals are required
to deliver competent services and adhere to certain standards of performance within their professions.
The standard of due care to which the members of the American Institute of Certified Public Accountants are
expected to adhere is set out in the chapter-opening quota- tion. Investors rely heavily on the opinions of
certified public accountants when making decisions about whether to invest in a company.
The failure of several major companies and leading public accounting firms in the past twenty years has
focused atten- tion on the importance of abiding by professional accounting standards. Numerous
corporations—from American Interna- tional Group (AIG, the world’s largest insurance company),
948
Article V,
Code of Professional Conduct American Institute of
Certified Public Accountants
to HealthSouth, Goldman Sachs, Lehman Brothers, Tyco International, and India-based Mahindra Satyam—
have been accused of engaging in accounting fraud. These companies may have reported fictitious revenues,
concealed liabilities or debts, or artificially inflated their assets.
Mark Burnett/Alamy Stock Photo
CHAPTER 40: Liability of Accountants and Other Professionals
949
40–1 Potential Liability to Clients
Under the common law, professionals may be liable to clients for breach of contract, negligence, or fraud.
40–1a LiabilityforBreachofContract
Accountants and other professionals face liability under the common law for any 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 as agreed, then he or she has breached the
contract, and the client has the right to pursue recovery of damages.
Possible damages include expenses incurred by the client in securing another professional to provide the
contracted-for services and any other reasonable and foreseeable losses that arise from the professional’s
breach. For instance, if the client had to pay penalties for fail- ing to meet deadlines, the court may order the
professional to pay an equivalent amount in damages to the client.
40–1b LiabilityforNegligence
Accountants and other professionals may also be held liable under the common law for negligence in the
performance of their services. Recall that the following elements must be proved to establish negligence:
1. Adutyofcareexisted.
2. Thatdutyofcarewasbreached.
3. Theplaintiffsufferedaninjury.
4. Theinjurywasproximatelycausedbythedefendant’sbreachofthedutyofcare.
Negligence cases against professionals often focus on the standard of care exercised by the professional. All
professionals are subject to standards of conduct established by codes of professional ethics, by state statutes,
and by judicial decisions. They are also governed by the contracts they enter into with their clients.
In performing their contracts, professionals must exercise the established standards of care, knowledge, and
judgment generally accepted by members of their professional group. Here, we look at the duty of care owed
by two groups of professionals that frequently perform services for business firms: accountants and
attorneys.
Accountant’s Duty of Care Accountants play a major role in a business’s financial sys- tem.
Accountants establish and maintain financial records, as well as design, control, and audit record-keeping
systems. They also prepare statements that reflect an individual’s or a business’s financial status, give tax
advice, and prepare tax returns.
Generally, an accountant must possess the skills that an ordinarily prudent accountant would have and must
exercise the degree of care that an ordinarily prudent accountant would exercise. The level of skill expected of
accountants and the degree of care that they should exercise in performing their services are reflected in the
standards discussed next.
GAAP and GAAS. When performing their services, accountants must comply with generally accepted
accounting principles (GAAP) and generally accepted auditing standards (GAAS). The Finan- cial Accounting
Standards Board (FASB, usually pronounced “faz-bee”) determines what accounting conventions, rules, and
procedures constitute GAAP at a given point in time. GAAS, established by the American Institute of Certified
Public Accountants, set forth the professional qualities and judgment that an auditor should exercise in
performing an audit. Normally, if an accountant conforms to generally accepted standards and acts in good
faith, he or she will not be held liable to the client for incorrect judgment.
Generally Accepted Accounting Principles(GAAP) The conventions, rules, and procedures developed by the Financial
Accounting Standards Board
to define accepted accounting practices at a particular time.
Generally Accepted Auditing Standards(GAAS) Standards established by the American Institute of Certified Public Accountants
to define the professional qualities and judgment that should be exercised by an auditor in performing an audit.
Learning Objective 1
Under what common law theories may professionals be liable to clients?
950
UNIT SIX: Government Regulation
International Financial Reporting Standards(IFRS) Asetofglobal accounting standards that are being phased in by U.S.
companies.
Defalcation Embezzlementor misappropriation of funds.
A violation of GAAP or GAAS is considered prima facie evidence of negligence on the part of the accountant.
Compliance with GAAP and GAAS, however, does not necessarily relieve an accountant from potential legal
liability. An accountant may be held to a higher standard of conduct established by state statute or by judicial
decisions.
For a discussion of how International Financial Reporting Standards (IFRS) are replacing GAAP, see this
chapter’s Landmark in the Law feature.
Discovering Improprieties. An accountant is not required to discover every impropriety, defalcation1
(embezzlement), or fraud in her or his client’s books. If, however, the impro- priety, defalcation, or fraud has
gone undiscovered because of the accountant’s negligence or failure to perform an express or implied duty,
the accountant will be liable for any resulting
1. This term, pronounced deh-fal-kay-shun, is derived from the Latin de (“off”) and falx (“sickle”—a tool used for cutting grain or tall grass). As used here,
the term refers to the act of an embezzler.
The SEC Adopts Global Accounting Rules
A
t one time, investors and companies considered U.S. accounting rules, known as generally
accepted account- ing principles (GAAP), to be the gold standard—the best system for reporting
earnings and other financial information. Then came the subprime mortgage melt- down and a
global economic crisis, which caused many to question the effectiveness and superiority of GAAP.
In 2008, the Securities and Exchange Commission (SEC) unanimously approved a plan to require
U.S. companies to use a set of global accounting rules known as the International Financial
Reporting Standards (IFRS). These rules, which are established by the London-based International Accounting Standards Board, are being phased in and will be required for all financial
reports filed with the SEC.
Why Shift to Global Accounting Standards? The SEC decided to replace the GAAP with the
IFRS for sev- eral reasons. GAAP rules are detailed and fill nearly 25,000 pages. The IFRS are
simpler and more straightforward, filling only 2,500 pages, and they focus more on general
principles than on specific rules. Consequently, companies should eventu- ally find it less difficult
to comply with the
international rules, and this should lead to cost savings.
Another benefit is that investors will find it easier to make cross-country comparisons between,
say, a technol- ogy company in Silicon Valley and one in Germany or Japan. Furthermore, hav- ing
uniform accounting rules that apply to all nations makes sense in a global economy. The European
Union and 113 other nations—including nearly all of the United States’ trading partners—already
use the IFRS.
The Downside to Adopting Global Rules Despite these benefits, the shift to the global rules
has had some draw- backs. Making the change has proved to be both costly and time consuming.
Com- panies have had to upgrade their commu- nications and software systems, study and
implement the new rules, and train their employees, accountants, and tax attorneys in the rules’
use. Some smaller U.S. firms have found it difficult to absorb the costs of converting to the IFRS.
Another concern is that although IFRS rules are simpler than GAAP rules, they may not be better.
Because the global rules are broader and less detailed, they give companies more leeway in
reporting, so less financial information may be disclosed. There are also indica- tions that using the
IFRS can lead to wide variances in profit reporting and may tend to boost earnings above what they
would have been under GAAP. Finally, the role of the U.S. Financial Accounting Standards Board
and the SEC in shaping and oversee- ing accounting standards will necessarily be reduced because
the London-based International Accounting Standards Board sets the IFRS.
Application to Today’s World The shift to the IFRS received broad biparti- san political support
even during the economic recession. Nevertheless, it will take years for the United States to completely
implement global accounting rules. Business students should study and understand the IFRS so that
they are pre- pared to use these rules in their future careers.
Landmark in the Law
CHAPTER 40: Liability of Accountants and Other Professionals
951
losses suffered by the client. Therefore, an accountant who uncovers suspicious financial transactions and
fails to investigate the matter fully or to inform the client of the discovery can be held liable to the client for
the resulting loss.
Audits. One of the most important tasks that an accountant may perform for a business is an audit. An audit is
a systematic inspection, by analyses and tests, of a business’s financial records. An accountant qualified to
perform audits is often called an auditor. After performing an audit, the auditor issues an opinion letter
stating whether, in his or her opinion, the financial statements fairly present the business’s financial position.
The purpose of an audit is to provide the auditor with evidence to support an opinion on the reliability of the
business’s financial statements. A normal audit is not intended to uncover fraud or other misconduct.
Nevertheless, an accountant may be liable for failing to detect misconduct if a normal audit would have
revealed it. Also, if the auditor agreed to examine the records for evidence of fraud or other obvious
misconduct and then failed to detect it, he or she may be liable.
Qualified Opinions and Disclaimers. In issuing an opinion letter, an auditor may qualify the opinion or
include a disclaimer. In a disclaimer, the auditor basically states that she or he does not have sufficient
information to issue an opinion. A qualified opinion or a disclaimer must be specific and must identify the
reason for the qualification or disclaimer.
Example 40.1 Richard Zehr performs an audit of Lacey Corporation. In the opinion letter, Zehr qualifies his
opinion by stating that there is uncertainty about how a lawsuit against the firm will be resolved. In this
situation, Zehr will not be liable if the outcome of the suit is unfavorable for the firm. Zehr could still be liable,
however, for failing to discover other problems that an audit in compliance with IFRS or GAAS rules would
have revealed. ■
Unaudited Financial Statements. Sometimes, accountants are called on to prepare unau- dited financial
statements. (A financial statement is considered unaudited if incomplete auditing procedures have been used
in its preparation or if insufficient procedures have been used to justify an opinion.) Lesser standards of care
are typically required in this situation.
Nevertheless, accountants may be liable for omissions from unaudited statements. Accountants may be
subject to liability for failing, in accordance with standard accounting procedures, to designate a balance
sheet as “unaudited.” An accountant will also be held liable for failure to disclose to a client any facts or
circumstances that give reason to believe that misstatements have been made or that a fraud has been
committed.
Defenses to Negligence. If an accountant is found guilty of negligence, the client can collect damages for
losses that arose from the accountant’s negligence. An accountant facing a claim of negligence, however, has
several possible defenses, including the following:
1. Theaccountantwasnotnegligent.
2. Iftheaccountantwasnegligent,thisnegligencewasnottheproximatecauseoftheclient’slosses.
3. Theclientwasalsonegligent(dependingonwhetherstatelawallowscontributorynegligenceasa defense).
Example 40.2 Coopers & Peterson, LLP, provides accounting services for Bandon Steel Mills, Inc. (BSM).
Coopers advises BSM to report a certain transaction as a $12.3 million gain on its financial statements. Later,
BSM plans to make a public offering of its stock. The SEC reviews its financial statements and determines that
the accounting treatment of the trans- action has to be corrected before the sale.
Because of the delay, the public offering does not occur on May 2, when BSM’s stock is selling for $16 per
share. Instead, it takes place on June 13, when, due to unrelated factors, the price has fallen to $13.50. If BSM
files a lawsuit against Coopers, claiming that the negligent accounting resulted in the stock’s being sold at a
lower price, BSM is unlikely to prevail. Although the accounting firm’s negligence may have delayed the stock
offering,
Auditor An accountant qualified
to perform audits (systematic inspections) of a business’s financial records.
“Never call an accoun- tant a credit to his profession; a good accountant is a debit to his profession.”
Attributed to Charles Lyell
1797–1875 (British lawyer)
Assume that the accounting firm for this steel manufacturer makes an error in a financial statement. If the initial public
offering is delayed and the stock price falls in the meantime, is the accounting firm liable for the lower price?
Ethical Issue
952 UNIT SIX: Government Regulation
the negligence was not the proximate cause of the decline in the stock price. Thus, Coopers
would not be liable for damages based on the price decline. ■
Attorney’s Duty of Care The conduct of attorneys is governed by rules established by each state and by
the American Bar Association’s Model Rules of Professional Conduct. All attorneys owe a duty to provide
competent and diligent representation.
Attorneys are required to be familiar with well-settled principles of law applicable to a case and to find
relevant law that can be discovered through a reasonable amount of research. They must also investigate and
discover facts that could materially affect clients’ legal rights.
Normally, an attorney’s performance is expected to be that of a reasonably competent gen- eral practitioner
of ordinary skill, experience, and capacity. An attorney who holds himself or herself out as having expertise in
a particular area of law (such as intellectual property) is held to a higher standard of care in that area of the
law than attorneys without such expertise.
What are an attorney’s responsibilities with respect to protecting data stored on the cloud? To achieve both cost savings and better security, more and
more attorneys are storing their data, including confidential client information, on the cloud.
Sometimes, professionals assume that once their data have migrated to the cloud, they no longer
have to be concerned with keeping the information secure. But cloud computing is simply the
virtualization of the computing process. In other words, the professional is
still ultimately responsible for the information.
Attorneys’ obligations for their clients’ information are spelled out in the American Bar Asso-
ciation’s Model Rules of Professional Conduct, which serve as the basis for the ethics rules for
attorneys adopted by most states. Comment 17 to Model Rule 1.6 states, “The lawyer must take
reasonable precautions to prevent the [client’s] information from coming into the hands of unintended recipients.” Thus, lawyers have an ethical duty to safeguard confidential client information,
whether it is stored as documents in a filing cabinet or as electromagnetic impulses on a server that
might be located anywhere. (Note that Rule 1.6 does not require an attorney to guarantee that a
breach of confidentiality will never occur.)
Certainly, it is harder to maintain control over information stored on the cloud. Although the attorney “owns” the data, he or she probably does not even know the location of the computer where the
information is stored. Furthermore, a provider of cloud computing services may move data from
one server to another. Nevertheless, attorneys should be aware of jurisdictional issues and make
sure that their cloud computing service provider is complying with data protection regulations and
privacy notification requirements wherever the provider’s servers are located.
Misconduct. Typically, a state’s rules of professional conduct for attorneys provide that committing a criminal
act that reflects adversely on the person’s “honesty or trustworthiness, or fitness as a lawyer in other
respects” is professional misconduct. The rules often further provide that a lawyer should not engage in
conduct involving “dishonesty, fraud, deceit, or misrepresentation.” Under these rules, state authorities can
discipline attorneys for many types of misconduct.
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CHAPTER 40: Liability of Accountants and Other Professionals
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Case Example 40.3 Daniel Johns, a Wisconsin attorney, was the driver in a one-vehicle drunk driving accident
in which his brother was killed. He pleaded guilty to homicide by use of a vehicle while driving with a blood
alcohol level over the legal limit. Johns served 120 days in jail and was released on five years’ probation. The
court terminated his probation early because of his good behavior, and he went back to practicing law.
The state’s office of lawyer regulation (OLR) then initiated disciplinary proceedings seeking to suspend
Johns’s license to practice for sixty days for professional misconduct. The court, however, explained that the
“commission of a criminal act by a Wisconsin licensed lawyer does not, per se, constitute professional
misconduct.” The OLR had not proved that Johns’s crime reflected adversely on his honesty, trustworthiness,
or fitness as a lawyer in other respects. In fact, except for this one tragic event, Johns had led an exemplary life
without a hint of professional misconduct. The court therefore dismissed the disciplinary complaint.2 ■
Liability for Malpractice. When an attorney fails to exercise reasonable care and profes- sional judgment,
she or he breaches the duty of care and can be held liable for malpractice (professional negligence). In
malpractice cases—as in all cases involving allegations of negligence—the plaintiff must prove that the
attorney’s breach of the duty of care actually caused the plaintiff to suffer some injury.
Case Example 40.4 The law firm of Husch Blackwell Sanders, LLP, represented Brian Nail in a dispute with his
former employer over stock options. When Nail left the company, he acquired options to purchase his former
employer’s stock within eighteen months. But then the former employer merged with another company, and
the stock was “locked up” for twelve months after the merger. The value of the stock declined significantly
during this period. Husch Blackwell eventually negotiated a settlement that extended Nail’s option period.
When Nail attempted to exercise his options under the settlement agreement, how- ever, complications arose
that prevented him from immediately obtaining the stock.
Nail sued Husch Blackwell in a Missouri state court for malpractice, alleging that the firm had negligently
drafted the settlement agreement and negligently delayed advising him to exercise the options. Nail sought to
recover damages equal to the difference between the highest value of the stock during the lock-up period and
his cost to acquire the stock. The trial court granted a summary judgment in favor of the law firm, and the
Missouri Supreme Court affirmed. Nail had failed to prove that Husch Blackwell’s alleged negligence was the
proximate cause of his damages. The decline in the stock price was unrelated to the law firm’s alleged
misconduct.3 ■
40–1c LiabilityforFraud
Recall that fraud, or fraudulent misrepresentation, involves the following elements:
1. Amisrepresentationofamaterialfact.
2. Anintenttodeceive.
3. Justifiablereliancebytheinnocentpartyonthemisrepresentation.
In addition, to obtain damages, the innocent party must have been injured. Both actual and constructive fraud
are potential sources of legal liability for an accountant or other professional.
Actual Fraud A professional may be held liable for actual fraud when (1) he or she inten- tionally
misstates a material fact to mislead a client, and (2) the client is injured as a result of justifiably relying on the
misstated fact. A material fact is one that a reasonable person would consider important in deciding whether
to act.
2. In re Disciplinary Proceedings against Johns, 2014 WI 32, 353 Wis.2d 746, 847 N.W.2d 179 (2014). 3. Nail v. Husch Blackwell Sanders, LLP, 436 S.W.3d 556
(Mo. 2014).
Malpractice Professional negligence, or failure to exercise reasonable care and professional judgment, that results in injury, loss, or
damage to those relying on the professional.
What must a plaintiff prove when when claiming that an attorney has committed malpractice?
Katarzyna Bialasiewicz/Dreamstime.com
Learning Objective 2
What are the rules concern- ing an auditor’s liability to third parties?
954
UNIT SIX: Government Regulation
ConstructiveFraud Conductthat is treated as fraud under the law even when there is no proof of intent to defraud, usually because of
the existence of a special relationship or fiduciary duty.
Among other penalties, an accountant guilty of fraudulent conduct may suffer penalties imposed by a state
board of accountancy. Case Example 40.5 Michael Walsh, a certified public accountant (CPA), impersonated his
brother-in-law, Stephen Teiper, on the phone to obtain financial information from Teiper’s insurance
company. Teiper wrote a letter reporting Walsh’s conduct to the Nebraska Board of Public Accountancy. After
a hearing, the board repri- manded Walsh, placed him on probation for three months, and ordered him to
attend four hours of ethics training. He also had to pay the costs of the hearing. The Nebraska Supreme Court
affirmed the board’s decision on appeal.4 ■
Constructive Fraud A professional may sometimes be held liable for constructive fraud whether or not
he or she acted with fraudulent intent. Liability arises because the profes- sional has a duty to the client and
violates that duty by making a material misrepresentation. The client must be injured as a result of justifiably
relying on the professional’s misstate- ments to obtain damages.
Constructive fraud may be found when an accountant is grossly negligent in performing his or her duties.
Example 40.6 Paula, an accountant, is conducting an audit of ComCo, Inc. Paula accepts the explanations of
Ron, a ComCo officer, regarding certain financial irregular- ities, despite evidence that contradicts those
explanations and indicates that the irregularities may be illegal. Paula’s conduct could be characterized as an
intentional failure to perform a duty in reckless disregard of the consequences of such failure. This would
constitute gross negligence and could be held to be constructive fraud. ■
40–2 Potential Liability to Third Parties
Traditionally, an accountant or other professional owed a duty only to those with whom she or he had a
direct contractual relationship—that is, those with whom she or he was in privity of contract. A professional’s
duty was solely to her or his client. Violations of statutes, fraud, and other intentional or reckless acts of
wrongdoing were the only exceptions to this general rule.
Today, numerous third parties—including investors, shareholders, creditors, corporate managers and
directors, and regulatory agencies—rely on the opinions of auditors when making decisions. In view of this
extensive reliance, many courts have all but abandoned the privity requirement in regard to accountants’
liability to third parties.
In this section, we focus primarily on the potential liability of auditors to third parties. The majority of courts
now hold that auditors can be held liable to third parties for negligence, but the standard for the imposition of
this liability varies.
40–2a TheUltramaresRule
The traditional rule regarding an accountant’s liability to third parties is based on privity of contract and was
enunciated by Chief Judge Benjamin Cardozo (of the New York Court of Appeals) in 1931. Classic Case
Example 40.7 Fred Stern & Company hired the public accounting firm of Touche, Niven & Company to review
Stern’s financial records and prepare a balance sheet for the year ending December 31, 1923. 5 Touche
prepared the balance sheet and supplied Stern with thirty-two certified copies. According to the certified
balance sheet, Stern had a net worth (assets less liabilities) of $1,070,715.26.
4. Walsh v. State of Nebraska, 276 Neb. 1034, 759 N.W.2d 100 (2009).
5. Banks, creditors, stockholders, purchasers, and sellers often rely on a balance sheet as a basis for making decisions relating to a company’s business.
CHAPTER 40: Liability of Accountants and Other Professionals 955
To what extent is an accounting firm liable for incorrect balance-sheet information that is distributed to the public?
In reality, however, Stern’s liabilities exceeded its assets. The company’s records had been falsified by
insiders at Stern so that assets exceeded liabilities, resulting in a positive net worth. In reliance on the
certified balance sheets, Ultramares Corporation loaned substantial amounts to Stern. After Stern was
declared bankrupt, Ultramares brought an action against Touche for negligence in an attempt to recover
damages.
The New York Court of Appeals (that state’s highest court) refused to impose liability on Touche. The court
concluded that Touche’s accoun- tants owed a duty of care only to those persons for whose “primary benefit”
the statements were intended. In this case, the statements were intended only for the primary benefit of
Stern. The court held that in the absence of privity or a relationship “so close as to approach that of privity,” a
party could not recover from an accountant.6 ■
The Requirement of Privity The requirement of privity has since been
referred to as the Ultramares rule, or the New York rule. It continues to
be used in some states. Case Example 40.8 Toro Company supplied equipment and credit to Summit Power
Equipment Distributors and required Summit to submit audited reports indi- cating its financial condition.
Accountants at Krouse, Kern & Company prepared the reports, which allegedly contained mistakes and
omissions regarding Summit’s financial condition.
Toro extended large amounts of credit to Summit in reliance on the audited reports. When Summit was
unable to repay the loans, Toro brought a negligence action against the account- ing firm and proved that
accountants at Krouse knew the reports would be used by Summit to induce Toro to extend credit.
Nevertheless, under the Ultramares rule, the court refused to hold the accounting firm liable because the firm
was not in privity with Toro.7 ■
“Near Privity” Modification The Ultramares rule was modified somewhat in a 1985 New York case,
Credit Alliance Corp. v. Arthur Andersen & Co.8 In that case, 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 the establish- ment of an accountant-client relationship. The rule enunciated in the
Credit Alliance case is often referred to as the “near privity” rule. Only a minority of states has adopted this
rule.
40–2b TheRestatementRule
The Ultramares rule has been severely criticized. Because much of the work performed by auditors is
intended for use by persons who are not parties to the contract, many argue that auditors should owe a duty
to these third parties. As support for this position has grown, there has been an erosion of the Ultramares rule
to expose accountants to liability to third parties in some situations.
The majority of courts have adopted the position taken by the Restatement (Third) of Torts, 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. Under the Restatement (Third) of Torts,
an accountant’s liability extends to the following:
1. Personsforwhosebenefitandguidancetheaccountant“intendstosupplytheinformationorknows that the recipient intends
to supply it.”
2. Personswhomtheaccountant“intendstheinformationtoinfluenceorknowsthattherecipient so intends.”
6. Ultramares Corp. v. Touche, 255 N.Y. 170, 174 N.E. 441 (1931). 7. Toro Co. v. Krouse, Kern & Co., 827 F.2d 155 (7th Cir. 1987).
8. 66 N.Y.2d 812, 489 N.E.2d 249, 498 N.Y.S.2d 362 (1985).
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956 UNIT SIX: Government Regulation
Example 40.9 Steve, an accountant, prepares a financial statement for Tech Software, Inc., a client, knowing
that Tech Software will submit the statement when it applies for a loan from First National Bank. If Steve
makes negligent misstatements or omissions in the statement, he may be held liable to the bank because he
knew that the bank would rely on his work product when deciding whether to make the loan. ■
40–2c The“ReasonablyForeseeableUsers”Rule
A small minority of courts hold accountants liable to any users whose reliance on an accoun- tant’s
statements or reports was reasonably foreseeable. This standard has been criticized as extending liability too
far and exposing accountants to massive liability.
The majority of courts have concluded that the Restatement’s approach is more reasonable because it allows
accountants to control their exposure to liability. Liability is “fixed by the accountants’ particular knowledge
at the moment the audit is published,” not by the foresee- ability of the harm that might occur to a third party
after the report is released. Exhibit 40–1 summarizes the three different views of accountants’ liability to
third parties.
40–2d LiabilityofAttorneystoThirdParties
Like accountants, attorneys may be held liable under the common law to third parties who rely on legal
opinions to their detriment. Generally, an attorney is not liable to a nonclient unless there is fraud (or
malicious conduct) by the attorney. The liability principles stated in the Restatement (Third) of Torts,
however, may apply to attorneys as well as to accountants.
40–3 Liability of Accountants under Other Federal Laws
Accountants also face potential liability under other federal statutes, several of which merit special
discussion. These include the Sarbanes-Oxley Act, the Securities Act of 1933, the 1934 Securities Exchange
Act, and the Private Securities Litigation Reform Act.
40–3a TheSarbanes-OxleyAct
The Sarbanes-Oxley Act imposes a number of strict requirements on both domestic and foreign public
accounting firms. These requirements apply to firms that provide auditing services to companies (“issuers”)
whose securities are sold to public investors. The act
Exhibit 40–1 Three Basic Rules of Accountant’s Liability to Third Parties
RULE
Ultramares rule
Restatement rule
“Reasonably
foreseeable users”
rule
DESCRIPTION
APPLICATION
Liability is imposed only if the accountant is in privity, or near
A minority of courts apply
privity, with the third party.
this rule.
Liability is imposed only if the third party’s reliance is fore- seen, or
The majority of courts have
known, or if the third party is among a class of fore- seen, or known,
adopted this rule.
users.
Liability is imposed if the third party’s use was reasonably
foreseeable.
A small minority of courts
use this rule.
CHAPTER 40: Liability of Accountants and Other Professionals 957
Deloitte & Touche audits public companies. What law requires oversight of its procedures?
defines an issuer as a company that (1) has securities that are registered under Section 12 of the Securities
Exchange Act of 1934, (2) is required to file reports under Section 15(d) of the 1934 act, or (3) files—or has
filed—a registration statement that has not yet become effective under the Securities Act of 1933.
The Public Company Accounting Oversight Board The Sarbanes-Oxley Act increased
government oversight of public accounting practices by creating the Public Company Accounting Oversight
Board, which reports to the Securities and Exchange Commission. The board oversees the audit of public
companies that are subject to securities laws. The goal is to protect public investors and to ensure that public
accounting firms comply with the provisions of the act. The act defines public accounting firms as firms
“engaged in the practice of public accounting or preparing or issuing audit reports.” The key provisions
relating to the duties of the oversight board and the requirements relating to public account- ing firms are
summarized in Exhibit 40–2.
As part of an audit, the board may compel persons to testify in an investigative interview. Under the board’s
rules, any person compelled to testify “may be accompanied, repre- sented and advised by counsel.” The
board can limit attendance at the interview to the person being examined, his or her counsel, and other
persons that the board determines are “appropriate.”
Exhibit 40–2 Key Provisions of the Sarbanes-Oxley Act Relating to Public Accounting Firms
AUDITOR INDEPENDENCE
To help ensure that auditors remain independent of the firms that they audit, Title II of the Sarbanes-Oxley Act does the
following:
1. Makes it unlawful for Registered Public Accounting Firms (RPAFs) to perform both audit and nonaudit services for the
same com- pany at the same time. Nonaudit services include the following:
•
•
•
•
•
•
Bookkeeping or other services related to the accounting records or financial statements of the audit client.
Financial information systems design and implementation.
Appraisal or valuation services.
Fairness opinions.
Management functions.
Broker or dealer, investment adviser, or investment banking services.
2. Requires preapproval for most auditing services from the issuer’s (the corporation’s) audit committee.
3. Requires audit partner rotation by prohibiting RPAFs from providing audit services to an issuer if either the lead audit
partner or the audit partner responsible for reviewing the audit has provided such services to that corporation in each of
the prior five years.
4. Requires RPAFs to make timely reports to the audit committees of the corporations. The report must indicate all
critical account- ing policies and practices to be used; all alternative treatments of financial information within generally
accepted accounting principles that have been discussed with the corporation’s management officials, the ramifications
of the use of such alternative treatments, and the treatment preferred by the auditor; and other material written
communications between the auditor and the corporation’s management.
5. Makes it unlawful for an RPAF to provide auditing services to an issuer if the corporation’s chief executive officer, chief
financial officer, chief accounting officer, or controller was previously employed by the auditor and participated in any
capacity in the audit of the corporation during the one-year period preceding the date that the audit began.
DOCUMENT INTEGRITY AND RETENTION
1. The act provides that anyone who destroys, alters, or falsifies records with the intent to obstruct or influence a federal
investiga- tion or in relation to bankruptcy proceedings can be criminally prosecuted and sentenced to a fine,
imprisonment for up to twenty years, or both.
2. Theactrequiresaccountantswhoauditorreviewpubliclytradedcompaniestoretainallworkingpapersrelatedtotheaudit
or review for a period of five years (amended to seven years). Violators can be sentenced to a fine, imprisonment for up
to ten years, or both.
tupungato/iStock Editorial/Getty Images
958 UNIT SIX: Government Regulation
Whether the board infringed a witness’s right to counsel under these rules was at issue in the following case.
Case 40.1
Laccetti v. Securities and Exchange Commission
United States Court of Appeals, District of Columbia Circuit, 885 F.3d 724 (2018).
Background and Facts The Public Company Account- ing Oversight Board investigated an audit
by the Ernst & Young accounting firm. The investigation focused on Mark Laccetti, who was the
Ernst & Young partner in charge of the audit. As part of the investigation, the board interviewed
Laccetti. During the interview, the board allowed him to be accompanied by an Ernst & Young
attorney. But the board denied his request to also be accompanied by an accounting expert who
would assist his counsel. Ultimately, the board found that Laccetti had violated the board’s rules
and auditing standards. The board suspended him from the accounting profession for two years
and fined him $85,000. The Securities and Exchange Commission (SEC) upheld the sanctions.
Laccetti appealed.
In the Words of the Court
KAVANAUGH, Circuit Judge: *** *
Third, even putting those points aside, the Board’s rules estab- lish that the Board could not bar
Laccetti from using an * * * expert to assist his counsel in these circumstances.
* * * Given the extraordinary complexity of matters raised in agency investigations * * *, counsel
trained only in the law, no matter how skillful, may on occasion be less than fully equipped to serve
the client in agency proceedings. Unless the lawyer can receive substantive guidance from an expert
technician—in this case, an accountant—when he determines in his professional judgment that
such assistance is essential, his client’s absolute right to counsel during the proceedings would
become substan- tially qualified. In this context, an expert is an extension of coun- sel. [Emphasis
added.]
*** *
Under the Board’s rules, the Board therefore may not bar a witness from bringing an * * * expert
who could assist the witness’s counsel during an investigative interview. * * * The Board itself has
long directed its staff to permit a techni- cal consultant to be present during investigative
testimony. * * * The problem is that the Board did not follow its rules in this particular case.
Decision and Remedy The U.S. Court of Appeals for the District of Columbia Circuit vacated the
orders and sanctions against Laccetti, and remanded the case. “The Board acted unlaw- fully when
it barred Laccetti from bringing an accounting expert to assist his [legal] counsel at the investigative
interview.”
Critical Thinking
• Legal Environment If the board were to open a new dis- ciplinary proceeding against Laccetti
and re-interview him, what would it have to do to comply with the court’s decision?
• What If the Facts Were Different? Suppose that the board’s rules guaranteed a witness’s right
to counsel but expressly excluded “technical consultants and experts” during an investigative
interview. Would the result have been different? Explain.
* * * The Board stated that it denied Laccetti’s request because Laccetti’s expert was employed at
Ernst & Young. The Board did not want Ernst & Young personnel present for the testimony of the
Ernst & Young witnesses because it apparently did not want Ernst & Young personnel to monitor
the investigation.
The Board’s rationale suffers from three independent flaws.
First, the arbitrary and capricious standard requires that an agency’s action be reasonable and
reasonably explained. Here, the Board’s explanation for denying Laccetti’s request was not
reasonable. [Emphasis added.]
* * * Given the presence of the Ernst & Young attorney at the interview, the Board’s rationale for
excluding the Ernst & Young accounting expert * * * makes no sense here.
*** *
Second, even if the Board wanted to bar an Ernst & Young- affiliated accounting expert, that
explanation would not justify the Board’s denying Laccetti any accounting expert. * * * The Board
could have told Laccetti that he could bring to the interview an accounting expert who was not
affiliated with Ernst & Young. The Board did not do so.
*** *
CHAPTER 40: Liability of Accountants and Other Professionals
959
Requirements for Maintaining Working Papers Performing an audit for a client involves an
accumulation of working papers—the documents used and developed during the audit. These include notes,
computations, memoranda, copies, and other papers that make up the work product of an accountant’s
services to a client.
Under the common law, which in this instance has been codified in a number of states, working papers
remain the accountant’s property. It is important for accountants to retain such records in the event that they
need to defend against lawsuits for negligence or other actions in which their competence is challenged. The
client also has a right to access an accountant’s working papers because they reflect the client’s financial
situation. On a client’s request, an accountant must return to the client any of the client’s records or journals,
and failure to do so may result in liability.
Section 802(a)(1) of the Sarbanes-Oxley Act required accountants to maintain working papers relating to an
audit or review for five years from the end of the fiscal period in which the audit or review was concluded.
The requirement was subsequently extended to seven years. A knowing violation of this requirement will
subject the accountant to a fine, impris- onment for up to ten years, or both.
40–3b TheSecuritiesActof1933
The Securities Act requires issuers to file registration statements with the Securities and Exchange
Commission (SEC) prior to an offering of securities.9 Accountants frequently prepare and certify the financial
statements that are included in the issuer’s registration statement.
Liability under Section 11 Section 11 of the 1933 Securities Act imposes civil liability on accountants
for misstatements and omissions of material facts in registration statements. Accountants may be liable if a
financial statement they prepared for inclusion “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.”10
An accountant’s liability for a misstatement or omission of a material fact in a registration statement extends
to anyone who acquires a security covered by the registration statement. A purchaser of a security need only
demonstrate that she or he has suffered a loss on the security. Proof of reliance on the materially false
statement or misleading omission ordinarily is not required. Nor is there a requirement of privity between
the accountant and the security purchaser.
The Due Diligence Standard. Section 11 imposes a duty on accountants to use due diligence in preparing the
financial statements included in registration statements. Thus, after a pur- chaser has proved a loss on a
security, the accountant has the burden of showing that he or she exercised due diligence in preparing the
financial statements.
To prove due diligence, an accountant must demonstrate that she or he followed generally accepted
standards and did not commit negligence or fraud. Specifically, to avoid liability, the accountant must show
that he or she did the following:
1. Conductedareasonableinvestigation.
2. Hadreasonablegroundstobelieveanddidbelieve,atthetimetheregistrationstatementbecame effective, that the statements
therein were true and that there was no omission of a material fact that would be misleading. 11
9. Many securities and transactions are expressly exempted from the 1933 Securities Act. 10. 15 U.S.C. Section 77k(a).
11. 15 U.S.C. Section 77k(b)(3).
Working Papers The documents used and developed by an accountant during an audit, such as notes, computations, and memoranda.
“Destroy the old files, but make copies first.”
Samuel Goldwyn
1879–1974
(American motion picture producer)
Due Diligence A required standard of care that certain professionals, such as accountants, must meet to avoid liability for securities
violations.
Learning Objective 3
How might an accountant violate the Securities Act?
960 UNIT SIX: Government Regulation
In particular, the due diligence standard places a burden on accountants to verify informa- tion furnished by a
corporation’s officers and directors. Merely asking questions is not always sufficient to satisfy the
requirement. Accountants may be held liable for failing to detect dan- ger signals in documents furnished by
corporate officers that required further investigation.
Other Defenses to Liability. Besides proving that he or she has acted with due diligence, an accountant can
raise the following defenses to Section 11 liability:
1.
2.
3.
4.
Therewerenomisstatementsoromissions.
Themisstatementsoromissionswerenotofmaterialfacts.
Themisstatementsoromissionshadnocausalconnectiontotheplaintiff’sloss.
Theplaintiff-purchaserinvestedinthesecuritiesknowingofthemisstatementsoromissions.
Liability under Section 12(2) Section 12(2) of the 1933 Securities Act imposes civil liability for fraud
in relation to offerings or sales of securities.12 Liability arises when an oral statement to an investor or a
written prospectus13 includes an untrue statement or omits a material fact. Some courts have applied Section
12(2) to accountants who aided and abetted (assisted) the seller or the offeror of the securities in violating
Section 12(2).
Those who purchase securities and suffer harm as a result of a false or omitted statement, or some other
violation, may bring a suit in a federal court to recover their losses and other damages. The U.S. Department
of Justice brings criminal actions against those who commit willful violations. The pen- alties include fines of
up to $10,000, imprisonment for up to five years, or both. The SEC is authorized to seek an injunction against
a willful violator to prevent further violations. The SEC can also ask a court to grant other relief, such as an
order to a violator to refund profits derived from an illegal transaction.
40–3c TheSecuritiesExchangeActof1934
Under Sections 18 and 10(b) of the Securities Exchange Act and SEC Rule 10b-5, an accountant may be found
lia- ble for fraud. A plaintiff has a substantially heavier burden of proof under the 1934 act than under the
1933 act because an accountant does not have to prove due diligence to escape liability under the 1934 act.
Liability under Section 18 Section 18 of the 1934 act imposes civil liability on 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. 14
Section 18 liability is narrow in that it applies only to applications, reports, documents, and registration
statements filed with the SEC. This remedy is further limited in that it applies only to sellers and purchasers.
Under Section 18, a seller or purchaser must prove one of the following:
1.
2.
Thatthefalseormisleadingstatementaffectedthepriceofthesecurity.
Thatthepurchaserorsellerreliedonthefalseormisleadingstatementinmakingthepurchaseor
sale and was not aware of the inaccuracy of the statement.
12. 15 U.S.C. Section 77l.
13. A prospectus contains financial disclosures about the corporation for the benefit of potential investors. 14. 15 U.S.C. Section 78r(a).
Which federal agency can bring criminal actions against professionals who commit willful violations under Section
12(2) of the Securities Act of 1933?
Hero Images/Getty Images
CHAPTER 40: Liability of Accountants and Other Professionals 961
Good Faith Defense. An accountant will not be liable for violating Section 18 if he or she acted in good faith in
preparing the financial statement. To demonstrate good faith, an accountant must show that he or she had no
knowledge that the financial statement was false and misleading. In addition, the accountant must have had
no intent to deceive, manipulate, defraud, or seek unfair advantage over another party.
Note that “mere” negligence in preparing a financial statement does not lead to liability under the 1934 act.
This differs from the 1933 act, under which an accountant is liable for all negligent acts.
Other Defenses. In addition to the good faith defense, accountants can escape liability by proving that the
buyer or seller of the security in question knew that the financial statement was false and misleading. Also,
the statute of limitations may be asserted as a defense to liability under the 1934 act.
Liability under Section 10(b) and Rule 10b-5 Accountants additionally face potential legal
liability under the antifraud provisions contained in the Securities Exchange Act and SEC Rule 10b-5. The
scope of these antifraud provisions is very broad and allows private parties to bring civil actions against
violators.
Prohibited Conduct. Section 10(b) makes it unlawful for any person, including accoun- tants, to use, in
connection with the purchase or sale of any security, any manipulative or deceptive device or contrivance in
contravention of SEC rules and regulations.15 Rule 10b-5 further makes it unlawful for any person, by use of
any means or instrumentality of interstate commerce, to do the following:
1.
2.
Employanydevice,scheme,orartifice(pretense)todefraud.
Makeanyuntruestatementofamaterialfactoromitamaterialfactnecessarytoensurethatthe
statements made were not misleading, in light of the circumstances.
3.
Engageinanyact,practice,orcourseofbusinessthatoperatesorwouldoperateasafraudor deceit on any
person, in connection with the purchase or sale of any security.16
Extent of Liability. Accountants may be held liable only to sellers or purchasers of securities under Section 10(b) and Rule 10b-5. Privity is not necessary for a recovery.
An accountant may be found liable not only for fraudulent misstatements of material facts in written material
filed with the SEC, but also for any fraudulent oral statements or omissions made in connection with the
purchase or sale of any security. In some situations, accountants may also have the duty to correct
misstatements that they discover in previous financial statements. For a plaintiff to succeed in recovering
damages under these antifraud provisions, he or she must prove intent (scienter) to commit the fraudulent or
deceptive act. Ordinary negligence is not enough.
40–3d ThePrivateSecuritiesLitigationReformAct
The Private Securities Litigation Reform Act made some changes to the potential liability of accountants and
other professionals in securities fraud cases. Among other things, the act imposed a statutory obligation on
accountants. An auditor must use adequate procedures in an audit to detect any illegal acts of the company
being audited. If something illegal is detected, the auditor must disclose it to the company’s board of
directors, the audit commit- tee, or the SEC, depending on the circumstances.17
15. 15 U.S.C. Section 78j(b)
16. 17 C.F.R. Section 240.10b-5. 17. 15 U.S.C. Section 78j-1.
If an accountant is unaware of a company officer’s fraud, will she still be held fully liable for any losses caused by the
misstatements?
Learning Objective 4
What crimes might an accountant commit under the Internal Revenue Code?
962 UNIT SIX: Government Regulation
Proportionate Liability The act provides that, in most situations, a party is liable only for the
proportion of damages for which he or she is responsible.18 An accountant who participates in, but is unaware
of, illegal conduct may not be liable for the entire loss caused by the illegality.
Example 40.10 Nina, an accountant, helps the president and owner of Midstate Trucking company draft
financial statements. The statements misrepresent Midstate’s financial condition, but Nina is not aware of the
fraud. Nina might be held liable, but the amount of her liability could be proportionately less than the entire
loss. ■
Aiding and Abetting The act also made it a separate crime to aid and abet a violation of the Securities
Exchange Act. Aiding and abet- ting might include knowingly participating in such an act, assisting in it, or
keeping quiet about it. If an accountant knowingly aids and abets a primary violator, the SEC can seek an
injunction or monetary damages.
Example 40.11 Smith & Jones, an accounting firm, performs an audit for ABC Sales Com- pany that is so
inadequate as to constitute gross negligence. ABC uses the materials provided by Smith & Jones as part of a
scheme to defraud investors. When the scheme is uncovered, the SEC can bring an action against Smith &
Jones for aiding and abetting on the ground that the firm knew or should have known of the material
misrepresentations that were in its audit and on which investors were likely to rely. ■
40–4 Potential Criminal Liability
An accountant may be found criminally liable for violations of securities laws and tax laws. In addition, most
states make it a crime to (1) knowingly certify false reports, (2) falsify, alter, or destroy books of account, and
(3) obtain property or credit through the use of false financial statements.
40–4a CriminalViolationsofSecuritiesLaws
Accountants may be subject to criminal penalties for willful violations of the 1933 Securities Act and the 1934
Securities Exchange Act. If convicted, they face imprisonment for up to five years and/or a fine of up to
$10,000 under the 1933 act, and imprisonment for up to ten years and a fine of $100,000 under the 1934 act.
Under the Sarbanes-Oxley Act, if an accountant’s false or misleading certified audit state- ment is used in a
securities filing, the accountant may be held criminally liable. The accoun- tant may be fined up to $5 million,
imprisoned for up to twenty years, or both.
40–4b CriminalViolationsofTaxLaws
The Internal Revenue Code makes it a felony to willfully make false statements in a tax return or to willfully
aid or assist others in preparing a false tax return. Felony violations are punishable by a fine of $100,000
($500,000 in the case of a corporation) and imprisonment for up to three years.19 This provision applies to
anyone who prepares tax returns for others for compensation—not just to accountants.20
18. 15 U.S.C. Section 78u-4(g). 19. 26 U.S.C. Section 7206(2). 20. 26 U.S.C. Section 7701(a)(36).
Kotin/Shutterstock.com
CHAPTER 40: Liability of Accountants and Other Professionals 963
A penalty of $250 per tax return is levied on tax preparers for negligent understatement of the client’s tax
liability. For willful understatement of tax liability or reckless or intentional disregard of rules or regulations,
a penalty of $1,000 is imposed.21 A tax preparer may also be subject to penalties for failing to furnish the
taxpayer with a copy of the return, failing to sign the return, or failing to furnish the appropriate tax
identification numbers.
In addition, a tax preparer may be fined $1,000 per document for aiding and abetting another’s
understatement of tax liability (the penalty is increased to $10,000 in corporate cases).22 The tax preparer’s
liability is limited to one penalty per taxpayer per tax year.
40–5 Confidentiality and Privilege
Professionals are restrained by the ethical tenets of their professions to keep all communications with their clients confidential.
40–5a Attorney-ClientRelationships
The confidentiality of attorney-client communications is protected by law, which confers a privilege on such
communications. This privilege exists because of the client’s need to fully disclose the facts of his or her case
to the attorney.
To encourage frankness, confidential attorney-client communications relating to represen- tation are
normally held in strictest confidence and protected by law. The attorney and her or his employees may not
discuss the client’s case with anyone—even under court order— without the client’s permission. The client
holds the privilege, and only the client may waive it—by disclosing privileged information to someone
outside the privilege, for instance.
Note, however, that the SEC has implemented rules requiring attorneys who become aware that a client has
violated securities laws to report the violation to the SEC. Because reporting a client’s misconduct can be a
breach of the attorney-client privilege, these rules have created potential conflicts for some attorneys.
Once an attorney-client relationship arises, all communications between the parties are privileged. The
question in the following case was whether communications between an attorney and an individual before
that individual was informed that the attorney was not his counsel were privileged.