FIU Chapter 40 Sarbanes Oxley Act Paper

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.

CHAPTER 40: Liability of Accountants and Other Professionals
965
Communications between professionals and their clients—other than those between an
attorney and her or his client—are not privileged under federal law. In cases involving federal law, state-provided rights to confidentiality of accountant-client communications are
not recognized. Thus, in those cases, an accountant must provide all information requested
in a court order.
Practice and Review
Superior Wholesale Corporation planned to purchase Regal Furniture, Inc., and wished to determine Regal’s net worth. Superior hired Lynette Shuebke, of the accounting firm Shuebke Delgado,
to review an audit that had been prepared by Norman Chase, the accountant for Regal. Shuebke
advised Superior that Chase had performed a high-quality audit and that Regal’s inventory on the
audit dates was stated 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 Section 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.
Key Terms
auditor 951
constructive fraud 954
defalcation 950
due diligence 959
30301_ch40_hr_948-970.indd 965
generally accepted accounting
principles (GAAP) 949
generally accepted auditing
standards (GAAS) 949
International Financial Reporting
Standards (IFRS) 950
malpractice 953
working papers 959
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UNIT SIX: Government Regulation
Chapter Summary: Liability of Accountants and Other Professionals
Potential Liability
to Clients
1. Breach of contract—A professional who fails to fulfill contractual obligations can be held liable for
breach of contract and resulting damages.
2. Negligence—An accountant, attorney, or other professional, in performing her or his duties, must
use the care, knowledge, and judgment generally used by professionals in the same or similar
circumstances. Failure to do so is negligence. An accountant’s violation of generally accepted
accounting principles or generally accepted auditing standards is prima facie evidence of
negligence.
3. Fraud—Intentionally misrepresenting a material fact to a client, when the client relies on
the misrepresentation, is fraud. Gross negligence in performance of duties is constructive
fraud.
Potential Liability
to Third Parties
An accountant may be liable for negligence to any third person the accountant knows or should have
known will benefit from the accountant’s work. The standard for imposing this liability varies, but generally courts follow one of the following rules (see Exhibit 40–1):
1. Ultramares rule—Liability will be imposed only if the accountant is in privity, or near privity, with the
third party.
2. Restatement rule—Liability will be imposed only if the third party’s reliance is foreseen or known, or
if the third party is among a class of foreseen or known users. The majority of courts have adopted
this rule.
3. “Reasonably foreseeable users” rule—Liability will be imposed if the third party’s reliance was
reasonably foreseeable.
Liability of Accountants
under Other Federal Laws
1. The Sarbanes-Oxley Act—The act imposes requirements on public accounting firms that provide
auditing services to companies whose securities are sold to public investors. It created the Public
Company Accounting Oversight Board, which oversees the audit of public companies that are
subject to securities laws. The act requires accountants to maintain working papers relating to an
audit or review for seven years from the end of the fiscal period in which the audit or review was
concluded.
2. The Securities Act of 1933—
a. Section 11—An accountant who makes a false statement or omits a material fact in audited
financial statements required for registration of securities under the act may be liable to anyone
who acquires securities covered by the registration statement. The accountant’s defense is
basically the use of due diligence and the reasonable belief that the work was complete and
correct. The burden of proof is on the accountant. Willful violations of this act may be subject
to criminal penalties.
b. Section 12(2)—An accountant may be liable when a prospectus or other communication
presented to an investor contained an untrue statement or omitted a material fact.
3. The Securities Exchange Act of 1934—
a. Section 18—Accountants may be held liable for false and misleading applications, reports, and
documents filed with the SEC. The burden is on the plaintiff, and the accountant has numerous
defenses, including good faith and lack of knowledge that what was submitted was false. Mere
negligence is not enough.
b. Section 10(b) and Rule 10b-5—Provisions allow private parties to bring civil actions against
violators. Accountants may be held liable only to sellers or purchasers of securities. Privity is not
necessary for recovery.
4. The Private Securities Litigation Reform Act—An auditor must use adequate procedures to detect
any illegal acts of the company being audited and disclose any illegalities detected. Parties are liable only for the proportion of damages for which they are responsible.
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CHAPTER 40: Liability of Accountants and Other Professionals
Potential Criminal Liability
967
1. Willful violations of the Securities Act of 1933 and the Securities Exchange Act of 1934 may be subject to criminal penalties.
2. Willfully making false statements in a tax return or willfully aiding or assisting in the preparation of
a false tax return is a felony. Aiding and abetting an individual’s understatement of tax liability is a
separate crime.
Confidentiality and Privilege Communications other than those between attorneys and clients are not privileged under federal law.
1. Attorney-client relationships—Communications relating to representation are normally held in the
strictest confidence and protected by law. Only the client may waive the privilege. The SEC, however, has implemented rules requiring attorneys who learn that a client has violated securities laws
to report the violation to the SEC.
2. Accountant-client relationships—The majority of states follow the common law. If a court so orders,
an accountant must disclose information about his or her client to the court.
Issue Spotters
1. Dave, an accountant, prepares a financial statement for Excel Company, a client, knowing that Excel will use the statement to obtain
a loan from First National Bank. Dave makes negligent omissions in the statement that result in a loss to the bank. Can the bank successfully sue Dave? Why or why not? (See Potential Liability to Third Parties.)
2. Nora, an accountant, prepares a financial statement as part of a registration statement that Omega, Inc., files with the Securities and
Exchange Commission before making a public offering of securities. The statement contains a misstatement of material fact that is not
attributable to Nora’s fraud or negligence. Pat relies on the misstatement, buys some of the securities, and suffers a loss. Can Nora be
held liable to Pat? Explain. (See Liability of Accountants under Other Federal Laws.)
—Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.
Business Scenarios and Case Problems
40–1. The Ultramares Rule. Larkin, Inc., retains Howard Perkins
to manage its books and prepare its financial statements.
Perkins, a certified public accountant, lives in Indiana and practices there. After twenty years, Perkins has become a bit bored
with generally accepted accounting principles (GAAP) and
has adopted more creative accounting methods. Now, though,
Perkins has a problem. He is being sued by Molly Tucker, one
of Larkin’s creditors. Tucker alleges that Perkins either knew
or should have known that Larkin’s financial statements would
be distributed to various individuals. Furthermore, she asserts
that these financial statements were negligently prepared and
seriously inaccurate. What are the consequences of Perkins’s
failure to follow GAAP? Under the traditional Ultramares rule,
can Tucker recover damages from Perkins? Explain. (See
Potential Liability to Third Parties.)
40–2. The Restatement Rule. The accounting firm of Goldman,
Walters, Johnson & Co. prepared financial statements for
Lucy’s Fashions, Inc. After reviewing the financial statements,
Happydays State Bank agreed to loan Lucy’s Fashions $35,000
for expansion. When Lucy’s Fashions declared bankruptcy
under Chapter 11 six months later, Happydays State Bank filed
an action against Goldman, Walters, Johnson & Co., alleging
negligent preparation of financial statements. Assuming that
30301_ch40_hr_948-970.indd 967
the court has abandoned the Ultramares approach, what is the
result? What are the policy reasons for holding accountants
liable to third parties with whom they are not in privity? (See
Potential Liability to Third Parties.)
40–3. Accountant’s Liability under Rule 10b-5. In early
2018, Bennett, Inc., offered a substantial number of new common shares to the public. Harvey Helms had a long-standing
interest in Bennett because his grandfather had once been
president of the company. On receiving Bennett’s prospectus, Helms was dismayed by the pessimism it embodied, so he
decided to delay purchasing stock in the company. Later, Helms
asserted that the prospectus prepared by the accountants had
been overly pessimistic and had contained materially misleading statements. Discuss fully how successful Helms would be in
bringing a suit under Rule 10b-5 against Bennett’s accountants.
(See Liability of Accountants under Other Federal Laws.)
40–4. Professional’s Liability. Soon after Teresa DeYoung’s
husband died, her mother-in-law also died, leaving an inheritance of more than $400,000 for DeYoung’s children. DeYoung
hired John Ruggiero, an attorney, to ensure that her children
would receive it. Ruggiero advised her to invest the funds in
his real estate business. She declined. A few months later,
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