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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- ***Debate This:
Only the largest publicly held companies should be subject to the Sarbanes-Oxley Act.
***The 4 questions are not required to be responded. The most important part is to read the above statement in boldface, take a position whether you agree or not and have 3 arguments supporting your position. Please take a look on the attachment because the debate has to be based on chapter (CH 40)***
2- ***The attached picture is a debate from a classmate. Please read his debate and write a reply in a few statements to him.
Quote
The goal is to develop your critical thinking and analytical skills. I do not want you just to say because it is unfair or simply repeat the law. The answer cannot be because the statute says so. I want you to EVALUATE it. What are the public policy reasons behind your answer? Why this specific proposition is or is not a beneficial, efficient, or positive position to take? I want to see 3 arguments supporting your answer. You do not have to answer the questions. You MUST DEBATE the prompt.
Mark Burnett/Alamy Stock Photo
40
Learning Objectives
The five Learning Objectives below are
designed to help improve your understanding. After reading this chapter, you
should be able to answer the following
questions:
1. Under what common law
theories may professionals be
liable to clients?
2. What are the rules
concerning an auditor’s
liability to third parties?
3. How might an accountant
violate the Securities Act?
4. What crimes might an
accountant commit under the
Internal Revenue Code?
5. What is protected by the
attorney-client privilege?
Liability of Accountants
and Other Professionals
“A member should
observe the profession’s technical and
ethical standards
… and discharge
professional responsibility 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 quotation. Investors rely heavily on the opinions of certified public
accountants when making decisions about whether to invest
in a company.
Article V,
The failure of several major companies and leading public
Code of Professional Conduct
accounting firms in the past twenty years has focused attenAmerican Institute of
tion on the importance of abiding by professional accounting
Certified Public Accountants
standards. Numerous corporations—from American International Group (AIG, the world’s largest insurance company),
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.
948
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CHAPTER 40: Liability of Accountants and Other Professionals
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 Liability for Breach of Contract
949
Learning Objective 1
Under what common law
theories may professionals
be liable to clients?
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 failing to meet deadlines, the court may order the professional to pay an equivalent amount in
damages to the client.
40–1b Liability for Negligence
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. A duty of care existed.
2. That duty of care was breached.
3. The plaintiff suffered an injury.
4. The injury was proximately caused by the defendant’s breach of the duty of care.
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 system. 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 Financial 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.
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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.
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UNIT SIX: Government Regulation
International Financial Reporting
Standards (IFRS) A set of global
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.
accounting standards that are being
phased in by U.S. companies.
Defalcation Embezzlement or
misappropriation of funds.
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 accounting principles (GAAP), to be the gold
standard—the best system for reporting
earnings and other financial information.
Then came the subprime mortgage meltdown 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 several 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 eventually find it less difficult to comply with the
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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 technology company in Silicon Valley and one
in Germany or Japan. Furthermore, having 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 drawbacks. Making the change has proved to
be both costly and time consuming. Companies have had to upgrade their communications 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
Landmark
in the Law
reporting, so less financial information
may be disclosed. There are also indications 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 overseeing 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 bipartisan 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 prepared to use these rules in their future
careers.
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CHAPTER 40: Liability of Accountants and Other Professionals
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 unaudited 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:
Auditor An accountant qualified
to perform audits (systematic
inspections) of a business’s financial
records.
“Never call an accountant a credit to his
profession; a good
accountant is a debit
to his profession.”
Attributed to Charles Lyell
1797–1875
(British lawyer)
1. The accountant was not negligent.
2. If the accountant was negligent, this negligence was not the proximate cause of the client’s losses.
3. The client was also negligent (depending on whether state law allows contributory negligence as a
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 transaction 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,
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UNIT SIX: Government Regulation
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?
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 general 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.
Ethical Issue
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 Association’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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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 professional 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, however, 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 ■
Recall that fraud, or fraudulent misrepresentation, involves the following elements:
1. A misrepresentation of a material fact.
2. An intent to deceive.
3. Justifiable reliance by the innocent party on the misrepresentation.
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.
negligence, or failure to exercise
reasonable care and professional
judgment, that results in injury, loss,
or damage to those relying on the
professional.
Katarzyna Bialasiewicz/Dreamstime.com
40–1c Liability for Fraud
Malpractice Professional
What must a plaintiff prove when
when claiming that an attorney
has committed malpractice?
Actual Fraud A professional may be held liable for actual fraud when (1) he or she intentionally 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).
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UNIT SIX: Government Regulation
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 reprimanded 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 Conduct that
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.
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 professional 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 misstatements 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 irregularities, 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 The Ultramares Rule
Learning Objective 2
What are the rules concerning an auditor’s liability to
third parties?
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.
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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 accountants 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 ■
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CHAPTER 40: Liability of Accountants and Other Professionals
To what extent is an accounting firm liable for incorrect
balance-sheet information that is distributed to the
public?
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 indicating 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 accounting 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 establishment 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 The Restatement Rule
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. Persons for whose benefit and guidance the accountant “intends to supply the information or knows
that the recipient intends to supply it.”
2. Persons whom the accountant “intends the information to influence or knows that the recipient
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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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 “Reasonably Foreseeable Users” Rule
A small minority of courts hold accountants liable to any users whose reliance on an accountant’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 foreseeability 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 Liability of Attorneys to Third Parties
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 The Sarbanes-Oxley Act
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
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RULE
DESCRIPTION
APPLICATION
Ultramares rule
Liability is imposed only if the
accountant is in privity, or near
privity, with the third party.
A minority of courts apply this
rule.
Restatement rule
Liability is 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.
“Reasonably foreseeable
users” rule
Liability is imposed if the third
party’s use was reasonably
foreseeable.
A small minority of courts use
this rule.
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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.
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 accounting 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, represented 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.”
tupungato/iStock Editorial/Getty Images
The Public Company Accounting Oversight Board The Sarbanes-Oxley Act increased
Deloitte & Touche audits public
companies. What law requires
oversight of its procedures?
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 company 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 accounting 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 investigation or in relation to bankruptcy proceedings can be criminally prosecuted and sentenced to a fine, imprisonment for up to twenty
years, or both.
2. The act requires accountants who audit or review publicly traded companies to retain all working papers related to the audit
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.
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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 Accounting 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:
****
* * * 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 & Youngaffiliated 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.
****
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Third, even putting those points aside, the Board’s rules establish 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 substantially qualified. In this context, an expert is an extension of counsel. [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 technical 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 unlawfully 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 disciplinary 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.
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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, imprisonment for up to ten years, or both.
Working Papers The documents
used and developed by an accountant
during an audit, such as notes,
computations, and memoranda.
40–3b The Securities Act of 1933
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 purchaser 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:
“Destroy the old files,
but make copies first.”
Samuel Goldwyn
1879–1974
(American motion picture producer)
Learning Objective 3
How might an accountant
violate the Securities Act?
Due Diligence A required standard
of care that certain professionals,
such as accountants, must meet to
avoid liability for securities violations.
1. Conducted a reasonable investigation.
2. Had reasonable grounds to believe and did believe, at the time the registration statement became
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).
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In particular, the due diligence standard places a burden on accountants to verify information 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 danger 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. There were no misstatements or omissions.
2. The misstatements or omissions were not of material facts.
3. The misstatements or omissions had no causal connection to the plaintiff’s loss.
4. The plaintiff-purchaser invested in the securities knowing of the misstatements or omissions.
Hero Images/Getty Images
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 penalties 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.
Which federal agency can bring criminal actions against professionals
who commit willful violations under Section 12(2) of the Securities
Act of 1933?
40–3c The Securities Exchange Act of 1934
Under Sections 18 and 10(b) of the Securities Exchange
Act and SEC Rule 10b-5, an accountant may be found liable 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. That the false or misleading statement affected the price of the security.
2. That the purchaser or seller relied on the false or misleading statement in making the purchase or
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).
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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 accountants, 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. Employ any device, scheme, or artifice (pretense) to defraud.
2. Make any untrue statement of a material fact or omit a material fact necessary to ensure that the
statements made were not misleading, in light of the circumstances.
3. Engage in any act, practice, or course of business that operates or would operate as a fraud or
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 The Private Securities Litigation Reform Act
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 committee, 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.
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Kotin/Shutterstock.com
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 abetting 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 Company 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. ■
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?
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 Criminal Violations of Securities Laws
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 statement is used in a securities filing, the accountant may be held criminally liable. The accountant may be fined up to $5 million, imprisoned for up to twenty years, or both.
Learning Objective 4
What crimes might an
accountant commit under
the Internal Revenue Code?
40–4b Criminal Violations of Tax Laws
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).
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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-Client Relationships
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 representation 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.
Learning Objective 5
What is protected by the
attorney-client privilege?
21. 26 U.S.C. Section 6694.
22. 26 U.S.C. Section 6701.
Case 40.2
Commonwealth of Pennsylvania v. Schultz
Superior Court of Pennsylvania, 133 A.3d 294 (2016).
Background and Facts An investigation into allegations
of sexual misconduct involving minors and Jerry Sandusky, a former defensive coordinator for the Pennsylvania State University
football team, led a grand jury to subpoena Gary Schultz. Schultz,
a retired vice president of the university, had overseen the campus
police at the time of the alleged events.
Before testifying, Schultz met with Cynthia Baldwin, counsel
for Penn State. He told her that he did not have any documents
relating to the two incidents, believing this disclosure to be in
the strictest confidence between attorney and client. Baldwin,
however, saw her role as counsel only for Penn State, representing Schultz as an agent of the university, not personally.
(Continues )
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She did not explain this to him, and she appeared with him
during his testimony.
Later, a file was found in Schultz’s office containing notes pertaining to the two incidents. When Baldwin was called to testify,
she revealed what he had told her at their meeting. On the basis
of this testimony, the grand jury charged Schultz with the crimes of
perjury, obstruction of justice, and conspiracy. Before a trial
was held on these charges, Schultz filed a motion to preclude
Baldwin’s testimony and quash (suppress) the charges, arguing
that her testimony violated the attorney-client privilege. The court
denied the motion. Schulz appealed.
In the Words of the Court
Opinion by BOWES, J. [Judge]
****
Communications between a putative [assumed] client and
corporate counsel are generally privileged prior to counsel informing the individual of the distinction between representing the
individual as an agent of the corporation and representing
the person in his or her personal capacity. [Emphasis added.]
When corporate counsel clarifies the potential inherent conflict of interest in representing the corporation and an individual
and explains that the attorney may divulge the communications
between that person and the attorney because they do not represent the individual, the individual may then make a knowing, intelligent, and voluntary decision whether to continue communicating
with corporate counsel.
****
* * * Where an attorney purports to offer only limited representation before and at a grand jury proceeding, * * * a putative
client must be made expressly aware of that fact. As Schultz
consulted with Ms. Baldwin for purposes of preparing for his
grand jury testimony * * * , and reasonably believed she represented him, and Ms. Baldwin neglected to adequately explain
the distinction between personal representation and agency
representation * * * , we conclude that all the communications
between Schultz and Ms. Baldwin were protected by the
attorney-client privilege.
* * * Accordingly, we preclude Ms. Baldwin from testifying in
future proceedings regarding privileged communications between
her and Schultz, absent a waiver by Schultz.
****
* * * Schultz * * * was not aware that Ms. Baldwin was not
appearing with him [during his grand jury testimony] in order
to protect his interests and therefore unable to provide advice
concerning whether he should answer potentially incriminating
questions or invoke his right against self-incrimination. Since
Schultz was constructively without counsel during his grand jury
testimony, and he did not provide informed consent as to limited
representation, * * * his right against self-incrimination was not
protected by Ms. Baldwin’s agency representation, and the appropriate remedy is to quash the perjury charge.
****
[Finally,] since the obstruction of justice and related conspiracy
charges in this matter relied extensively on a presentment from an
investigating grand jury privy to impermissible privileged communications, we quash the counts of obstruction of justice and the
related conspiracy charge.
Decision and Remedy A state intermediate appellate
court reversed the order of the lower court regarding Schultz’s
pretrial motion. Baldwin was precluded from testifying about
Schultz’s privileged communications with her, and the charges
of perjury, obstruction of justice, and conspiracy against Schultz
were quashed.
Critical Thinking
• What If the Facts Were Different? Suppose that a
hearing had been held on the question of the attorney-client
privilege before Baldwin testified. Would the result have been
different?
40–5b Accountant-Client Relationships
In a few states, accountant-client communications are privileged by state statute. In these
states, accountant-client communications may not be revealed even in court or in courtsanctioned proceedings without the client’s permission.
The majority of states, however, abide by the common law, which provides that, if a court
so orders, an accountant must disclose information about his or her client to the court. Physicians and other professionals may similarly be compelled to disclose in court information
given to them in confidence by patients or clients.
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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
8/30/18 2:03 PM
The largest publicly held companies should not be the only ones subject to the Sarbanes-Oxley Act. This Act was created to regulate the accounting
practice of accounting firms that do auditing for companies that sell shares to the public (Miller, 2021). The objective of the law was to prevent
accounting firms from being used in fraud and other activities that can result in damages (Miller, 2021). Both large and small publicly held companies
should be subject to Sarbanes-Oxley Act because companies that sell securities to the public involve either of them. Requiring only the largest publicly
held companies to be subject to this law assumes that it is only these companies that sell securities to the public investors. Both the large and small
companies are subject to the securities law. Both companies have the potential of engaging in fraud by intentionally misrepresenting their accounting
information. Following Sarbanes-Oxley Act requirements will help to minimize fraud (Miller, 2021). Chase was not a large publicly held company yet it
engaged in fraud. Superior, the company that purchased it, was large. It discovered that Chase’s accountant had misrepresented Chase’s inventory by
grossly overstating it. As a result of this misrepresentation, public investors at Superior will make a loss. Sarbanes-Oxley Act seeks to protect the public
investors from such misfortunes despite the size of the companies. It ought to ensure that the auditors and accountants maintain a high level of
professionalism. This would lead to the production of audits that are accurate and reliable (Miller, 2021). Once the law is complied with, auditing is
done in good faith. This minimizes the risk of fraud, and subsequently loss of money. Being subject to the law would make the accountants and
auditors who work for these companies to be very careful so as to avoid liability.
