© 2010 Pearson Education, Inc., publishing as Prentice-Hall 1 ACCOUNTANTS’ LIABILITY © 2010 Pearson Education, Inc., publishing as Prentice-Hall CHAPTER 51

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 2 Functions of Accountants Primary functions: –Auditing financial statements. –Rendering opinions about those audits. Other functions: –Rendering tax advice and tax preparation. –Preparing unaudited financial statements. –Consulting services.

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 3 Certified Public Accountant CPA – an accountant who has: –met certain educational requirements. –passed the CPA examination. –had a certain number of years of audit experience. Public Accountant – a person who is not certified.

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 4 Accounting Standards and Principles Generally Accepted Accounting Principles (GAAP) –Standards for the preparation and presentation of financial statements. Generally Accepted Accounting Principles (GAAP) –Standards for the preparation and presentation of financial statements. Generally Accepted Auditing Standards (GAAS ) –Standards for the methods and procedures that must be used to conduct audits. Generally Accepted Auditing Standards (GAAS ) –Standards for the methods and procedures that must be used to conduct audits.

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 5 Audit Verification of a company’s books and records pursuant to: –Federal securities laws –State laws –Stock exchange rules Must be performed by an independent CPA. –Must conduct sampling of inventory. –Verify information from third parties.

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 6 Auditor’s Opinions After the audit is complete, the auditor must render an opinion about how fairly the financial statements present: –the company’s financial position, –results of operations, and –change in financial position.

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 7 Auditor’s Opinions (continued) The auditor’s opinion may be: –Unqualified –Qualified –Adverse Disclaimer of Opinion indicates auditor’s inability to draw a conclusion as to accuracy of company’s financial records. Company not receiving unqualified opinion may have difficulty selling securities or obtaining loans.

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 8 Limited Liability Partnership (LLP) All partners are limited partners. Only loss incurred is capital contributions. Most public accounting firms operate as an LLP.

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 9 Limited Partnership

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 10 Accountants’ Liability to Clients Breach of Contract Fraud Negligence

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 11 Breach of Contract Terms of engagement specified in contract. Accountant who fails to perform is liable for breach. Damages include: –Expenses incurred in securing new accountant. –Fines and penalties owed because of delay.

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 12 Fraud When accountant is liable for actual or constructive fraud, client can recover damages. Punitive damages may be awarded in cases of actual fraud.

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 13 Negligence Accountant owes duty to use reasonable care, knowledge, skill, and judgment. –E.g., comply with GAAPs or GAASs. Measured against those actions of a reasonable accountant. Liable for damages if fail to meet standards.

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 14 Liability to Third Parties Major rules of liability: – Ultramares Doctrine – Section 552 of the Restatement (Second) of Torts – Foreseeability standard

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 15 Ultramares Doctrine Accountant is liable only for negligence to third parties who are in privity of contract or a privity-like relationship with the accountant. Provides the narrowest standard for holding accountants liable to third parties for negligence. Majority rule for accountants’ liability.

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 16 Section 552 of Restatement Accountant is liable only for negligence to third parties who are members of a limited class of intended users of the client’s financial statements. Broader standard than Ultramares doctrine.

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 17 Foreseeability Standard Accountant is liable for negligence to third parties who are foreseeable users of the client’s financial statements. Broadest standard for holding accountants liable to third parties for negligence.

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 18 Fraud If an accountant engages in actual or constructive fraud, a third party who relies on the accountant’s fraud and is injured may bring tort action to recover damages.

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 19 Breach of Contract Third parties generally cannot sue accountants for breach of contract. –Third parties are merely incidental beneficiaries who do not acquire any rights under the accountant-client contract. –Not in privity of contract with the accountant.

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 20 Accountant’s Duty to Report Client’s Illegal Activity Section 10A of Securities Act of 1934 imposes duty on auditor to detect and report illegal acts committed by clients. –Any act or omission that violates law, rule, or regulation, unless act is “clearly inconsequential.” –Report to client’s management and audit committee. –If management fails to act, report to board of directors.

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 21 Statutory Liability of Accountants Section 11(a) of Securities Act of 1933 –Liability for making or failing to find misstatements or omission in registration statement. Section 10(b), 18(a) and Rule 10b-5 of Securities Exchange Act of 1934 –Liability for deception in sale or purchase of securities, making false statements to SEC.

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 22 Private Securities Litigation Reform Act of 1995 Imposes pleading and procedural requirements on plaintiffs in class action lawsuits. Imposes proportionate liability. Parties liable only up to degree of fault, unless acted knowingly.

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 23 Aiders and Abettors No private right of action for aiding and abetting a Section 10(b) violation. –May mean that auditors not civilly liable under securities law. –Government may still bring criminal action. –May still be held liable for state common law action in negligence.

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 24 Criminal Liability of Accountants Section 24 of Securities Act of 1933 –Untrue statements or omissions in registration statements. Section 32(a) of Securities Exchange Act of 1934 –False or misleading statements in SEC filings Tax Reform Act –Willful understatement of tax liability. RICO liability.

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 25 Sarbanes-Oxley Act of 2002 Establishment of the Public Company Accounting Oversight Board. Public accounting firms must register with the board. Separation of audit and nonaudit services. Audit reports sign-offs. Prohibited employment.

© 2010 Pearson Education, Inc., publishing as Prentice-Hall 26 Accountant-Client Privilege Exists in 20 states. Accountant cannot be called as a witness against a client in a court action. –May also be work product immunity. Does not apply under federal law.