© Cavico & Mujtaba, 2008 Business Law for the Entrepreneur and Manager Frank Cavico and Bahaudin G. Mujtaba Chapter 14 – Liability of Accountants and Other Professionals

© Cavico & Mujtaba, 2008 Business Law for the Entrepreneur and Manager (Frank Cavico & Bahaudin g. Mujtaba, 2008; ILEAD Academy, LLC) Table of Contents – Chapter Titles Chapter 1 – Introduction to Law and the Legal System Chapter 2 – Torts and Business Chapter 3 – Products Liability Chapter 4 – Contract Law Chapter 5 – Sales Law and the Uniform Commercial Code Chapter 6 – Agency and Employment Law Chapter 7 – Business Organizations Chapter 8 – Commercial Paper and Banking Transactions Chapter 9 – Creditors and debtors – Rights and Responsibilities Chapter 10 – Internet Law Chapter 11 – Intellectual Property Law Chapter 12 – Real Property Law Chapter 13 – International Business Law Chapter 14 – Liability of Accountants and Other Professionals Chapter 15 – Wills and Trusts Chapter 16 – Personal Property, Gifts, and Bailment Chapter 17 – Conclusion and Case Problems

© Cavico & Mujtaba, 2008 Chapter Topics Common Law Liability – Breach of Contract –Negligence –Fraud Liability to Third Parties Statutory Liability Criminal Liability State Laws Confidentiality and Privilege –Summary

© Cavico & Mujtaba, 2008 Accountants and the Profession Accountants are members of a profession who provide a variety of professional services: for example, tax, consulting, bookkeeping (compilations), and various assurance services. Assurance services provide information enhancement and include audits and reviews of financial statements. An audit is the examination of financial statements performed by a certified public accountant in accordance with specific professional standards. The product of this work is the auditor’s opinion which, according to the Public Company Accounting Oversight Board’s (PCAOB) standard auditor’s report, gives the users of financial statements reasonable assurance that the entity’s statements are free from material misstatement and “…present fairly, in all material respects, the financial position,…results of…operations, and…cash flows…in conformity with accounting principles accepted in the United States of America.” A certified public accountant, known as a CPA, is an accountant who has attained certain educational requirements, typically five years of college study, and who has passed the rigorous Uniform CPA Exam administered in 55 U.S. jurisdictions.

© Cavico & Mujtaba, 2008 Accountants and Services In the performance of their professional services, accountants, like members of the legal and medical profession, are exposed to legal liability. Legal liability against accountants is based on both the common law and statutory law. In the former category, the accountant can be sued for breach of contract, negligence, and fraud. In the statutory category, the accountant faces legal liability based on a variety of federal and state statutes, especially federal securities laws. Moreover, accountants may confront legal liability not only from their clients but also third parties.

© Cavico & Mujtaba, 2008 Common Law Liability As previously discussed in the first chapter of this book, common law is derived from case law. That is, it is based on prior adjudicated precedent (which is the legal opinion of judges). Pursuant to the common law, accountants are exposed to legal liability from their clients and potentially third parties based on three doctrines: –1) breach of contract, –2) negligence, and –3) fraud.

© Cavico & Mujtaba, 2008 Breach of Contract Accountants are retained by their clients to perform a variety of professional accounting services; as such, accountants regularly enter into contracts with their clients; these contracts are at times called “engagements” or engagement letters. The standards of the accounting profession require an engagement letter for each audit and review. The failure of the accountant to perform or to substantially perform his or her contract duties subjects the accountant to a lawsuit for breach of contract premised on common law contract principles.

© Cavico & Mujtaba, 2008 Negligence Accountants, as members of a profession, like lawyers, are under a legal duty to perform their professional accounting and auditing services in a careful, reasonable, and prudent manner. They must exercise the degree of care and skill and possess the requisite knowledge of the ordinary, reasonable, and prudent member of their profession. Accountants are thus held to the old common law negligence standard of the “reasonably prudent person,” but in the specific, reasonably prudent, accountant professional context. The failure to adhere to this legal duty, referred to as due care, subjects the accountant to legal liability for negligence, which on the professional level is deemed “malpractice,” and thereby accounting malpractice.

© Cavico & Mujtaba, 2008 Fraud An accountant may be liable for fraud, which (as explained in the Contracts and Tort chapters), is a very broad term encompassing liability for intentional misrepresentation, called deceit in the old common law, and negligent misrepresentation. In the former more serious formulation of fraud, the accountant could be subject to punitive damage liability. Also, accountants are regarded as fiduciaries; and thus are in a relationship of trust and confidence with their clients; consequently, the breach of this fiduciary relationship, for example, by purposefully omitting a material fact which is relied on by the client, is regarded in the law as the equivalent of fraud, thereby subjecting the accountant to punitive damage liability.

© Cavico & Mujtaba, 2008 Liability to Third Parties Most negligence lawsuits instituted against accountants are brought by their clients who contend that the accountants’ carelessness has caused them some harm. However, it is possible that another party also suffered harm and thus seeks to sue the accountant. This party is characteristically a third party, such as a corporate shareholder or financial institution, who relied on the information supplied (or not supplied) by the accountant. This area of the accountant’s negligence liability to third parties is a very difficult one in the law because there are three competing legal principles: 1) the Ultramares rule, 2) the Restatement (Second) of Torts rule, and 3) the negligence “foreseeability” rule.

© Cavico & Mujtaba, 2008 Statutory Liability There are several statutes, both federal and state, that impact the liability of the accountant. First, the civil liability of the accountant under major statutes will be addressed; and then in the next statutory section, the criminal liability of the accountant will be examined.

© Cavico & Mujtaba, 2008 Sarbanes-Oxley Act (SOX) The Sarbanes-Oxley Act (SOX) of 2002 was a Congressional response to the spate of corporate scandals as exemplified by the famous (infamous) Enron collapse. SOX emerged as one of the most important modifications of federal securities laws since the enactment of the 1933 and 1934 acts. The main purposes of SOX are to protect investors by improving the accuracy and reliability of corporate disclosure and to increase and improve corporate accountability and governance.

© Cavico & Mujtaba, 2008 The Securities Act of 1933 The Securities Act of 1933 is a disclosure type of statute. It is designed to promote fairness and stability in the securities markets by requiring that certain essential information concerning the issuance of stocks and the principals behind the issuance are made available to the investing public. There are two major sections of the Act: Section 5, which details the requirements for a registration statement as well as a prospectus; and Section 11, which sets forth the penalties for non- compliance with Section 5 requirements.

© Cavico & Mujtaba, 2008 The Securities and Exchange Act of 1934 The Securities and Exchange Act of 1934 has several purposes. It provides for the registration and regulation of security exchanges, securities brokers and dealers, and national security associations. It also provides for the regulation of proxy solicitations for voting. Most importantly, the 1934 Act is a very broad anti-fraud statute, which applies to all purchase and sales of securities, and which seeks to police, punish, and deter fraudulent, deceptive, and manipulative practices in the securities marketplace.

© Cavico & Mujtaba, 2008 The Securities and Exchange Act of 1994 The Securities and Exchange Act of 1994, as amended by the U.S. Congress in 1995, in Section 10A imposed significant new duties on auditors to investigate, detect, and report illegal acts committed by their clients. Specifically, unless the illegality is clearly inconsequential, the auditor is required to disclose to the client’s management and audit committee the illegal act. Moreover, if the management of the firm fails to take timely and proper remedial action to correct the illegal activity, the auditor must report the illegal act to the firm’s board of directors; but only if the illegal conduct would have a material effect on the client’s financial statements and the auditor intends to issue a non-standard audit report or intends to resign for the audit engagement.

© Cavico & Mujtaba, 2008 Criminal Liability Accountants as well as other professionals and members of the public can be held criminally liable under federal and state laws, especially securities laws. Section 24 of the 1933 Act makes it a crime for any person to make an intentional false statement of material fact in a registration statement filed with the SEC. It is also a crime for any person to purposefully omit any material fact that would be necessary to ensure that the registration statement is not misleading.

© Cavico & Mujtaba, 2008 Confidentiality and Privilege Accountants and attorneys are regarded as members of a profession in a fiduciary relationship with their clients. One of the characteristics of this professional relationship is a duty of confidentiality. The legal system also recognizes this duty of confidentiality as a legal privilege, but to a much greater degree for lawyers than accountants.

© Cavico & Mujtaba, 2008 Attorney-Client Relationship The attorney-client privilege is the privilege a client has to reveal information given to his or her attorney in confidence without fear of disclosure. The common law has long recognized such a privilege. The privilege is also constitutionally protected on the federal and state levels by the right against self-incrimination and the right to legal counsel. In order for a person to secure effective legal representation, and particularly to obtain a viable defense to criminal prosecution, the client must feel confident that he or she can fully tell the attorney the facts of the case without any apprehension that the attorney will be called as a witness against the client.

© Cavico & Mujtaba, 2008 Summary This chapter has examined the legal liability of the accountant as well as other professionals under a variety of laws – federal and state, statutory and common law, civil and criminal. –This chapter underscored the very important Sarbanes- Oxley Act of 2002, and discussed how it impacted corporate governance, the securities laws, and the accounting profession. –This chapter compared and contrasted the privilege of confidentiality and non-disclosure between lawyers and their clients and accountants and their clients. –Finally, this chapter provided certain practical recommendations for the accountant to avoid legal liability.

© Cavico & Mujtaba, 2008 Reference 1.Cavico, F. & Mujtaba, B. G., (2008). Business Law for the Entrepreneur and Manager. ILEAD Academy Publications; Davie, Florida, USA. ISBN: Cavico, F. and Mujtaba, B. G. (2008). Legal Challenges for the Global Manager and Entrepreneur. Kendal Hunt Publishing; United States.