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Regulation > 10-Accountant Liability > Flashcards

10-Accountant Liability Flashcards

1
Q

where can accountant liability arise?

A

several different areas like common law, federal securities laws (1933/1934 acts) or violating accountant client privileged information (taxes or workpapers)

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2
Q

what is the most obvious liability facing an auditor?

A

breach of contract because an audit is performed as a result of a contract between the auditor and the client

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3
Q

since the auditor promises to perform the audit accordance with generally accepted auditing standards, a lawsuit charging breach of contract by the auditor must usually show a violation of what?

A

a violation of at least one standard and the standard most often utilized is the 3rd general standard of due professional care. as a result the most common lawsuit will charge negligence which is the absence of due care.

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4
Q

what happens if an accountant does not fulfill the terms of the contract or engagement?

A

will be held liable for breach of contract as a result of non performance. the accountant will be liable to the client (in privity) and any intended third party beneficiaries for compensatory (monetary/financial) damages.

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5
Q

who can sue the accountant or auditor?

A
  • anyone in privity which is any one who hired the accountant or auditor
  • intended 3rd party beneficiary (named in contract by the client)
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6
Q

what does the plaintiff (purchaser) have to prove for breach of contract?

A

M-I-L-E

  • material misstatement or omission of a material fact (the financial statements must contain MATERIAL misstatements or omissions of a material fact.
  • Info (in the F/S was the proximate cause of the harm to the plaintiff
  • Loss (damages; the plaintiff must have suffered a FINANCIAL LOSS as a result of the above ex. material misstatement or omission of a material fact and the financial statements were the approximate cause of the harm to the plaintiff
  • Error (caused by breach meaning non performance which is either you breached the contract or you just didn’t perform what you were supposed to perform)
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7
Q

what must the defenses (the accountant) prove if they are accused of breaching the contract?

A

that they didn’t breach or that they fully performed under the contract terms.

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8
Q

what is a tort?

A

a wrongful act or infringement of rights (other than under contract) leading to civil legal liability

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9
Q

what are the 3 different torts resulting from auditors liability?

A
  • negligence
  • gross negligence also known as constructive fraud
  • or actual fraud
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10
Q

what is the accountants duty in the performance of an engagement?

A

its to exercise due professional care which is expected of an ordinary prudent CPA. the accountant will be liable to the client or an intended 3rd party beneficiary named in the engagement privity.

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11
Q

in states that follow the 2nd restatement of torts, what is the accountant liable for?

A

the liability extends to anyone (3rd party) who is known (IN PRIVITY to sue WHICH IS THE CLIENT AND INTENDED 3RD PARTY) or FORESEEN BY the CPA LIKE A SHAREHOLDER.

NOTE: in the minority of states that follow the decision in Ultramares vs Touche are excluded from the foreseen 3rd party rule. they lack privity

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12
Q

in a negligence suit the plaintiff must prove what?

A

m-i-l-e

  • material misstatements or omissions of a material fact
  • info (in the F/S was the proximate cause of the harm to the plaintiff
  • loss due to misstatements or omissions of a material fact or information caused harm to the plaintiff
  • errors (no due professional care / NEGligent; absence of due care (the auditor must have demonstrated carelessness in the audit)
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13
Q

what exactly is NEGligence?

A

N-E-G

  • Nondisclosure of information to the client which is an internal control weakness (means that you found errors during the audit and they were not communicated to the client)
  • Errors previously discovered not corrected
  • GAAS/GAAP not followed
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14
Q

when is an accountant liable for negligence to a foreseen third party?

A

when the accountant knew the foreseen third party or member of a limited class would be relying on the financial statements for a limited transaction. the accountant is liable to foreseen parties for negligence.

NOTE: foreseeable parties are any party the accountant could reasonably foresee would receive financial statements and use them. the accountant is NOT usually liable for negligence to foreseeable parties

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15
Q

in order for a plaintiff to be successful in a case based on negligence what must be proven?

A

ALL of the following must be proven: C-A-M-P-S or M-I-L-E

C- casual relationship (the behavior of the accountant must be the PROXIMATE CAUSE of the harm to the plaintiff)
A-absence of due care (the accountant must have performed the audit in a careless manner)
M-material misstatement (the financial statements must have contained material misstatements or omissions of a material fact
P-privity or equivalent (the plaintiff must show they have the proper standing to be following 2nd restatement of torts)
S-suffered loss (the plaintiff must have suffered a financial loss)

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16
Q

what are the defenses the accountant must defend to prove against a loss being suffered by the plaintiff?

A

the accountant must defend the following:

  • followed GAAS (showing due professional care)
  • lack of privity (useless against client or intended 3rd party however - lack of privity means that you were NOT known or foreseen)
  • not the proximate cause of the loss
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17
Q

what is a CPA’s duty of due care guided by?

A

the following standards:

  • state and federal statues
  • court decisions
  • contract with the client
  • GAAS and GAAP
  • customs of the profession
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18
Q

what is a common law theory that can be used by any party including one who is unknown to the auditor?

A

fraud!

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19
Q

what does fraud refer to?

A

it refers to the intent to deceive. and it comes in two basic forms:

actual fraud - making false statements with knowledge of their falsity. ex an auditor issues an unmodifed opinion on financial statements knowing they contain material misstatements and should be receiving a qualified or adverse opinion, or recording a bribe in the financial statements as a consulting fee

constructive fraud (gross negligence) - making false statements with a RECKLESS DISREGARD FOR TRUTH, not knowing if the statements are true or false. for ex. an auditor issues an unmodifed opinion on financial statements that have not been audited, and on which they should be disclaiming an opinion. an audit meets the standards of constructive fraud if it is performed in a GROSSLY NEGLIGENT MANNER.

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20
Q

what is scienter?

A

knowingly made with INTENT

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21
Q

does ordinary negligence meet the definition of fraud?

A

no

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22
Q

what must a plaintiff prove in order to succeed in a case based on fraud?

A

it must prove ALL of the following: R-I-M-S

  • reliance (the plaintiff must have justifiably relied on the financial statements
  • intent to deceive (the auditor must have had actual or constructive knowledge that their opinion was inappropriate
  • material misstatement (the financial statements must have contained material misstatements or omissions of a material fact
  • suffered loss (the plaintiff must have suffered a FINANCIAL LOSS as a result of the above
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23
Q

what is the best defense for an auditor in a negligence or fraud case?

A

to prove that the audit was conducted in accordance with GAAS (generally accepted auditing standards) because that would demonstrate that the audit was performed with due professional care.

24
Q

if the auditor cannot prove that they conducted the audit in accordance with GAAS when other defense could they use?

A

they could use the privity defense because parities unknown to the auditor, and foreseen parties in a jurisdiction following ultramares, lack the standing of privity required in a negligence case. since privity need not apply in a fraud case, the privity defense wouldn’t be useful in a case based on actual or constructive fraud, including gross negligence.

25
Q

what is the auditors defense in fraud cases?

A

good faith is a good defense in fraud cases. the auditor does not deny carelessness but claims a lack of knowledge of the falsity of the financial statement. this would not be sufficient to escape liability in a negligence case. also the auditor must lack BOTH ACTUAL AND CONSTRUCTIVE KNOWLEDGE OF THE FALSITY OF THE STATEMENTS.

26
Q

are punitive damages levied under common law?

A

no

27
Q

as it relates to contracts what are the rules for suing the accountant?

A
  • who may bring an action against the accountant: client or an intended user
  • what type of error has to be proven: breach of contract
  • what must the plaintiff proves: material misstatements or omissions of material facts; info was relied upon; loss sustained financially; the accountant was in error

the defendents best defense is that they did not breach the contract

28
Q

as it relates to negligence; what are the rules for suing the accountant?

A
  • who can bring action to sue against the accountant: client or foreseen user
  • what type of error has to be proven: carelessness
  • what must the plaintiff prove: material misstatements or omissions of material facts; info was relied upon; loss sustained financially; the accountant was in error
29
Q

as it relates to GROSS negligence; what are the rules for suing the accountant?

A
  • who can bring action to sue against the accountant: anyone injured
  • what type of error has to be proven: recklessness or intentional misconduct (scienter)
  • what must the plaintiff prove: material misstatements or omissions of material facts; info was relied upon; loss sustained financially; the accountant was in error
30
Q

as it relates to 1933 Act Section 11; what are the rules for suing the accountant?

A
  • who can bring action to sue against the accountant: any purchaser
  • what type of error has to be proven: lack of due diligence
  • what must the plaintiff prove: material misstatements or omissions of material facts; loss sustained financially;
31
Q

as it relates to 1934 Act Rule 10B-5 Fraud; what are the rules for suing the accountant?

A
  • who can bring action to sue against the accountant: any purchaser
  • what type of error has to be proven:recklessness or intentional misconduct (scienter)
  • what must the plaintiff prove: material misstatements or omissions of material facts; info was relied upon; loss sustained financially; the accountant was in error
32
Q

what is privity

A

a relationship between two parties that is recognized by law, such as that of blood, lease, or service. party to the contract

33
Q

what are the federal statutes that auditor liability arises?

A
  • 1933 Securities act is the earliest law; this law requires that audited financial statements be included in the prospectus and registration statement required when public offers fall within the law. SECTION 11 makes ANYONE who signs a registration statement liable for all damages caused by ANY MISSTATEMENT OF MATERIAL FACT IN THE REGISTRATION STATEMENT. the PLAINTIFF MUST PROVE THEY SUFFERED A LOSS, THE AUDIT WAS INCLUDED IN THE PROSPECTUS & MATERIAL MISSTATEMENT/MISREPRESENTATION OR MATERIAL OMISSION OF FACT.
  • 1934 securities exchange act of 1934 section 10(b) and rule 10(b)-5 ANTI-FRAUD PROVISION; all audits of companies involved interstate commerce are covered by the securities act of 1934. the primary source of liability is section 10(b) and rule 10(b)-5, commonly known as the anti-fraud provision of the act. the principles for auditor liability are virtually identical to common law fraud, and the PLAINTIFF in the case must prove; reliance, intent to deceive, material misstatement/misrepresentation or material omission of fact, suffered loss.
34
Q

when is the plaintiff considered to have suffered a loss?

A

the plaintiff must have sustained a loss in connection w/their purchase of the securities (they NEED NOT HAVE PURCHASED THEM DIRECTLY FROM THE ISSUER. the monetary damages are the difference between the amount PAID AND THE MARKET VALUE OR SALE PROCEEDS IF SOLD.

35
Q

what is the plaintiff NOT required to prove under the securities act of 1933 section 11?

A
  • NO OBLIGATION TO PROVE RELIANCE (since the receipt of the prospectus creates that presumption.)
  • NO PRIVITY REQUIREMENT
  • the PLAINTIFF NEED NOT DEMONSTRATE THAT THE AUDITOR’S WORK WAS DEFICIENT (NEGLIGENCE), THE LAW PRESUMES THAT THE AUDIT MUST HAVE BEEN DEFICIENT DUE TO THE MATERIAL MISSTATEMENTS.
36
Q

if the plaintiff is able to demonstrates they suffered a loss, the audit was included in the prospectus, and there was a material misstatement or omission; what does the auditor then have to prove?

A
  • due diligence (the audit was conducted with due diligence demonstrating that the audit is in conformity with GAAS should be persuasive on this point, since due professional care is one of the standards)
  • plaintiff knowledge (the plaintiff KNEW of the material misstatements before making their purchase.
  • THE AUDITOR MUST PROVE THEY WERE NOT NEGLIGENT
37
Q

a suit under the securities act of 1933-section 11 can only be for what?

A

it can only be for damages and it must be brought within 1 year after discovery and within 3 years from OFFERING DATE.

38
Q

what does federal law call fraud?

A

scienter. this law is identical to the common law fraud M-I-L-E.

39
Q

for the federal security regulations liability what does the 1933 section 11 stipulate in regards to misleading info in registration statement?

A
  • the purchaser must prove that the audited financials statement contained material misstatements or omissions; a loss was suffered because of this
  • the auditor must prove and is guilty until they prove: investor KNEW of ERROR (prove he did NOT RELY) or that the auditor performed their due diligence (without NEGligence)
40
Q

1995 Private securities litigation reform act states what?

A
  • the law places into the code several responsibilities already considered part of an effective audit under GAAS
  • related party transactions (the auditor must include substantive testing designed to identify all significant/material related party transactions)
  • illegal acts (the auditor should attempt to identify illegal acts with a direct and material effect on the financial statements.)
  • going concern (the auditor should perform tests to determine if there is substantial doubt as to the ability of the client to continue in existence throughout the following fiscal year.
41
Q

what are the responsibilities of the auditor whenever illegal acts are identified?

A

the auditor has the responsibility to report the illegal acts to the appropriate level of management; if management fails to take appropriate action in connection with material illegal acts, the auditor must inform the board of directors as soon as it is practicable. the board is given only 1 business day to make a filing informing the SEC of these illegal acts and must provide proof of filing to the auditor. if the auditor does not receive this proof by the filing deadline, the auditor is given only 1 business day to do either of these:

  • *resign from the engagement
  • *notify the SEC of the failure of the board to make the appropriate filing.

**AN AUDITOR WHO FAILS TO COMPLY WITH THE REPORTING PROVISIONS MAY BE HELD CIVILY LIABLE FOR A PROPORTIONATE SHARE OF THE DAMAGES THEY CAUSED, HOWEVER AN AUDITOR WHO COMPLIES MAY NOT BE HELD LIABLE IN ANY PRIVATE ACTION FOR STATEMENTS FILED WITH THE SEC

42
Q

what is the corporate and criminal fraud accountability act of 2002 (SOX)?

A

this act has significant influence on the auditors professional environment concerning the detection of fraud

43
Q

what does the provisions of the corporate and criminal fraud accountability act of 2002 (SOX)?

A
  • auditors are required to maintain all audit working papers for 7 years
  • it is a felony to knowingly destroy or create documents (including audit working papers) to impede, obstruct, or influence any existing or contemplated federal investigation
  • the statue of limitations on securities fraud claims is extended to 5 years from the fraud, or 2 years after the fraud was discovered
  • employees of CPA firms (and audit clients) are extended whistleblower protection that would prohibit the employer from taking certain actions against employees.
  • whistleblower employees are also granted a remedy of special damages and attorneys fee
  • securities fraud by CPAs (and audit clients) is punishable by up 10 years in prison
44
Q

what penalties can the IRS access on paid tax preparers?

A

if the tax preparer fails to do the following:

  • fails to sign the return and provide the appropriate federal identification number
  • fails to provide a copy of the return to the client and retain a copy for the time specified by law
  • negotiates or endorses a clients tax refund check.

in addition the preparer may be held liable by the client if the preparer: fails to provide the client with the completed return to allow a timely filing; fails to advise the client of tax elections that would have provided the client with substantial tax savings.

45
Q

discussions between a client and cpa on federal tax issues are considered what?

A

privileged except when they involve criminal matters or communications pertaining to tax shelters.

46
Q

who owns the accountant working papers?

A

the accountant/auditor owns the working papers not the client. the accountant must maintain CONFIDENTIALITY AND CANNOT PROVIDE THE PAPERS OR INFORMATION OBTAINED DURING THE ENGAGEMENTS TO OTHER parties WITHOUT client permission. the accountant/auditor CAN provide access to other members of his/her firm.

47
Q

what are the exceptions to the confidentiality rules regarding accountant workpapers or information obtained during an engagement?

A

information/working papers CAN be provided for the following reasons/request:

  • valid subpoena (the accountant must honor a valid COURT ORDER to turn over information
  • IRS administrative subpoena
  • COURT ORDER (unless rare state privilege statute)
  • QUALITY CONTROL PEER REVIEW (the accountant may allow other accountants and the PCAOB to see confidential information in connection with a valid program of peer review.
  • where disclosure is in compliance w/GAAP or GAAS
48
Q

what is the purpose of privilege information?

A

it is to protect the client not the accountant.

49
Q

can the accountant assert privilege if the client waives the privilege rights?

A

no

50
Q

what provisions might assert an accountant to criminal liability?

A
  • section 24 of the securities act of 1933, in regards to registration statements filed under the act, specifies that anyone who WILLFULLY makes an UNTRUE STATEMENT OF MATERIAL FACT OR OMITS A MATERIAL FACT REQUIRED TO BE INCLUDED MAY BE FINED UP TO $10,000 IMPRISONED UP TO 5 YEARS OR BOTH.
  • section 32 of the securities act of 1934 makes the WILLFUL violation of any ACT punishable by fines of up to $5,000,000 and imprisonment of up to 20 years. a similar penalty may result from WILLFULLY OR KNOWINGLY making a false or misleading statement relative to a material fact in any application, report or document contained in a registration statement.
  • Racketeer Influenced and Corrupt Organizations (RICO) ACT
51
Q

what are the criminal offenses stated under the internal revenue code title 26 (RICO act)

A
  • actions taken with the intention to evade or defeat taxation
  • willfully failing to file a return, provide information, or pay tax
  • willfully making false statements or declarations, assisting in preparing false tax documents, or preparing a false or fraudulent return.

RICO was passed to allow prosecution of individuals and organizations involved in ongoing criminal activity. it makes it illegal to invest funds obtained through a pattern of racketeering in entities involved in interstate or foreign commerce; to use a pattern of racketeering activities to obtain an interest in, or control over, an entity involved interstate or foreign commerce and obtain an interest in, or control over, an entity involved in interstate or foreign commerce to engage in a pattern of racketeering activities.

RICO also includes “any act or threat involving murder, kidnapping, gambling, arson, robbery, bribery, extortion, dealing in obscene matter or dealing in a controlled substance.

it is chargeable under STATE law, and subject to punishment by imprisonment for more than one year. to be prosecuted under RICO there must be a PATTERN of racketeering. the definition of PATTERN involves repeat offenses and requires that the party be guilty of at least 2 ACTS of RACKETEERING within a 10 YEAR PERIOD.

52
Q

what is racketeering?

A

it is an illegal activity carried out as part of an enterprise that is owned or controlled by those who are engaged in the illegal activity ex. organized crime.

racketeering involves such activities as extortion, loansharking, bribery, and obstruction of justice.

53
Q

what are the consequences for violations under the RICO ACT?

A

may result in fines of up to $250,000.00 or double the amount of profits or losses caused by the criminal activity, and imprisonment for up to 20 years as well as the forfeiture of any property obtained through or used in criminal activities. Treble damages are also allowed, which is a statute that PERMITS A COURT TO TRIPLE THE AMOUNT OF damages awarded by a court of law.

54
Q

what is common law?

A

real estate and services; BREACH OF CONTRACT; NEGLIGENCE; GROSS NEGLIGENCE/FRAUD

55
Q

what is a donee?

A

it means that you received something as a gift or beneficiary

56
Q

what is negligence law?

A

who can sue:
-anyone with privity and who is known or foreseen

what does the plaintiff have to prove?

  • MATERIAL ERRORS OR OMISSION; INFORMATION CAUSED HARM; SUFFERED LOSSES FROM THE USE OF THE INFORMATION; THERE WERE ERRORS OR OMISSIONS.
  • -* THE ERROR IS LACK OF DUE DILIGENCE;
57
Q

what is the criteria for gross negligence or fraud law?

A

who can sue:
-anyone even unforeseen even unknown people can sue

what has to be proven by the plaintiff?
-RELIANCE HAS TO BE PROVEN; YOU HAVE TO PROVE YOU RELIED ON THOSE STATEMENTS

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