I. Legal Duties and Responsibilities

Question 1

11. Common Law Duties and Liabilities to Clients and Third Parties
12. Part One: Liability to Clients

I. Introduction

C. The most significant common law theories

Answer 1

1. Breach of contract; based on breach of an agreement between two parties
2. Negligence
3. Fraud

tort actions (such as negligence and fraud) are based on a duty (not to be careless and not to mislead) that the courts have imposed on accountants as a matter of public policy.

Question 2

11. Common Law Duties and Liabilities to Clients and Third Parties
12. Part One: Liability to Clients

II. Breach of Contract

D. Elements of a Breach of Contract Suit

To win a breach of contract lawsuit, a plaintiff must prove the following four elements:

1. Breached the contract
2. Complied with contractual obligations
3. Damages were caused by the breach
4. Existence of an Enforceable contract

Answer 2

1. Existence of an enforceable contract;
   
   1. While some agreements must be in writing to be enforceable, most do not, so breach of an oral contract is typically actionable.
   2. Obligations may be expressly spelled out (orally or in writing) but may also be implied. The law reads into professional contracts the obligation to perform to a professional standard.
2. Plaintiff client complied with contractual obligations;
   
   1. If the client, for example, promised to pay 50% of the agreed-upon fee in advance but then failed to do so, it would be unreasonable to require the accountant to do the taxes for free.
3. Defendant accountant breached the contract; and
   
   1. The breach may be intentional but need not be for this element to be satisfied.
   2. Examples of breach:
      
      1. Accountant failed to complete the tax return as promised.
      2. Accountant filed the tax return late.
      3. Accountant filed the tax return filled with errors.
      4. Accountant gave faulty tax planning advice to client.
4. Damages were caused by the breach.
   
   1. Plaintiffs may recover “compensatory” damages to compensate them for losses they sustained because of the breach. Such damages usually are not recoverable unless they were reasonably foreseeable at the time the contract was made.
   2. Punitive damages are not recoverable in BOK claims.

Question 3

11. Common Law Duties and Liabilities to Clients and Third Parties
12. Part One: Liability to Clients

II. Breach of Contract

F. Defenses to Breach of Contract Claims

Answer 3

1. Statute of limitations
   
   1. To prevent the uncertainty caused by memories fading and documents being lost, the law requires lawsuits to be filed reasonably promptly.
   2. Although there is considerable variation from state to state, in many states the statute of limitations is:
      
      1. Oral contract: two years from breach; or
      2. Written contract: four years from breach.
2. Justifiable breach
   Sometimes a client’s misconduct justifies an accountant’s breach, precluding liability.
3. Substantial performance

Question 4

11. Common Law Duties and Liabilities to Clients and Third Parties
12. Part One: Liability to Clients

III. Negligence

A. Elements of a Cause of Action for Professional Negligence

Answer 4

1. Defendant accountant owed a duty of care to the client plaintiff.
2. Defendant breached the standard of care.

Examples of negligent breach

1. D carelessly neglects to file tax return on time.
2. D carelessly fails to file documentation needed to support a tax position.
3. D carelessly researches a tax issue and therefore erroneously advises the client to take a position that results in a substantial penalty.
4. D carelessly fails to consider tax return options that would save the client substantial tax liability.
5. D carelessly advises a client to sell a business at a loss, but the transaction does not generate the tax savings promised.

3. The breach proximately causes an injury.
4. Plaintiff client suffers damages.

Question 5

11. Common Law Duties and Liabilities to Clients and Third Parties
12. Part One: Liability to Clients

III. Negligence

B. Defenses

Answer 5

1. Statute of limitations
2. Comparative negligence

Question 6

11. Common Law Duties and Liabilities to Clients and Third Parties
12. Part Two: Liability to Third Parties

I. Breach of Contract

C. Types of Beneficiaries

1. Intended beneficiaries (can sue)

Answer 6

a. Creditor beneficiaries

Example

Tam agrees to paint Dax’s house. Dax agrees to pay Tam $1,000. Tam owes his creditor, Purdle, $1,000. Tam and Dax agree that Dax will pay the $1,000 to Purdle. If Tam paints Dax’s house and Dax does not pay the $1,000 to Purdle, Purdle may sue Dax for breach of contract as an intended creditor beneficiary.

b. Donee beneficiaries

Question 7

11. Common Law Duties and Liabilities to Clients and Third Parties
12. Part Two: Liability to Third Parties

I. Breach of Contract

C. Types of Beneficiaries

2.Incidental beneficiaries (cannot sue)

Answer 7

Tam agrees to paint Dax’s house. Dax agrees to pay Tam $1,000. Pong, Dax’s next-door neighbor is pleased because Dax’s house is an eyesore and a new paint job for Dax’s house may raise Pong’s property value. Tam breaches the contract and does not paint Dax’s house. Dax may sue, but Pong may not. Tam and Dax did not intend to benefit Pong (though they would have incidentally). Pong is a mere incidental beneficiary and cannot successfully sue on this contract to which he was not a party.

Question 8

11. Common Law Duties and Liabilities to Clients and Third Parties
12. Part Two: Liability to Third Parties

II. Negligence

Answer 8

Liability to Third Parties

1. Intended beneficiary (merger/acquisition/will beneficiary) (Ultramares)
2. Knowledge of distribution to limited third parties
3. Reasonably foreseeable
4. Privity (Ultramares)

Question 9

11. Common Law Duties and Liabilities to Clients and Third Parties
12. Part Two: Liability to Third Parties

II. Negligence

B. Audit Cases

Answer 9

Example

Trejo audited ABC Co. and carelessly certified financial statements that greatly inflated ABC’s value. Soon thereafter, ABC decided to put itself up for sale, and XYZ bought ABC after examining the audited financial statements. After XYZ completed the purchase, it realized that the financial statements were inaccurate and that it had overpaid for ABC. XYZ sued Trejo for negligence but lost because it was not foreseeable to Trejo that XYZ would rely on the financial statements because ABC was not yet for sale at the time he completed the audit.

Question 10

11. Common Law Duties and Liabilities to Clients and Third Parties
12. Part Two: Liability to Third Parties

II. Negligence

B. Tax Cases

Answer 10

Examples

1. Sam and Pam were partners in various real estate ventures, some of which were not going well. Sam owed Pam $4 million. They signed a settlement agreement in which Sam promised to pay Pam a $1 million tax refund that he was entitled to. They also agreed that Sam would hire CPA Smith to prepare the tax return and pay the refund to Sam’s lawyer, Jones, who would convey the money to Pam. Sam did hire Smith. Smith knew of the settlement agreement. However, when the tax refund came, Smith carelessly conveyed the checks to Sam instead of Jones. Sam took the money and left the country. Pam sued Smith for negligence (as well as breach of the contract). Smith denied that he owed any duty of care to Pam, who was not his client. But because Sam knew that Pam would be relying on his actions, he was held to owe her a duty of care.
2. CPA Dolan carelessly recommended a tax position to his client, Fanny. Fanny told her neighbor, Dipson, about the tax strategy, and Dipson tried it on his own return. The IRS rejected the position as being without any reasonable basis, and Fanny was hit with tax penalties. She sued Dolan for negligence and won. Dipson also sued Dolan for negligence; he lost. Dolan could not have reasonably foreseen that Dipson would also rely on his advice so he owed Dipson no legal duty of care.
3. CPA Willis joined with others to promote a tax shelter involving worthless coal rights. Willis issued a tax opinion concluding that the IRS would allow the deduction of large advance royalty payments. He and the other principals did not disclose that most of the money invested would go into their pockets. Plaintiff Pym was one of the investors who, based on the opinion, bought into the tax shelter. He lost a lot of money when the shelter was declared bogus by the IRS. Pym was allowed to sue Willis because he was part of a limited class of people to whom Willis supplied the negligently researched tax opinion knowing that they would rely on it to make the investment decision.

Question 11

11. Common Law Duties and Liabilities to Clients and Third Parties
12. Part One: Liability to Clients
13. Part Two: Liability to Third Parties

A plaintiff who proves that a CPA has committed fraud may recover both compensatory damages and punitive damages.

Answer 11

True

Question 12

11. Common Law Duties and Liabilities to Clients and Third Parties
12. Part One: Liability to Clients
13. Part Two: Liability to Third Parties

CPA Jindahl recklessly disregarded the tax law when he gave advice to his client Smithers. This is an example of actual fraud.

Answer 12

"Reckless disregard" is unprofessional behavior and when it results in damage to a client could be construed as constructive fraud. The CPA should have known better!

In actual fraud, there is intent to deceive.

Question 13

12. Privileged Communications, Confidentiality, and Privacy Acts

Confidential Communications

Answer 13

A. General Rule—According to the AICPA Code of Professional Conduct, absent client consent, a CPA shall not disclose confidential information disclosed by clients.

B. Exceptions—Recognized exceptions include:

1. GAAP calls for disclosure
2. An enforceable subpoena or summons has been issued
3. An ethical examination is being conducted
4. A peer review requires disclosure
5. Disclosure is to other firm members on a “need-to-know” basis

Question 14

12. Privileged Communications, Confidentiality, and Privacy Acts

Confidential Communications

Q. Which of the following is a correct statement about the circumstances under which a CPA firm may or may not disclose the names of its clients without the clients’ express permission?

Answer 14

A CPA firm may disclose this information unless disclosure would suggest that the client may be experiencing financial difficulties.

Question 15

AICPA.951123REG-AR_0319

Bass Corp., a calendar-year C corporation, made qualifying 2019 estimated tax deposits based on its actual 2018 tax liability.

On March 15, 2020, Bass filed a timely automatic extension request for its 2019 corporate income tax return. Estimated tax deposits and the extension payment totaled $7,600. This amount was 95% of the total tax shown on Bass’s final 2019 corporate income tax return. Bass paid $400 additional tax on the final 2019 corporate income tax return filed before the extended due date. For the 2019 calendar year, Bass was subject to pay

I. Interest on the $400 tax payment made in 2020.

II. A tax delinquency penalty.

Answer 15

II Only

Question 16

AICPA.951110REG-BL

Which of the following is the best defense a CPA firm can assert in a suit for common law fraud based on its unqualified opinion on materially false financial statements?

(Defense for fraud or negligence)

1. Contributory negligence on the part of the client.
2. A disclaimer contained in the engagement letter.
3. Lack of privity.
4. Lack of scienter.

Answer 16

4.

Question 17

AICPA.970501REG-BL

Which of the following statements is generally correct regarding the liability of a CPA who negligently gives an opinion on an audit of a client’s financial statements?

1. The CPA is only liable to those third parties who are in privity of contract with the CPA.
2. The CPA is only liable to the client.
3. The CPA is liable to anyone in a class of third parties who the CPA knows will rely on the opinion.
4. The CPA is liable to all possible foreseeable users of the CPA’s opinion.

Answer 17

3.

There are three general viewpoints regarding an accountant’s liability to third parties.

1. One view requires privity of contract for a third party to recover.
2. Another view allows all reasonably foreseeable users of an accountant’s report to sue.
3. But the majority view, known as the Restatement view, limits an accountant’s liability to a limited class of actually foreseen users.

This question obviously asks the student to apply the majority (Restatement) view.

Question 18

AICPA.931105REG-BL

While conducting an audit, Larson Associates, CPAs, failed to detect material misstatements included in its client’s financial statements.

Larson’s unqualified opinion was included with the financial statements in a registration statement and prospectus for a public offering of securities made by the client. Larson knew that its opinion and the financial statements would be used for this purpose.

In a suit by a purchaser against Larson for common law fraud, Larson’s best defense would be that

1. Larson did not have actual or constructive knowledge of the misstatements.
2. Larson’s client knew or should have known of the misstatements.
3. Larson did not have actual knowledge that the purchaser was an intended beneficiary of the audit.
4. Larson was not in privity of contract with its client.

Answer 18

1.

To be convicted of common law fraud, a CPA must make misstatements with knowledge or recklessly make the misstatements. A CPA acts recklessly when s/he has constructive knowledge, that is, s/he should have known that the statements were false. Showing that a CPA had neither actual nor constructive knowledge of the falsities is an adequate defense.

Question 19

AICPA.951108REG-BL

Under the “Ultramares” rule, to which of the following parties will an accountant be liable for negligence?

Parties in privity__Foreseen parties

1. Yes Yes
2. Yes No
3. No Yes
4. No No

Answer 19

2.

The “Ultramares” rule, established in a 1931 case of the same name, requires privity before an accountant is liable for negligence. Other rules, such as the Restatement rule, allow foreseeable users who rely on a negligently false statement to sue.