Chapter 4 - Solution Manual

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Chapter 04 - Legal Liability of CPAs CHAPTER 4 Legal Liability of CPAs Review Questions 4-1 There There are sever several al reasons reasons why why the the poten potentia tiall legal legal liabi liability lity of CPA CPAs for professi professiona onall "malpract "malpractice" ice" excees that of physicians an other professionals! ne reason is the vast n#mber of people who who may s#stain amages! $f a physician or attorney commits commits a serio#s error% the n#mber of in&#re  parties generally generally is is limite limite to to one iniv inivi#al i#al patient patient or client! client! 'hen 'hen a CPA(s CPA(s report is in error% error% literally millions of investors may s#stain losses! )econ% the feeral )ec#rities Acts regaring CPAs( liability are #ni*#e in that m#ch of the  b#ren of of proof is shifte shifte to to the efen efenant! ant! +ormally% +ormally% efenan efenants ts are "pres#me "pres#me innocen innocentt #ntil #ntil  proven g#ilty!" g#ilty!" ,ner ,ner the feeral )ec#rities Acts% Acts% however% however% CPAs CPAs charge charge with "malpractice "malpractice"" m#st  prove their their innocen innocence! ce! inally% when investors s#stain losses in the many millions of ollars% the economics of the sit#ation ictates bringing s#it against the CPAs even if the prospects for recovery appear remote! 'hen the possible ollar recovery is smaller% which #s#ally is the case in other professional malpractice s#its% the plaintiffs are more li.ely to be eterre from filing s#it simply by the costs of  litigation! 4-/ rinary rinary neglig negligenc encee means means lac. of reason reasonabl ablee care! care! ross ross negl neglig igenc encee means means lac. of even even slight slight care% inicative of rec.less isregar for #ty! #t y! An oversight oversight by a CPA res#lting in a misstatement in a financial statement might be consiere orinary negligence% whereas if a CPA faile s#bstantially to comply with generally accepte a#iting stanars the charge might be gross negligence! 4- Privity Privity is is the relation relationshi ship p betwe between en parties parties to a contract! contract! A CPA CPA firm is in in privity privity with with the the clien clientt which it is serving% as well as with any thir party beneficiary% s#ch as a creitor ban. name in the engagement letter 2the contract between the CPA CPA firm an its client3! ,ner common common law% if the a#itors o not comply with their obligations to the client% res#lting in amages% the client may s#e an recover its losses by proving that the a#itors were negligent in performing their #ties #ner the contract! 4-1 Chapter 04 - Legal Liability of CPAs 4-4 A thir-party beneficiary is a person other than the contracting parties who is name in the contract or intene by the contracting parties to have efinite rights an benefits #ner the contract! or example% a ban. wo#l be a thir party beneficiary if the a#itors an the client agree that the  p#rpose of the a#it was to provie the ban. with an a#it report to ma.e a ban. loan to the client! 4- Common law is #nwritten law that has evelope thro#gh co#rt ecisions5 it represents &#icial interpretation of a society(s concept of fairness! )tat#tory law is law that has been aopte by a governmental #nit% s#ch as the feeral government! 4-6 The primary ifference between the ,ltramares an the 7estatement approaches relates to whether the CPA has liability for orinary negligence to thir parties not specifically ientifie as #sers of the CPA(s report! ,ner the Ultramares  approach a CPA may be hel liable for orinary negligence to a thir party only when that CPA 213 was aware that the financial statements were to  be #se for a partic#lar p#rpose by a .nown party or parties% an 2/3 some action of the CPA inicates s#ch .nowlege! ,ner the Restatement  approach the specific ientity of the thir parties nee not be .nown to the CPA to establish liability for orinary negligence! 8owever% s#ch liability for orinary negligence is only to a limite class of .nown or intene #sers of the a#ite financial statements! 4-9 $n Ultramares v. Touche % the +ew :or. Co#rt of Appeals r#le that a#itors co#l be hel liable to thir parties 2not in privity of contract3 for gross negligence or fra#% b#t not for acts of orinary negligence! $n Rosenblum v. Adler % the +ew ;ersey )#preme Co#rt r#le that a#itors co#l be hel liable for orinary negligence to any "foreseeable" thir parties who #tili ,ner common law% a#itors are liable to their clients for orinary negligence as well as for fra# an breach of contract! A#itors are liable to thir party beneficiaries 2an in some &#risictions to foreseen or foreseeable thir parties3 for fra# an for orinary negligence! A#itors are liable for gross negligence an fra# to other thir parties! 4-10 ,ner &oint an several liability one efenant may be re*#ire to pay the losses attrib#te to the actions of other efenants who o not have the financial reso#rces to pay! Th#s% if two parties were negligent an fo#n to each be 0? liable% if one was #nable to pay% the other party co#l be re*#ire to pay the entire 100?! ,ner proportionate liability a efenant is liable only for his or her proportion of fa#lt! ,sing the previo#s example% neither efenant co#l be re*#ire to pay more than 0? of the amages! 4-/ Chapter 04 - Legal Liability of CPAs 4-11 Legal actions #ner common law re*#ire the plaintiffs to bear most of the b#ren of affirmative  proof! The plaintiffs m#st prove they s#staine losses% that they relie #pon financial statements that were misleaing% that this reliance ca#se their losses% an that the a#itors were g#ilty of a certain egree of negligence! $n legal actions bro#ght #ner the )ec#rities Act of 1>% the b#ren of proof is shifte to the a#itors% who m#st show that they were not negligent 2the #e iligence efense3 or that misleaing financial statements were not the proximate ca#se of the plaintiffs( losses! 4-1/ The )ec#rities Act of 1> reg#lates the initial sale of sec#rities in interstate commerce 2new iss#es3% an the )ec#rities @xchange Act of 1>4 reg#lates traing of sec#rities after initial istrib#tion! 4-1 The Hochfelder v. Ernst  ecision is regare as a "victory" for the acco#nting profession beca#se it is one of the few ecisions to limit% rather than expan% a#itors( legal liability to thir parties! $n this ecision the ,!)! )#preme Co#rt r#le that orinary negligence was not a s#fficient egree of miscon#ct for a#itors to be hel liable to thir parties #ner 7#le 10b- of the )ec#rities @xchange Act of 1>4! 4-14 The Continental Vending  case was #n#s#al in that it involve criminal charges against the CPAs for violating provisions of the )ec#rities Acts! Altho#gh there was no intent to efra# on the part of the CPAs% they were convicte of criminal fra# on the basis of gross negligence! The three CPAs were later parone by the presient of the ,nite )tates! 4-1 The 7ac.eteer $nfl#ence an Corr#pt rgani +o! 7ogers an reen appear to be g#ilty of gross negligence% which often is consiere tantamo#nt to constr#ctive fra#! 8owever% act#al fra# involves .nowlege of misrepresentation within the financial statements an an intention to eceive #sers of those statements! Altho#gh 7ogers an reen faile s#bstantially to comply with generally accepte a#iting stanars% there is no inication that they .new of misrepresentation in the statements or intene to eceive thir  parties! ross negligence may be consiere constr#ctive fra#% beca#se the a#itors are misleaing the p#blic as to the egree of creibility that they are able to a to the statements! 'hile s#ch con#ct is highly #nprofessional% it is still *#ite ifferent from attesting to the "fairness" of financial statements .nown by the a#itors to be misleaing! Questions Requiring Analysis 4-/0 CPA liability to clients may be base on 213 breach of contract% 2/3 a tort action for negligence% or 23 both! ,ner common law% in general% the client m#st prove the following to establish CPA liabilityD #tyEthe CPA accepte a #ty to exercise s.ill% pr#ence an iligence! Breach of #tyEthe CPA breache that #ty! LossEthe client s#ffere a loss! Ca#sationEthe loss res#lte from the CPA(s negligent performance! • • • • $n this circ#mstance it wo#l seem that the above elements might be proven in a case against 8er  $rwin! This seems partic#larly li.ely given the fact that inexperience staff assistants operate witho#t s#fficient s#pervision! 4-/1 A client has a vali claim to recover its losses from a CPA firm if it can prove the CPAs were negligent an this negligence was the proximate ca#se of the client(s loss! 8owever% in this case% ;ensen% $nc! may be hel g#ilty of contrib#tory negligence for not having followe the CPAs( recommenations for improving internal control! )#ch contrib#tory negligence might ca#se a co#rt to prohibit the client(s recovery from the CPA firm% or limit the losses recovere from the CPA firm thro#gh the concept of comparative negligence! 4-4 Chapter 04 - Legal Liability of CPAs 4-// :es! Creitors #s#ally are thir parties not in privity of contract with the a#itors! ,ner common law% these "other" thir parties may recover from the a#itors any losses proximately ca#se by the a#itors( gross negligence% or% in some &#risictions% orinary negligence! $n this sit#ation% whether the co#rts ahere to the Ultramares % Restatement % or Rosenblum approach is not an iss#e5 the a#itors were g#ilty of gross negligence tantamo#nt to constr#ctive fra#! )mall exhibite a rec.less isregar for his professional responsibilities by falsifying the a#it wor.ing papers! As state in o#r isc#ssion of professional ethics% CPAs are responsible for the acts of their assistants5 th#s% the firm of 8anson an Brown is liable for )mall(s gross negligence! 4-/ The facts clearly inicate negligence by )cott  reen! A#itors have a responsibility to esign their a#it to provie reasonable ass#rance of etecting material misstatements #e to errors an fra#! nce evience of even immaterial fra# is bro#ght to the a#itors( attention% they are obligate to isclose the sit#ation to the client! )cott  reen co#l be hel liable for losses that res#lt from fail#re to isclose their s#spicions to the client! 4-/4 )par.s% 'atts% an 'ilcox% CPAs are liable to their client for amages ca#se by the negligence of the senior a#itor! The assistant a#itor selecte a sample of 60 transactions in her test of controls for hanling p#rchases% receiving% vo#chers payable% an cash isb#rsements! 'hen a#itors rely #pon a sample to form an opinion abo#t an entire pop#lation% they m#st examine each item in the sample caref#lly! $n this case% the assistant a#itor fo#n n#mero#s inications of fra# 2missing receiving reports3% b#t the in-charge a#itor too. no action! This con#ct by the senior a#itor clearly shows lac. of the "#e professional care" re*#ire by generally accepte a#iting stanars% an is th#s inicative of orinary negligence! The tests of controls mae by the a#itors are part of their f#rther a#it proce#res! 'hen the tests isclose wea.nesses in internal control that may allow material fra# to occ#r% the a#itors have two specific responsibilities! They sho#lD 213 Comm#nicate the sit#ation to the appropriate levels of the client(s management incl#ing the a#it committee of the client(s boar of irectors! 2/3 @xpan their a#it proce#res to etermine if material fra# act#ally has occ#rre an% if so% the effects of this fra# on the financial statements! The ollar amo#nt of the CPAs( liability will epen #pon what portion of the client(s F900%000 loss was proximately ca#se by the a#itors( negligence! The a#itors almost certainly will be liable for the F00%000 loss occ#rring after the completion of the a#it! $n aition% they may be hel responsible for all or part of the F/00%000 loss occ#rring earlier% epening #pon whether this loss might have been prevente or recovere ha the a#itors ta.en prompt an appropriate action! 4- Chapter 04 - Legal Liability of CPAs 4-/ 4-/6 2a3 1>4! The stoc.holers co#l initiate the laws#it #ner the )ec#rities @xchange Act of 2b3 The Private )ec#rities Litigation 7eform Act of 1>> establishes a form of proportionate liability #ner the 1>4 )ec#rities @xchange Act! 'hen all efenants are able to pay their share each party pays its pro-rate share! Accoringly% )awyer an )awyer wo#l be liable for F/0%000 2? G F%000%0003! 2c3 $f management 2or any other liable party3 is #nable to pay its share each other efenant may be re*#ire to pay 0? over its pro rata share! )awyer an )awyer wo#l be liable for a maxim#m of F9%000 2the original F/0%000 pl#s F1/%0003! Beca#se management is responsible for F%00%0000 of the total 290? G F%000%0003 an is #nable to pay% )awyer an )awyer will probably en #p paying the entire F9%000! Also% this amo#nt may increase somewhat #e to the ActHs re*#irements that the losses of certain small investors be entirely pai if possible! 2a3 The #ni*#e aspect of this case is that the CPA firm of Arth#r Anersen was fo#n g#ilty of of the felony of criminal estr#ction of oc#ments! The inictment name only the firm an not any inivi#al partner or professional staff! The conviction ca#se the emise of this international acco#nting firm! 2b3 This case ill#strates how the actions of a few inivi#al partners an employees can lea to isastro#s res#lts for the firm! 8owever% it sho#l be note that the conviction was overt#rne  by the ,!)! )#preme Co#rt base on the instr#ctions given to the &#rors! 4-/9 2a3 The case sho#l be ismisse! $n the  Hochfelder  case% the ,!)! )#preme Co#rt hel that action for amages #ner )ection 102b3 an 7#le 10b- was not warrante in the absence of intent to efra# 2scienter3 on the part of the CPA firm! Altho#gh oron  Ioore was negligent in the performance of its a#its% the firm was #naware of the existence of the scheme% an therefore not g#ilty of fra# #ner )ection 102b3 of the )ec#rities @xchange Act of 1>4! 2b3 The plaintiffs might have file s#it #ner common law for negligence! Their prospects for s#ccess wo#l epen #pon two factorsD 213 'hether the &#risiction in which the s#it was bro#ght recogni or the )ec#rities @xchange Act of 1>4! 2e3 213 The Creit Alliance Corp! v! Arth#r Anersen  Co! case reaffirme the principles in the ,ltramares case by clarifying the conitions necessary for parties to be consiere thir-party beneficiaries! 2f3 213 Contrib#tory negligence% negligence on the part of the plaintiff% may be #se as a efense an the co#rt may limit or bar recovery by a plaintiff whose own negligence contrib#te to the loss! 2g3 23 The #rivate $ecurities %itigation Reform Act of 1'  amene the )ec#rities an @xchange Act of 1>4 to place limits on the amo#nt of the a#itorsH liability thro#gh establishing proportionate liability! 2h3 243 A CPA may avoi liability #ner the 1> Act by proving that their negligence was not the proximate ca#se of the plaintiff(s loss! Accoringly% a fining that the false statement is immaterial wo#l in all circ#mstances represent a viable efense! 2i3 23 A CPA may be fo#n liable to a client when #e care has not been exercise! 2&3 23 ,ner the )ec#rities Act of 1> p#rchasers of sec#rities who s#stain losses nee only prove that the financial statements containe in the registration statement were misleaing! Then the b#ren is shifte to the a#itors to prove that they performe the a#it with "#e iligence!" 4-9 Chapter 04 - Legal Liability of CPAs 2.3 213 The Continental Vending  case was a lanmar. in establishing a#itors(  potential criminal liability #ner the )ec#rities @xchange Act of 1>4! The case involve a#ite financial statements% was bro#ght #ner stat#tory law% an i not involve registration statements 2which are covere by the )ec#rities Act of 1>3! 2l3 2/3 The 11! Tenants  case was a lanmar. case concerning a#itors( liability when they are associate with #na#ite financial statements! 4-/> 2a3 Tr#e! The )ec#rities Act of 1> reg#lates interstate offerings of sec#rities to the  p#blic! 2b3 Tr#e! The effect of the )ec#rities Act of 1> is to give to thir parties who p#rchase registere sec#rities the same rights against the a#itor as are possesse by the client #ner  common law! 2c3 alse! )ection 112a3 of the )ec#rities Act of 1> specifically bars recovery by anyone .nowing of an #ntr#th or omission in a registration statement! 23 Tr#e! The )ec#rities Act of 1> shifts the b#ren of proving that the a#it was con#cte  properly to the efenant a#itors! 2e3 Tr#e! An acco#ntant s#ccessf#lly asserting the "#e iligence" efense can avoi liability! 2f3 Tr#e! The acco#ntants( efense will #s#ally incl#e efforts to establish that there were other ca#ses for the plaintiffs( losses! 2g3 alse! The )@C oes not pass on the merit of sec#rities% nor oes it efen acco#ntants! 4-0 2a3 2b3 2c3 23 2e3 2f3 2g3 Liable +ot liable Liable Liable Liable Liable +ot liable 4-1 2a3 2b3 2c3 23 2e3 2f3 2g3 23 23 293 213 263 2/3 243 4-= Chapter 04 - Legal Liability of CPAs 4-/ 4- 2a3 23 )ection 11 of the )ec#rities Act of 1> imposes liability on a#itors for misstatements or omissions of a material fact in certifie financial statements or other information provie in registration statements! )imilarly% #ner )ection 102b3% 7#le 10b of the )ec#rities @xchange Act of 1>4% the plaintiff m#st prove there was a material misstatement or omission in information release by the company% s#ch as a#ite financial statements! 2b3 23 ,ner both )ection 11 of the 1> Act an )ection 102b3 of the 1>4 Act% the plaintiff m#st allege or prove that sJhe inc#rre monetary amages!  2c3 213 ,ner )ection 11 of the 1> Act% the b#ren of proof is shifte to the efenant% acco#ntant! The acco#ntant may then efen himself or herself by establishing #e iligence! The plaintiff oes not have to show lac. of #e iligence by the CPA ,ner )ection 10% the plaintiff m#st prove scienter! 23 243 The plaintiff oes not have to prove that sJhe was in privity with the CPA #ner either section! 2e3 2/3 ,ner )ection 102b3% the plaintiff m#st prove &#stifiable reliance on the financial information! This is not tr#e #ner )ection 11 in which the plaintiff nee prove only the items in item 2a3 an 2b3 isc#sse above! 2f3 2/3 The plaintiff oes have to prove that the CPA ha scienter #ner )ection 102b3 of the 1>4 Act! )cienter is not neee #ner the 1> Act! 2a3 2b3 2c3 23 2e3 2f3 2g3 2h3 2i3 2&3 1/ 10 > 1 11   / 9 14 )ec#rities Act of 1> Proportionate liability Proximate ca#se Breach of contract )cienter   ra# Constr#ctive fra# Common law +egligence )tat#tory law 4-> Chapter 04 - Legal Liability of CPAs Probles 4-4 4- )L,T$+D 'ilson an 'yatt 2@stimate timeD /0 min#tes3 2a3 The first basis for liability wo#l be to assert orinary negligence by 'ilson an 'yatt! The fail#re to meet the stanars of the profession wo#l be inicative of orinary negligence! )ince the p#rpose of the a#it was the p#rchase of the treas#ry stoc.% 7is. Capital is a thir-party beneficiary #ner the contract between 'ilson an 'yatt an loria )#nshine! Therefore% 'ilson an 'yatt wo#l be hel liable for orinary negligence to 7is. Capital! The secon basis for liability is constr#ctive fra#! 8ere 7is. Capital m#st show that the acco#ntants either .new the financial statements were incorrect or examine them witho#t regar for #e professional care5 that is% that their negligence was so great 2i!e!% grossly negligence3 as to constit#te constr#ctive fra#! $f fra# is proven% privity is not necessary for recovery by a thir party! 2b3 :es! $n this case 7is. Capital is clearly a thir-party beneficiary! Therefore% 7is. Capital co#l recover losses% if it can be establishe that the firm of 'ilson an 'yatt is g#ilty of orinary negligence! )L,T$+D )eavers  ean CPAs 2@stimate timeD /0 min#tes3 2a3 :es% b#t only to the extent of F90%000! B#sch is a thir-party beneficiary of the contract  between Ieglow an its a#itors% an may therefore recover from the a#itors losses ca#se by the CPAs( orinary negligence! 8owever% the original F0%000 loan was mae  prior to B#sch(s reliance #pon the negligently a#ite financial statements! Th#s% the a#itors( negligence was not the proximate ca#se of this portion of B#sch(s loss! The a#itors( negligence may% however% be consiere the proximate ca#se of the F90%000 loss inc#rre as a res#lt of reliance #pon the misleaing statements! 2b3 The prospects for Iaxwell(s recovery of its F0%000 loss are s#bstantially less than those of B#sch! Iaxwell was not a thir-party beneficiary to the contract! Th#s% in many  &#risictions following Ultramares % Iaxwell cannot recover losses attrib#table to the CPAs( orinary negligence! )imilarly% it is o#btf#l that Iaxwell wo#l *#alify as a foreseen thir party as necessary #ner the  Restatement   approach! @ven in a &#risiction accepting the  Rosenblum preceent% which allows thir parties to recover losses ca#se by the a#itors( orinary negligence% Iaxwell wo#l have to prove that it was a "foreseeable thir party relying #pon the financial statements for ro#tine b#siness p#rposes!" $t is *#estionable whether the loan by Iaxwell was either "reasonably foreseeable" or "ro#tine%" as Iaxwell was a c#stomer of Ieglow% not a lener! 4-10 Chapter 04 - Legal Liability of CPAs 4-6 )L,T$+D Thomas  7oss% CPAs 2@stimate timeD 1 min#tes3 2a3 213 ,ner common law in a &#risiction that aheres to the Ultramares octrine% the stoc.holers m#st show that they inc#rre losses% that the CPAs were grossly negligent% an that this gross negligence was the proximate ca#se of the stoc.holers( losses! 2/3 2b3 213 $n a s#it bro#ght #ner the )ec#rities Act of 1>% initial p#rchasers of the sec#rity m#st show only that they ha a loss an that the financial statements were misleaing! 2/3 2c3 The a#itors% in orer to avoi liability% m#st prove either that they performe their  a#it with "#e iligence" 2that is% were not negligent3 or that their negligence was not the proximate ca#se of the plaintiffs( losses! 213 $n a s#it bro#ght #ner the )ec#rities @xchange Act of 1>4% the plaintiffs normally m#st prove reliance #pon the misleaing financial statements% as well as that they s#staine a loss an that the statements were misleaing! 2/3 4-9 ,ner common law% the efenant is "pres#me innocent #ntil proven g#ilty%" an therefore bears no b#ren or affirmative proof! The a#itors will% however% intro#ce evience ref#ting the plaintiffs( allegations! To avoi liability% the a#itors m#st prove either that they "acte in goo faith" 2were not grossly negligent3% an that their gross negligence was not the proximate ca#se of the plaintiffs( losses! )L,T$+D Charles 'orthington% CPA 2@stimate timeD /0 min#tes3 Craft has state that the CPA firm has "reviewe the boo.s an recors of lac. Kent#res%" when in fact no s#ch "review" has occ#rre! A "review" of financial statements consists of limite investigatory proce#res esigne to provie statement #sers with a limite egree of ass#rance that the financial statements are in conformity with generally accepte acco#nting principles! Craft(s actions are similar to iss#ing an a#itors( report witho#t first performing an a#it! )#ch an action may well be consiere an act of criminal fra#% intene to mislea #sers of the financial statements! $n aition% Craft(s actions violate 7#les 10/% /0/% an 01 of the A$CPA Code of  #rofessional Conduct ! $f the financial statements of lac. Kent#res t#rn o#t to be misleaing% there is little o#bt that any co#rt wo#l fin the CPA firm g#ilty of at least constr#ctive fra# an liable to any thir party who s#stains a loss as a res#lt of reliance #pon the statements! The fact that Craft violate 'orthington(s policy of s#bmitting all reports for 'orthington(s review wo#l not lessen the CPA firm(s liability! The concept of m#t#al agency allows Craft% as a partner% to commit the firm to contracts% incl#ing a#itors( reports an acco#ntants( reports! The fact that this report was not s#bmitte for 'orthington(s review might be intro#ce as evience against Craft in the event he is acc#se of criminal fra#! 4-11 Chapter 04 - Legal Liability of CPAs 4-= 4-> )L,T$+D ,na#ite )tatements 2@stimate timeD 0 min#tes3 2a3 The compilation 2preparation3 of financial statements is *#ite ifferent from an a#it% an it is important that the client #nerstan this! ral commitments% s#ch as telephone conversations% can often be mis#nerstoo an sho#l be followe #p by a written engagement letter spelling o#t the nat#re an limitations of the services to be performe! 2b3 @ven a reg#lar a#it cannot be relief #pon to isclose efalcations% an in an engagement involving the compilation of #na#ite financial statements% the CPAs o not even perform any a#it proce#res! The fact that the CPA intens to perform no investigative  proce#res an will rely #pon the representations of the managing agent sho#l specifically  be set forth in the written engagement letter! f co#rse% if the CPA has reason to s#spect that the representations of the managing agent are erroneo#s% the concept of #e professional care re*#ires that she inform her client of her reservations! 2c3 The wor "A#it" sho#l be avoie in referring to all engagements other than a#its! therwise% it may appear that the CPAs have le the client to believe that they were acting as a#itors% in which case they may be hel acco#ntable for con#cting their wor. in accorance with generally accepte a#iting stanars! The CPA sho#l explain this sit#ation to the client an pers#ae the client to change the acco#nt title to "Acco#nting ees!" 23 'hile ay oes not have a responsibility to perform a#it proce#res when compiling #na#ite financial statements% he oes have a responsibility to exercise #e professional care! This wo#l incl#e avising the client of any sit#ation that might s#ggest a problem for the client! The CPA sho#l alert his client to the missing invoices in writing an avise the client to follow #p on the matter% or% if the client wishes% the CPA co#l investigate the matter as an aitional acco#nting service! The .ey point is that the CPA m#st not fail to alert the client to the #nerlying potential for fra#! )L,T$+D Iar. 'illiams% CPA 2@stimate timeD /0 min#tes3 2a3 CPAs as members of a profession are obligate to exercise #e professional care! Th#s% a CPA may be hel liable to the client for the amages res#lting from the CPA(s orinary negligence! )ince ;ac.son inancial was the client% ;ac.son can recover losses proximately ca#se by 'illiams( negligence! $t wo#l appear that ;ac.son inancial co#l also recover  the a#it fee as amages beca#se of 'illiams( breach of contract! 4-1/ Chapter 04 - Legal Liability of CPAs 4-40 2b3 The first arg#ment which 'illiams( attorney wo#l ma.e is that Apex ha no rights #ner the contract between ;ac.son an 'illiams! $n most &#risictions% an "other" thir party is able to recover losses attrib#table to the a#itor(s gross negligence% b#t not orinary negligence! A secon arg#ment is that 'illiams( negligence was not the proximate ca#se of Apex(s loss! The loss apparently occ#rre prior to the a#it by 'illiams an co#l not have been prevente even if 'illiams ha iscovere the efalcations! inally% the attorney wo#l arg#e contrib#tory negligence on the part of Apex! +ormally losses are allocate  between the parties when both parties are negligent! 'hether the first arg#ment that ;ac.son has no rights #ner the contract will prevail is an interesting *#estion! There is little a#thority on the precise sit#ation in the problem! Altho#gh Apex is not the client an is not mentione as a beneficiary in the engagement letter% it is the company whose financial statements were a#ite! 'hether this fact creates the #ty of care owe by 'illiams to ;ac.son inancial is% at present% #nclear! 2c3 +o! A CPA firm is not prevente from recovering against its ins#rer! This is precisely the  p#rpose of this type of ins#rance5 it serves to protect the ins#re firm from its own negligence! CPAs may be barre from recovering from their ins#rers% however% if they are fo#n g#ilty of criminal fra#! )L,T$+D Cragsmore  Company% CPAs 2@stimate timeD /0 min#tes3 The legal problems for Cragsmore  Company involve possible criminal liability% as well as civil liability% for fra#! The facts in the Iarlowe Ian#fact#ring% $nc! a#it bear mar.e similarities to the facts in the Continental Vending  case! $n Continental Vending % the co#rt fo#n two partners an a manager of a CPA firm g#ilty of criminal fra# for failing to insist #pon ae*#ate isclos#re of the #ncollectibility of a s#bstantial receivable from an affiliate! Ir! Cragsmore(s con#ct has implications of a conspiracy with management an owners of Iarlowe to conceal the relate-party aspects of the lease between Iarlowe an Acme Leasing Company! Altho#gh the inae*#ate isclos#re of the facts of the lease is not the proximate ca#se of losses to Iarlowe(s creitors  beca#se of the company(s ban.r#ptcy% it is conceivable that a fining of fra# against Cragsmore  Company with respect to the lease isclos#re wo#l lea to recovery of amages against the CPA  by the creitors of Iarlowe! enerally% there is no re*#irement that financial statements or notes isclose the lac. of fire ins#rance! Iany companies o not obtain ins#rance coverage by choice5 others cannot obtain coverage beca#se of the ha )ec#rities Act offers protection only to a limite gro#p of investorsEthose who p#rchase a sec#rity offere or sale #ner the registration statement! Accoringly% the company itself will not orinarily be able to recover! 2/3 +o! The 1> )ec#rities Act offers protection only to a limite gro#p of investors  Ethose who p#rchase a sec#rity offere or sale #ner the registration statement! Accoringly% the ban. will not orinarily be able to recover! 4-14 Chapter 04 - Legal Liability of CPAs 23 +o! The 1> )ec#rities Act offers protection only to a limite gro#p of investorsEthose who p#rchase a sec#rity offere or sale #ner the registration statement! )ince the shareholers here i not p#rchase sec#rities% they will not orinarily be able to recover! inally% the sec#rities ha been o#tstaning for 10 years which far excees the three year stat#te of limitations! Answer  wo#l change as it is o#btf#l that the a#itors wo#l #43  be able to establish that the a#it ha been performe with #e iligence when orinary negligence is involve! Accoringly% the shareholers might well be able to recover their loses! 2c3 213 +o! The )ec#rities @xchange Act of 1>4 offers protection only to  p#rchasers an sellers of sec#rities registere with the )@C! 2/3 +o! ,nless the loan was an )@C registere sec#rity 2or sho#l have been% which is #nli.ely here3 the ban. will not be able to recover #ner the )ec#rities @xchange Act of 1>4! 23 o#btf#l! 'hile these shareholers are offere some protection #ner the )ec#rities @xchange Act of 1>4% the orinary negligence of the CPA is #nli.ely to  be s#fficient to warrant s#ch recovery as )ection 10 re*#ires the existence of scienter 2orinarily gross negligence or even fra#3 an )ection 1= allows the CPAs to avoi liability by proving that they perform with goo faith% which they  probably will be able to o in the case! Researc$ an% &iscussion Case 4-4/ )L,T$+D Io#ntain 7eso#rces an )#per#n 2@stimate timeD 40 min#tes3 This case is closely moele after the case of The (und of (unds) %td.) v. Arthur Andersen & Co. 'e i not s#ggest reference material relating to this case to the st#ents beca#se we have fo#n that it totally ominates their concl#sions5 they opt to avoi the F=0 million &#gment at all costs! There are several significant ifferences between o#r case an the  (und of (unds case% which may well affect the ecision were o#r case bro#ght before the same co#rt! The most important ifference is that o#r client companies have not signe any agreement regaring the  prospective sales price of the properties! 8ence% Io#ntain 7eso#rces cannot be eeme in violation of a contract! Also% the same .ey a#it personnel a#ite #n of #ns an ing 7eso#rces Company! $n o#r case% the two clients are a#ite by ifferent offices of the same firm an% therefore% by entirely ifferent personnel! inally% in o#r case the a#itors have previo#sly approve a write-own of the carrying val#e of the #nprove properties #ner  (A$* A$C +,!-, '! ing 7eso#rces ha not recogni million to avoi overstatement of assets! As we have .nowlege of the impaire val#e of these properties% it wo#l be iffic#lt for #s to allow )#perf#n to not write the asset own to a similar amo#nt! • 2b3 $f we insist that )#per#n write these properties own to% say% F> million% )#per#n will probably s#e #s an allege that o#r silence was the proximate ca#se of their loss! #r expos#re appears to be approximately F million 2F4/ million - F> million3! The following arg#ments might be avance in favor of not offering avice to )#per#nD • • • • iving )#per#n any information abo#t these properties wo#l violate o#r ethical responsibilities to Io#ntain 7eso#rces for confientiality! The transaction price in the p#rchase or sale of assets is a managerial prerogative! $t is inconsistent with the role of the inepenent a#itors to intervene beca#se they  believe one or the other of the transacting parties is receiving a ba eal! 'e are not experts in the val#e of oil an gas properties% which is highly spec#lative  by any stanars! $t may t#rn o#t that these properties are a bargain at F4/ million! As far as we .now% Io#ntain 7eso#rces has not mae any misrepresentations of fact or violate any laws! 'e have no right to intervene in a transaction merely beca#se we  believe that o#r client is abo#t to earn a s#rprisingly large profit! 4-16 Chapter 04 - Legal Liability of CPAs • • 2c3 $f we offer o#r opinion of the val#e of the properties to )#per#n% Io#ntain 7eso#rces will probably s#e #s for breach of confientiality! There is a certain a#tonomy between offices of a national firm! Io#ntain 7eso#rces is a client of the enver office% while )#per#n is not! $f )#per#n were the client of another CPA firm% it is o#btf#l that we wo#l even consier the possibility of alerting the other a#itors or their client as to o#r opinion of the economic val#e of the  properties! #r opinionD 'e consier it to be totally inconsistent with the role of an inepenent a#itor to intervene in a transaction between a company an its c#stomers on the premise that the a#itors have a "greater wisom" than the transacting parties! Io#ntain 7eso#rces is not% to the a#itors( .nowlege% oing anything illegal! #rthermore% all of the information at the a#itors( isposal is confiential! Barring a flagrant violation of the law by one of the transacting parties% we o not believe that a#itors have either the legal responsibility or the right to inter&ect their #nsolicite opinion into the b#siness transaction of a#it clients! $f the a#itors ha become aware that the client was fra##lently overcharging for the property 2as was the case in  (unds of (unds3 o#r sol#tion wo#l of co#rse% be ifferent! 4-19