1. Chapter 11 Liability of Accountants and Other Professionals Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

2. 11-2 Chapter 11 Ethical Dilemma As Chapter 11 indicates, Ultramares v. Touche is the most famous case of accountant legal liability to third parties. In this case, Justice Benjamin Cardozo, writing for the highest state court in New York, took a narrow view of which third parties were permissible plaintiffs in civil causes of action against accountants. Concerned that a more liberal rule would subject accountants to a liability of “an indeterminate amount, for an indeterminate time, to an indeterminate class,” Cardozo held an accountant liable in negligence only to those with whom he or she had privity of contract. This decision is now known as the “Ultramares Rule,” and according to this rule, an accountant will be held liable for negligence only to the client and anyone for whose “primary benefit” the accounting statements were prepared. In your reasoned opinion, is the Ultramares Rule sound law? Is it ethical?

3. 11-3 Chapter 11 Ethical Dilemma As Chapter 11 indicates, The Sarbanes-Oxley Act of 2002 prohibits registered public accounting firms (RPAFs) from engaging in the following non-auditing acts for their auditing clients: 1. Bookkeeping; 2. Financial information systems design and implementation; 3. Appraisal or valuation services; 4. Actuarial services; 5. Internal-audit outsourcing services; 6. Management functions or human resources; 7. Broker or dealer, investment adviser, or investment banking services; 8. Legal or expert services unrelated to the audit; or 9. Any additional service the board of directors of the client company deems impermissible. Is this provision of Sarbanes-Oxley “good” law, or does it represent over-regulation by the government?

4. 11-4 Chapter 11 Ethical Dilemma Evan McGill is a prominent member of the community. A “self-made man,” his entrepreneurial rise to wealth and power is known throughout Madison County, his county of birth, where he continues to live and operate his business, McGill Construction Company. McGill is an active member of the community, and is proud of his service as a deacon at the local Baptist church. Gordon Linder has been McGill’s personal and business accountant for the past twenty years. McGill pays Linder generously for his accounting services, and Linder’s professional relationship with the well-known businessman has generated him scores of other clients. In fact, it could be said that Linder owes his professional success, and the health of his accounting practice, to McGill. During tax season, McGill arrives at Linder’s office for preparation of his personal and business tax returns. When Linder asks McGill for the amount of his deductible business expenses, McGill quotes a figure of $148,000; however, he is only able to provide documentation for $120,000 in deductible expenses. When Linder asks McGill for documentation of the additional $28,000 in expenses, McGill states “Gordy, you of all people should understand that I don’t have the time or the inclination to keep every receipt, but you should also know by now that I have a photographic memory. I can tell you where I ate for lunch on November 7, 1990, and I can sure tell you that I had exactly $148,000 in business expenses last year. Besides, if I get audited by the Internal Revenue Service, that’s my problem, not yours. Let’s get these tax returns finished. I have to be back out at a work site by 2:00 p.m.” From an ethical standpoint, would it be permissible for Linder to “take McGill’s word for it” with regard to the non-documented $28,000 in business deductions? From a professional and legal standpoint, are there risks inherent in Linder’s acceptance of McGill’s assertion without documentation?

5. 11-5 Common Law Accountant Liability to Clients: Accountant Liability for Negligence Accountant liable to client for negligence if he/she fails to exercise care of competent, reasonable professional, and that failure causes loss/injury to client Accountant liable to client for negligence if he/she fails to exercise care of competent, reasonable professional, and that failure causes loss/injury to client Accountant has duty to perform his/her responsibilities according to generally accepted accounting principles (“GAAP”) and generally accepted auditing standards (“GAAS”) Accountant has duty to perform his/her responsibilities according to generally accepted accounting principles (“GAAP”) and generally accepted auditing standards (“GAAS”)

6. 11-6 Common Law Accountant Liability to Clients: Accountant Liability for Breach of Contract Whenever accountant hired to perform specific task, he/she enters into contract with client Whenever accountant hired to perform specific task, he/she enters into contract with client Explicitly, accountant agrees to perform contractual tasks Explicitly, accountant agrees to perform contractual tasks Implicitly, accountant agrees to complete work in a competent and professional manner, according to professional standards (GAAP and GAAS) Implicitly, accountant agrees to complete work in a competent and professional manner, according to professional standards (GAAP and GAAS) Accountants may be liable for violating explicit and/or implicit agreements Accountants may be liable for violating explicit and/or implicit agreements

7. 11-7 Common Law Accountant Liability to Clients: Accountant Liability for Fraud Accountants who commit fraud liable to those parties accountant reasonably should have foreseen as being injured through justifiable reliance on fraudulent information Accountants who commit fraud liable to those parties accountant reasonably should have foreseen as being injured through justifiable reliance on fraudulent information Accountants may be liable for “actual” or “constructive” fraud Accountants may be liable for “actual” or “constructive” fraud Actual fraud—Accountant’s actions meet criteria necessary to prove fraud Actual fraud—Accountant’s actions meet criteria necessary to prove fraud Constructive fraud—No fraudulent intent, but accountant “grossly negligent” in performing his/her duties Constructive fraud—No fraudulent intent, but accountant “grossly negligent” in performing his/her duties

8. 11-8 Common Law Accountant Liability to Third Parties Privity or near-privity (the “Ultramares” rule): Privity or near-privity (the “Ultramares” rule): Requires that third party be in privity of contract with accountant, or be close enough to accountant to constitute near-privity Foreseen users and class of users (the Restatement rule): (About 50% of jurisdictions) Foreseen users and class of users (the Restatement rule): (About 50% of jurisdictions) Requires that third party be known recipient, or be from a class of known recipients, of accountant’s work Reasonably foreseeable users: Reasonably foreseeable users: Allows any third party that should have been reasonably foreseen as using product of accountant’s work to bring suit (Slide 2)

9. 11-9 Accountants’ and Clients’ Rights “Working Papers”—Various documents used and developed during audit “Working Papers”—Various documents used and developed during audit Accountant is legal owner of working papers, but client may access at any time upon request Accountant is legal owner of working papers, but client may access at any time upon request Papers must be kept by accountant at least five years after audit pursuant to Sarbanes-Oxley Act Papers must be kept by accountant at least five years after audit pursuant to Sarbanes-Oxley Act Accountant-Client Privilege Accountant-Client Privilege Does not exist under federal law, but some states have granted this right Does not exist under federal law, but some states have granted this right When granted, client has right to privilege, but accountant has fewer protections When granted, client has right to privilege, but accountant has fewer protections

10. 11-10 Federal Securities Law and Accountant Liability: The Securities Act of 1933 Section 11—Accountants civilly liable for misstatements and omissions of material facts made in registration statements filed with the Securities and Exchange Commission (“SEC”) Section 11—Accountants civilly liable for misstatements and omissions of material facts made in registration statements filed with the Securities and Exchange Commission (“SEC”) Section 15—Applies liability to controlling persons (executive board members) when Section 11 violation occurs Section 15—Applies liability to controlling persons (executive board members) when Section 11 violation occurs Affirmative defense of Good Faith Affirmative defense of Good Faith

11. 11-11 Federal Securities Law and Accountant Liability: The Securities Exchange Act of 1934 Section 18—Accountants liable for fraudulent statements made to SEC Section 18—Accountants liable for fraudulent statements made to SEC Section 10(b) and SEC Rule 10b-5—unlawful for accountants to use “any manipulative or deceptive device/contrivance” in contravention of SEC rules and regulations Section 10(b) and SEC Rule 10b-5—unlawful for accountants to use “any manipulative or deceptive device/contrivance” in contravention of SEC rules and regulations Section 20(a)—When person is “in control” of primary violator of act and person who significantly participated in the illegal activity, he or she may be liable Section 20(a)—When person is “in control” of primary violator of act and person who significantly participated in the illegal activity, he or she may be liable Affirmative defense of Good Faith Affirmative defense of Good Faith

12. 11-12 Federal Securities Law and Accountant Liability: The Private Securities Litigation Reform Act of 1995 Requires that accountants use adequate procedures when performing audit, so they can detect any illegal acts of company being audited Requires that accountants use adequate procedures when performing audit, so they can detect any illegal acts of company being audited Includes specific actions/guidelines accountant must follow after identifying potentially illegal activity when conducting audit Includes specific actions/guidelines accountant must follow after identifying potentially illegal activity when conducting audit Certain situations accountant must immediately notify Board of directors, audit committee, or SEC Certain situations accountant must immediately notify Board of directors, audit committee, or SEC

13. 11-13 Federal Securities Law and Accountant Liability: The Sarbanes-Oxley Act of 2002 Consists of new rules/regulations for public accounting firms, in attempt to reduce fraud in accounting practices Consists of new rules/regulations for public accounting firms, in attempt to reduce fraud in accounting practices Created Public Company Accounting Oversight Board Created Public Company Accounting Oversight Board Titles I and II outline duties of board, and establish new requirements for public accounting firms Titles I and II outline duties of board, and establish new requirements for public accounting firms

14. Liability of Other Professionals (Exhibit 11-1) Many professionals who provide services (including attorneys, real estate brokers, doctors, and architects) are professionally liable, under theories similar to accountants’ liability Can also apply to computer and software professionals Can also apply to computer and software professionals 11-14