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					Chapter 38 - Accountants                                                      Business Law and Ethics


  Sarbanes-Oxley Act 2002
    Provisions of the act as it relates to auditors for public companies:

    The Public Company Accounting Oversight Board (PCAOB)
           Regulates the public accounting firms
           5 members, at most 2 can be CPA
           All accounting firms that audit public companies have to register with PCAOB

    Reports to Audit Committee
    Auditors report to the audit committees of its clients.

    Conflict of Interests
    An auditing firm cannot audit a company if one of the company’s top officers has worked for
    the auditing firm the prior year. That is, a client cannot hire one of its auditors.

    Term Limits on Audit Partners
    A lead audit partner cannot work for a partner in any auditing role for more than 5 years.

    Consolidation in the Accounting Profession
    Congress ordered a study of the factors leading the Big 8 accounting companies to become
    the Big 4 (a.k.a. Final 4) – Deloitte & Touche, Ernst & Young, KPMG, and

    The main role of the auditors is to serve as independent evaluators of the financial
    statements, issued by management to the investors and creditors.
    Auditors sample various types of transactions. To verify transactions – two methods:
           Vouching (backward check) – verify the original data that supports a sample
            transaction from the company’s books
           Tracing (forward check) – trace items from the original data to the records in the
            company’s books
    Accountants have to follow 2 sets of principles:
           GAAP – Generally Accepted Accounting Principles are used for preparing financial
           GAAS – Generally Accepted Auditing Standards are the rules for conducting audits

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    Auditor issues an opinion on the financial statements. Four choices:
           Unqualified Opinion – (a.k.a. Clean Opinion) – the best opinion a company can
            get. It states that the financial reports fairly represent company’s condition according
            to GAAP.
            All other (non-clean) opinions are warnings to the potential investors and creditors.
           Qualified Opinion – financial statements are generally accurate but there is an
            unresolved issue. Could be a violation of GAAP or something else.
           Adverse Opinion – bad news. The company’s financial statements do not accurately
            reflect the financial position. “Materially misstating certain items”. Adverse opinion
            generally prevents the company from selling stocks or borrowing money.
           Disclaimer of Opinion – not as bad as Adverse Opinion, but still a bad news.
            Indicates not enough information for issuing an opinion.

Liability to Clients
    Client can sue accountants based on contract, negligence, fraud, or breach of trust.

    Contracts b/w accountants and their clients are either written (a.k.a. engagement letter)
    or oral.
    Contracts have express and implied terms. The accountant expressly promises to finish the
    work by a given date. The accountant also implies that the work will be done as carefully as
    an ordinarily prudent accountant would under the circumstances. If an accountant breaches
    any of the two promises, he is liable for the damages that result.

    An accountant is liable for negligence to client if client can prove BOTH of the following:
           The accountant failed to exercise the degree of skill and competence that an
            ordinarily prudent accountant would under the circumstances. E.g., failure to follow
            GAAP and GAAS.
           Accountant’s violation of duty harmed the client

    An accountant is liable for fraud if:
        1. He makes a false statement of fact,
        2. He either knows it is not true or recklessly disregards the truth, and
        3. The client justifiably relies on the statement.

  Breach of Trust
    Accountants occupy a position of enormous trust. Accountants have legal obligation to:

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        1. Keep all client information confidential, and
        2. Use client information only for the benefit of the client.

Liability to Third Parties
    Accountants are generally not liable to third parties in contract because there is no privity of
    contract. If two parties enter into a contract that affects third parties, these third parties are
    not in privity. Most third parties are incidental beneficiaries who are not entitled to enforce a
    contract (see Chapter 16 – Third Parties).

    Accountant’s liability to negligence is determined by state law. Most states follow one of the
    following rules: the Ultramares Doctrine, the Foreseeable Doctrine, or the Restatement

    Ultramares Doctrine
    Under the Ultramares Doctrine (1931, Ultramares Corp. vs. Touche) the accountant is
    liable for negligence to a third party only if he knows that the third party:
        1. Will see their work product, and
        2. Will rely on the work product for a particular, know purpose.
    The Ultramares Doctrine is rejected by majority of states – it is considered too narrow.

    Foreseeable Doctrine
    Under the Foreseeable Doctrine the accountant is liable for negligence to a third party if:
        1. It was foreseeable that the third party would receive financial statements from the
           accountant’s client, and
        2. The third party relied on these statements.
    The Foreseeable Doctrine creates grater liability for the accountants than the Ultramares
    Doctrine. The Foreseeable Doctrine is rejected by majority of states – it is considered too
    Restatement Doctrine
    According to the Restatement (Second) of Torts, an accountant who fails to exercise due
    care is responsible to:
        1. Anyone they knew would rely on the information, and
        2. Anyone else in the same class.

    An accountant who commits fraud is liable to any foreseeable user of the work product who
    justifiably relies on it.

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  Liability for Qualified Opinions
    Auditors can, under some circumstances, avoid liability by using less than clean opinion,
    that is, a qualified, adverse, or disclaimer opinion. Because the less than clean opinion has
    to be issued for the right reasons, the auditors may avoid liability for some reasons but be
    held responsible for damages caused by other reasons.

  Securities Act of 1933 (1933 Act)
    Third parties who have been injured by an accountant’s error usually file suit under the
    securities laws – Securities Act of 1933 and Securities Exchange Act of 1934.
    The 1933 Act requires an issuer to register securities before offering them for sale to the
    public. To do this, the issuer files a registration statement with SEC. The registration
    statement must include audited financial statements.
    Under §11 of the 1933 Act, auditors are liable for any material misstatement or omission
    in the financial statements that they prepare for a registration statement.
    The auditors can avoid liability under §11 if they demonstrate due diligence. Typically,
    auditors are not liable if they comply with GAAP and GAAS.

  Securities Exchange Act of 1934 (1934 Act)
    A company that is subject to the 1934 Act must file with SEC an annual report with audited
    financial statements and quarterly reports with unaudited financial statements.

    Liability for Inaccurate Disclosure in a Required Filing
    Under §18 of the 1934 Act, an auditor who makes a false or misleading statement in a
    required filing is liable to any buyer or seller of the stock who has acted in reliance on the
    The auditor can avoid liability if he can show that he acted in good faith and did not know
    that the information was misleading.

    Primary Liability: Under §10(b) of the 1934 Act, an auditor is liable for making (1) a
    misstatement or omission of a material fact (2) knowingly or recklessly (3) that the plaintiff
    relies on in purchasing or selling a security.
    Aiding and Abetting: Primary liability can be hard to prove. But the accountant who had
    not made knowing or reckless misstatements himself could be liable for aiding and abetting
    others who made untrue statements.

    Under §10A of the 1934 Act, auditors who suspect that a client has committed an illegal
    act must:
        1. Notify client’s board of directors.
        2. If the board fails to take corrective actions, the auditor must issue an official report
           to the board.
        3. If the board receives such a report from its auditors, it must

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            a) notify SEC within 1 business day, and
            b) send a copy of the notice to its accountant.
        4. If the auditors do not receive the copy, they must notify SEC themselves.
    The scope of §10A of the 1934 Act includes insider trading, price fixing, and other violations
    of state and federal law.

    Joint and Several Liability
    Traditionally, liability under the 1934 Act was joint and several. When several different
    participants were potentially liable, the plaintiff could sue any one [still existing] defendant
    or group of defendants for the full amount.
    The Congress amended the 1934 Act to provide that accountants are liable jointly and
    severally only if they knowingly violate the law. Otherwise, the defendants are
    proportionally liable (only for the share of the damages that they caused).

Criminal Liability
    So far – only civil liability discussed.
    The penalty for civil liability is payment of monetary damages.

    Some offenses are criminal acts. The punishment for them is a fine and imprisonment.
           The Justice Department has the right to prosecute willful violations under the 1933
            Act and the 1934 Act.
           The Internal Revenue Code imposes criminal penalties on accountants for
            wrongdoing in the preparation of tax returns.
           Many states prosecute violations of their securities laws.

Other Account-Client Issues
  The Accountant-Client Relationship
    SEC rules on independence specifically prohibits accountants or their families from owning
    stock in a company that their firm audits.
    The Sarbanes-Oxley Act prohibits accounting firms that audit public companies from
    providing consulting services on topics such as bookkeeping, financial information systems,
    human resources, and legal issues.

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