110/4141 STUDY GUIDE Flashcards
4141.01
The CPA may be held liable to clients in an audit, taxation, or consulting services engagement for the following:
- Fraud
- Gross negligence or constructive fraud
- Negligence (ordinary or simple)
- Breach of contract
4141.02
Fraud is an intentional misrepresentation of a material fact with resultant harm to another party, intending to result in financial or personal gain.
4141.03
Gross negligence (constructive fraud) is extreme, flagrant, or reckless departure from the standards of due care and competence in performing or reporting upon professional engagements.
- There need not be actual intent to deceive (scienter).
- Fraud may be inferred from sloppy performance (e.g., CPA omits a vital procedure such as a bank reconciliation in order to save time).
4141.04
Negligence (ordinary or simple) is the failure to do what an ordinary, reasonable, prudent CPA would do in similar circumstances.
- To establish negligence, the plaintiff (client) must establish the following:
1. The defendant (CPA) owed a legal duty
2. The CPA breached that duty.
3. The CPA’s action was the proximate cause of the resulting injury to the client.
4. The CPA’s actions caused damage (loss). - CPAs are not liable for an honest error in judgment as long as they act with reasonable care.
Authorities
Restatement of Torts: Negligence
4141.05
The CPA’s responsibility to the client is determined by the applicable State Board of Accountancy. Such authorities increasingly rely on the profession’s standards, as defined by:
- generally accepted auditing standards (GAAS) and/or specific terms of the contract for attest services,
- AICPA Statements on Standards for Tax Services and Treasury Circular 230 for tax compliance services, and
- AICPA Statements on Standards for Consulting Services for management advisory services.
4141.06
Greater responsibility may be assumed by an express contract that goes beyond the professional standard.
4141.07
The agreement between the CPA and the client should be expressed in writing in an engagement letter. The engagement letter, written to the client on the CPA’s letterhead, should provide a place for the client to indicate agreement with the terms of the undertaking via the client’s signature. An important case on this point is 1136 Tenants’ Corporation. Because the CPA firm did not have an engagement letter, it was found liable for $237,000 (relative to a $600 annual fee) of damages for failure to discover defalcations. The CPA firm contended that the engagement called for preparation of unaudited financial statements, not an audit. The plaintiff was successful in establishing that an audit was agreed upon.
4141.08
Many legal actions by clients involve claims based upon failure to discover a theft or, more commonly today, bad tax advice or failure to identify a tax compliance issue.
4141.09
Defenses available to the CPA include the following:
The CPA was not negligent or fraudulent.
Contributory negligence of the client caused the loss.
The CPA adhered to professional standards.
The error was immaterial.
The proximate cause of loss was not the CPA’s error.
4141.10
Tax return preparer liability. A client may be able to sue the CPA who prepared a tax return that caused the client to incur penalties or other sanctions due to the CPA’s wrongful action. Basis of liability could be breach of contract or the tort of negligence.
4141.11
For taxation engagements, while many claims arise from the CPA’s failure to meet a filing date for a tax return, some of the largest claims allege failure to properly apply the law to a transaction.
- The CPA may be liable for interest on late payment plus penalty.
- The CPA may be liable for interest, penalty, and tax if the client can prove erroneous tax advice rendered by the CPA.
4141.12
The CPA may be held liable to third parties for any of the following:
- Fraud
- Gross negligence
4141.13
Under common law, CPAs have not (until recently) been found liable to those not in privity on the theory of ordinary negligence.
- Third parties include investors and creditors.
- The term “privity” refers to a contractual or near contractual relationship.
4141.14
In 1931, the common-law Ultramares rule was promulgated. The court in Ultramares stated that where a CPA recklessly certifies to the truth of financial statements without taking the proper procedures to determine whether or not the financial statements are in fact true, a jury might find the CPA guilty of fraud.
Ultramares developed a concept of gross negligence or constructive fraud.
According to Ultramares, the third party that proves gross negligence will be successful in reaching the CPA without regard to privity.
Gross negligence is a deceit that involves a misrepresentation of a material fact, with lack of reasonable ground for belief, relied upon by another, which causes damage to that party.
Ultramares refused to hold a CPA liable to third parties for simple negligence.
4141.15
Ultramares is still a good precedent in some jurisdictions; however, in many states substantial inroads have been made on Ultramares through creation of the following rules.