110/4141 STUDY GUIDE

Question 1

4141.01

Answer 1

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

Question 2

4141.02

Answer 2

Fraud is an intentional misrepresentation of a material fact with resultant harm to another party, intending to result in financial or personal gain.

Question 3

4141.03

Answer 3

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).

Question 4

4141.04

Answer 4

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

Question 5

4141.05

Answer 5

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.

Question 6

4141.06

Answer 6

Greater responsibility may be assumed by an express contract that goes beyond the professional standard.

Question 7

4141.07

Answer 7

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.

Question 8

4141.08

Answer 8

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.

Question 9

4141.09

Answer 9

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.

Question 10

4141.10

Answer 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.

Question 11

4141.11

Answer 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.

Question 12

4141.12

Answer 12

The CPA may be held liable to third parties for any of the following:

• Fraud
• Gross negligence

Question 13

4141.13

Answer 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.

Question 14

4141.14

Answer 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.

Question 15

4141.15

Answer 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.

Question 16

4141.16

Answer 16

The CPA may be held liable for ordinary negligence by third parties when the CPA knows that the services for a client are primarily for the benefit of a third party.

Question 17

4141.17

Answer 17

When the services are primarily for the benefit of a third party, the third party is, in effect, a party to the contract.

Question 18

4141.18

Answer 18

In order for plaintiff to be a third-party beneficiary, the aim and end of the transactions must be to benefit the third party.

Question 19

4141.19

Answer 19

A CPA who is negligent in issuing the report can be liable to third parties who can be foreseen as being injured.

Question 20

4141.20

Answer 20

According to the foreseen user rule applied by some courts, if a CPA is retained by a client to perform an audit examination for purposes of obtaining a bank loan from Fourth National Bank, the bank may successfully recoup loan losses by proving that the CPA was negligent (if the bank, in fact, relied upon the audited financial statements).

Question 21

4141.21

Answer 21

Under the foreseen class of users rule applied by some courts, any bank creditor in reliance upon the negligently audited financial statements proving negligence will be successful.

Question 22

4141.23

Answer 22

According to Restatement of Torts, the plaintiff (third party) does not have to be identified by a specific person to the accountant but only has to be identified by class (e.g., bank credit). This follows the foreseen class of users rule. The Restatement of Torts is an attempt by the American Law Institute “…to present an orderly statement of the general common law of the United States, including in that term not only the law developed solely by judicial decision, but also the law [that] has grown from the application by the courts of statutes….” (Restatement, Torts viii, ix (1st ed.))

Question 23

4141.24

Answer 23

In recent years, a few courts have applied a foreseeable users test. For CPAs to be liable, it is only necessary that they generally could expect or foresee the use of their work product by the third party in question.

Question 24

4141.25

Answer 24

The following matrix summarizes what the plaintiff (third party) must prove to successfully reach the defendant (CPA) for fraud, gross negligence, and simple negligence.

Question 25

4141.26

Answer 25

Common law varies from state to state; thus, some jurisdictions are Ultramares states while others apply the foreseeability doctrine. Both alternatives should be presented in responding to a CPA Examination question. An Ultramares state, of course, ignores the foreseeability rule and requires the third-party plaintiff to establish fraud or gross negligence.

Question 26

4141.27

Answer 26

A third party in a common-law suit involving unaudited financial statements must prove that the CPA was either fraudulent or grossly negligent in order to successfully reach the CPA.

Question 27

4141.28

Answer 27

The concept of foreseeability has yet to be applied to unaudited financial statements.