110/4141 VOCABULARY Flashcards
Gross Negligence
Gross negligence is extreme, flagrant, or reckless departure from the standards of reasonable due care and competence. It is a lack of even minimal due care, a reckless disregard of truth, the presence of unfairness, inequality in bargaining power, or overreaching, deceptive nondisclosure, but not to the extent of actual fraud.
Intent to deceive and privity need not be present to establish liability. It is alternatively called gross negligence and constructive fraud.
Privity is not a defense for gross negligence (Ultramares rule).
Fraud
Fraud is the intentional misrepresentation or failure to disclose a material fact or facts that results in injury or loss to someone relying on it.
Elements necessary to prove fraud include the following:
- A material (significant) misrepresentation or omission of fact
- Knowledge of the falsity (scienter)
- Intent that the misrepresentation be relied on
- Actual reliance by another party
- Resultant damage suffered as a result of reliance
Research shows that there are usually three conditions present when fraud occurs:
- A situational pressure (a nonshareable financial need)
- A perceived opportunity to commit and conceal the dishonest act (viewed as a way to secretly resolve the nonshareable pressure)
- Some aspect of the individual’s personal integrity that allows him to rationalize his dishonest behavior
Fraud has four elements: (1) intentional (2) misrepresentation (lying) of a (3) material fact that (4) harms someone else.
Error
An error is an unintentional misstatement or omission of amounts or disclosures in financial statements. (AU-C 240.02)
Errors may involve the following:
- Mistakes in gathering or processing accounting data
- Incorrect accounting estimates arising from oversight or misinterpretation of facts
- Mistakes in the application of accounting principles relating to amount, classification, manner of presentation, or disclosure (Compare to fraud.)
The primary factor that distinguishes errors from fraud is whether the underlying cause of the misstatement in the financial statements is intentional. Intent is often difficult to determine and must involve the auditor’s professional judgment and professional skepticism.
The independent auditor has the responsibility to design the audit to provide reasonable assurance of detecting errors and fraud that are material to the financial statements.
An assessment of the likelihood of errors and fraud is an element of the auditor’s assessment of audit risk in the planning stage.
In statistics, the error refers to the difference of one observation in a sample from the unobservable, theoretical value that would be derived from the entire population. Statistics assumes that the errors from individual observations are uniformly dispersed from the theoretical value.
Negligence
Negligence is the failure to exercise the ordinary reasonable care required under the circumstances.
Negligence (ordinary or simple) is the failure to do what an ordinary, reasonable, prudent CPA would do in similar circumstances.
In a civil tort, no knowledge of error or falsity or reckless disregard need be proven (ordinary or simple negligence as distinguished from gross negligence).
When applied to accountants, negligence involves the following:
*Failure to follow GAAP/GAAS
*Failure to do what duty requires to be done (e.g., failure to investigate further missing or suspicious data)
*Disregard of warnings or suspicious comments, behavior, or documents
Negligent Misrepresentation
Contributory Negligence
Contributory negligence is the defense used by a party (e.g., an accountant) accused of negligence which holds that the plaintiff (client) was also at fault; that is, also failed to exercise reasonable care and thereby contributed to the loss.
Engagement Letter
An engagement letter is a letter written by the CPA to the client that represents the contractual understanding between the CPA and the client of the work to be performed, signed by both the CPA and the client.
Ultramares Rule
The Ultramares rule is a precedent from a 1931 court case (Ultramares v. Touche) that developed the concept of gross negligence (constructive fraud).
Prior to Ultramares, an accountant was liable for negligence to a client but not to a third party: the third party was not a party to the contract between the accountant and the client (i.e., was not in privity with the accountant) and, therefore, had no standing to bring suit. The Ultramares decision upheld the privity defense for negligence: the accountant is not liable to an unidentified third party for simple negligence. However, the decision also held that when the degree of negligence is so gross as to amount to the inference of fraud (constructive fraud), the auditor could then be liable to third parties.
Some modern courts are modifying the Ultramares ruling by holding that the auditor may be liable for simple negligence to third parties who can reasonably be foreseen, e.g., bankers, creditors, and investors (third-party beneficiary rule).
Ultramares Corporation v. Touche, 174 N.E. 441 (1932)
Privity
Privity is the existence of a contractual relationship between two parties. It is the relationship of direct involvement between the parties to a contract. When privity exists, the plaintiff need only prove simple negligence in a lawsuit for breach of contract.
Foreseeability Rule
The foreseeability rule is a legal doctrine that specifies the negligent accountant is liable to all parties who can be foreseen to be injured, even though he may lack knowledge of actual third parties who may rely on the report. For example, in the case of financial statements prepared for purposes of obtaining a bank loan, the bank and any creditor of the bank may be foreseen as being injured by any misstatement; however, trade creditors of the client would not. It is an alternative doctrine to (rejection of) the Ultramares rule; there is no privity defense.
Third-Party (Primary) Beneficiary Rule
The third-party (primary) beneficiary rule is a modern modification of the Ultramares ruling. An accountant may be liable for simple negligence to third parties, despite lack of privity, when the accountant knows that the services performed for the client were primarily for the benefit of the third party (e.g., when the client needs audited financial statements to obtain funds or credit from a bank, investor or creditor). Under this rule, the third party is treated as if it were a party to the contract between the accountant and the client.
Scienter
Scienter refers to the knowledge of a falsity, knowingly acting with malice or evil intent. It is an essential element of fraud that must be proven to impose liability.
Scienter refers to a legal term that denotes knowledge on the part of a person or entity that they were engaging in improper or fraudulent conduct. It implies a level of intent or recklessness regarding the wrongful act, especially in the context of securities fraud and certain types of litigation under U.S. law. Scienter is associated with the intent to deceive, manipulate, or defraud.
SEC Rule 10b-5
SEC Rule 10b-5 is a rule promulgated by the Securities and Exchange Commission (SEC) to augment Section 10(b) of the Securities Exchange Act of 1934 to strengthen the antifraud provisions of that act.
Scienter is intentional misconduct: an intent to deceive, manipulate, or defraud. Scienter is required for an SEC Rule 10b-5 violation. Fraud includes any action or event intended to deceive. As a result, a fraud conviction requires this intent to deceive to be proven.
Due Care
To act with due care is to act with competence and diligence. It is the obligation to perform professional services with concern for the best interest of the recipient of the service and in a manner consistent with the profession’s responsibility to the public. Due care is the duty to perform each audit as a professional possessing the degree of skill commonly possessed by others in the field.
Due care is the subject of ET 0.300.060 and the General Standards Rule of the AICPA Code of Professional Conduct:
“A member should observe the profession’s technical and ethical standards, strive continually to improve competence and the quality of services, and discharge professional responsibility to the best of the member’s ability.”
“General Standards Rule: A member shall comply with the following standards and with any interpretations thereof by bodies designated by Council:
- “Professional Competence…
- “Due Professional Care…
- “Planning and Supervision…
- “Sufficient Relevant Data…”
ET 0.300.060.01 and 1.300.001.01
A CPA must exercise due professional care in the performance of professional services. This concept refers to what the CPA must do in performing a task and how well the CPA needs to accomplish it. It is assumed that each CPA performs with a high level of skill but is not infallible. The concept recognizes that a CPA is subject to human error.
Due care means acting with competence and diligence. Competence is derived from a synthesis of education, experience and professional judgment. Diligence implies a prompt, careful, thorough rendering of service in accordance with applicable technical standards. Because the acceptance of a professional engagement implies that a CPA has the necessary level of skills to complete the professional service according to the professional standards, a CPA must undertake only those professional engagements that he or she can reasonably expect to complete with professional competence.
ET 0.300.060 states that due care requires a member to plan and supervise adequately any professional activity undertaken. The exercise of due care requires critical review at every level of supervision of the work done and the judgment exercised by those assisting in the audit.
