Lindner fund v abney

CH51

“By certifying the public reports that collectively depict a corporation’s financial status, the independent auditor assumes a public respon-sibility transcending any employment relationship with the client.”

—Justice Burger

United States v. Arthur Young & Co.

465 U.S. 805, 104 S.Ct. 1495, 1984 U.S. Lexis 43 (1984)

Introduction to Accountants’ Duties and Liability

Although accountants provide a wide variety of services to corporations and other businesses, their primary functions are (1) auditing financial statements and

rendering opinions about those audits. Accountants also prepare unaudited financial statements for clients, render tax advice, prepare tax forms, and provide consulting and other services to clients.

Audits generate the majority of litigation against accountants. Lawsuits against accountants are based on the common law (e.g., breach of contract, misrepresen-tation, negligence), or on violation of certain statutes (particularly federal securi-ties laws). Accountants can be held liable both to clients and to third parties. This chapter examines the legal liability of accountants.

Public Accounting

The term accountant applies to persons who perform a variety of services, includ-ing bookkeepers and tax preparers. The term certified public accountant (CPA) applies to accountants who meet certain educational requirements, pass the CPA examination, and have a certain number of years of auditing experience. A person who is not certified is generally referred to as a public accountant.

Limited Liability Partnership (LLP)

Most public accounting firms are organized and operated as limited liability partnerships (LLPs). In this form of partnership, all the partners are limited part-ners who lose only their capital contribution in the LLP if the LLP fails. The lim-ited partners are not personally liable for the debts and obligations of the LLP (see Exhibit 51.1). A limited partner whose negligent or intentional conduct causes injury is personally liable for his or her own conduct.

Accounting

Debt or

obligation

Firm

Third

owed

(Limited

Liability Party

Partnership)

Capital investment

Accountant

Accountant

Accountant

Accountant

Partner

Partner

Partner

Partner

Liability limited

to capital

contribution

No personal liability

for partnership’s

debts and obligations

In our complex society the accountant’s certificate and the lawyer’s opinion can be instruments for inflicting pecuniary loss more potent than the chisel or the crowbar.

Justice Blackman

Dissenting Opinion, Ernst & Ernst v. Hochfelder 425 U.S. 185, 96 S.Ct. 1375, 1976 U.S. Lexis 2 (1976)

certified public accountant (CPA)

An accountant who has met certain educational requirements, has passed the CPA examination, and has had a certain number of years of auditing experience.

limited liability partnership (LLP)

A special form of partnership in which all partners are limited partners.

Exhibit 51.1  ACCOUNTING

FIRM LLP

  PART XI Accounting Profession

Example Suppose Alicia, Min-Wei, Holly, Won Suk, and Florence, each a certified public accountant (CPA), form an LLP called “Min-Wei Florence, LLP.” While working on an audit for Min-Wei Florence LLP’s client Microhard Corporation, Holly commits accounting malpractice (negligence) and fails to detect an ac-counting fraud at Microhard. Because of the fraud, Microhard goes bankrupt and its shareholders lose their entire investment. In this case, the shareholders of Microhard Corporation can sue and recover against Holly, the negligent party, and against Min-Wei Florence LLP. As limited partners, Alicia, Min-Wei, Won Suk, and Florence can lose their capital contribution in Min-Wei Florence LLP but are not personally liable for the losses suffered by Microhard’s shareholders. Holly loses her capital in the LLP and is also personally liable to the shareholders of Micro-hard Corporation because she was the negligent party.

Accounting Standards and Principles

Certified public accountants must comply with two uniform standards of profes-sional conduct: (1) generally accepted accounting principles (GAAPs) and (2) generally accepted auditing standards (GAASs). Both are discussed in the fol-lowing paragraphs.

generally accepted account-ing principles (GAAPs)

Standards for the preparation and presentation of financial statements.

WEB EXERCISE

For a description of generally ac-cepted accounting principles (GAAPs), go to www.fasab.gov/ accepted.html.

WEB EXERCISE

Go to the IFRS website at www.ifrs. org. Click on “Global convergence” and read the article.

generally accepted auditing standards (GAASs)

Standards for the methods and procedures that must be used to conduct audits.

WEB EXERCISE

For a description of generally ac-cepted auditing standards (GAASs), go to www.aicpa.org/download/ members/div/auditstd/AU- 00150.pdf.

audit

A verification of a company’s books and records pursuant to federal se-curities laws, state laws, and stock exchange rules that must be per-formed by an independent CPA.

Generally Accepted Accounting Principles

Generally Accepted Accounting Principles (GAAPs) are standards for the prepa-ration and presentation of financial statements.1 These principles set forth rules for how corporations and accounting firms present their income, expenses, as-sets, and liabilities on the corporation’s financial statements. There are more than 150 “pronouncements” that comprise these principles. GAAPs establish uniform principles for reporting financial statements and financial transactions. The Fi-nancial Accounting Standards Board (FASB), an organization created by the ac-counting profession, issues new GAAP rules and amends existing rules. GAAP applies mainly to U.S. companies.

Most companies in other counties abide by International Financial Report-ing Standards (IFRSs). These principles are promulgated by the International Accounting Standards Board (IASB), which is located in London, England. The IFRSs differ in some respects from GAAPs. As U.S. companies become more global, and as foreign companies increase their business in the United States, the International Financial Reporting Standards are replacing GAAPs.

Generally Accepted Auditing Standards

Generally Accepted Auditing Standards (GAASs) specify the methods and proce-dures that are to be used by public accountants when conducting external audits of company financial statements.2 The standards are set by the American Institute of Certified Public Accountants (AICPA). GAASs contain general standards of proficiency, independence, and professional care. They also establish standards for conducting fieldwork and require that sufficient evidence be obtained to afford a reasonable basis for issuing an opinion regarding the financial statements under audit. Compliance with audit standards provides a measure of audit quality.

Audit

Audit can be defined as a verification of a company’s books and records. Pursuant to federal securities laws, state laws, and stock exchange rules, an audit must be performed by an independent CPA. The CPA must review the company’s financial records, check their accuracy, and otherwise investigate the financial position of the company.

  CHAPTER 51 Accountants’ Duties and Liability 851

The auditor must also (1) conduct a sampling of inventory to verify the fig-ures contained in the client’s financial statements and (2) verify information from third parties (e.g., contracts, bank accounts, real estate, and accounts receiv-able). An accountant’s failure to follow GAASs when conducting audits consti-tutes negligence.

Auditor’s Opinions

After an audit is complete, the auditor usually renders an opinion about how fairly the financial statements of the client company represent the company’s financial position, results of operations, and change in cash flows. The auditor’s opinion may be unqualified, qualified, or adverse. Alternatively, the auditor may offer a disclaimer of opinion. Most auditors give unqualified opinions. The various types of opinions are the following:

Unqualified opinion.  An unqualified opinion represents an auditor’s finding that the company’s financial statements fairly represent the company’s finan-cial position, the results of its operations, and the change in cash flows for the period under audit, in conformity with generally accepted accounting prin-ciples (GAAPs). This is the most favorable opinion an auditor can give.

Qualified opinion.  A qualified opinion states that the financial statements are fairly represented except for, or subject to, a departure from GAAPs, a change in accounting principles, or a material uncertainty. The exception, de-parture, or uncertainty is noted in the auditor’s opinion.

Adverse opinion.  An adverse opinion determines that the financial state-ments do not fairly represent the company’s financial position, results of opera-tions, or change in cash flows in conformity with GAAPs. This type of opinion is usually issued when an auditor determines that a company has materially misstated certain items on its financial statements.

Disclaimer of Opinion

A disclaimer of opinion expresses the auditor’s inability to draw a conclusion about the accuracy of the company’s financial records. This disclaimer is gen-erally issued when the auditor lacks sufficient information about the financial records to issue an overall opinion.

The issuance of other than an unqualified opinion can have substantial ad-verse effects on the company audited. A company that receives an opinion other than an unqualified opinion may not be able to sell its securities to the public, merge with another company, or obtain loans from banks. The Securities and Exchange Commission (SEC) has warned publicly held companies against “shop-ping” for accountants to obtain a favorable opinion.

Accountants’ Liability to Their Clients

Accountants are employed by their clients to perform certain accounting ser-vices. Under the common law, accountants may be found liable to the clients who hire them under several legal theories, including breach of contract, fraud, and negligence.

auditor’s opinion

An opinion of an auditor about how fairly the financial statements of the client company represent the company’s financial position, results of operations, and change in cash flows.

unqualified opinion

An auditor’s opinion that the com-pany’s financial statements fairly represent the company’s financial position, the results of its opera-tions, and the change in cash flows for the period under audit, in con-formity with generally accepted ac-counting principles (GAAPs).

qualified opinion

An auditor’s opinion that the financial statements are fairly rep-resented except for, or subject to, a departure from GAAPs, a change in accounting principles, or a material uncertainty.

adverse opinion

An auditor’s opinion that the fi-nancial statements do not fairly represent the company’s financial position, results of operations, or change in cash flows in conformity with GAAPs.

disclaimer of opinion

An auditor’s opinion expressing the auditor’s inability to draw a conclu-sion about the accuracy of the com-pany’s financial records.

Liability to Clients: Breach of Contract

The terms of an engagement are specified when an accountant and a client enter into a contract for the provision of accounting services by the accountant. An accountant who fails to perform may be sued for damages caused by the breach of contract. Generally, the courts consider damages to be the expenses the client incurs in securing another accountant to perform the needed services as well as

engagement

A formal entrance into a contract between a client and an accountant.

  PART XI Accounting Profession

any fines or penalties incurred by the client for missed deadlines, lost opportuni-ties, and such.

Rather fail with honor than succeed with fraud.

Sophocles (497 bce–406 bce)

Liability to Clients: Fraud

Where an accountant has been found liable for actual or constructive fraud, the client may bring a civil lawsuit and recover any damages proximately caused by that fraud. Punitive damages may be awarded in cases of actual fraud. Actual fraud is defined as intentional misrepresentation or omission of a material fact that is relied on by the client and causes the client damage. Such cases are rare.