Professional Documents
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Boynton SM Ch.04
Boynton SM Ch.04
a.
Privity of contract refers to the contractual relationship that exists between two
contracting parties. A CPA firms is in privity with their client by nature of a contractual
relationship with the client. The courts have given the benefits of privity to some third
party beneficiaries of an audit, such as a creditor named in an engagement letter. Under
common law, if the audit firm does not comply with their obligations to the client,
resulting in damages, the client may sue and recover its losses by proving that the audit
firm was negligent in performing its duties under the contract. The same rights extend
to third party beneficiaries that are given the benefits of privity by the courts.
b. An auditor may breach a contract by (1) issuing a standard audit report when the audit
has not been made in accordance with GAAS, (2) not delivering the audit report before
the agreed-upon date, and (3) violating the client's confidential relationship.
c.
4-2.
a. Under common law the two classes of third parties are primary beneficiaries and other
beneficiaries.
b. The auditor may be held liable by both classes of third parties for fraud and gross
negligence. The auditor may be held liable for ordinary negligence by primary
beneficiaries.
4-3.
Foreseen parties are a person or one of a limited group of persons for whose benefit or
guidance the preparer intends to supply the information and who suffer a loss through
reliance upon it in a transaction or similar transactions that the information is intended to
influence. For example, if the client plans to use the audit report to obtain a bank loan, all
banks who use the report are foreseen parties.
Foreseeable parties are any parties that are not foreseen. They include all creditors,
stockholders, and present and future investors who suffer a loss by relying on the
accountant's representation.
4-4.
Ultramares limited the accountant's liability for ordinary negligence to parties who are in
privity of contract with the accountant (i.e., primary beneficiaries). The case did not
emancipate the accountant from the consequences of fraud, and it concluded that gross
negligence may constitute fraud.
Rusch Factors held that accountants should be liable for ordinary negligence to actually
foreseen and limited classes of persons, even if not named or identified.
Rosenblum vs Adler held that accountants could be sued for ordinary negligence by
foreseeable parties.
Credit Alliance restored a "near privity rule" in New York state by establishing three criteria
for determining whether a plaintiff can bring a claim for ordinary negligence: (1) plaintiff
relied on auditor's report, (2) auditor knew plaintiff would rely, and (3) the auditor, through
some actions on his or her own part, evidenced understanding of the plaintiff's intended
reliance.
Bily ended the foreseeability standard in California, and established that (1) the auditor owes
no general duty of care regarding the conduct of an audit to persons other than the client and
(2) the auditor's liability to third parties for negligent misrepresentation through a faulty audit
report is the same as that under the Restatement (Second) of Torts.
4-5.
a. The accountant's primary defenses against charges of negligence in tort actions are due
care and contributory negligence.
b. The Restatement (Second) of Torts defines contributory negligence as "(Conduct on the
part of the plaintiff which falls below the standard to which he (she) should conform his
(her) own protection, and which is a legally contributing cause co-operating with the
negligence of the defendant in bringing about the plaintiff's harm."
c.
4-6.
a. Suits may be brought under the 1933 Act by any person purchasing or otherwise
acquiring the securities.
b. The basis for action under the 1933 Act is that the financial statements contain an untrue
statement of a material fact or omit a material fact necessary to make the statements not
misleading.
4-7.
May be any person acquiring securities described in the registration statement, whether
or not he or she is a client of the auditor.
Must base the claim on an alleged material false or misleading financial statement
contained in the registration statement.
Does not have to prove reliance on the false or misleading statement or that the loss
suffered was the proximate result of the statement if purchase was made before the
issuance of an income statement covering a period of at least twelve months following
the effective date of the registration statement.
Does not have to prove that the auditors were negligent or fraudulent in certifying the
financial statements involved.
Defendant
Has the burden of establishing freedom from negligence by proving that he or she had
made a reasonable investigation and accordingly had reasonable ground to believe, and
did believe, that the statements certified were true at the date of the statements and as of
the time the registration statement became effective.
Must establish, by way of defense, that the plaintiff's loss resulted in whole or in part
from causes other than the false or misleading statements.
4-8.
The issue in BarChris was whether the defendant accountants had performed a proper S-1
Review (a subsequent events review). The court concluded that a proper review was not
made and ruled that the accounting firm had not established a due diligence defense, stating
that
The firms audit program was in conformity with GAAS but the senior did not meet the
firms own standards when carrying out the audit program.
The senior's review was useless because it failed to discover a material change for the
worse in Bar Chris's financial position that required disclosure to prevent the balance
sheet from being misleading.
The senior did not meet the standards of the profession because he did not take some of
the steps prescribed in the written program.
The senior did not spend an adequate amount of time on a task of this magnitude and,
most important of all, he was too easily satisfied with glib answers.
There were enough danger signals in the materials examined to require some further
investigation.
4-9.
a. Plaintiffs under the 1934 Act may be any person buying or selling the securities.
b. The bases for action are basically the same as under the 1933 Act, -- the claim on an
alleged material false or misleading financial statement
4-10.
Engage in any act, practice, or course of business which operates, or would operate, as a
fraud or deceit upon any person in connection with the purchase or sale of any security.
4-11.
Under both sections of the 1934 Act, the plaintiff must prove (a) the existence of a material
false or misleading statement, and (b) reliance on such statement and damage resulting from
such reliance. Under Section 18 the plaintiff does not have to prove the auditor acted
fraudulently, but under Section 10, Rule 10b-5 such proof is required. The defendant under
Section 18 must prove he or she acted in good faith and had no knowledge of the false or
misleading statement.
4-12.
a. The basis of the Hochfelder case was that the auditor's negligence had aided and abetted
the president's fraudulent actions relative to an escrow account, and that the auditor was
therefore liable under Rule 10b-5.
b. This decision means the auditor is not liable to unnamed third parties for ordinary
negligence under this rule.
4-13.
a. The jury in Fund of Funds found the defendant accountants guilty of (1) aiding and
abetting violations of securities laws (Rule 10b-5), (2) common law fraud, and (3)
breach of contract. The jury also found that the requisite of scienter had been met
through the accountants' recklessness.
b. The critical issue in Continental Vending was whether the fairness of the financial
statements should be based on GAAP. The judge ruled that the "critical test" was
whether the balance sheet fairly presented financial position without reference to GAAP.
The accountants were found to be guilty of criminal liability under the 1934 Act.
4-14.
4-15.
a.
b.
Previously auditors were jointly and severally for all damage that might be assessed. For
example, if both management and the auditor were found guilty and management was
bankrupt, then the auditor could be liable for all the damages. Proportionate liability
limits the auditors liability to the proportion that the auditor was held liable (plus the
auditor could be liable for any uncollectible amount up to 50% of the auditors initial
share).
Following is a list of ways that the Private Securities Reform Act of 1995 (Reform Act)
will potentially change auditors legal liability. The Reform Act:
Places a cap on damages that would potentially reduce the maximum amount that
auditors could be liable for.
4-16. The Reform Act imposed new reporting requirements on auditors of public companies who
detect or otherwise become aware of illegal acts by issuers of securities. If an auditor
concludes that an illegal act has a material effect on the financial statements, that senior
management has not taken appropriate action, and the failure warrants a departure from a
standard report or a resignation from the engagement, the auditor should report these
conclusions directly to the board of directors. The board should then notify the SEC within
one day. If the board does not file a timely report with the SEC, the auditor should make a
report to the SEC. The Reform Act explicitly states that the auditor will not be held liable in a
private action for any finding, conclusions, or statements made in such reports.
4-17.
a.
b.
Following is a list of key changes for auditors as a result of the Sarbanes Oxley Act
of 2002.
A number of non-attest services are prohibited for auditors of public companies.
The Act gave the PCAOB authority to establish auditing standards, quality control
standards, and independence standards for auditors of public companies.
Following is a list of key changes for auditors as a result of the Sarbanes Oxley Act
of 2002.
Section 302 requires a public companys CEO and CFO to prepare a statement to
accompany the audit report to certify the appropriateness of the financial statements
and disclosures.
Section 303 makes it unlawful for any officer or director of an issuer to take any
action to fraudulently influence, coerce, manipulate, or mislead any auditor.
Section 305 requires the CEO and CFO of a company that restates financial
statements due to material noncompliance with financial reporting requirements to
4-18.
a.
RICO was originally drafted to curtail inroads of organized crime into legitimate
business. However, RICO has been extended to losses suffered from fraudulent
securities offerings and failures of legitimate businesses.
b.
A plaintiff victimized by a "pattern of racketeering activity" may sue for treble damages and
attorneys' fees. In addition, a plaintiff may sue when he or she cannot satisfy the
requirements for bringing suit under the antifraud provisions of the federal securities acts.
c.
A CPA may be involved in a RICO suit due to an audit failure. In such cases, it is usually
alleged that the CPA either (1) knew or should have known that the financial statements
were materially misstated or (2) recklessly ignored indications of fraud by management. To
be liable, there must be some "scienter" or actual knowledge of the fraud. In addition, based
on the Reves v. Ernst & Young decision, RICO requires some participation in the operation
or management of the enterprise itself.
Comprehensive Questions
4-20. (Estimated time - 20 minutes)
City is likely to prevail against Winston based on constructive fraud. To establish a cause of
action for constructive fraud, City must prove that:
Winston lacked a reasonable ground for belief that the statement was true.
Constructive fraud may be inferred from evidence of gross negligence or
recklessness.
Under the facts of this case, Winston is likely to be liable to City based on constructive
fraud. Winston made a materially false statement of fact by rendering an unqualified opinion
on Bell's financial statements. Winston lacked a reasonable ground for belief that the
financial statements were fairly presented by recklessly departing from the standards of due
care in that it failed to investigate other embezzlements, despite having knowledge of at least
one embezzlement, and did not notify Bell's management of the matter. Winston intended
that others rely on the audited financial statements. City justifiably relied on the audited
financial statements in deciding to loan Astor $600,000 and damages resulted evidenced by
Astor's default on the City loan.
City is not likely to prevail against Winston based on negligence. In order to establish a
cause of action for negligence against Winston, City must prove that:
Winston breached that legal duty by failing to perform the audit with the due care
or competence expected of members of the profession.
Winston's failure to exercise due care proximately caused City to suffer damages.
The facts of this case establish that Winston was negligent by not detecting the overstatement
of accounts receivable because of its inadvertent failure to follow its audit program.
However, Winston will not be liable to City for negligence because Winston owed no duty to
City. This is the case because Winston was not in privity of contract with City, and the
financial statements were neither audited by Winston for the primary benefit of City, nor was
City within a known and intended class of third party beneficiaries who were to receive the
audited financial statements.
b. The first major exception to the privity requirement is fraud. Although a CPA may
generally avoid liability for ordinary negligence based upon privity, where the action is
for fraud, an injured third party has the requisite standing to sue. However, in order to
recover based on fraud, the third party (Capitol) must prove scienter or guilty knowledge
on the part of the CPA
The second exception to the privity defense is constructive fraud. Constructive fraud
is generally defined as a false representation of a material fact with lack of reasonable
ground for belief and with an expectation of reliance by another, and, in fact, there is
reasonable reliance resulting in damage. Constructive fraud may also be inferred from
evidence of gross negligence or recklessness, although they are not necessarily
constructive fraud in and of themselves. The dividing line between what actions will
meet the scienter requirement for actual fraud and what is necessary to evoke the
constructive fraud doctrine is not clear.
The third exception to the privity defense is gross negligence. Gross negligence
represents an extreme, flagrant, or reckless departure from standards of due care. For
example, a knowing failure to follow GAAS on a material matter might be held by a jury
to be gross negligence. The jury might then find that the defendant's conduct was so gross
as to satisfy the scienter requirement.
In addition to fraud and its various offshoots, one may avoid the privity barrier if it
can be established by the third party that it was the party that the contract was intended to
benefit. Thus, if a third party plaintiff suing a CPA can establish that the audit was for his
benefit, then the injured third party may have standing to sue. He or she is a third party
beneficiary of the contract and privity will not bar him or her from recovery. Recovery
under this theory has been significantly expanded. It has recently been held that liability
extends to those in a fixed, definable, and contemplated group whose conduct is to be
governed by the contract's performance.
4-23.
True. The offering was filed with the SEC and was public.
2.
True. This is the essence of the 1933 Act. The effect of the Securities Act of 1933 is
to give to third parties who purchase registered securities similar rights against the
auditor as are possessed by the client under law.
3.
True. Plaintiffs can show that the financial statements omitted material facts
necessary to prevent the statements from being misleading. Investors need not prove
that they relied on the statements, however. The burden is on the auditors to
demonstrate that the losses were not the result of omissions in the financial
statements.
4.
True. Accountants have no liability if they can show that their work was adequate to
support their opinion (the "due diligence" defense).
5.
True. One defense available to the accountants is to demonstrate that the losses of
the inventories were due to causes other than errors or omissions in the financial
statements.
6.
True. Any action must be filed within three years after the securities have been
offered to the public and within one year after the discovery of the error or omission
has been made.
7.
False. That is not the function of the SEC. The SEC does not pass judgment on the
merit of securities, nor does it defend accountants.
8.
False. The fact that the financial statements are managements responsibility is not a
defense if the auditor know of loans and collateral that were not disclosed.
4.30
Cases
4-26. (Estimated time - 25 minutes)
Part I
a. No. Peters will not prevail. The facts do not involve liability in the sale of registered
securities nor liability for reports filed with the SEC. Because the stock transaction
involved interstate commerce, Peter's claim may be based on Section 17 (the antifraud
provision) of the Securities Act of 1933 and Rule 1Ob-5 under the Securities Exchange
Act of 1934. In either case, he will have to show fraud on the part of Doe, or a
manipulative device or scheme, in connection with the sale of a security under the 1933
act or the purchase or sale of a security under the 1934 act. If this can be shown, an
implied civil damage remedy is available to Peters against Doe. (Note - Section 17 is not
discussed in the chapter.)
Although Doe was negligent, the United States Supreme Court, in the Hochfelder
case, held that a violation of Rule 10b-5 requires scienter, something greater than mere
negligence. Unless the violation of GAAS involves intent, or gross negligence, Doe
would not be held in violation of Rule 10b-5.
Similarly, Peters might claim a remedy against Doe for violation of Section 17 of
the 1933 Securities Act. The Supreme Court, in the Aaron case, held no scienter is
required in certain Section 17 cases brought by the SEC, but it appears that private
actions, such as the one by Peters, would be subject to provisions similar to those in Rule
10b-5.
b. No. Peters will not prevail based upon his state common law action either. At common
law, privity is required before an accountant can be held liable to users of the financial
statements, absent fraud. Doe was not in privity of contract with Peters, nor does the
question indicate that Doe was even aware that Peters would rely on the financial
statements.
Part II
Yes. Ira will prevail and recover damages from Baker. He will base his action on Section 11
of the Securities Act of 1933. Section 11 imposes liability on experts, including accountants,
whose opinions appear in a registration statement. The experts are liable to all those who in
reliance on their opinions purchase securities in a public offering under the 1933 act. Ira does
not have to prove Baker was negligent in auditing Able. All he need allege and prove is that
there is a material false statement or omission of a material fact in the registration statement.
The only defense that Baker may assert is that it exercised the degree of care that would be
Communication
Situation
To:
Re:
Audit File
Liability for Negligence Under Common Law and under Section 10(b) and Rule 10b-5 of the
Securities Exchange Act of 1934.
From: CPA Candidate
1.
2.
3.
A causal relationship, i.e., that the failure to exercise due care resulted in the
plaintiffs loss.
Actual damage or loss resulting from the failure to exercise due care.
Apple is not in privity of contract with Musk because there is no direct contractual
relationship between them. Therefore, in the absence of other factors, Apple would not be
liable to Musk for Apple's alleged negligence based on the Ultramares decision.
However, the privity defense would not protect Apple if Musk could prove that Apple
had committed actual or constructive fraud (that is, Apple owes a duty to all persons,
including third persons, to practice its profession in a non-fraudulent manner).