Accountant's Liability To Third Parties

Table of Contents

Introduction

Accountants' Liability to the Client and Third-Party

A) Breach of Contract

B) Ordinary Negligence (Accountant Malpractice)

C) Fraud

a. Constructive Fraud (Gross Negligence)

b. Actual Fraud

Accountants' Liability under Common Law for Third-Party

A) The Near-Privity Doctrine

B) The Restatement Doctrine

C) The Foreseeability Doctrine

D) The Balancing-Factors Doctrine

Accountants' Liability under Statutory Law - Third-Party

A) Securities Act of 1933

B) Securities Exchange Act of 1934

C) The Sarbanes Oxley Act

D) The RICO Act

Accountants' Deep Pockets

Conclusion

Works Cited

Introduction

This research paper analyzes the degree of an auditor's liability to clients and third parties under applicable law. Specifically, it focuses on accountants in their professional role engaged by contract to express an opinion about a company's financial statements and the professional commitment to exercise due care in providing those services. An accountant's failure to comply with the promised obligations can result in the accountant being held liable to clients for fraud, negligence, and breach of contract. In some cases, accountants may have a potential legal obligation to third parties as a result of not following established professional standards.

Accountant liability for the most part is based on contract, common and statutory law. Section 2 discusses the degree of liability accountant's face under a negligence standard. When an accountant performs work for a client a contract of employment is created, usually called an "engagement letter." The engagement letter specifies the work to be performed and the compensation to be paid. Because an accountant is an agent of his/her client, agency law also applies to the relationship. Under agency law, the accountant owes his/her client important duties, including competence in performing the work. The standard of competence used by the court is that of a reasonably competent accountant, which is a negligence standard. Most courts agree that a reasonably competent accountant will follow the principles of Generally Accepted Accounting Principles (GAAP) and Generally Accepted Accounting Standards (GAAS).

Accountants also are subject to common law liability, particularly claims of negligence and fraud. If an accountant fails to exercise the degree of care of a reasonably competent accountant, and as a result he/she issues incorrect financial information, he or she faces claims of negligence. Fraud occurs when an accountant issues false financial information with the knowledge that it is false and with intent to deceive someone. The degree of liability the law imposes on accountants varies by the nature of the negligent act. For example, an accountant's error may constitute breach of contract, ordinary negligence, or Fraud which include constructive fraud and Actual Fraud.

Section 3 of the paper addresses the four main doctrines of accountant liability under the common law: (1) The Ultramares Doctrine; (2) The Restatement of Torts Section 552; (3) the Foreseeability doctrine and (4) the balancing-factors doctrine. The tort of negligence against an accountant is a dangerous legal theory of liability, because there can be more than one or two plaintiffs. Under contract liability, only the client or an intended third party can claim contract liability, and the amount of the loss and the accountant's liability are limited. However, under the theory of negligence, an entire class of claimants, potentially numbering in the hundreds, may be able to assert liability. This concern for imposing mass liability on an accountant and its potential to destroy the accountant and the firm, led to the Supreme Court decision in Ultramares v. Touch in 1931. The Ultramares doctrine stems from the rule created by this case, stating that mass liability should not apply to accountants and only the client and an intended third party could hold an accountant liable for the accountant's negligence.

The Ultramares doctrine limiting accountants' liability for negligent acts was the controlling legal principle in the United States until the 1950s. At that time, courts began to expand the world of potential claimants in negligence cases beyond the client and the intended third party. The Restatement of Torts, Section 552 created a broader rule by expanding liability to include claims brought by a limited group of persons for whose benefits and guidance the accountant intends to provide the information. Over time, the Restatement rule has replaced the Ultramares doctrine as the majority rule. The most expansive view of accountant liability, adopted by some states, was the foreseeability doctrine, which allows nearly anyone who suffers a loss as a result of an accountant's negligence to be a potential claimant, as long as that person's reliance was foreseeable to the accountant. The mid-way doctrine of balancing-factors allows a subjective approach to the matter by examining each case separately and weighing all the different factors subjectively.

The fourth section of this paper summarizes accountant liability imposed by statutory law. The most significant source of potential liability for accountants, especially those who perform work for public companies, is the liability imposed by federal statutes. Federal legislation of accountants began after the 1929 New York Stock Exchange crash, with the enactment of the Securities Act of 1933 and the Securities Act of 1934. This historic crash led to the Great Depression and an era of economic destabilization with significant impact on the population. False financial reporting, fraud, and manipulation had contributed to the crash and public opinion called for reform and regulation. The resulting statutes created increased liability for those involved with the issue or sale of securities, including criminal liability. Accountants involved in the preparation of