CPA Exam Prep - Study Unit One - PDF

1 Study Unit One Ethics, Professional Responsibilities, and Liability of CPAs 1.1 Tax Preparers -- Practice before the IRS..................................................

1 Study Unit One Ethics, Professional Responsibilities, and Liability of CPAs 1.1 Tax Preparers -- Practice before the IRS........................................................................ 2 1.2 Tax Preparer Professional Conduct, Penalties, and Sanctions....................................... 6 1.3 Licensing and Disciplinary Systems................................................................................ 15 1.4 Liability to Clients and Third Parties Under State Law.................................................... 16 1.5 Privileged Communication and Confidentiality................................................................. 20 The Internal Revenue Service (IRS) may dispute or disagree with a taxpayer concerning tax positions taken by the taxpayer or the taxpayer’s lack of filing a return. In these situations, the taxpayer may have to defend their positions either in writing or in person before the IRS. Not everyone can represent taxpayers before the IRS. Treasury Department Circular 230 declares the rules for “practice before the IRS,” limiting persons who may represent taxpayers before the IRS to CPAs, enrolled agents (EAs), attorneys, and other individuals authorized to practice before the IRS. The first and second subunits of this study unit discuss the various individuals who may practice before the IRS and their standards of conduct. In addition to the IRS, the state boards of accountancy, the AICPA, and the SEC may also discipline CPAs. Beyond regulatory concerns, CPAs are potentially liable to civil suits from clients and third parties as a result of their actions. The third and fourth subunits discuss disciplinary actions and civil liability. CPAs can also find themselves as witnesses in civil litigation or criminal prosecutions. While CPAs must keep their clients’ information confidential, CPAs must obey court orders. In extremely limited circumstances, such as tax advice, there is an accountant-client privilege. Consequently, CPAs need to be aware that disclosures by their clients can only be kept confidential to a certain extent. The fifth and final subunit discusses privileged communications and confidentiality. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 2 SU 1: Ethics, Professional Responsibilities, and Liability of CPAs 1.1 Tax Preparers -- Practice before the IRS Practice before the IRS is defined as the presentation to the IRS or any of its officers or employees of any matter relating to a client’s rights, privileges, or liabilities under laws or regulations administered by the IRS. This includes the following: Representing a taxpayer at conferences, hearings, or meetings with the IRS Preparing necessary documents and filing them with the IRS for a taxpayer Rendering written advice with respect to any entity, transaction, plan, or arrangement having a potential for tax avoidance or evasion Corresponding and communicating with the IRS for a taxpayer The following situations are not considered practice before the IRS: Preparing less than substantially all of a tax return, an amended return, or a claim for refund Furnishing information upon request to the IRS Appearing as a witness for a taxpayer A revenue agent’s review and collection of overdue taxes IRS officers and employees may not practice before the IRS, except on behalf of immediate family or as a personal fiduciary. These individuals are not eligible to obtain a preparer tax identification number (PTIN). Those authorized to practice before the IRS are tax practitioners who are Attorneys in good standing of the bar of any state, territory, or possession of the U.S. CPAs qualified to practice as a CPA in any state, territory, or possession of the U.S. Enrolled agents (EAs) An EA is an individual, other than an attorney or a CPA, who is eligible, qualified, and licensed as authorized to represent a taxpayer before the IRS. The EA designation is issued by the IRS to individuals passing the EA exam. Enrolled actuaries, enrolled retirement plan agents, and annual filing season program (AFSP) participants To practice before the IRS, an attorney or a CPA must Not be suspended or disbarred File a written declaration for each party (s)he represents that (s)he Is currently qualified Has been authorized to represent the party Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: Ethics, Professional Responsibilities, and Liability of CPAs 3 A tax return preparer is defined as any person–not just a practitioner–who for compensation prepares or assists with the preparation of, or employs one or more persons to prepare or assist with the preparation of, all or a substantial portion of any return of tax, amended return, or claim for refund under the Internal Revenue Code (IRC). The distinction of “any person” means that all tax practitioners fall within the tax return preparer category, but a tax return preparer is not necessarily a tax practitioner. Under Circular 230, “any person” is defined as people who are compensated and prepare tax returns. This includes the following: ► A person who does not physically prepare the tax return but provides to a taxpayer or other preparer sufficient information and advice so that completion of the return is simply a mechanical matter ► A nonsigning tax return preparer who prepares all or a substantial portion of a return or claim for refund Examples include preparers who provide advice that constitutes a substantial portion of the return. Persons who are not tax return preparers include the following: ► An employee who prepares a return for the employer by whom (s)he is regularly and continuously employed ► A fiduciary who prepares a return or refund claim for any person (the trust) ► A person who prepares a refund claim in response to a notice of deficiency issued to another ► A person who performs clerical work, such as a person who provides typing, reproducing, or other mechanical assistance ► A person who performs tax planning services, such as when a person provides an opinion about events that have not happened Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 4 SU 1: Ethics, Professional Responsibilities, and Liability of CPAs Substantial vs. unsubstantial portion The litmus test is whether a portion of any return or claim for refund is either ► Less than $10,000 or ► Less than $400,000 and also less than 20% of the gross income on the return or claim. If the portion of any return or claim satisfies the test above, it is considered an unsubstantial portion. Inversely, if it does not satisfy the test above, it is considered a substantial portion. All tax return preparers must comply with the following: Have a preparer tax identification number Be subject to the duties and restrictions relating to practice before the IRS Be subject to the sanctions for violation of the regulations of Circular 230 One of the duties for tax preparers is performing due diligence. Significant aspects of return preparation require Making factual inquiries to ensure clients’ accuracy and truthfulness and Taking a position relative to tax law. ► In other words, tax preparers must assess the scenario and appropriately apply tax law to the facts. A tax return preparer may rely, if in good faith, on information provided by the taxpayer without having to obtain third-party verification. However, the preparer may not ignore the implications of the information. The preparer must make reasonable inquiries if the information appears inaccurate or incomplete. The preparer should make appropriate inquiries of the taxpayer about the existence of documentation for deductions. When a tax return preparer discovers that a taxpayer has made an error in or omission from any document filed with the IRS, (s)he must notify the taxpayer of the error or omission immediately. The tax return preparer also must advise the taxpayer of the consequences of the error or omission. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: Ethics, Professional Responsibilities, and Liability of CPAs 5 Procedural Requirements of Tax Return Preparers A return preparer is required to sign the return or claim for refund after it has been completed and before it is presented to the taxpayer. Before a return preparer allows the client to sign the prepared return, the return preparer is required to provide a completed copy of the return or refund claim to the taxpayer. The return preparer must include his or her correct preparer taxpayer identification number (PTIN) on the return or claim for refund. A return preparer is required to retain a completed copy of each return or claim for refund prepared for 3 years after the close of the return period. An alternative to retaining a copy of the return is to keep a list that includes, for the returns and claims prepared, the following information: The taxpayers’ names Taxpayer identification numbers Their tax years Types of returns or claims prepared The return period is the 12-month period beginning on July 1 each year. Failure to do any of the above may result in a $60 penalty for each occurrence. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 6 SU 1: Ethics, Professional Responsibilities, and Liability of CPAs 1.2 Tax Preparer Professional Conduct, Penalties, and Sanctions Rules of Conduct before the IRS: Nine Elements Tax Preparers Must Adhere To 1. Conflict of interest A conflict of interest exists if ► The practitioner’s representation of a client will be directly adverse to another client or ► There is a significant risk that the representation of one or more clients will be materially limited by the practitioner’s responsibilities to another or former client, a third person, or by the practitioner’s personal interests. A practitioner may represent conflicting interests before the IRS only if ► All directly affected parties provide informed, written consent once the existence of the conflict is known by the practitioner (written consent must be provided within 30 days of informed consent); ► The representation is not prohibited by law; and ► The practitioner reasonably believes that (s)he can provide competent and diligent representation to each client. A practitioner is not required to disclose the conflict of interest to the IRS. 2. Diligence must be exercised in preparing, assisting in preparing, approving, and filing returns, documents, and other papers relating to IRS matters. Diligence is presumed if the practitioner ► Relies upon the work product of another person and ► Uses reasonable care in engaging, supervising, training, and evaluating the person. A practitioner may not unreasonably delay the prompt settlement of any matter before the IRS. 3. Information or records properly and lawfully requested by a duly authorized officer or employee of the IRS must be promptly submitted. However, if reasonable basis exists for a good-faith belief that (1) the information is privileged or (2) the request is not proper and lawful, the practitioner is excused from submitting the requested information. If a practitioner does not have possession or control of the requested information, the practitioner is required to provide information about the identity of persons that (s)he reasonably believes may have possession or control of the requested information. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: Ethics, Professional Responsibilities, and Liability of CPAs 7 4. Known client noncompliance. A practitioner who knows about a client’s noncompliance– which may be that a client (a) has not complied with the revenue laws of the U.S. or (b) has made an error or omission–is required to promptly advise the client of noncompliance and the consequences of such noncompliance, error, or omission under the Code and regulations. Circular 230 does not require the practitioner to notify the IRS. 5. A practitioner must not negotiate, including by endorsement, any income tax refund check issued to a client. 6. A practitioner may not charge an unconscionable fee in connection with any matter before the IRS. 7. Contingent fees. A practitioner may not charge a contingent fee in relation to any matter before the IRS except in relation to (a) an IRS examination of an original return, (b) an amended return, (c) a claim for refund or credit, or (d) a judicial proceeding. 8. Return of client records. A practitioner must return client records upon request, regardless of any fee dispute. However, the practitioner may retain copies of client records. Records deemed returnable for purposes of this requirement are those records necessary for a client to comply with his or her federal tax obligations. However, documents prepared by the practitioner that (s)he is withholding pending payment of a fee, with respect to such documents, are not included (provided state law permits retention of records in a fee dispute). 9. Circular 230 allows advertising and solicitation with the following conditions: False, fraudulent, misleading, deceptive, or unfair statements or claims are not allowed. Claims must be subject to factual verification. Specialized expertise may not be claimed except as authorized by federal or state agencies having jurisdiction over the practitioner. Each of the following fees may be advertised: ► Fixed fees for specific routine services ► A range of fees for particular services ► The fee for an initial consultation ► Hourly rates ► Availability of a written fee schedule Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 8 SU 1: Ethics, Professional Responsibilities, and Liability of CPAs Best Practices for Tax Return Preparers Tax return preparers should provide clients with the highest quality representation regarding federal tax issues. They should adhere to best practices in providing advice and in preparing or assisting in the preparation of a submission to the IRS. Best practices include four general elements: 1. Performing the steps needed to support the facts for a tax filing Practitioners should establish the facts, determine which facts are relevant, evaluate the reasonableness of any assumptions or representations, relate applicable law to the relevant facts, and arrive at a conclusion supported by the law and the facts. 2. Communicating clearly with the client about the terms of the engagement 3. Advising the client regarding the importance of the conclusions reached, including, for example, whether a taxpayer may avoid accuracy-related penalties under the Internal Revenue Code (IRC) if a taxpayer acts in reliance on the advice 4. Acting fairly and with integrity in practice before the IRS Tax return preparers with responsibility for overseeing a firm’s practice of providing advice about federal tax issues or preparing or assisting in the preparation of submissions to the IRS should take reasonable steps to ensure that the firm’s procedures for all members, associates, and employees are consistent with the best practices. Written Tax Advice When providing written advice about any federal tax matter, a practitioner must Base the advice on reasonable assumptions, Reasonably consider all relevant facts that are known or should be known, and Use reasonable efforts to identify and determine the relevant facts. The advice cannot rely upon representations, statements, findings, or agreements that are unreasonable, i.e., are known to be incorrect, inconsistent, or incomplete. The advice must not consider the possibility that either a tax return will not be audited or a matter will not be raised during the audit in evaluating a federal tax matter. When providing written advice, a practitioner may rely in good faith on the advice of another practitioner only if the advice is reasonable given all the facts and circumstances. The practitioner cannot rely on the advice of a person who either the practitioner knows or should know is not competent to provide the advice or has an unresolved conflict of interest. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: Ethics, Professional Responsibilities, and Liability of CPAs 9 Penalties Tax return preparers are subject to severe penalties for violations. The degree of severity varies among the penalties. Direct involvement in preparing a tax return is not a prerequisite for penalties. Any individuals with overall supervisory responsibility for advice given by a firm are also subject to penalties. The following are penalties that a tax return preparer can be subjected to. Unreasonable positions. Taking an undisclosed position without a reasonable belief that substantial authority exists that it will be sustained on its merits results in a penalty of an amount equal to the greater of $1,000 or 50% of the income to be derived. If the position is disclosed, its tax treatment must have a reasonable basis. The penalty does not apply if the preparer proves that ► (S)he acted in good faith and ► Reasonable cause exists for the understatement. Positions relating to tax shelters are unreasonable unless reasonable belief exists that such positions would more likely than not be sustained on their merits. Negligence. Negligence includes any failure to make a reasonable attempt to either comply with the provisions of the Internal Revenue laws or exercise ordinary and reasonable care in the preparation of a return. Willful or reckless conduct. If the understatement was caused by the preparer’s willful or reckless conduct, the penalty is the greater of $5,000 or 75% of the income to be derived. Frivolous submission. Filing a frivolous return is penalized. A return is considered frivolous when it Omits information necessary to determine the taxpayer’s tax liability, Shows a substantially incorrect tax or willful understatement of tax liability, Is based on a frivolous position (e.g., that wages are not income), or Is based on the taxpayer’s desire to impede the collection of tax. The tax code provides that any tax return preparer who endorses or otherwise negotiates any check issued to a taxpayer with respect to taxes imposed by the IRC is subject to a penalty of $635 per check. Furthermore, any tax return preparer who operates a check cashing agency that cashes, endorses, or negotiates tax refund checks for returns prepared also is subject to a penalty. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 10 SU 1: Ethics, Professional Responsibilities, and Liability of CPAs Aiding or abetting in preparation of any document is subject to a penalty if using the document would result in an understatement of tax liability. A preparer may be subject to only one aiding or abetting penalty per taxpayer (i.e., client) per taxable period (or event when there is no taxable period). However, other types of penalties may still apply. The penalty applies to the preparer even when a subordinate has been ordered to understate the tax liability or the preparer knows but does not attempt to prevent the subordinate from understating the tax liability. Any act that constitutes a willful attempt to evade federal tax liability, even that of another person, is subject to criminal penalties including imprisonment. ► Furthermore, any person who willfully aids or assists in preparation or presentation of a materially false or fraudulent return is guilty of a felony. Violations of these rules may result in disciplinary action by the director of the IRS, and an injunction may be issued prohibiting the violator from acting as a tax preparer. Fraud and false statements. Fraudulent transactions ordinarily involve a willful or deliberate action with the intent to obtain an unauthorized benefit. For such action, the penalties are a fine not greater than $250,000 for an individual client ($500,000 for a corporate client), imprisonment of not more than 3 years, or both. Disclosure of Taxpayer Information A penalty is imposed on any tax return preparer who discloses or uses any tax return information without the consent of the taxpayer. ► But the penalty is not imposed if the disclosure was specifically for preparing, assisting in preparing, or providing services in connection with the preparation of any tax return of the taxpayer. The penalty is $250 ($1,000 for misappropriation of identity) per disclosure, with a maximum of $10,000 ($50,000 for misappropriation of identity) per year. If convicted of knowingly or recklessly disclosing the information, a preparer is guilty of a misdemeanor and subject to up to $1,000 in fines and up to a year in prison. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: Ethics, Professional Responsibilities, and Liability of CPAs 11 Exceptions ► The penalty for disclosure is not imposed if the disclosure was made in the following circumstances: In accordance with the Internal Revenue Code To a related taxpayer, provided the taxpayer did not expressly prohibit the disclosure Under a court order (subpoena) or to the tax return preparer’s legal counsel in the event of legal proceedings To tax return preparers within the same firm For the purpose of a quality or peer review to the extent necessary to accomplish the review For use in preparing, assisting in preparing, or providing services in connection with tax return preparation Consent ► The taxpayer’s consent must be a written, formal consent authorizing the disclosure for a specific purpose. ► The taxpayer must authorize a preparer to Use the taxpayer’s information to solicit additional current business from the taxpayer in matters not related to the IRS Disclose the information to additional third parties Disclose the information in connection with another person’s return Confidentiality ► The confidentiality privilege is extended to certain nonattorneys. The privilege may not be asserted to prevent the disclosure of information to any regulatory body other than the IRS. ► In noncriminal tax proceedings before the IRS, a taxpayer is entitled to common-law protections of confidentiality with respect to the tax advice given by any federally authorized tax practitioner. They are the same protections a taxpayer would have if the advising individual were an attorney. A federally authorized tax practitioner includes any nonattorney who is authorized to practice before the IRS, such as a CPA. Tax advice is advice given by an individual with respect to matters that are within the scope of the individual’s authority to practice before the IRS. ► The privilege also applies in any noncriminal tax proceeding in federal court brought by or against the U.S. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 12 SU 1: Ethics, Professional Responsibilities, and Liability of CPAs Sanctions for violations. In addition to penalties, tax preparers may be censured (public reprimand), suspended, or disbarred from practice before the IRS for willful violations of any of the regulations contained in Circular 230. A notice of disbarment or suspension of a CPA from practice before the IRS is issued to IRS employees, interested departments and agencies of the federal government, and state licensing authorities. The Secretary of the Treasury may censure, suspend, or disbar from practice before the IRS any practitioner who Is shown to be incompetent or disreputable Refuses to comply with the rules and regulations relating to practice before the IRS Willfully and knowingly, with intent to defraud, deceives, misleads, or threatens any client The following is a brief list of conduct that may result in suspension or disbarment: Being convicted of an offense involving dishonesty or breach of trust Providing false or misleading information to the Treasury Department, including the IRS Negotiating a client’s refund check or not promptly remitting a refund check Circulating or publishing matter related to practice before the IRS that is deemed libelous or malicious Using abusive language Suspension from practice as a CPA by any state licensing authority, any federal court of record, or any federal agency, body, or board Conviction of any felony involving conduct that renders the practitioner unfit to practice before the IRS Attempting to influence the official action of any IRS employee by bestowing a gift, favor, or anything of value Willfully evading or assisting others to evade any federal tax payments Copyright © 2024 Gleim Publications, Inc. 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Contact [email protected].  SU 1: Ethics, Professional Responsibilities, and Liability of CPAs 13 Act Fine Imprisonment Understatement: Greater of Due to unreasonable positions a) $1,000 or N/A [IRC Sec. 6694(a)] b) 50% of income to be derived Greater of Due to willful or reckless conduct a) $5,000 or N/A [IRC Sec. 6694(b)] b) 75% of income to be derived Preparing tax returns for other persons (IRC Sec. 6695): Various failures related to furnishing a complete, signed copy of the return to $60 each N/A the taxpayer Failure to file correct information returns $60 each N/A Endorses or negotiates checks made to $635 each, unlimited N/A taxpayer in respect of taxes imposed Failure to be diligent in determining credits and head of household status $635 each, unlimited N/A (for the best benefit of taxpayer) Others: False statements about the tax benefits of the transaction: 50% of income to be derived Promoting abusive tax shelters Provides a gross valuation overstatement: N/A [IRC Sec. 6700(a)] Lesser of a) $1,000 for each organization or sale of promotion plan b) 100% of income to be derived Identity theft crime: $1,000 per Aiding and abetting understatement of unauthorized disclosure, limited to $50,000 N/A tax liability [IRC Sec. 6701(a)] per year Disclosure or use of information $250 per unauthorized disclosure, limited to N/A [IRC Sec. 6713(a)] $10,000 per year Convicted of knowingly or recklessly disclosing information (misdemeanor) $1,000 Up to 1 year (IRC Sec. 7216) False or fraudulent tax returns $100,000 (individual clients) Up to 3 years (IRC Sec. 7206) $500,000 (corporate clients) Fraudulent returns, statements, or other $10,000 (individual clients) Up to 1 year documents (IRC Sec. 7207) $50,000 (corporate clients) Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 14 SU 1: Ethics, Professional Responsibilities, and Liability of CPAs Example 1-1 Penalty Application - Understatement Bernard is a tax return preparer. While preparing a 2023 tax return for a client, Bernard determines the client owes a substantial amount of tax. In order to generate a refund for the client, Bernard substantially overstates itemized deductions and expenses claimed on the Schedule C. Bernard is subject to a penalty of the greater of $5,000 or 75% of income derived by the preparer as to the return, to be assessed against a return preparer whose willful or reckless conduct in preparing a tax return causes an understatement of liability. The penalty is applied if the understatement is due either to a willful attempt to understate the tax liability or to any reckless or intentional disregard of rules or regulations by the return preparer. The penalty is assessed against each return containing an understatement of liability caused by the return preparer’s willful or reckless conduct. Example 1-2 Penalty Application - Taxpayer Refund Checks Received by Tax Return Preparer A taxpayer specifically authorized on a power of attorney form for the preparer of the taxpayer’s return to receive the taxpayer’s refund check. Taxpayers may use a power of attorney form to authorize a representative, including a return preparer, to receive a refund check. However, if the representative is a return preparer, (s)he cannot be authorized to endorse or otherwise cash the check related to the tax return. Thus, the preparer will incur no penalty by being authorized to receive the taxpayer’s refund check so long as (s)he does not try to endorse or otherwise cash it. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: Ethics, Professional Responsibilities, and Liability of CPAs 15 1.3 Licensing and Disciplinary Systems State Boards of Accountancy State boards of accountancy are governmental agencies that license accountants to use the designation Certified Public Accountant (CPA). Requirements for licensure vary from state to state. In addition to passing the CPA Exam and paying the applicable license fee, a candidate may need to satisfy a state’s educational, experience, and residency criteria. Continuing professional education (CPE), peer review, and ethics standards also may vary by state. Meeting these standards is necessary to remain licensed. State boards can suspend or revoke licensure through administrative process, for example, in board hearings. State CPA societies are voluntary, private entities that can admonish, suspend, or expel members. AICPA Disciplinary Mechanisms Professional Ethics Division The Professional Ethics Division investigates ethics violations by AICPA members. It imposes sanctions in less serious cases. For example, it may require a member to take additional CPE courses as a remedial measure. Joint Ethics Enforcement Program (JEEP) The AICPA and most state societies have agreements that permit referral of an ethics complaint either to the AICPA or to a state society. The AICPA handles matters of national concern, those involving two or more states, and those in litigation. JEEP also promotes formal cooperation between the ethics committees of the AICPA and of the state societies. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 16 SU 1: Ethics, Professional Responsibilities, and Liability of CPAs 1.4 Liability to Clients and Third Parties Under State Law While the AICPA does not test state-specific law, the U.S. is founded on English common law. With the exception of Louisiana, every state as well as federal law are based on English common law. Therefore, a basic and general understanding of how a CPA can be liable to clients and third parties under English common law is testable. At a high level, virtually all jurisdictions in which a CPA could practice encompass the same liability principles. In the U.S., CPAs do not face strict liability where there is liability when a CPA commits a fault or mistake. However, there are three types of civil liability that a CPA could have: contractual liability, negligence, and fraud. Contractual Liability to Client (Privity of Contract) An understanding should be established regarding what services the CPA is to perform for the client. An engagement letter puts this understanding into writing to form the basis of a legal contract. The engagement letter should describe the services agreed upon by the client and CPA (regardless of whether required by professional standards), fees to be paid, and other pertinent details. Example 1-3 Engagement Letter vs. Professional Standards The engagement letter may provide for positive confirmation of all accounts receivable. Professional standards may, in the circumstances of the specific engagement, permit negative confirmation of a sample of accounts receivable. The engagement letter between a CPA and a client is a personal service contract, so it can be litigated like any other type of contract. The usual remedy for breach of contract is compensatory monetary damages. In addition to being liable to the client, a CPA may be liable to third-party beneficiaries of the contract. Example 1-4 Accountant’s Breach of Contract A CPA and a client contract for the CPA to perform an audit of the business for $2,500. The audit is contracted to be done within 3 months so the client can provide the audited financial statements to an insurance company to show compliance. However, the audit takes 6 months. A breach of contract has occurred. The CPA is liable to the client and the insurance company (third-party beneficiary). Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: Ethics, Professional Responsibilities, and Liability of CPAs 17 CPA’s duties. The CPA is implicitly bound by the contract to perform the engagement with due care (meaning non-negligently) and in compliance with professional standards. Moreover, a CPA must comply with the law and is responsible for exercising independent professional judgment. CPA’s defense. Typical defenses include the argument that the engagement letter lacks a necessary element to form a legal contract, substantial performance of the contract, or the impossibility of the client to perform. For example, suspension or termination of performance may be justified because of the client’s prior breach. Common Law Negligence Liability A CPA may be liable in tort for losses caused by the CPA’s negligence. A tort is a private wrong resulting from the breach of a legal duty imposed by society. The duty is not created by contract or other private relationship but rather through English common law. Types of Negligence Ordinary negligence may result from a CPA’s act or failure to act given a duty to act, for example, failing to observe inventory or confirm receivables. Negligent misrepresentation is a false representation of a material fact not known to be false but intended to induce reliance as opposed to intentional misrepresentation (fraud). The plaintiff must have reasonably relied on the misrepresentation and incurred damages. Gross negligence is failure to use even slight care. In extreme circumstances, a CPA may be liable for punitive damages if (s)he is grossly (not ordinarily) negligent. Protection from Liability A CPA has a duty to exercise reasonable care and diligence. A CPA is not a guarantor of the work. Compliance with professional standards demonstrates that the CPA exercised reasonable care and diligence and is therefore a defense against negligence claims. A CPA should have the degree of skill commonly possessed by other CPAs performing a similar engagement. CPAs may be liable for failure to communicate to the client findings or circumstances that indicate misstatements in the accounting records or fraud. They also must communicate all significant deficiencies and material weaknesses in internal control. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 18 SU 1: Ethics, Professional Responsibilities, and Liability of CPAs Client’s Burden of Proof A client must prove all four of the following elements of negligence. 1. The CPA owed the client (who is the plaintiff) a duty. 2. The CPA breached this duty. 3. The CPA’s breach actually and proximately caused harm to the plaintiff. 4. The plaintiff incurred damages. Liability to Third Parties A CPA is liable for negligence to a plaintiff in privity of contract with the CPA or a primary (intended third-party) beneficiary of the engagement. A third party is a primary beneficiary if The CPA is retained principally to benefit the third party, The third party is identified, and The benefit pertains to a specific transaction. ► Thus, the CPA knows the particular purpose for which the third party will use and rely upon the work. Example 1-5 Primary Beneficiary Smith, CPA, was engaged by Client, Inc., to audit Client’s annual financial statements. Client told Smith that the audited financial statements were required by Bank in connection with a loan application. Bank is a primary beneficiary and may recover damages caused by the CPA’s negligence. The majority of jurisdictions hold that CPAs are liable to foreseen third parties. Foreseen third parties are not necessarily identified specifically in the contract but are parties ► To whom the CPA intends to supply the information, ► To whom the CPA knows the client intends to supply the information, or ► Who use the information in a way the CPA knows it will be used. Example 1-6 Foreseen Users and Foreseen Class of Users Smith, CPA, was engaged by Client, Inc., to audit its annual financial statements. Client’s president told Smith that the financial statements would be distributed to South Bank in connection with a loan application. Smith was negligent in performing the audit. Subsequently, the financial statements were given to West Bank as well. West Bank lent Client $50,000 in reliance on the financial statements. West Bank suffered a loss on the loan. Smith is liable to West Bank because it is within a foreseen class of users, and the loan is a transaction similar to that for which the financial statements were audited. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: Ethics, Professional Responsibilities, and Liability of CPAs 19 Liability for Fraud Fraud is an intentional misrepresentation. It is a willful and deceitful act. A CPA is liable for losses that result from his or her commission of fraud. Punitive and compensatory damages are both permitted. CPAs, including those practicing auditing, have no general duty to discover fraud. Nevertheless, an auditor is held liable for failure to discover fraud when the auditor’s negligence prevented discovery. An auditor who fails to follow professional standards and therefore does not discover fraud will most likely be liable if compliance with professional standards would have detected the fraud. Plaintiffs’ burden of proof of fraud requires proving the following five elements: 1. The CPA made a misrepresentation. 2. The misrepresentation was made with scienter, which is a legal term meaning with actual knowledge of fraud. 3. The misrepresentation was of a material fact. 4. The misrepresentation induced reliance. 5. Another person justifiably relied on the misstatement to his or her detriment. Example 1-7 Fraud A CPA is engaged to audit financial statements. To increase profits from the engagement, the CPA planned to and did omit necessary audit procedures. The CPA committed fraud. Constructive fraud. If a plaintiff cannot prove the CPA had actual knowledge of fraud, the plaintiff may try to replace this requirement of proving fraud with the CPA having committed gross negligence. Gross negligence is such a reckless disregard for truth or applying reasonable care and diligence that fraud is implied. CPA’s defense to fraud. A plaintiff must prove each element of fraud with particularity. Credible evidence that disproves one of the elements tends to negate liability. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 20 SU 1: Ethics, Professional Responsibilities, and Liability of CPAs Liability to third parties for fraud. Liability is to all reasonably foreseeable users of the work product. Any foreseeable user has the right to sue. A foreseeable user is any person that the CPA should have reasonably foreseen would be injured by justifiable reliance on the misrepresentation. The CPA can be sued by others who rely on the work product. The plaintiff does not have to be the person or entity that entered into the contract with the accountant. Background 1-1 Duty to Discover Fraud U.S. GAAS and PCAOB standards require an auditor to plan and perform the audit to provide reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. An auditor must (1) identify risks of material misstatement due to fraud; (2) assess the identified risks; and (3) respond by changing the nature, timing, and extent of audit procedures. 1.5 Privileged Communication and Confidentiality Accountant-Client Privilege Federal Law Federal law does not recognize a broad privilege of confidentiality for accountant-client communications. As discussed on page 11, a confidentiality privilege covers most tax advice provided to a current or prospective client by any individual qualified under federal law to practice before the IRS (i.e., a CPA, attorney, enrolled agent, or enrolled actuary). State Law A majority of states do not recognize a privilege for accountant-client communications. Client communications with accountants requested and retained by attorneys to aid in litigation are protected by the work product privilege. This privilege is recognized in federal and state courts. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: Ethics, Professional Responsibilities, and Liability of CPAs 21 Working Papers Working papers are confidential records of an accountant’s performance of an engagement. They document the procedures performed, evidence obtained, and conclusions reached. Working papers are the property of the accountant. Because they are prepared by the accountant, they provide the best evidence of the accountant’s performance. However, working papers may be subpoenaed by a third party for use in litigation in the many states that do not recognize a privilege for accountant-client communications. Without a court order or client consent, third parties have no right of access to working papers. However, working papers may be disclosed to another CPA partner of the accounting firm without the client’s consent because such information has not been communicated to outsiders. Confidential Client Information Rule A member of the AICPA in public practice must not disclose confidential client information without the client’s consent. This rule does not affect the following: Professional obligations under the Compliance with Standards Rule and the Accounting Principles Rule The duty to comply with a valid subpoena or summons or with applicable laws and regulations An official review of the member’s professional practice A review of a CPA’s practice by a CPA as part of a purchase, sale, or merger of the practice Appropriate precautions (e.g., a written agreement) should prevent disclosures by the prospective buyer. The member’s right to initiate a complaint with or respond to any inquiry made by an appropriate investigative or disciplinary body, e.g., the Professional Ethics Division or a trial board of the AICPA or a state CPA society peer review body Retention of Working Papers At a minimum, an accountant who does not audit public companies should retain working papers until the state statute of limitations on legal action has lapsed. The limitation period varies by state and according to the type of claim. Auditors of public companies must retain working papers for at least 7 years. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].