NINJA BOOK

R E G U L AT I O N I

ETHICS & PROFESSIONAL RESPONSIBILITIES

COPYRIGHT

This book contains material copyrighted 1953 through 2016 by the American Institute of Certified Public Accountants, Inc., and is used or adapted with permission.
Material from the Uniform CPA Examination Questions and Unofficial Answers, copyright 1976 through
2016, American Institute of Certified Public Accountants, Inc., is used or adapted with permission.
This book is written to provide accurate and authoritative information concerning the covered topics. It is
not meant to take the place of professional advice in any way.
2016 NINJA CPA Review, LLC. All Rights Reserved.
i

ETHICS IN TAX PRACTICE

A.

Treasury Department Circular 230

01
The Secretary of the Treasury has the power to prescribe rules and regulations regarding the conduct of tax
practitioners who represent taxpayers before the IRS. These rules are in Title 31 of the Code of Federal Regulations and
are commonly referred to as Circular 230.
Application: Which of the following statements is true about the IRS?
The IRS promulgates the rules governing CPAs as they practice before the IRS.
The IRS follows the rules set forth by the individual state boards of accountancy.
The IRS uses the rules provided by the AICPA when determining professional rules surrounding CPAs.
None of the answer choices are true statements.
A - The IRS determines what rules CPAs that practice in front of them will follow. While it is true that numerous other
regulatory agencies, including state boards of accountancy, provide insight and overview, when it comes to practicing in
front of the IRS, the IRS has the final word.
02
The Secretary of the Treasury also has the power to appoint a director of practice under Circular 230. The
directors duties include:
a.
b.
c.
d.

acting upon applications for enrollment to practice before the IRS,

instituting and conducting disciplinary hearings,
making inquiries as to matters under his jurisdiction, and
other duties that are necessary to carry out his functions.

03
Practice before the IRS is defined in Circular 230 as involving all matters connected with a presentation to the IRS,
or any of its officers or employees, relating to a taxpayers rights, privileges, or liabilities under laws or regulations
administered by the IRS. This includes:
a.
b.
c.
d.

preparing and filing documents,

corresponding and communicating with the IRS,
rendering written advice with respect to any entity, transaction, plan, or arrangement, and
representing a client at conferences, hearings, and meetings.

04
Certified public accountants (CPAs) and attorneys may practice before the IRS provided they are not under
suspension or disbarment from practice before the IRS. A CPA is any person duly qualified to practice as a CPA in any
state, possession, territory, commonwealth, or the District of Columbia. An attorney is a person who is a member in good
standing of the bar of the highest court of any state, possession, territory, commonwealth, or the District of Columbia.
CPAs and attorneys must file a written declaration that they are currently qualified as a CPA or attorney and that they are
authorized to represent the taxpayer in question.
05
Individuals may also practice before the IRS if they qualify as an enrolled agent. An application for enrollment must
be filed with the Director of Practice. The applicant must then demonstrate competence in tax matters by passing a written
examination.
06
An individual who is enrolled as an actuary by the Joint Board for the Enrollment of Actuaries may also practice
before the IRS. Practice by an enrolled actuary is limited by Circular 230 to issues concerning pension and employee
benefit plans.

07
An individual may also practice before the IRS as an enrolled retirement plan agent (practice is limited to certain
issues and programs involving retirement plans). Enrollment as a retirement plan agent is granted after the individual
passes a written examination that demonstrates special competence in qualified retirement plan matters.
08
Former IRS employees may be granted enrollment as an enrolled agent or enrolled retirement plan agent by virtue
of their past service and technical experience gained as an IRS employee.
09
Circular 230 allows individuals who are not CPAs, attorneys, or enrolled agents to engage in limited practice before
the IRS. As a result, an individual can represent themselves before the IRS provided they present satisfactory
identification.
10
An individual may also engage in limited practice before the IRS even if the taxpayer is not present, in the following
situations:
a.
b.
c.
d.
e.
f.
g.
h.

An individual may represent a member of their immediate family.

A regular, full-time employee of an individual employer may represent the employer.
A general partner or a regular full-time employee of a partnership may represent the partnership.
A bona fide officer or regular full-time employee of a corporation (including a parent, subsidiary, or other affiliated
corporation), association, or organized group may represent the corporation, association, or organized group.
A regular full-time employee of a trust, receivership, guardianship, or estate may represent the trust.
An officer or a regular employee of a government unit, agency, or authority may represent the governmental unit,
agency, or authority in the course of his or her official duties.
An individual may represent any individual or entity who is outside the United States, when the representation
takes place outside the United States.
An individual who signs the taxpayers return as the preparer (or who prepares a return but is not required to sign
the tax return) may represent the taxpayer before IRS employees of the examination division regarding the tax
liability of the taxpayer for the period covered by the return.

Application: Joe is the trustee of a trust set up for his father. Under the Internal Revenue Code, when Joe prepares the
annual trust tax return, IRS Form 1041, he:
must obtain the written permission of the beneficiary prior to signing as a tax return preparer.
is not considered a tax return preparer.
may not sign the return unless he receives additional compensation for the tax return.
is considered a tax return preparer because his father is the grantor of the trust.
B - An individual may represent a member of their immediate family before the IRS. Since Joe is the trustee of a trust
set up for his father, he is representing his father.
Circular 230 allows individuals who are not CPAs, attorneys, or enrolled agents to engage in limited practice before the
IRS.

11
Duties and Restrictions - A practitioner has a duty to promptly submit records or information to the IRS upon
proper request. Also, there is a duty not to interfere with any lawful effort of the IRS to obtain such records or information.
These duties exist unless the practitioner in good faith and on reasonable grounds believes the record or information is
privileged.
12
A practitioner has a duty to provide the director of practice with any requested information regarding violations of
any regulations dealing with practice before the IRS.
13
A practitioner who knows that a client has not complied with the revenue laws of the United States, or has made an
error in or omission from any return, document, affidavit, or other paper, has a duty to advise the client promptly of such
noncompliance, error, or omission.
Application: Vee Corp. retained Water, CPA, to prepare its 20X4 income tax return. During the engagement, Water
discovered that Vee had failed to file its 20X0 income tax return. What is Water's professional responsibility regarding
Vee's unfiled 20X0 income tax return?
Prepare Vee's 20X0 income tax return and submit it to the IRS.
Advise Vee that the 20X0 income tax return has not been filed and recommend that Vee ignore filing its 20X0 return
since the statute of limitations has passed.
Advise the IRS that Vee's 20X0 income tax return has not been filed.
Consider withdrawing from preparation of Vee's 20X4 income tax return until the error is corrected.
D - A submission of a client's tax return cannot ethically be done without the client's permission.
Advise Vee that the tax return has not been filed, but do not ignore filing it now.
Advising the IRS that the tax return has not been filed is an unethical act without the client's permission.
If Vee refuses to file the return (which is illegal), Water should consider withdrawing from the 20X4 tax preparation
assignment. Under SSTS 6, the CPA should recommend that the tax return be filed, but can only withdraw from the
assignment, not report the lack of reporting.
14

A practitioner must exercise due diligence in the following situations:

a.

In preparing or assisting in the preparation of, approving, and filing returns, documents, affidavits, and other papers
relating to IRS matters
In determining the correctness of oral or written representation made by the practitioner to the Department of the
Treasury
In determining the correctness of oral or written representations made by the practitioner to clients with reference to
any matter administered by the IRS

b.
c.

A practitioner will be presumed to have exercised due diligence if the practitioner relies on the work product of another
person.

15

A practitioner may not unreasonably delay prompt disposition of any matter before the IRS.

Application: When must a practitioner exercise due diligence?

In determining the correctness of oral or written representations in any matter administered by the IRS
In preparing, approving, and filing returns
In determining the correctness of oral or written representations by the practitioner to the Department of the Treasury
All of the answer choices are correct.
D - A practitioner must exercise due diligence in:

determining the correctness of oral or written representations in any matter administered by the IRS,

preparing, approving, and filing returns, and

determining the correctness of oral or written representations by the practitioner to the Department of the
Treasury.
16
A practitioner may not knowingly and directly or indirectly accept assistance from or assist any person who is under
disbarment or suspension from practice before the IRS. The practitioner must also not accept assistance from any former
government employee disqualified from practice under any rule or U.S. law.
17
A practitioner may not act as a notary public with respect to any matter administered by the IRS for which the
practitioner is employed as counsel, attorney, or agent, or in which the practitioner may in any way be interested.
18

A practitioner may not charge an unconscionable fee in connection with any matter before the IRS.

19
A practitioner generally may not charge a contingent fee for services rendered in connection with any matter before
the IRS. However, a practitioner may charge a contingent fee for services rendered in connection with the IRSs
examination of or challenge to:
a.
b.

an original return or
an amended return or claim for refund or credit where the amended return or claim for refund or credit was filed
within 120 days of the taxpayer receiving a written notice of the examination of or a written challenge to the original
return.

A practitioner may charge a contingent fee for services rendered in connection with a claim for credit or refund filed solely
in connection with the determination of statutory interest or penalties assessed by the IRS. A practitioner can charge a
contingent fee for services rendered in connection with any judicial proceeding arising under the Internal Revenue Code.
20
In general, a practitioner must, at the request of the client, promptly return any and all records of the client that are
necessary for the client to comply with his or her federal tax obligations. The practitioner may retain copies of the records
returned to a client.

Application: According to the ethical standards of the profession, which of the following acts is generally prohibited?
Issuing a modified report explaining a failure to follow a governmental regulatory agency's standards when conducting
an attest service for a client
Revealing confidential client information during a quality review of a professional practice by a team from the state CPA
society
Accepting a contingent fee for representing a client in an examination of the client's federal tax return by an IRS agent
Retaining client records after an engagement is terminated prior to completion and the client has demanded their return
D - Rule 501 prohibits the retention of client records after the client has demanded them, even if the engagement is
terminated prior to its completion. This would be considered an act discreditable to the profession.
21
Generally, a practitioner is not allowed to represent conflicting interests in his or her practice before the IRS.
However, the practitioner may represent conflicting interests provided each affected client waives the conflict of interest by
informed, written consent.
Application: According to the standards of the profession, which of the following events would require a CPA
performing a consulting services engagement for a non-audit client to withdraw from the engagement?
I.

The CPA has a conflict of interest that is disclosed to the client and the client consents to the CPA continuing the
engagement.

II.

The CPA fails to obtain a written understanding from the client concerning the scope of the engagement.

I only
II only
Both I and II
Neither I nor II
D - The fact that the CPA has a conflict of interest will not prevent the CPA from performing a consulting service for a
non-audit client, provided the CPA is able to carry out the task while maintaining objectivity and integrity. Since the CPA
in this case has disclosed this potential conflict of interest to the client and the client has given consent, continuation of
the service is permitted. While there should be some understanding with the client regarding the nature of the
engagement, this understanding does not have to be reduced to writing. Note: Adding non to audit completely
changes the meaning of the question. Watch out for negative questions (and even double negatives) on the CPA
Examination.
22
Practitioners are subject to various duties and restrictions regarding advertising and solicitation. For example, a
practitioner may not use any form of public communication that contains any statement or claim that is false, fraudulent,
unduly influencing, coercive, unfair, misleading, or deceptive. Also, a practitioner may not make any uninvited written or
oral solicitation of employment in matters before the IRS if the solicitation violates federal or state law or other applicable
rule.

Application: Which of the following statements best describes the ethical standard of the profession pertaining to
advertising and solicitation?
All forms of advertising and solicitation are prohibited.
There are no prohibitions regarding the manner in which CPAs may solicit new business.
A CPA may advertise in any manner that is not false, misleading, or deceptive.
A CPA may only solicit new clients through mass mailings.
C - A quick review of the answers shows key characteristics of questions that often are wrong, all,no prohibitions,
and may only. Whenever you see these types of answers, be very careful.
Under AICPA Ethics Rule ET 502.01: Advertising and other forms of solicitation. A member in public practice shall not
seek to obtain clients by advertising or other forms of solicitation in a manner that is false, misleading, or deceptive.
Solicitation by the use of coercion, over-reaching, or harassing conduct is prohibited.
23
A practitioner who prepares tax returns may not endorse or otherwise negotiate any check issued to a client by the
government in respect of a federal tax liability.
Application: Clark, a professional tax return preparer, prepared and signed a client's 20X1 federal income tax return
that resulted in a $600 refund. Which of the following statements is correct with regard to an Internal Revenue Code
penalty Clark may be subject to for indorsing and cashing the client's refund check?
Clark will be subject to the penalty if Clark indorses and cashes the check.
Clark may indorse and cash the check, without penalty, if Clark is enrolled to practice before the Internal Revenue
Service.
Clark may not indorse and cash the check, without penalty, because the check is for more than $500.
Clark may indorse and cash the check, without penalty, if the amount does not exceed Clark's fee for preparation of the
return.
A - Clark is not permitted to indorse and cash (i.e., convert) a client's federal income tax refund check regardless of the
check's amount, Clark's status as an enrolled agent, or the preparation fee owed to Clark.
24
A practitioner may not advise a client to take a position on a document, affidavit, or other paper submitted to the
IRS unless the position is not frivolous.
25

A practitioner may not advise a client to submit a document, affidavit, or other paper to the IRS:

a.
b.
c.

the purpose of which is to delay or impede the administration of the federal tax law,
that is frivolous, or
that contains or omits information in a manner that demonstrates an intentional disregard of a rule or regulation,
unless the practitioner also advises the client to submit a document that evidences a good faith challenge to the
rule or regulation.

26
A practitioner must inform a client of any penalties that are reasonably likely to apply to the client with respect to a
position taken on a tax return if the practitioner advised the client with respect to the position or the practitioner prepared
or signed the return. Also, a practitioner must inform the client of any penalties reasonably likely to apply regarding any
document, affidavit, or other paper submitted to the IRS. A practitioner must inform the client of the opportunity to avoid
any penalties by disclosure, if relevant, and of the requirements for adequate disclosure.

Application: A tax preparer has advised a company to take a position on its tax return. The tax preparer believes that
there is a 75% possibility that the position will be sustained if audited by the IRS. If the position is not sustained, an
accuracy-related penalty and a late-payment penalty would apply. What is the tax preparer's responsibility regarding
disclosure of the penalty to the company?
The tax preparer is responsible for disclosing both penalties to the company
The tax preparer is responsible for disclosing only the accuracy-related penalty to the company.
The tax preparer is responsible for disclosing only the late-payment penalty to the company.
The tax preparer has no responsibility for disclosing any potential penalties to the company, because the position will
probably be sustained on audit.
A - A practitioner must inform a client of any and all penalties that are likely to apply to the client with respect to a
position taken on a tax return.
27
A practitioner can generally rely on information furnished by a client without verification. However, a practitioner
cannot ignore information which is actually known and must make reasonable inquiries if the information furnished by the
client appears incorrect, inconsistent, or incomplete.
Application: According to the profession's ethical standards, a CPA preparing a client's tax return may rely on
unsupported information furnished by the client, without examining underlying information, unless the information:
is derived from a pass-through entity.
appears to be incomplete on its face.
concerns dividends received.
lists charitable contributions.
B - According to Statement on Standards for Tax Services 3, Certain Procedural Aspects of Preparing Returns,In
preparing or signing a return, a member may in good faith rely, without verification, on information furnished by the
taxpayer.... This rule would not be applicable if the information provided appears to be incorrect, incomplete, or
inconsistent on its face or on the basis of other facts known to the CPA.
Circular 230 10.34(d) states that a preparer may rely in good faith without verification upon information furnished by the
client. The practitioner may not, however, ignore the implications of information furnished to, or actually known by, the
practitioner, and must make reasonable inquiries if the information as furnished appears to be incorrect, inconsistent
with an important fact or another factual assumption, or incomplete.
28
A practitioner must not give written advice (including electronic communication) concerning federal tax issues if the
practitioner:
a.
b.
c.
d.

bases the written advice on unreasonable factual or legal assumptions,

unreasonably relies upon representations, statements, findings, or agreements of the taxpayer or any other person,
does not consider all the relevant facts the practitioner knows or should know, or
in evaluating a federal tax issue, takes into account the possibility that a tax return will not be audited, that an issue
will not be raised on audit, or that an issue will be resolved through settlement if raised.

Application: Under Treasury Circular 230, which of the following actions of a CPA tax advisor is characteristic of a best
practice in rendering tax advice?
Requesting written evidence from a client that the fee proposal for tax advice has been approved by the board of
directors
Recommending to the client that the advisor's tax advice be made orally instead of in a written memorandum
Establishing relevant facts, evaluating the reasonableness of assumptions and representations, and arriving at a
conclusion supported by the law and facts in a tax memorandum
Requiring the client to supply a written representation, signed under penalties of perjury, concerning the facts and
statements provided to the CPA for preparing a tax memorandum
C - Generally, a CPA can rely on information furnished by a client in the preparation of a tax memorandum. If the
information seems to be incorrect, inconsistent, or incomplete, the CPA must make reasonable inquiries. When the facts
are established, then relevant tax law must be applied accurately to the known facts.

B.

AICPA Statements on Standards for Tax Services

01

The AICPA has issued a series of ethical tax practice standards called Statements on Standards for Tax Services.

Application: Which of the following statements best explains why the CPA profession has found it essential to
promulgate ethical standards and to establish means for ensuring their observance?
A distinguishing mark of a profession is its acceptance of responsibility to the public.
A requirement for a profession is to establish ethical standards that stress primary responsibility to clients and
colleagues.
Ethical standards that emphasize excellence in performance over material rewards establish a reputation for
competence and character.
Vigorous enforcement of an established code of ethics is the best way to prevent unscrupulous acts.
A - The AICPA Code of Professional Conduct stipulates that a distinguishing mark of a profession is acceptance of its
responsibility to the public. The notion of responsibility to the public underlies almost all of the ethical standards
established by the AICPA. However, it is not a requirement for a profession to establish such a code.
Moreover, it is ethical conduct, not the mere existence of a standard, that emphasizes excellence in performance over
material rewards that establishes a reputation for competence and character.
02

Tax Return Positions

a.

A CPA should determine and comply with the standards, if any, that are imposed by the applicable taxing authority
with respect to recommending a tax return position, or preparing or signing a tax return.

b.

If the applicable taxing authority has no written standards with respect to recommending a tax return position or
preparing or signing a tax return, or if the standards are lower than the standards set forth in this provision, the
following standards will apply:
(1)

A CPA should not recommend to a client that a position be taken with respect to the tax treatment of any
item on a return unless the CPA has a good faith belief that the position has a realistic possibility of being
sustained administratively or judicially on its merits if challenged.

10

c.

(2)

A CPA may recommend a tax return position if the CPA:

(a)
concludes that there is a reasonable basis for the position and
(b)
advises the taxpayer to appropriately disclose that position.

(3)

A CPA may prepare or sign a tax return that reflects a position if:
(a)
the CPA concludes there is a reasonable basis for the position and
(b)
the position is appropriately disclosed.

(4)

In recommending certain tax return positions and in signing a return on which a tax return position is taken,
a CPA should, when relevant, advise the client as to the potential penalty consequences and the opportunity,
if any, to avoid such penalty through disclosure.

(5)

When recommending a tax return position, a CPA has both the right and responsibility to be an advocate for
the taxpayer with respect to any position satisfying the aforementioned standards.

The CPA should not recommend a tax return position that does either of the following:
(1)
Exploits the audit selection process of a taxing authority
(2)
Serves as a mere arguing position advanced solely to obtain leverage in the bargaining process of
settlement negotiation with a taxing authority

Application: A CPA assists a taxpayer in tax planning regarding a transaction that meets the definition of a tax shelter
as defined in the Internal Revenue Code. Under the AICPA Statements on Standards for Tax Services (SSTS), the CPA
should inform the taxpayer of the penalty risks unless the transaction, at the minimum, meets which of the following
standards for being sustained if challenged?
More likely than not
Not frivolous
Realistic possibility
Substantial authority
A - More likely than not is now the standard for judging the chances of a position being accepted by the IRS and the
courts. More likely than not can also be stated as better than one chance out of two.
03
Questions on Returns - A CPA should make a reasonable effort to obtain from the client, and provide appropriate
answers to, all questions on a tax return before signing as preparer.
04

Procedural Aspects of Preparing Returns

a.

In preparing or signing a return, the CPA may in good faith rely without verification upon information furnished by
the client or by third parties. The CPA should not, however, ignore the implications of information furnished and
should make reasonable inquiries if the information appears to be incorrect, incomplete, or inconsistent either on its
face or on the basis of other known facts. A CPA should refer to the taxpayers returns for one or more prior years
where feasible.
Where the tax law or regulations impose a condition to deductibility or other tax treatment of an item, the CPA
should make appropriate inquiries to determine to his satisfaction whether such condition has been met.
The individual CPA who is required to sign the return should consider information actually known to that CPA from
the tax return of another client when preparing a tax return if the information is relevant to that tax return, its
consideration is necessary to properly prepare that tax return, and use of such information does not violate any law
or rule relating to confidentiality.

b.
c.

11

Application: According to the standards of the profession, which of the following sources of information should a CPA
consider before signing a client's tax return?
I.
Information actually known to the CPA from the tax return of another client
II.
Information provided by the client that appears to be correct based on the client's returns from prior years
I only
II only
Both I and II
Neither I nor II
C - Before signing a client's tax return, a CPA may rely in good faith without verification upon information provided by
the client. However, the CPA should not ignore the implications of other information which has come to his or her
attention. This would include information known to the CPA from the tax return of another client. The consideration of
this information does not violate any rules regarding confidentiality.
05
Use of Estimates - Unless prohibited by statute or by rule, a CPA may prepare tax returns involving the use of the
taxpayers estimates if it is impracticable to obtain exact data and the estimated amounts are reasonable under the facts
and circumstances known to the CPA. If the taxpayers estimates are used, they should be presented in a manner that
does not imply greater accuracy than exists.
06

Form and Content of Advice to Taxpayers

a.

In providing tax advice to a taxpayer, the CPA should use judgment to ensure that the advice given reflects the
professional competence and appropriately serves the taxpayers needs. A CPA should comply with relevant taxing
authorities standards, if any, applicable to written tax advice. Professional judgment should be used regarding the
need to document oral advice. The CPA is not required to follow a standard format or guidelines in communicating
written or oral advice to a taxpayer.
In advising or consulting with a taxpayer on tax matters, the CPA should assume that the advice will affect the
manner in which the matters or transactions considered ultimately will be reported on the taxpayers tax returns. A
CPA should consider, when relevant, return reporting and disclosure standards applicable to the related tax return
position and the potential penalty consequences of the return position. Thus, for all tax advice the CPA gives to a
taxpayer, the CPA should follow the standards in Statement on Standards for Tax Services 1, Tax Return Positions.
The CPA may choose to communicate with a taxpayer when subsequent developments affect advice previously
provided with respect to significant matters. The CPA cannot, however, be expected to have assumed responsibility
for initiating such communication except while assisting a taxpayer in implementing procedures or plans associated
with the advice provided or when the CPA undertakes this obligation by specific agreement with the taxpayer.

b.

c.

Application: According to the AICPA Statements on Standards for Tax Services, which of the following factors should a
CPA consider in choosing whether to provide oral or written advice to a client?
Whether the client will seek a second opinion
The tax sophistication of the client
The likelihood that current tax litigation will impact the advice
The client's business acumen
B - The advice given should serve the taxpayer's needs adequately. Oral advice should be documented if the taxpayer
seems to not truly understand the consequences of the tax implication. The CPA is not required to follow a standard on
documenting oral or written communications.

12

C.

Internal Revenue Code of 1986

01
Tax Preparer Liability - A compensated tax return preparer can be liable for civil and criminal penalties for
negligently or intentionally understating a taxpayers liability.
02
A compensated preparer can be liable for a $1,000 or 50% penalty of income derived (first-tier penalty) for each tax
return or claim for refund that understates the taxpayer's liability. There is a second-tier penalty of $5,000 or 50% penalty
of income derived if the preparer willfully or recklessly understated the liability. This penalty applies if the preparer did the
following:
a.
b.
c.

Understated tax liability by taking a position that does not have a realistic possibility of being sustained
Knew or should have known of this position
Did not disclose the position in the return or an attachment to the return

Application: Kopel was engaged to prepare Raff's 20X0 federal income tax return. During the tax preparation interview,
Raff told Kopel that he paid $3,000 in property taxes in 20X0. Actually, Raff's property taxes amounted to only $600.
Based on Raff's word, Kopel deducted the $3,000 on Raff's tax liability. Kopel had no reason to believe that the
information was incorrect. Kopel did not request underlying documentation and was reasonably satisfied by Raff's
representation that Raff had adequate records to support the deduction. Which of the following statements is correct?
To avoid the preparer penalty for willful understatement of tax liability, Kopel was obligated to examine the underlying
documentation for the deduction.
To avoid the preparer penalty for willful understatement of tax liability, Kopel would be required to obtain Raff's
representation in writing.
Kopel is not subject to the preparer penalty for willful understatement of tax liability because the deduction that was
claimed was more than 25% of the actual amount that should have been deducted.
Kopel is not subject to the preparer penalty for willful understatement of tax liability because Kopel was justified in
relying on Raff's representation.
D - In tax practice, the CPA is justified in relying in good faith upon the client's representations. The CPA who acts in
good faith is not required to obtain verification of representations made by the client.
03

The following are some of the compensated tax return preparers requirements under the Internal Revenue Code:

a.
b.
c.

Sign, give address and IRS identification number of self or employer.

Furnish the taxpayer a copy of the prepared return no later than the time the original return is presented for signing.
Maintain a file of returns and log of all returns prepared for three years following the close of the return period. The
penalty assessed for failure to comply with the requirements of sections a.b. is $50 per occurrence. The penalty
will not apply if the failure is due to reasonable cause and not to willful neglect.
Do not cash another persons tax refund check. A penalty of $500 is assessable against a preparer who violates
this provision.

d.

13

Application: Louis, the volunteer treasurer of a nonprofit organization and a member of its board of directors, compiles
the data and fills out its annual Form 990, Return of Organization Exempt From Income Tax. Under the Internal
Revenue Code, Louis is not considered a tax return preparer because:
he is a member of the board of directors.
the return does not contain a claim for a tax refund.
he is not compensated.
returns for nonprofit organizations are exempt from the preparer rules.
C - Compensated tax return preparers can be liable for such things as tax evasion, perjury on a tax return, or bribery of
an IRS employee. Since Louis is not a paid tax return preparer, he is not considered a tax return preparer and therefore
cannot sign the tax return.
04

Criminal penalties can be imposed for the following:

a.
b.
c.

Tax evasion
Perjury on a tax return
Bribery of an IRS employee

14

II

LICENSING & DISCIPLINARY SYSTEMS

15

A.

Liability

01
As an expert, the CPA must exercise due carethe ordinary skill and competence of members of his profession
and a failure to do so will subject the CPA to liability for negligence.
Application: According to the standards of the profession, which of the following activities may be required in
exercising due care?
Consulting with experts
Obtaining specialty accreditation
Both consulting with experts and obtaining specialty accreditation
Neither consulting with experts nor obtaining specialty accreditation
A - The standards of the profession provide that an accountant may be required to consult with an expert in order to
carry out the job in a competent fashion. The obtaining of specialty accreditation is generally not required.
02
The CPA is held only to the standards of reasonable care and competence and is not charged with the duty to be
infallible.
03
The CPA has a confidential fiduciary relationship with each client. This relationship involves varying obligations,
which range from the general requirement of dealing fairly and honestly with the client to the more specific requirements
of voluntarily disclosing any potential conflict of interest.
04
The CPA is responsible not only to clients, but to investors, creditors, and other third parties who may rely upon the
financial statements audited by the CPA. The multiple responsibility demands a standard of care that goes beyond the
parochial wishes of the client.
Application: Which of the following statements is generally correct regarding the liability of a CPA who negligently
gives an opinion on an audit of a client's financial statements?
The CPA is only liable to those third parties who are in privity of contract with the CPA.
The CPA is only liable to the client.
The CPA is liable to anyone in a class of third parties who the CPA knows will rely on the opinion.
The CPA is liable to all possible foreseeable users of the CPA's opinion.
C - A CPA has duties towards his client due to their privity of contract, and since no such privity exists between the CPA
and third persons there is no duty of care owing to them, with one major exception. When the CPA has reason to
believe his accounting services will be made available to third persons, then a legal duty of care is imposed on the CPA.
When the services are primarily for the benefit of a third party, the third party is in effect a party to the contract between
the CPA and the client (i.e., a third-party beneficiary).

16

B.

Role of State Boards of Accountancy

01
The professional ethics division of the AICPA interprets the Code of Professional Conduct, investigates potential
disciplinary matters involving members, and presents cases before the AICPA joint trial board (this board judges
disciplinary charges against state CPA society and AICPA members).
02
The AICPA professional ethics divisions activities are performed within the joint ethics enforcement program
(JEEP), in which 48 state CPA societies participate. Generally, the codes of conduct of these societies conform to the
AICPA Code.
Application: During the investigative process of any license discrepancies, state boards initially work to ensure that:
a full investigation is performed to determine if the matter should be pursued.
the state's legal community is put on notice of the action.
new regulations are written that address the issue.
records are protected from becoming public information.
A - The state boards will perform a full investigation to determine if the matter should be pursued. This will include not
only subpoenaing witnesses and collecting documents, but state boards will also take whatever administrative or
judicial action they deem necessary.
03
The Institute and state societies act as agents of each other in ethics investigations. They present cases before the
joint trial board according to the bylaws of each organization. For example, if the AICPA conducts an ethics investigation
of a member, it does so on its own behalf and also on behalf of the state society of which the individual is a member. The
same idea applies in reverse if a state society is conducting the investigation.
04
Bylaws provide for the jurisdiction of the joint trial board over the membership of both the AICPA and the state
societies.
05
The AICPA professional ethics division is authorized to start an investigation based on information from various
sources. This information of a potential disciplinary matter can come from such sources as written complaints, reports in
the media, or referrals from government agencies.
06

The AICPA professional ethics division works through several committees:

a.
b.
c.

The professional ethics executive committee

The technical standards subcommittee (an investigative body)
The government technical standards subcommittee (which investigates engagements in which the clients are state
or local government entities or receive federal financial assistance)
The independence-behavioral standards subcommittee (which investigates and interprets the Codes rules on
independence, confidentiality of client information, and other behavioral concerns)

d.

07
The AICPA professional ethics division has the authority to settle cases brought before it. This enables the division
to conclude investigations without the delay or expense of formal hearings.
08
CPE requirements: State boards of accountancy are generally in charge of maintaining records of continuing
education of all CPAs licensed in that state. The CPA must attest to the state board that the continuing education
requirements have been completed. Most jurisdictions run random audits of the CPA records to determine if the reporting
of continuing education was both accurate and timely.

17

Application: State boards of accountancy are generally in charge of maintaining records of all members and following
up on continuing professional education (CPE) requirements presented by licensed members. Although state board
requirements differ, licensees must normally:
get pre-approval from the jurisdiction as to CPE courses.
attend only board CPE sessions.
wait for the accrediting body to provide the courses necessary for recertification.
attest that they have met their jurisdiction's CPE requirements.
D - State boards typically require that the licensees attest to their jurisdiction that they have completed the requirements
for continuing education. Most jurisdictions will run random audits to determine that reporting was both accurate and
timely.
09
Requirements for a CPA license: Most states have specific requirements for the college credit hours that must be
completed in auditing and accounting courses by a candidate for a CPA license. Candidates with deficiencies must
complete college credit courses to fulfill the requirements for a CPA license.
10
Reciprocity is a recognition of licenses between states. Therefore, before a certified public accountant moves to
another state, he/she must look into the reciprocity rules in the new state. The ability to transfer licensing credentials from
one state to another is controlled by state boards and reciprocity is not guaranteed.
Application: The ability to transfer licensing credential from one state to another is controlled by state boards and
reciprocity is not guaranteed. Individuals seeking a particular state's licensing credential must present:
a form attesting to the fact that the candidate is licensed elsewhere.
authorization for release of score information.
letters of recommendation from the prior jurisdiction.
a letter of intent to transfer between states.
B - The correct answer is to present an authorization for release of score information. This rule is not hard and fast, as it
is essential to check each state's rules and regulations. Since the CPA Examination is uniform in all jurisdictions, the
scoring is uniform and will be accepted in all locations. The major differences are in experience required to receive a
license. However, most states do provide a procedure for this process.
11
The NASBA (National Association of State Boards of Accountancy) is the regulating department for the state
boards. The NASBA Tools for Accounting Compliance give the candidate much information to inform him/her of the
requirements for multiple jurisdictions.

18

Application: The National Association of State Boards of Accountancy (NASBA) is in place to establish standards for
providers of continuing professional education (CPE) units throughout the country. The organization also works to:
establish uniform rules of accountancy for all 54 U.S. Boards.
require CPE program sponsors to provide program-level content.
provide background checks on candidates.
promulgate rules surrounding continuing education.
B - State boards dictate the rules and expectations of licensure within their individual jurisdictions, so the NASBA is
tasked with monitoring CPE programs for accuracy and content. Keep in mind that not every jurisdiction has the same
education requirements, so it is essential to check with each locale in order to determine what is necessary and what is
not.
12
In the United States, licensing of certified public accountants is the responsibility of state boards of accountancy.
There are 54 jurisdictions that license CPAs, including the 50 states, the District of Columbia (Washington, D.C.), Puerto
Rico, Guam, and the U.S. Virgin Islands. Each board of accountancy operates under the AICPA and National Association
of State Boards of Accountancy (NASBA) Uniform Accountancy Act (UAA), which establishes the board and sets the
requirements for licensing for certified public accountants. The state laws are generally modeled on the UAA.
13
To qualify for a CPA license in any of the 54 jurisdictions, a candidate must successfully complete the Uniform CPA
Examination. Every state uses the examination prepared by the AICPA. The scores are sent to the state where the
candidate has registered, but the scores can then be transferred from the test state to any other state.
14
State boards of accountancy all use scores from the Uniform CPA Examination to qualify candidates for certification
and licenses to practice. Each state board establishes its own rules on residency, citizenship, education, and experience,
and some require the completion of an ethics examination to qualify for a CPA license. After licensing, state boards have
established requirements for continuing professional education (CPE). State boards establish the rules to qualify for a
license and also the rules for revoking a license.
Application: Which of the following bodies ordinarily would have the authority to suspend or revoke a CPA's license to
practice public accounting?
The SEC
The AICPA
A state CPA society
A state board of accountancy
D - There are 54 jurisdictions that administer the licensing of Certified Public Accountants. These include the 50 states,
Washington, D.C., Guam, Puerto Rico, and the U.S. Virgin Islands. In each state or other jurisdiction a board of
accountancy has been established by statute. All boards utilize the scores from the Uniform CPA Examination and
evaluate the qualifications of those who take the exam. The boards issue certificates and licenses to practice to those
that pass. On the disciplinary side, the boards investigate complaints, hold hearings, and, where necessary, suspend or
revoke licenses to practice public accounting.

19

C.

Regulatory Agencies

01

PCAOB

a.

The Sarbanes-Oxley Act establishes the Public Company Accounting Oversight Board (PCAOB), which is
appointed and overseen by the Securities and Exchange Commission.

b.

The Board is composed of five members appointed for 5-year terms. Two of the members must be or must have
been CPAs. The remaining three members must not be and cannot have been CPAs. The chair may be held by
one of the CPAs provided he or she has not been engaged as a practicing CPA for five years.

c.

No member of the Board may currently share in any of the profits of, or receive payments from, a public
accounting firm, other than fixed continuing payments such as retirement payments.

d.

The duties of the Board include:

(1)
Registering public accounting firms
(2)
Establishing or adopting auditing, quality control, ethics, independence, and other standards relative to the
preparation of audit reports for issuers
(3)
Conducting inspections of accounting firms
(4)
Conducting investigations and disciplinary proceedings
(5)
Imposing appropriate sanctions.

e.

The Board is required to issue standards or adopt standards issued by other groups or organizations. The Board
has the authority to amend, modify, repeal, and reject any standards suggested by any other group. On an annual
basis the Board must report on its standard setting activity to the SEC.

f.

The Board will conduct annual quality reviews of firms that audit more than 100 issuers. All other firms that are
registered with the Board will be reviewed every three years. The SEC and/or Board may order a special inspection
of any firm at any time.

g.

Foreign accounting firms that prepare or furnish an audit report involving U.S. registrants are subject to the
authority of the Board. This includes a foreign firm that performs some audit work (i.e. auditing a foreign subsidiary
of a US company). Also, if a U.S. accounting firm relies on the opinion of a foreign accounting firm, the audit
workpapers of the foreign firm must be supplied upon request to the Board or the SEC.

h.

A violation of the rules of the Board is treated as a violation of the Securities Exchange Act of 1934 and gives rise
to the same penalties that may be imposed for violations of that Act.

Application: How many audits of public companies per year does a CPA firm that is registered with the Public
Company Accounting Oversight Board (PCAOB) have to perform before it receives an annual inspection from the
PCAOB?
1 audit
More than 10 audits
More than 50 audits
More than 100 audits
D - The PCAOB is required to make an annual inspection of any CPA firm that audits more than 100 companies. All
other firms are to be reviewed every three years.

20

02

SOX Requirements for CPA Firms

a.

CPA firms that participate in the preparation or issuance of any audit report with respect to a public company are
required to register with the Public Company Accounting Oversight Board.

b.

Registered accounting firms must prepare and maintain for a period of not less than seven years, audit work
papers, and other information related to any audit report, in sufficient detail to support the conclusions reached in
the report.

c.

The Sarbanes-Oxley Act requires a second partner review and approval of all audit reports and their issuance.

d.

The lead audit partner and audit review partner must rotate off of the audit every five years on public company
engagements.

e.

A registered accounting firm is prohibited from auditing any SEC registered client if the CEO, Controller, CFO, Chief
Accounting Officer, or person in an equivalent position has been employed by the auditor during the 1-year period
prior to the audit.

f.

The accounting firm is required to report to the clients audit committee:

(1)
All critical accounting policies and practices to be used
(2)
All alternative treatments of financial information within GAAP that have been discussed with management
(3)
The ramifications of the use of such alternative disclosures and treatments
(4)
The treatment preferred by the firm

g.

The Act makes it unlawful for a registered public accounting firm to provide certain non-audit services to an issuer
contemporaneously with the audit. These prohibited services include:
(1)
Bookkeeping and related services
(2)
Design and implementation of financial information systems
(3)
Appraisal or valuation services, fairness opinions, or contribution-in-kind reports
(4)
Actuarial services
(5)
Internal auditor outsourcing services
(6)
Management or human resource services
(7)
Broker, dealer, investment adviser, or investment banking services
(8)
Legal or expert services unrelated to the audit
(9)
Any other services that the Board determines by regulation are impermissible

h.

Firms may provide other services not listed above (i.e. tax services) provided the firm receives pre-approval by the
audit committee. Pre-approval is not required provided:
(1)
The aggregate amount of non-audit services provided to the issuer constitutes less than 5% of the total
amount of revenues paid by the issuer to its auditor,
(2)
Such services were not recognized by the issuer at the time of the engagement to be non-audit services,
(3)
Such services were promptly brought to the attention of the audit committee and approved prior to the
completion of the audit.

21

Application: You are a new audit member of a medium sized CPA firm which has as a client a public company covered
under the Sarbanes-Oxley Act (SOX). The audit firm has had the publicly traded SOX client for seven years. You are
concerned since your firm has audited the client for that many years. Your concerns are:
unfounded since most of the team has new members.
unfounded since the review partner had rotated off after four years.
founded since seven years have gone by and an audit firm may only audit the same public firm five years.
unfounded since the lead audit partner and reviewing partner rotated off the audit two years ago.
D - While it is true SOX has restricted or modified many attributes of audit behavior, it does not require a public
company to rotate to a new audit firm every five years at this time. It does require the lead audit partner and the
reviewing partner to rotate off of the audit at least every five years. Here, the lead audit partner and reviewing partner
have rotated off before the five-year requirement.
03

SOX Requirements for Corporations, Officers, and Board Members

a.

Publicly traded companies subject to the Sarbanes-Oxley Act are those defined as an issuer under Section 3 of
the Securities Exchange Act of 1934.

b.

The Act requires the CEO and CFO of each issuer to certify the appropriateness of the financial statements and
disclosures contained in the periodic report and that the financial statements and disclosures fairly present, in all
material respects, the operations and financial condition of the issuer. Knowing and willful violations are subject to a
fine of not more than $5 million and/or imprisonment of up to 20 years.

c.

The Act provides that it is unlawful for any officer or director of an issuer to take any action to fraudulently influence,
coerce, manipulate, or mislead any auditor engaged in the performance of an audit for the purpose of rendering
financial statements materially misleading.

d.

Under the Act, if an issuer is required to prepare a restatement due to material noncompliance with financial
reporting requirements, the chief financial officer must reimburse the issuer for:
(1)
Any bonus or other incentive-based or equity-based compensation received during the 12-month period
following the issuance or filing of the noncompliant document.
(2)
Any profits realized from the sale of securities of the user during that period.

e.

The Act prohibits the purchase or sale of stock by officers and directors and other insiders during pension fund
black-out periods.

f.

The SEC is given the authority under the Act to:

(1)
Prohibit an individual from serving as an officer or director if it finds that their conduct violates securities laws
and demonstrates unfitness to serve as an officer or director.
(2)
Freeze the payment of an extraordinary payment to any director, officer, partner, controlling person, agent,
or employee of a company during an investigation of possible violations of securities laws.

g.

The Act provides the following requirements regarding audit committees:

(1)
Each member of the audit committee shall be a member of the board of directors of the issuer, and shall
otherwise be independent. The SEC may make exceptions for certain individuals on a case-by-case basis.
(2)
Independent is defined as not receiving, other than for service on the board, any consulting, advisory, or
other compensatory fee from the issuer, and as not being an affiliated person of the issuer, or any subsidiary
thereof.

22

(3)
(4)
(5)

The audit committee shall be directly responsible for the appointment, compensation, and oversight of the
work of any registered public accounting firm employed by that issuer.
The audit committee shall establish procedures for receipt, retention, and treatment of complaints that are
received by the issuer regarding accounting, internal controls, and auditing.
The audit committee shall have authority to hire independent counsel or other advisors to carry out its
duties.

Application: According to the profession's ethical standards, a CPA would be considered independent in which of the
following instances?
A client leases part of an office building from the CPA, resulting in a material indirect financial interest to the CPA.
The CPA has a material direct financial interest in a client, but transfers the interest into a blind trust.
The CPA owns an office building and the mortgage on the building is guaranteed by a client.
The CPA belongs to a client country club in which membership requires the acquisition of a pro rata share of equity.
D - ET Section 191.034 indicates that if membership in a client social club, such as a country club, is basically only for
social purposes and the CPA does not serve on the board of directors, then independence would not be violated.
The other answer alternatives, according to ET Section 191, are impairments of independence:

A client leases part of an office building from the CPA, resulting in a material indirect financial interest to the CPA.

The CPA has a material direct financial interest in a client, but transfers the interest into a blind trust.
The CPA owns an office building and the mortgage on the building is guaranteed by a client.

23

III

LEGAL DUTIES & RESPONSIBILITIES

24

A.

Liability to Clients Under Common Law

01

The CPA may be held liable to clients in an audit, taxation, or consulting services engagement for the following:

a.
b.
c.
d.

Fraud
Gross negligence or constructive fraud
Negligence (ordinary or simple)
Breach of contract

Application: A CPA, while employed as an employee in a securities company, prepares misleading financial records for
the company at his superior's directive. He knows what the correct entry should be, yet does not make the correct entry,
although the actual making of such an entry is under his control. The CPA has chosen to look the other way due to his
superior's orders. Which of the choices listed is the best answer concerning the CPA's responsibilities?
The CPA has no responsibility since he prepared the materials under the orders of his superior. The superior has the
responsibility.
The CPA has responsibility only if he has not documented his objection.
The CPA is a bad person and should be fired since he made incorrect entries.
The CPA is responsible for the accuracy of the financial records prepared by himself.
D - The CPA certainly could document his objections in writing, but he is still ethically bound to prepare correct financial
records.
02

Fraud is an intentional misrepresentation of a material fact with resultant harm to some party.

Application: While conducting an audit, Larson Associates, CPAs, failed to detect material misstatements included in
its client's financial statements. Larson's unqualified opinion was included with the financial statements in a registration
statement and prospectus for a public offering of securities made by the client. Larson knew that its opinion and the
financial statements would be used for this purpose. In a suit by a purchaser against Larson for common law fraud,
Larson's best defense would be that:
Larson did not have actual or constructive knowledge of the misstatements.
Larson's client knew or should have known of the misstatements.
Larson did not have actual knowledge that the purchaser was an intended beneficiary of the audit.
Larson was not in privity of contract with its client.
A - The essence of fraud is the intentional misrepresentation of a material fact with resultant harm to another party.
To prove common law fraud a purchaser has to prove scienter, that is, that Larson had knowledge of the misstatements.
Thus, Larson's best defense is that it did not intentionally mislead the purchaser.
That Larson's client knew or should have known of the misstatements, that Larson did not have actual knowledge that
the purchaser was an intended beneficiary, or that Larson was not in privity of contract with its client, are not valid
defenses against a charge of fraud.

25

03
Gross Negligence (constructive fraud) is extreme, flagrant, or reckless departure from the standards of due care
and competence in performing or reporting upon professional engagements.
a.
b.

There need not be actual intent to deceive (scienter).

Fraud may be inferred from sloppy performance (e.g., CPA omits a vital procedure such as a bank reconciliation in
order to save time).

Application: Which of the following statements is (are) correct regarding the common law elements that must be
proven to support a finding of constructive fraud against a CPA?
I.
The plaintiff has justifiably relied on the CPA's misrepresentation.
II.
The CPA has acted in a grossly negligent manner.
I only
II only
Both I and II
Neither I nor II
C - Actual fraud requires the professional to intentionally misstate a material fact or otherwise mislead the client. While
common law fraud requires an intent to deceive, constructive fraud does not require the CPA (or any professional) to act
with fraudulent intent. In general, the injured party need only allege that the injured party had a relationship of trust and
confidence with the professional and that the injured party was hurt by that relationship.
Constructive fraud results when a professional is grossly negligent in performance of their duties. A very common
corollary of gross negligence includes the professional intentionally disregarding the consequences of a failure to
perform their professional duties. As the fact situation specifically calls for a finding of constructive fraud, both elements
of I and II apply.
04
Negligence (ordinary or simple) is the failure to do what an ordinary, reasonable, prudent CPA would do in similar
circumstances.
a.

b.

To establish negligence, the plaintiff (client) must establish the following:

(1)
The defendant (CPA) owed a legal duty.
(2)
The CPA breached that duty.
(3)
The CPAs action was the proximate cause of the resulting injury to the client.
(4)
The CPAs actions caused damage (loss).
CPAs are not liable for an honest error in judgment as long as they act with reasonable care.

Application: When performing an audit, a CPA will most likely be considered negligent when the CPA fails to:
detect all of a client's fraudulent activities.
include a negligence disclaimer in the client engagement letter.
warn a client of known internal control weaknesses.
warn a client's customers of embezzlement by the client's employees.
C - A CPA will be guilty of simple negligence if he or she fails to warn a client of known internal control problems. This is
based upon the CPA's general obligation to carry out professional duties with the same skill and judgment possessed
by the average CPA. There is no obligation to detect all of a client's fraudulent activities or to warn customers of the
client that some of the client's employees may be guilty of embezzlement. Negligence disclaimers in engagement letters
are inappropriate and probably not legally enforceable.

26

05

The CPAs responsibility to the client is defined by GAAS and/or specific terms of the contract.

06

Greater responsibility may be assumed by an express contract that goes beyond the standard audit engagement.

07
The agreement between the CPA and the client should be expressed in writing in an engagement letter. The
engagement letter, written to the client on the CPAs letterhead, should provide a place for the client to indicate agreement
with the terms of the undertaking via the clients signature. An important case on this point is 1136 Tenants Corporation.
Because the CPA firm did not have an engagement letter, it was found liable for $237,000 (relative to a $600 annual fee)
of damages for failure to discover defalcations. The CPA firm contended that the engagement called for preparation of
unaudited financial statements, not an audit. The plaintiff was successful in establishing that an audit was agreed upon.
08
Most legal actions by clients involve claims based upon employee defalcations or fraud not discovered by the audit
examination.
09

Defenses available to the CPA include the following:

a.
b.
c.
d.
e.

The CPA was not negligent or fraudulent.

Contributory negligence of the client caused the loss.
The CPA adhered to GAAS and planned audit examination to search for material fraud.
The error was immaterial.
The proximate cause of loss was not the erroneous financial statements.

Application: While conducting an audit, Larson Associates, CPAs, failed to detect material misstatements included in
its client's financial statements. Larson's unqualified opinion was included with the financial statements in a registration
statement and prospectus for a public offering of securities made by the client. Larson knew that its opinion and the
financial statements would be used for this purpose. In a suit by a purchaser against Larson for common law
negligence, Larson's best defense would be that the:
audit was conducted in accordance with generally accepted auditing standards.
client was aware of the misstatements.
purchaser was not in privity of contract with Larson.
identity of the purchaser was not known to Larson at the time of the audit.
A - Under a common law negligence suit, Larson escapes liability by showing that the audit was conducted in
accordance with generally accepted auditing standards. Larson's showing that the client knew of the misstatements or
that privity did not exist (between the purchaser and Larson) or that Larson had no knowledge of the identity of the
purchaser at the time of the audit will not help Larson's defense.
10
Tax Return Preparer Liability - A client may be able to sue the CPA who prepared a tax return that caused the
client to incur penalties or other sanctions due to the CPAs wrongful action. Basis of liability could be breach of contract or
the tort of negligence.
11

For taxation engagements, most claims arise from the CPAs failure to meet a filing date for a tax return.

a.
b.

The CPA may be liable for interest on late payment plus penalty.
The CPA may be liable for interest, penalty, and tax if the client can prove that the transaction was primarily
motivated by erroneous tax advice rendered by the CPA.

27

Application: A CPA will be liable to a tax client for damages resulting from all of the following actions, except:
failing to timely file a client's return.
failing to advise a client of certain tax elections.
refusing to sign a client's request for a filing extension.
neglecting to evaluate the option of preparing joint or separate returns that would have resulted in a substantial tax
savings for a married client.
C - A CPA will be liable to a tax client for damages from:

failing to timely file a client's return,

failing to advise a client of certain tax deductions, and

neglecting to evaluate the option of preparing joint or separate returns that would have resulted in substantial tax
savings for a married client.
12

Ultramares Rule - The CPA may be held liable to third parties for any of the following:

a.
b.

Fraud
Gross negligence

Application: Under common law, which of the following statements most accurately reflects the liability of a CPA who
fraudulently gives an opinion on an audit of a client's financial statements?
The CPA is liable only to third parties in privity of contract with the CPA.
The CPA is liable only to known users of the financial statements.
The CPA probably is liable to any person who suffered a loss as a result of the fraud.
The CPA probably is liable to the client even if the client was aware of the fraud and did not rely on the opinion.
C - The key to answering this question is the phrase who fraudulently gives an opinion. Under the Ultramares doctrine,
a CPA is not liable to third parties for mere negligence, but may be held liable to any party who suffered a loss as a
result of fraud or gross negligence. These third parties need not be in privity of contract with the CPA and need not be
specifically known to the CPA.
If the client was aware of the fraud and did not rely on the opinion, the client would not be successful in holding the CPA
liable, even for fraud.
13
Under common law, CPAs have not (until recently) been found liable to those not in privity on the theory of ordinary
negligence.
a.
b.

Third parties include investors and creditors.

The term privity refers to a contractual or near contractual relationship

28

Application: In a common law action against an accountant, lack of privity is a viable defense in most jurisdictions if the
plaintiff:
is the client's creditor who sues the accountant for negligence.
can prove the presence of gross negligence that amounts to a reckless disregard for the truth.
is the accountant's client.
bases the action upon fraud.
A - Privity of contract is the existence of a contractual relationship between the accountant and the client. Therefore,
there is no lack of privity defense in an action brought by the client. In most cases privity is a required element of any
lawsuit by an aggrieved party against the accountant. However, privity is not required if the accountant has been guilty
of fraud or gross negligence.
A client's creditor (a third party) suing for mere negligence does not have privity with the accountant and does not fall
within either of the mentioned exceptions, and therefore lack of privity of contract is a viable defense against such a
lawsuit (under the Ultramares doctrine).
However, recently, many jurisdictions apply the Foreseeable Third-Party Beneficiary Rule, which holds the auditor liable
for simple negligence to all third parties who can reasonably be foreseen to rely on the audited financial statements. In
such circumstances, the client's creditor could be a foreseeable third-party beneficiary and lack of privity would not be a
valid defense against suit for negligence.
14
In 1931, the common law Ultramares rule was promulgated. The court in Ultramares stated that where a CPA
recklessly certifies to the truth of financial statements without taking the proper procedures to determine whether or not
the financial statements are in fact true, a jury might find the CPA guilty of fraud.
a.
b.
c.
d.

Ultramares developed a concept of gross negligence or constructive fraud.

According to Ultramares, the third party that proves gross negligence will be successful in reaching the CPA without
regard to privity.
Gross negligence is a deceit that involves a misrepresentation of a material fact, with lack of reasonable ground for
belief, relied upon by another, which causes damage to that party.
Ultramares refused to hold a CPA liable to third parties for simple negligence.

Application: Hark, CPA, failed to follow generally accepted auditing standards in auditing Long Corp.'s financial
statements. Long's management had told Hark that the audited statements would be submitted to several banks to
obtain financing. Relying on the statements, Third Bank gave Long a loan. Long defaulted on the loan. In a jurisdiction
applying the Ultramares decision, if Third sues Hark, Hark will:
win because there was no privity of contract between Hark and Third.
lose because Hark knew that banks would be relying on the financial statements.
win because Third was contributorily negligent in granting the loan.
lose because Hark was negligent in performing the audit.
A - In a jurisdiction applying the Ultramares decision, if Third Bank sues Hark CPA, Hark will win because there was no
privity of contract between Hark and Third. The Ultramares court ruled that even if a CPA firm knows that the audited
financial statements are to be used by a creditor to make lending decisions, the third-party user lacks privity with the
CPA firm and cannot recover for negligence.

29

15
Third-Party Beneficiary Rule - The CPA may be held liable for ordinary negligence by third parties when the CPA
knows that the services for a client are primarily for the benefit of a third party.
16

When the services are primarily for the benefit of a third party, the third party is, in effect, a party to the contract.

17
In order for plaintiff to be a third-party beneficiary, the aim and end of the transactions must be to benefit the third
party.
18

A CPA who is negligent in issuing the report can be liable to third parties who can be foreseen as being injured.

19
According to the foreseen user rule applied by some courts, if a CPA is retained by a client to perform an audit
examination for purposes of obtaining a bank loan from Fourth National Bank, the bank may successfully recoup loan
losses by proving that the CPA was negligent (if the bank, in fact, relied upon the audited financial statements).
Application: Beckler & Associates, CPAs, audited and gave an unqualified opinion on the financial statements of
Queen Co. The financial statements contained misstatements that resulted in a material overstatement of Queen's net
worth. Queen provided the audited financial statements to Mac Bank in connection with a loan made by Mac to Queen.
Beckler knew that the financial statements would be provided to Mac. Queen defaulted on the loan. Mac sued Beckler
to recover for its losses associated with Queen's default. Which of the following must Mac prove in order to recover?
I.
Beckler was negligent in conducting the audit.
II.
Mac relied on the financial statements.
I only
II only
Both I and II
Neither I nor II
C - This question deals with the concept of professional liability of the CPA to a foreseeable third-party beneficiary.
Under this concept, the CPA can be held liable to a third party who can be foreseen as a user of the financial
statements under ordinary common law negligence and lack of due professional care in the performance of the audit.
In order to recover from Beckler, Mac Bank must prove that the financial statements contained a material
misrepresentation (given), that the user suffered damage (the defaultgiven), and both:
I.
Beckler was negligent in conducting the audit and
II.
Mac relied on the financial statements.
20
The following matrix summarizes what the plaintiff (third party) must prove to successfully reach the defendant
(CPA) for fraud, gross negligence, and simple negligence.

Fraud

Gross
Negligence

Simple
Negligence

Knowledge

Reckless
disregard

Failure to
exercise care

Intention to induce reliance

Justifiable reliance

Resultant damage

False representation
Awareness

* = Plaintiff must prove

X = Not essential

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21
Common law varies from state to state; thus, some jurisdictions are Ultramares states while others apply the
foreseeability doctrine. Both alternatives should be presented in responding to a CPA Examination question. An
Ultramares state, of course, ignores the foreseeability rule and requires the third-party plaintiff to establish fraud or gross
negligence.

B.

Federal Statutory Liability

01

The Securities Act of 1933 regulates public offerings of securities through the mails or in interstate commerce.

02
The Securities Act of 1933 requires the filing of a registration statement with the SEC prior to the sale of securities.
The act requires disclosure of all material facts concerning the securities to be sold.
03

Section 11(A) of the Securities Act of 1933 provides the following:

a.
b.
c.
d.

Any person who acquires securities may sue the CPA.

Plaintiff may sue if the financial statements contain an untrue statement or omit a material fact.
Plaintiff does not have the burden of proving that the CPA was negligent or fraudulent.
Plaintiff does not have to prove reliance on untrue financial statements or that financial statements were the
proximate cause of any loss.
CPA has the burden of proof to establish innocence or that the cause of the plaintiffs loss was something other
than the untrue financial statement.

e.

Application: Under the liability provisions of Section 11 of the Securities Act of 1933, which of the following must a
plaintiff prove to hold a CPA liable?
I.
The misstatements contained in the financial statements certified by the CPA were material.
II.
The plaintiff relied on the CPA's unqualified opinion.
I only
II only
Both I and II
Neither I nor II
A - Section 11 deals with the civil liability for damages related to registration statements that are filed with the SEC.
Generally, the accountant will be liable if the accountant prepared any financial statements that contained an untrue
statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the
statements therein not misleading (15 USC 77k(a)) (Emphasis added).
The reliance on an unqualified statement, for purposes of this liability section, is not enough. There must have been
material factseither misstated or omittedin the filing statement. Note that defendants may assert a due diligence
defense. The defendant must prove that, after reasonable investigation, there were reasonable grounds to believe that
there were no omissions of material facts or any untrue statements.
04

Liability under the Securities Act of 1933:

a.
b.
c.
d.
e.

Privity of contract is not a necessary element.

Burden of proof, beyond proving material misstatement, is shifted from the plaintiff to the CPA.
The CPA owes third-party due diligence standard of care.
The Plaintiff does not have to prove fraud or deceitsimple negligence is enough.
The Plaintiff does not have to prove reliance.

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Application: Jay and Co., CPAs, audited the financial statements of Maco Corp. Jay intentionally gave an unqualified
opinion on the financial statements even though material misstatements were discovered. The financial statements and
Jay's unqualified opinion were included in a registration statement and prospectus for an original public offering of Maco
stock. Which of the following statements is correct regarding Jay's liability to a purchaser of the offering under Section
10(b) and Rule 10b-5 of the Securities Exchange Act of 1934?
Jay will be liable if the purchaser relied on Jay's unqualified opinion on the financial statements.
Jay will be liable if Jay was negligent in conducting the audit.
Jay will not be liable if the purchaser's loss was under $500.
Jay will not be liable if the misstatement resulted from an omission of a material fact by Jay.
A - Under Section 10(b) and Rule Sections/Rules 10b-5 of the Securities Exchange Act of 1934, the professional's
intentional material misstatement coupled with reasonable reliance by the purchaser results in liability. Jay's liability
under these sections/rules requires more than mere negligence (carelessness) and a misstatement or omission of
material fact. Furthermore, the amount of the loss is irrelevant.
05

Defenses under the Securities Act of 1933:

a.
b.
c.

The financial statements are true and not misleading.

The misstatement is immaterial.
The plaintiff purchased securities after issuance of a generally available earnings statement and did not rely on
registration statement (usually a generally available earnings statement is published 12 months after effective date
of registration).
The CPA exercised due diligence (i.e., that after a reasonable investigation the CPA had reason to believe that the
representations contained in the financial statements were true and complete).
The damage does not relate to misstatement by CPA.
The plaintiff had prior knowledge of falsity.
The statute of limitations (three years from securities sale) has expired.

d.
e.
f.
g.

Application: Under the liability provisions of Section 11 of the Securities Act of 1933, an auditor may help to establish
the defense of due diligence if:
I.
the auditor performed an additional review of the audited statements to ensure that the statements were accurate
as of the effective date of a registration statement.
II.
the auditor complied with GAAS.
I only
II only
Both I and II
Neither I nor II
C - The accountant bears the responsibility of proving that the accountant had exercised due diligence under Section 11
of the Securities Act of 1933. This burden includes the necessity to verify information provided by the corporation
through its officers and directors. The subsequent effort and review if it had been performed by the accountant would no
doubt be considered due diligence. Under various court interpretations, the failure to follow GAAP and GAAS is usually
proof of a lack of due diligence. Thus, if it can be shown the accountant followed GAAS, this will thwart the attempted
proof of lack of due diligence.

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06
The CPAs duty under the Securities Act of 1933 as to the fairness of the financial statements contained in the
registration statement extends to the time when the registration statement becomes effective.
Application: Dart Corp. engaged Jay Associates, CPAs, to assist in a public stock offering. Jay audited Dart's financial
statements and gave an unqualified opinion, despite knowing that the financial statements contained misstatements.
Jay's opinion was included in Dart's registration statement. Larson purchased shares in the offering and suffered a loss
when the stock declined in value after the misstatements became known.
If Larson succeeds in the Section 11 suit against Dart, Larson would be entitled to:
damages of three times the original public offering price.
rescind the transaction.
monetary damages only.
damages, but only if the shares were resold before the suit was started.
C - If Larson succeeds in the Section 11 suit against Dart (issuer), the investor would be entitled to monetary damages
only. Section 11 of the Securities Act of 1933 does not provide for treble damages or for rescission. There is also no
requirement that the shares be resold before the suit is started.
07
The Securities Exchange Act of 1934 regulates securities exchanges and securities listed and traded on
exchanges.
08

The United States Supreme Court has ruled that third parties must prove scienter.

a.
b.
c.

Scienter is intent to deceive, manipulate, or defraud on the CPAs part.

Simple negligence is not enough to hold the CPA responsible.
Recovery is limited to the actual losses resulting from the fraud.

Application: Which of the following is the best defense a CPA firm can assert in a suit for common law fraud based on
its unqualified opinion on materially false financial statements?
Contributory negligence on the part of the client
A disclaimer contained in the engagement letter
Lack of privity
Lack of scienter
D - The essential element of common law fraud is an intent to defraud or deceive. Another expression for an intent to
defraud is scienter. Thus, if a CPA is sued for fraud, a good defense would be proof that there was a lack of scienter.

33

09

Defenses under the Securities Act of 1934:

a.
b.
c.
d.

The CPA is not an insurer.

The CPAs conduct does not include scienter.
There is a lack of reliance and materiality.
The statute of limitations has expiredthis defense varies from state to state since Rule 10b-5 is silent on this point
and, therefore, courts look to state statutes of limitations.

Application: Under the Securities Exchange Act of 1934, which of the following penalties could be assessed against a
CPA who intentionally violated the provisions of Section 10(b), Rule 10b-5 of the Act?
I.
Civil liability of money damages
II.
Criminal liability of a fine
Both I and II
I only
II only
Neither I nor II
A - Rule 10b-5 of the Securities Exchange Act of 1934 requires that companies trading securities, brokers, dealers, and
transfer agents register and report to the SEC on a regular basis. The Act provides liability for an intentional
misrepresentation or omission of fact in connection with the purchase or sale of any security. This rule applies to
anyone who receives important information that affects securities trading, including a CPA. The CPA is involved in the
periodic reporting process required by the Act, since the required reports must be filed with audited financial statements.
The penalties for violating the rule can be civil liability of monetary damages and a criminal liability of a fine.
10
Criminal Proceedings Against CPAs - Violations of the securities acts that give rise to civil liability also subject
the CPA to criminal penalties (fine or imprisonment or both). The CPA may be found criminally liable for violation of the
Securities Act of 1933 or the Securities Exchange Act of 1934 if the violation can be shown to be willful or intentional.
Application: Under the liability provisions of Section 18 of the Securities Exchange Act of 1934, for which of the
following actions would an accountant generally be liable?
Negligently approving a reporting corporation's incorrect internal financial forecasts
Negligently filing a reporting corporation's tax return with the IRS
Intentionally preparing and filing with the SEC a reporting corporation's incorrect quarterly report
Intentionally failing to notify a reporting corporation's audit committee of defects in the verification of accounts receivable
C - The Securities Exchange Act of 1934 provides for liability in the case of an intentional misrepresentation or omission
of a material fact in connection with the purchase or sale of any security. Therefore, the only answer which is associated
with reporting to the SEC and does not involve negligence is intentionally preparing and filing with the SEC a reporting
corporation's incorrect quarterly report.

34

C.

Privileged Communications, Confidentiality, and Privacy Acts

01
Privileged Communications - In common law, there is not a privilege that an accountant or client may invoke to
prevent disclosures.
Application: At a confidential meeting, an audit client informed a CPA about the client's illegal insider-trading actions. A
year later, the CPA was subpoenaed to appear in federal court to testify in a criminal trial against the client. The CPA
was asked to testify to the meeting between the CPA and the client. After receiving immunity, the CPA should do which
of the following?
Take the Fifth Amendment and not discuss the meeting.
Cite the privileged communications aspect of being a CPA.
Discuss the entire conversation, including the illegal acts.
Discuss only the items that have a direct connection to those items the CPA worked on for the client in the past.
C - Although the CPA has a confidential fiduciary relationship with the client, under common law there is no privilege
that an accountant or client may invoke to prevent disclosures. Under a subpoena, the CPA would be required to
disclose information regarding the conversation. Compliance with a court summons, a subpoena, laws, or government
regulations would be an exception to the Confidential Client Information Rule (ET 301).
02

Some states have adopted statutes creating an accountant-client privilege. The statutes vary as follows:

a.
b.
c.
d.

Some apply only to CPAs, while others extend to all public accountants.
Some provide that the privilege is not applicable to criminal or bankruptcy actions.
Some exclude certain services such as auditing.
Some statutes do not state clearly whether the client or the CPA has the benefit of the privilege. Usually, the
privilege belongs to the client and the client is in control of whether or not the information is disclosed by the CPA.

03

There is no general federal accountant-client privilege.

a.
b.

Generally, any state-created accountant-client privilege is not recognized for federal law purposes.
Under Internal Revenue Code Section 7525, however, a privilege is available for communication between a
federally authorized tax practitioner (e.g., a CPA, attorney, enrolled agent, or enrolled actuary) and a client or
potential client.
(1)
This privilege can only be asserted in either of the following:
(a)
Noncriminal tax matters before the Internal Revenue Service
(b)
Noncriminal tax proceedings in federal court brought by or against the United States
(2)
Tax advice is advice given with respect to a matter that is within the scope of the tax practitioners authority
to practice before the IRS.
(3)
The privilege exists only to the extent the communication would be privileged under the attorney-client
privilege if the communication had been made between a client and an attorney.
(4)
The privilege does not apply to any written communication between a tax practitioner and a corporate
representative (including a director, shareholder, officer, employee, or agent) concerning the corporations
participation in any tax shelter (as defined in Internal Revenue Code Section 6662 (d)(c)(iii)).

35

Application: Thorp, CPA, was engaged to audit Ivor Co.'s financial statements. During the audit, Thorp discovered that
Ivor's inventory contained stolen goods. Ivor was indicted and Thorp was subpoenaed to testify at the criminal trial. Ivor
claimed accountant-client privilege to prevent Thorp from testifying.
Which of the following statements is correct regarding Ivor's claim?
Ivor can claim an accountant-client privilege only in states that have enacted a statute creating such a privilege.
Ivor can claim an accountant-client privilege only in federal courts.
The accountant-client privilege can be claimed only in civil suits.
The accountant-client privilege can be claimed only to limit testimony to audit subject matter.
A - The accountant-client privilege does not generally exist, although some states have adopted statutes providing for
such a privilege. The accountant in this case could successfully claim the accountant-client privilege only in those states
that have adopted a statute creating such a privilege. The privilege does not apply in federal court or federal
administrative agencies. While a limited privilege exists in a noncriminal tax matter, this fact situation does not allow a
consideration of that very limited privilege.
04

The Code of Professional Conduct mandates a confidential relationship, but not privileged communication.

05
Workpapers - CPAs are independent contractors, not employees; thus, they have legal title to their workpapers.
The workpapers do not belong to the client; however, the CPAs ownership of the workpapers is custodial. This means the
accountant cannot generally transfer them to a third party without the clients permission. Exceptions include subpoena by
a federal court or agency or inspection by an AICPA or state society quality review team.
Application: A CPA's working papers:
need not be disclosed under a federal court subpoena.
must be disclosed under an IRS administrative subpoena.
must be disclosed to another accountant purchasing the CPA's practice even if the client hasn't given permission.
need not be disclosed to a state CPA society quality review team.
B - An IRS administrative subpoena has judicial or quasi-judicial force and may require a CPA to disclose working
papers. A federal court subpoena or a request from a state agency or CPA society quality review team likewise forces
disclosure. The client must give permission to reveal working papers to another CPA.

36

06
A seller of an accounting practice has a duty to obtain permission of the client before making workpapers available
to a purchaser of the practice.
Application: Which of the following statements is correct with respect to ownership, possession, or access to a CPA
firms audit working papers?
Working papers may never be obtained by third parties unless the client consents.
Working papers are not transferable to a purchaser of a CPA practice unless the client consents.
Working papers are subject to the privileged communication rule which, in most jurisdictions, prevents any third-party
access to the working papers.
Working papers are the clients exclusive property.
B - Even though CPAs are independent contractors and have legal title to their workpapers, their possesion is custodial.
The workpapers cannot be transferred without first obtaining the consent of their client.
Workpapers can be obtained by subpoena, which does not involve the client consent. The AICPA Code of Professional
Conducts confidential relationship rule, not the privileged communication rule, prevents third-party access without the
clients permission.
07

A deceased partner can convey workpapers to copartners.

Application: To which of the following parties may a CPA partnership provide its working papers, without being lawfully
subpoenaed or without the client's consent?
The IRS
The FASB
Any surviving partner(s) on the death of a partner
A CPA before purchasing a partnership interest in the firm
C - Without a subpoena or client consent, a CPA partnership may provide its working papers only to surviving partners
on the death of a partner or under a review of the CPA's professional practice under AICPA or State CPA Society or
Board of Accountancy authorization. In most other cases, including the IRS and a CPA purchasing a partnership interest
in the firm, a subpoena or the client's consent is required.
The FASB should have no reason to need access to a practitioner's working papers.
08

CPAs do not have a common-law lien on client workpapers coming into their possession.

09

The CPA must generally keep the information in the workpapers confidential.

37