Ethics, Professional, and Legal Responsibilities – Flashcards

A. Circular 230 contains the IRS's rules of practice governing CPAs and others who practice before the agency. The government may censure, fine, suspend, or disbar tax advisors from practice before the IRS if they violate Circular 230's standards of conduct. B. Subpart A of Circular 230 sets forth rules governing authority to practice before the IRS. Most importantly, *Section 10.3 provides that "[a]ny certified public accountant who is not currently under suspension or disbarment from practice before the Internal Revenue Service may practice before the Internal Revenue Service by filing with the Internal Revenue Service a WRITTEN DECLARATION that he or she is currently qualified as a certified public accountant and is authorized to represent the party or parties on whose behalf he or she practices."* C. Subpart B contains the *SUBSTANTIVE RULES* that govern tax practitioners, including CPAs. D. Subpart C spells out sanctions for violations and Subpart D contains procedural rules for disciplinary proceedings.

Aspect of a legal system that creates, defines, and regulates the duties, liabilities, and rights of the legal entities. In contrast, procedural law deals with the technical aspects (practices and procedures) and prescribes the steps for enforcing civil and criminal law.

requires prompt cooperation with all IRS requests for information

requires the practitioner to promptly notify the client, but the practitioner need not notify the IRS of the error and may not do so without the client's permission.

Practitioners must exercise due diligence in all aspects of their tax practice, including preparing tax returns and making representations to the IRS. With the exception of situations involving aggressive tax shelters, Section 10.22 allows a practitioner to rely upon the work product of others, if the practitioner used reasonable care in engaging, supervising, training, and evaluating them.

Practitioners may not unreasonably delay the prompt disposition of any matters before the Service. Stalling tactics are strongly discouraged by Section 10.23.

Section 10.24 provides that a practitioner should not knowingly accept even indirect assistance from any person disbarred or suspended from practice by the IRS.

The IRS is concerned about abuses by former IRS agents who might try to exploit their former position when they leave the Service. Therefore, Section 10.25 contains extensive rules meant to prevent conflicts of interest, such as IRS employees going into private practice and working on cases they had knowledge of when they worked for the government. For example, if IRS agent Fred worked on a matter involving taxpayer Stan within one year before he left the IRS, he could not join an accounting firm and represent Stan in that matter within two years of leaving the Service.

A practitioner must not act as a notary public with respect to matters before the IRS in which he or she is involved or interested (Section 10.26).

*Unconscionable fees* -- No practitioner may charge an unconscionable fee for representing a client before the IRS. *Contingent fees* -- The rest of Section 10.27 relates to contingent fees, providing that a practitioner may not charge a contingent fee for providing services before the IRS, with three exceptions. A contingent fee may be charged: a. For services rendered in connection with an IRS examination or challenge to either (i) an original tax return or (ii) an amended return or claim for refund when they were filed within 120 days of receiving a written notice of examination or written challenge to the original exam b. Where a claim for refund is filed solely in connection with determination of statutory interest or penalties c. When the accountant is representing the client in judicial proceedings. In these three situations, the threat that the tax practitioner and client will play the "audit lottery" (taking an aggressive position because it is unlikely that the Service will substantively examine it) is small *PCAOB* -- Remember that the PCAOB believes that a public company auditor is not independent from an audit client if it offers that client any services on a contingent fee basis.

What if you have fired the client, or the client has fired you? You still have the client's tax records, but perhaps the client has not paid you. You don't want to give the client's records back until you are paid. Section 10.28 instructs the practitioner to promptly return any and all records needed for the client to comply with federal tax obligations. The practitioner may keep a copy. The rule specifies that the existence of a fee dispute does not change this obligation, but does go on to recognize that if applicable state law permits retention in the case of a fee dispute, the practitioner need return only those records that must be attached to the taxpayer's return. However, the rule further provides, the practitioner "must provide the client with reasonable access to review and copy any additional records of the client retained by the practitioner under state law that are necessary for the client to comply with his or her Federal tax obligations." The rule broadly defines "records of the client," but states that "[t]he term does not include any return, claim for refund, schedule, affidavit, appraisal or other document prepared by the practitioner ... if the practitioner is withholding such documents pending the client's performance of its contractual obligation to pay fees with respect to such document."

Section 10.29 provides that practitioners should not represent a client before the IRS if to do so would create a conflict of interest. 1. Such a conflict exists if the representation of one client would be adverse to that of another, or if there is a significant risk that the representation of one client would be materially limited by the practitioner's responsibilities to another client. 2. Notwithstanding the existence of a conflict of interest, however, practitioners may represent a client if they: a. Reasonably believe that they can provide competent and diligent representation to the client b. The representation is not prohibited by law and c. The affected client gives informed consent in writing. Practitioners should keep the consents on file for at least three years

Section 10.30 contains several limitations upon solicitation of clients. Among others, false advertising is, of course, prohibited. But practitioners may publish accurate written schedules of fees and hourly rates.

A practitioner who prepares tax returns may not endorse or negotiate any check issued to a client by the IRS, according to Section 10.31.

Tax accountants, typically, learn quite a bit of tax law, but nothing in Circular 230 is meant to authorize persons who are not members of the bar to practice law (Section 10.32).

Section 10.33 sets forth best practices for tax advisors, including: 1. Communicating clearly with the client regarding the terms of the engagement, including the purpose, use, scope, and form of the advice; 2. Establishing the facts, determining which facts are relevant, evaluating the reasonableness of assumptions or representations, relating the applicable law to the relevant facts, and arriving at a conclusion supported by the law and the facts 3. Advising the client regarding the import of the conclusions reached, including whether taxpayers may avoid accuracy-related penalties if they rely on the advice 4. Acting fairly and with integrity when practicing before the IRS 5. Exercising any firm supervisory powers to ensure that firm employees act in accordance with best practices

Section 10.34 instructs practitioners not to advise clients to take positions that are frivolous and to inform clients of any penalties that are reasonably likely to apply with positions taken on tax returns. Consistent with AICPA standards, it also authorizes practitioners recommending tax positions to rely in good faith without verification upon information furnished by the client.

Tax shelter scandals caused the IRS to rewrite some provisions of Circular 230 to raise performance standards. Background -- The Service believed that in the late 1990s and early 2000s, accounting and law firms were marketing large numbers of questionable tax shelter opinions. These firms would promise to issue "more likely than not" opinions to wealthy tax clients. These opinions would protect the clients who relied in good faith upon them from imposition of tax penalties (typically 20% of additional tax owed), should the tax shelter later be disqualified by the IRS. Given assurances that the worst that could happen to them was that they would have to pay the taxes normally owed, many clients were willing to invest in these tax shelter schemes. Section 10.35 sets out requirements for practitioners who issue certain types of tax opinions. THERE IS MORE (P. 15)

Section 10.36 provides that practitioners who have or share principal authority and responsibility for overseeing a firm's tax practice may be sanctioned if they either (a) willfully, recklessly, or through gross incompetence fail to take reasonable steps to assure that the firm has adequate procedures in place to ensure that all members and employees are complying with 10.35, or (b) know or should know that a member or employee is not complying with 10.35, but through willfulness, recklessness or gross incompetence fail to take prompt corrective action. The obvious purpose of this provision is to prevent those officials at the top of an accounting firm from placing all the blame for inappropriate tax shelter activity upon lower-ranking members of the firm. The provision is an exception to Section 10.22's provision that allows a practitioner to rely upon the work product of others if the practitioner used reasonable care in engaging, supervising, training, and evaluating them.

Section 10.37 provides that tax practitioners should not give written advice, even in situations not involving covered opinions, if the practitioner (a) bases the advice on unreasonable factual or legal assumptions, (b) unreasonably relies on representations or statements of the taxpayer or some other person, (c) fails to consider all relevant facts, or (d) 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 settled.

A. Subpart C of Circular 230 sets forth the rules and penalties for disciplinary proceedings. 1. As a general notion, Circular 230 authorizes the IRS to punish any tax professional who is incompetent, disreputable, violates the Treasury Department's rules of practice or with intent to defraud willfully and knowingly misleads or threatens the person being represented. 2. Section 10.50 empowers the IRS to impose a monetary penalty on practitioners who have violated practice rules. The maximum penalty equals 100% of the gross income derived from the conduct and may be added to other penalties, such as suspensions and censures. It may also be added to the 50% penalty of gross income authorized by 26 U.S.C. Section 6694, meaning that the penalty could theoretically be up to 150% of the income derived from an engagement. B. The remainder of Subpart C, as well as Subchapter D, contains sections setting forth the procedures governing the process when the IRS takes disciplinary action against tax practitioners.

A. Overview -- SSTS No. 1 begins by instructing members that they should comply with standards, if any, imposed by applicable taxing authorities. This is required because Congress has raised its standard to a higher level than the AICPA standard. In 26 U.S.C. Section 6694, Congress has provided that a tax return preparer who takes an "unreasonable position" may be punished. A position is unreasonable unless there is "substantial authority" supporting it. This provision is discussed at length in the next section on tax return preparers under the Internal Revenue Code, but it has been suggested that if after proper research a preparer concludes that there is at least a 40% chance that the IRS would accept a particular position, then it has "substantial authority" supporting it. If a tax position relates to a tax shelter, then it is unreasonable unless it is "more likely than not" (more than 50%) to be sustained on its merits. So, for federal tax work, members must be aware of Section 6694. B. Tax return position -- If a taxing authority has no written standards for preparing or signing tax returns, or if its standards are lower, then two AICPA standards apply: 1. "A member should not recommend a tax return position or prepare or sign a tax return taking a position unless the member has a good faith belief that the position has at least a realistic possibility (generally regarded as 33% likelihood) of being sustained administratively or judicially on its merits if challenged." 2. Even if there is not a realistic possibility of a position being sustained, a member may recommend a tax return position or prepare or sign a return if he or she concludes that (i) there is a reasonable basis (generally regarded as a 20%-33% likelihood) for the position, and (ii) the position is disclosed to the IRS so it can be reviewed.

C. Potential penalties -- SSTS No. 1 instructs members to advise taxpayers regarding potential penalty consequences of the tax positions they take and of potential opportunities to avoid penalties through disclosure. D. Prohibitions -- Members should never recommend a tax return position or prepare or sign a return reflecting a position that: 1. exploits the audit selection process (In other words, a preparer should never be heard to say, "This is not correct, but the IRS never checks it"); or 2. serves as a mere arguing position advanced to obtain leverage in settlement negotiations (in other words, a preparer should never be heard to say, "You're entitled to a $20,000 deduction, but the IRS will fight you on this, so we'll claim $40,000 and see if we can compromise with the Service at $20,000"). E. Advocacy -- Unlike auditors, who are watchdogs, members recommending tax positions have both the "right and the responsibility" to advocate for their taxpayer clients if claimed positions meet the applicable standards. CPAs owe a duty both to their clients and to the tax system. F. Authority -- Internal Revenue Code Section 6662 and accompanying Treasury Regulation 1.662-4(d)(3)(iii) are very narrow in what it recognizes as valid authority. The AICPA allows members to consider (1) a well-reasoned construction of the applicable statute, (2) well-reasoned articles or treatises, and (3) pronouncements issued by the applicable taxing authority regardless of whether Section 6662 would recognize them.

A. Reasonable efforts -- Members should make "reasonable efforts" to obtain from their clients the information necessary to provide "appropriate answers" to all questions on a tax return that they sign as preparers. 1. Reasons for the rule -- a. A question may be important in determining taxable income or loss, or the tax liability so that its omission would detract from the return's quality. b. A request for information may require a disclosure necessary for a complete return or to avoid penalties. c. A member often must sign a preparer's declarations stating that the return is true, correct, and complete. 2. Grounds for omission -- Reasonable grounds (which need not be explained) for omitting an answer to a question or a request for information: a. Information not readily available and answer is not significant in terms of taxes. b. Uncertainty as to meaning of question in relation to the particular return. c. Answer is voluminous and return states that data will be supplied upon examination. 3. It is impermissible to omit information for the reason that disclosure might disadvantage the taxpayer.

A. Good faith reliance -- In preparing or signing a return, a member may in good faith rely, without verification, on information furnished by the taxpayer or by third parties. Members need not put their clients through a lie detector test to check the truthfulness of the clients' representations. B. Red flags -- Members should not ignore red flags and should make "reasonable inquiries" if the information furnished appears to be incorrect, incomplete, or inconsistent either on its face or on the basis of other facts known to the member. C. Check earlier returns -- Where feasible, a member should examine the taxpayer's returns for other years to check for inconsistencies. D. Conditions -- Sometimes tax law imposes conditions for qualification for a deduction or other tax treatment, such as production of substantiating documentation. In such cases, a member should make "appropriate inquiries" to determine whether the conditions are met. E. Others' returns -- When preparing a tax return, a member should consider information known from other taxpayers' returns. For example, a CPA preparing tax returns for both a limited partnership and one of its limited partners should note any inconsistencies. In using such information, the member should keep in mind confidentiality rules.

A. General rule -- Unless prohibited by statute or rule, a member may use the taxpayer's estimates in preparing a tax return if: 1. It is not practical to obtain exact data; and 2. The member determines that the estimates are reasonable based on known facts and circumstances known to the member. B. Limitation -- The taxpayer's estimates should not imply greater accuracy than exists. For example, an estimate should not read: "$1,296.19." C. Disclosure -- It is usually not necessary to disclose that an estimate is being used. However, disclosure should be made if needed to avoid misleading the taxing authority as to accuracy, as where: 1. A taxpayer has died or is ill at the time the return must be filed 2. A taxpayer has not received a Schedule K-1 for a pass-through entity at the time the tax return is to be filed 3. There is litigation pending (e.g., a bankruptcy proceeding) that bears on the return 4. Fire, computer failure, or natural disaster has destroyed the relevant records

A. General rule -- The fact that a return position was rejected by the IRS or the Tax Court last year does not mean that it is necessarily improper to take that position again this year as long as the member believes in good faith that the standards of SSTS No. 1 are met. B. Possible grounds for asserting the position again -- 1. The position lacked documentation last year; this year, documentation is available; 2. The taxpayer simply wanted to settle the dispute last year, even though the advice met the standards of SSTS No.1. 3. New court decisions, rulings, or other authorities have developed since the prior ruling and they support the previous position. C. Exception -- If, in order to settle a proceeding with the IRS or in Tax Court, the taxpayer promises in a formal closing agreement not to take the position again, then, of course, the position should not be asserted a second time.

A. The issue -- What should members do when they learn that a required return has not been filed or that a material error has been made in a previously filed return or a return subject to an administrative proceeding? B. The answer -- The member should promptly notify the taxpayer. However, the member "is not allowed to inform the taxing authority without the taxpayer's permission, except when required by law." So, tell the taxpayer, but not the IRS. C. The following year -- If the member has informed the taxpayer of the previous error and the taxpayer has not taken appropriate action to correct the error, the member should consider severing the professional relationship. If the member does go ahead to prepare the next year's return, he or she should take reasonable efforts to prevent the previous error from being repeated. 1. Additional advice -- a. Once a taxpayer has given permission to correct, the member should act promptly. b. If a member believes the client may face fraud or other criminal charges, he or she should advise the client to consult an attorney. c. A member need not inform the client of errors that have no more than an insignificant effect upon the taxpayer's tax liability.

A. Format -- No standard format for communicating tax advice is required by the AICPA, but members are urged to consider putting advice in writing when it involves important, unusual, substantial dollar value, or complicated transactions. B. Standards to consider -- In giving tax advice, members should remember that their advice will affect their clients' actions in filing their tax returns and should therefore consider, when relevant, (a) return reporting and disclosure standards, including SSTS No.1 and (b) potential penalty consequences of recommended return positions. C. No duty to update -- Finally, a member has no general duty to update tax advice when tax law later changes. There are two exceptions: (1) when changes occur while the member is assisting a taxpayer in implementing procedures or plans associated with the advice provided; and (2) when a member specifically agrees to provide updates.

The Internal Revenue Code (IRC) has many provisions that relate solely or largely to tax return preparers (TRPs). Some also apply to tax advisors. This section surveys those provisions, both civil and criminal.

Tax Return Preparer : A TRP, generally speaking, is "any person who prepares for compensation, or who employs one or more persons to prepare for compensation, all or a substantial portion of any return of tax or any claim for refund of tax under the Internal Revenue Code."

A. Coverage -- Although this provision used to apply only to federal income tax returns, it now also covers federal estate and gift tax returns, employment tax returns, and excise tax returns. From this definition one may conclude that people are TRPs if they: 1. Are paid 2. To prepare, or retain employees to prepare 3. A substantial portion 4. Of any federal tax return or refund claim B. Subtypes -- It is slightly more complicated than this. For example, Smith is a signing TRP who bears primary responsibility for the overall accuracy of the return. Kahn is a nonsigning TRP who is responsible for that part of the return in which he played a major role. Obviously Khan might do a lot of work on a tax return that is signed by Smith. Therefore, the rules recognize two sub-types - signing and nonsigning TRPs. 1. Signing TRPs are individual TRPs who bear "primary responsibility" for the overall accuracy of the return or claim for refund (Smith in our example). 2. Nonsigning TRPs are those other than the signing TRP who prepare all or a substantial portion of a return or claim for refund (Khan in our example). C. Substantial portion -- Under the rules, the signing TRP is always responsible for a substantial portion of the return, but what about nonsigning TRPs? Current rules indicate that if Khan (to return to our example), evaluates a corporate taxpayer's just-completed transaction and concludes that it entitles the taxpayer to take a large deduction, he has prepared a "substantial portion" unless the deduction involves either: 1. Less than $10,000 or 2. Less than $400,000, which is also less than 20% of the gross income indicated on the return

C. Substantial portion -- Under the rules, the signing TRP is always responsible for a substantial portion of the return, but what about nonsigning TRPs? Current rules indicate that if Khan (to return to our example), evaluates a corporate taxpayer's just-completed transaction and concludes that it entitles the taxpayer to take a large deduction, he has prepared a "substantial portion" unless the deduction involves either: 1. Less than $10,000 or 2. Less than $400,000, which is also less than 20% of the gross income indicated on the return Example: Kahn opines that the taxpayer may take a deduction of $300,000 on a return reflecting $26 million in gross income. Kahn would not be a nonsigning TRP because, although $300,000 is a lot of money for some of us, it is not a "substantial portion" of a return featuring $26 million in gross income. D. Not a TRP -- One is not a TRP merely because he or she: 1. Furnishes typing, reproducing, or other mechanical assistance 2. Prepares a return or claim for refund of the employer (or of an officer or employee of the employer) by whom he or she is regularly and continuously employed 3. Prepares as a fiduciary a return or claim for refund for any person E. Additional clarification -- 1. A firm that employs a TRP is treated as the sole signing TRP. 2. When there are multiple people working on a return, the one who is primarily responsible for the position giving rise to an understatement is the TRP punishable under these provisions. 3. If it is unclear who is responsible, the one with overall supervisory responsibility for the return or for the position will be the TRP.

A. Understatement of taxpayer's liability -- Subsection (a) of Section 6694 imposes a penalty against a TRP when an "unreasonable" position causes an understatement of tax liability. 1. Guidelines -- a. A position is unreasonable if there is no substantial authority (less than 40% chance of being sustained) for the position. b. A position is unreasonable if it is disclosed yet there is no reasonable basis (less than 20% chance of being sustained) for it. c. If the position relates to a tax shelter, it is unreasonable unless it is more likely than not (MLTN) (less than 50% chance) that the position will be sustained. 2. Fortunately for TRPs, there is a good faith defense. 3. Whereas Subsection (a) focuses on negligent conduct, Subsection (b) of 6694 imposes a larger penalty if the understatement is due to willful or reckless conduct. B. Disclosure provisions -- Section 6695 punishes TRPS for, among other things: 1. Failure to furnish copy of return to taxpayer 2. Failure to sign return and show own identity 3. Failure to furnish preparer's identifying number to the IRS 4. Failure to keep copy of return

C. Abusive tax shelters -- Section 6700 punishes TRPs and others who promote abusive tax shelters when they: 1. Organize or participate in the sale of a shelter; and 2. Either: a. Knowingly or recklessly make a material false statement that affects tax liability or b. Engage in a gross overvaluation of property (twice actual value) D. Aiding and abetting understatement of tax liability -- Civil penalties can also be imposed under Section 6701 upon TRPs and others who: 1. Aid, assist, procure, or advise in preparation or presentation of any portion of any return or other document 2. Know or have reason to know it will be used in matters arising under tax law 3. Know that if the return or document is so used, an understatement of the tax liability of another person will result E. Confidentiality -- With obvious exceptions for court orders, peer reviews, and the like, Section 6713 penalizes both: 1. Disclosure of any information furnished to the TRP in connection with preparation of a return or 2. Use of any such information for any purpose other than to prepare the return F. Injunctions -- In addition to civil fines, Section 7407 authorizes the IRS to enjoin TRPs and others from committing specific violations of the IRC (narrow injunctions) and can enjoin accountants and others from serving at all as TRPs (broad injunctions).

The IRC also contains criminal provisions to punish TRPs and others for various tax-related wrongdoing. The burden of proof is on the government to establish the crime beyond a reasonable doubt. A. Tax evasion -- IRC Section 7201 punishes tax evasion. It has been used to prosecute failure to file a return, falsifying income, and falsifying amounts that reduce taxable income. It is applied very broadly. The government must prove: 1. An affirmative act constituting an attempt to evade or defeat payment of a tax; 2. Willfulness 3. Existence of a tax deficiency B. Tax fraud -- IRC Section 7206 punishes fraud and false statements, criminalizing: 1. Willfully making and subscribing to any document made under penalty of perjury, which the accountant does not believe to be true as to every material matter 2. Willfully aiding the preparation of any tax-related matter which is fraudulent as to any material matter 3. Concealing client's property with intent to defeat taxes.

C. Miscellaneous tax crimes -- Although most criminal prosecutions are brought under Sections 7201 or 7206, other criminal provisions include: 1. Willful failure to file return, supply information, or pay tax (Section 7203) 2. Willful failure to collect or pay over tax (Section 7202) 3. Fraudulent returns, statements, or other documents (Section 7207) 4. Attempts to interfere with administration of the Internal Revenue laws, such as threatening IRS agents or misleading them (Section 7212) 5. Unauthorized disclosure of taxpayer information (with obvious exceptions for court orders, peer reviews, and the like) (Section 7213) 6. Willful disclosure or use of confidential information learned while preparing a tax return (Section 7216) 7. Conspiracy to commit any offense or fraud against the United States, including tax offenses (18 U.S.C. Section 371)

A. Authority -- State boards of accountancy license CPAs and can prohibit non-CPAs from performing attest functions: 1. It is only state boards that can grant CPA licenses and only state boards that can take them away. 2. While the AICPA and state societies of CPAs cannot grant or take away CPA licenses, they can grant membership, take away membership, and punish members by suspensions, etc. The AICPA's authority in this regard is covered in the AUD materials. B. Licensing -- To qualify to be licensed as a "certified public accountant," one must meet several requirements. In most states, three steps are the key and may be accomplished in any order: 1. Education -- a. "BA + 30" (150 hours of college education); b. Professional ethics course (required by many states); c. CPE - Once certification is gained, there are also continuing professional education requirements. 2. Examination -- a. Pass the CPA exam. 3. Experience -- a. How long? One year of professional experience (but at least 2,000 hours). b. In what areas? In accounting, attest, management advisory, financial advisory, tax or consulting areas and may be attained while working for any employer (accounting firm, corporation, government agency, etc.).

C. Attest-related functions -- 1. One needs a CPA license to perform attest-related functions: a. Any audit or other engagement to be performed in accordance with SAS (Statements on Auditing Standards) b. Any review of a financial statement to be performed in accordance with SSARS (Statements on Standards on Accounting and Review Services) c. Any examination of prospective financial information to be performed in accordance with SSAE (Statements on Standards for Attest Engagements) d. Any engagement to be performed in accordance with the standards of the PCAOB D. Nonattest services -- 1. One does not need a CPA license to perform such nonattest services as a. Preparation of tax returns b. Management advisory services (consulting) c. Preparing financial statements without issuing a report thereon

E. Discipline -- State boards may revoke CPA licenses and impose other penalties (such as fines) for such acts as: 1. Fraud or deceit in obtaining a certificate 2. Cancellation of a certificate in any other state for disciplinary reasons 3. Failure to comply with requirements for renewal 4. Revocation of the right to practice before any state or federal agency, including the PCAOB 5. Dishonesty, fraud or gross negligence in performance of services or failure to file one's own income tax returns 6. Violation of professional standards 7. Conviction of a felony or any crime involving fraud or dishonesty F. Reciprocity -- Most states are now an active part of the "UAA Mobility" project supported by the AICPA and the National Association of State Boards of Accountancy (NASBA). When fully implemented, accountants from one state will be able to represent clients in another state without obtaining a license from or paying a fee to the latter state's accountancy board.

A. Professional Ethics Division -- 1. Investigates violations of AICPA Code and sanctions minor cases. B. Joint Trial Board -- 1. Hears more serious cases; 2. Has power to acquit, admonish, suspend, or expel; 3. Initial decisions are made by a panel whose actions are reviewable by the full trial board whose decisions are conclusive. C. Automatic expulsion from the AICPA without a hearing results when a member has been convicted or received an adverse judgment for: 1. Committing a felony 2. Willfully failing to file a tax return 3. Filing a fraudulent tax return on own or client's behalf 4. Aiding in preparing a fraudulent tax return for a client Rationale: If a member has already been convicted or received an adverse judgment, then there has already been an opportunity for the member to have a full-blown criminal or civil trial. Consequently, it would be a waste of resources to have a second hearing and summary punishment is justified.

D. Revocation of certificate by a state board of accountancy also leads to automatic expulsion. E. Joint Ethics Enforcement Program (JEEP) 1. The AICPA and most state CPA societies have agreements to split the handling of ethics complaints. 2. Typically, the AICPA handles: a. Matters of national concern b. Matters involving more than one state c. Matters in litigation 3. The individual states handle the rest.

Breach of Contract : An accountant breaches the contract when s/he fails to perform substantially as agreed under contract.

I. *Accountants' Duties* Accountants' duties arise from: A. Express agreement of the parties -- 1. In a written engagement letter 2. An oral agreement may also be enforceable. B. Implied agreement -- (read in as a matter of law) To perform in a nonnegligent manner consistent with the standards of the profession. Ex. An accountant carelessly performs a tax (or audit or consulting) engagement. When the client sues for breach of contract, the accountant points out that nowhere in the contract did he promise to perform nonnegligently. The accountant is nonetheless in breach of contract because the law implies such a promise on the accountant's behalf.

II. An Accountant is Not a Guarantor or Insurer A. "Normal" audit is not intended to uncover fraud, shortages, defalcations, or irregularities in general (although it may do so), but is meant to provide auditor evidence needed to express opinion on fairness of financial statements. (Note: Juries often have difficulty grasping this concept.) B. An accountant is generally not liable for failure to detect fraud or irregularities, unless: 1. A normal audit by a careful accountant would have detected them or 2. In the engagement letter, accountant undertakes greater responsibility to detect fraud, etc. or 3. The wording of the audit report indicates that the auditor does have such a duty. C. An accountant should follow up on "red flags" and that investigation should not accept explanations at face value.

III. Client Breaches the Contract The client breaches the contract when it interferes with or prevents the accountant from performing. IV. Consequences of Breach by Accountant Accountant entitled to fee —if breach is major - No —if breach is minor - Yes Client entitled to: —compensatory damages - Yes —punitive damages - No V. Disclaimers Attempts by accountants to avoid liability by disclaimers in the contract are generally ineffective.

VI. Basic Elements The basic elements apply whether the auditor has erred in audit, tax, or consulting work. The more complex issue of when accountants should be liable to third parties (nonclients) is addressed later. VII. Negligence vs. Breach In many jurisdictions, the proper cause of action is breach of contract if an accountant simply failed to perform a contract, but negligence if the accountant performed the contract but did so carelessly. A. On the other hand, in some jurisdictions a negligence claim cannot be brought for mere economic injuries. Such a theory is reserved for personal injury claims and all claims of economic loss must be brought as breach of contract or warranty. VIII. Elements of Recovery These are to be proved by plaintiff in a negligence case A. Duty B. Breach C. Damages D. Proximate cause

IX. Duty A. Standard -- That degree of judgment and skill possessed by a reasonable accountant under all the circumstances. B. Sources of standard -- 1. State and federal statutes 2. Court decisions 3. Contract with client 4. GAAP and GAAS (persuasive, not conclusive): a. Evidence of violation of GAAP or GAAS almost automatically establishes negligence. b. Evidence of compliance with GAAP and GAAS does not necessarily establish reasonable care. 5. Customs of the profession (persuasive, not conclusive). C. The standard can be raised above that of the reasonable accountant by: 1. An accountant being a specialist 2. An accountant holds self out as having special expertise or 3. A contractual provision in which the accountant undertakes higher duty

X. Breach of Duty by Accountant An error of judgment or other mistake is not actionable unless it is negligent. (Accountants, like others in our society, are not expected to be perfect.) XI. Damages A. Of course, a plaintiff cannot recover from a careless accountant unless the plaintiff has suffered some injury. B. Key point -- Punitive damages are not allowed in a mere negligence action. - Damages Recoverable by Client in a Negligence Action 1. Compensatory damages for reasonably foreseeable injuries = Yes 2. Compensatory damages for unforeseeable injuries = No 3. Compensatory damages for injuries caused by client's contributory negligence = No 4. Punitive damages = No

XII. Proximate Cause A plaintiff must prove that the accountant's negligence directly (proximately) caused his or her injuries. A. Elements -- 1. "But for" causation (that is, a court can say that "but for" the accountant's negligence, the loss would not have occurred), and 2. Reasonable foreseeability - i.e., no "independent intervening causes" unforeseeable to, and beyond the control of, the accountant broke up the chain of causation between the accountant's careless act and the plaintiff's loss. Example: A CPA negligently fails to discover during an audit that diamond rings are missing from the client's inventory. In fact, an employee stole rings both before and after the audit. The CPA would not be liable for the rings stolen before the audit because it cannot be said that "but for" the accountant's carelessness the rings would not have been stolen. The CPA would likely be liable for the rings stolen after the audit, however, because successful defalcations by employees are one of the reasonably foreseeable consequences of a defective audit. XIII. Loss with Multiple Causes If loss had multiple causes, accountant is liable if his or her negligence was a "substantial factor" (but perhaps not the sole proximate cause) in bringing about the loss.

XIV. Defenses to a Negligence Claim - Contributory Negligence of Client There are two types of client carelessness. A. All jurisdictions recognize that accountants can raise as a defense the client's carelessness when that carelessness interferes with the accountant's performance of his or her task. B. Most jurisdictions, but not all, recognize that accountants can raise as a defense the client's carelessness that contributes to a loss even when that carelessness does not interfere with the accountant's performance of his or her task. XV. Chart Status of Contributory Negligence Defense 1. Client's carelessness interferes with accountant's performance of audit = all jurisdictions 2.Client's carelessness helps create the situation which the audit fails to detect = most jurisdictions

XVI. Elements A. False Representation of Fact -- Accountant made a false representation of fact (or omitted to state a fact in the face of a duty to do so). 1. A false statement of expert opinion is deemed tantamount to a representation of fact. B. The misrepresented (or omitted) fact was material. C. The accountant knew or recklessly disregarded the falsity. 1. Knowledge (scienter) = actual fraud 2. Reckless disregard or gross negligence = constructive fraud D. The accountant intended to and did induce plaintiff's reasonable reliance on the misstatement or omission. E. The client suffered damages. 1. Fraud is an intentional tort, whereas the essence of negligence is mere carelessness. 2. A defrauder's liability runs to all foreseeable victims of the fraud, whereas a negligent accountant's liability is much more limited in scope. 3. A defrauder may be liable for punitive damages as well as compensatory damages. A defendant who was merely negligent is not liable for punitive damages.

- Plaintiff must prove bad intent or recklessness = F - Plaintiff must prove carelessness =N - Plaintiff must prove proximate cause = BOTH - Plaintiff can recover compensatory damages = BOTH - Plaintiff can recover punitive damages = F - Contributory negligence is a defense = N - All reasonably foreseeable persons may recover = F

XVIII. Restatement View If you can understand the table presented in this section, you should be able to answer any question that can be presented to you on the exam. Remember that the Restatement view is the majority view around the country, but that several states have adopted the privity point of view either judicially or via statute. If a question is silent as to which approach is to be used, assume that the Restatement view applies. It is the majority rule. XIX. Three Primary Approaches A. The Privity approach of Ultramares v. Touche -- Accountant is liable only to those with whom he or she is in privity of contract, i.e., the client, or third-party beneficiaries of the contract. 1. Rationale -- Whereas plaintiffs suing for fraud, recklessness, or gross negligence may recover simply by being reasonably foreseeable victims of the fraud, courts adopting the privity approach are worried about accountant liability for simple carelessness extending to an indeterminate class for an indeterminate time and for an indeterminate amount. Therefore, they limit liability to the client and third parties expressly mentioned in the engagement letter. 2. Fact -- A substantial number of jurisdictions have adopted the privity approach either through judicial decision or by legislation. B. The Restatement "Limited Class" approach -- An accountant is liable to a limited class of nonclients where the accountant knows: 1. The information being supplied to the client will be given to, or is for the benefit and guidance of, a limited group of third persons. 2. The information will influence those third persons in a specific transaction or type of transaction.

I. Introduction The FCPA was a post-Watergate response to illegal foreign bribes paid by U.S. companies. It contains two major provisions. A. It contains anti-bribery provisions aimed at preventing U.S. companies from gaining or retaining foreign business by bribing foreign government officials. A 1998 amendment banned foreign bribery as a means of obtaining a competitive advantage; B. More relevant to accountants, it contains accounting provisions aimed specifically at preventing companies from hiding huge bribes on their financial statements. II. Accounting Provisions A. All companies registered with the SEC must keep "reasonably detailed" records which "accurately and fairly" reflect the company's financial activities. The accounting portion of the FCPA does not require the company to do any business abroad. B. These companies must devise sufficient internal accounting controls (IACs) to provide "reasonable assurance" that: 1. Transactions are executed in accordance with the management's general or specific authorization, 2. Transactions are recorded as necessary to: a. Permit preparation of proper financial statements b. Maintain accountability for assets 3. Access to assets is authorized 4. Recorded assets are compared with existing assets at reasonable intervals.

III. Penalties A. Criminal: 1. Individual: maximum of $100,000 fine and/or five years in jail 2. Corporation: maximum of $1,000,000 fine 3. There will be no criminal prosecutions for inadvertent or insignificant errors. B. Civil: maximum civil fine of $10,000

V. Purpose To prevent organized crime's infiltration into legitimate business. VI. RICO Has Two Sides A. Criminal -- Charges can be brought by the Department of Justice (DOJ). B. Civil -- Injured individuals can sue for treble damages and attorneys' fees. VII. RICO Prohibits A. Receiving money or property through a pattern of racketeering activity and subsequently investing that money into an enterprise (Section 1962[a]) B. Acquiring and controlling an enterprise through a pattern of racketeering activity (Section 1962[b]) C. Conducting or participating, directly or indirectly, in the conduct of an enterprise's affairs (Section 1962[c]) D. Conspiring to violate A., B., or C. (Section 1962[d])

VIII. Section 1962(c) Most RICO cases are brought under Section 1962(c), which has four elements. (1) defendant conducted or participated in the conduct (2) of an enterprise (3) through a pattern (4) of racketeering activity. A. Conduct or participation - Defendant conducted or participated in the conduct -- 1. The Supreme Court has held that the "conduct or participation" test is met only by those who actually manage a business. If an accountant sticks to accounting and does not become involved in "calling the shots," the accountant will not meet this test. Since this case was decided, RICO has become much less fearsome to accountants. B. Of an enterprise -- 1. The enterprise requirement means that the "person" being charged under RICO must be separate and distinct from the "enterprise." a. Example -- The auditor could be the "person," the client could be the "enterprise." C. Through a pattern -- 1. A "pattern" is defined in the statute as two acts of racketeering occurring within a 10-year period, but the Supreme Court has held that the pattern requirement is not met unless the acts a. Are related and b. Threaten a continuity of racketeering activity

D. Of racketeering activity -- 1. "Racketeering activity" is defined in the statute by example and includes: a. Mail fraud: any lie told through the mail b. Wire fraud: any lie told over the phone ("The check is in the mail.") c. About 30 other listed acts that are known as RICO "predicate acts" 2. The plaintiff usually must prove that these racketeering acts occurred but it doesn't mean that defendant has been convicted of them already. a. Exception -- Any civil plaintiff bringing a RICO claim for damages in a case involving acts that could constitute securities fraud (any lie told involving the sale or purchase of securities) must prove that the defendant had already been criminally convicted of securities fraud. b. Fact -- This greatly reduces accountants' exposure to liability under RICO because most RICO claims brought against accountants have involved securities fraud, and accountants are seldom criminally convicted of securities fraud.

IX. Fraud A. Any fraud committed with use of the mail or telephones (telegraphs, Internet, etc.) is a federal crime. Example: An accountant mails fraudulent financial statements to a potential investor in the audited company. This would be mail fraud. Misconception: It seems logical to assume that if the defendant communicates a fraudulent statement through the mail or over the phone he or she could be liable for mail or wire fraud. However, the rule is that the use of mail or wires must be an essential part of the fraudulent scheme for liability to attach. X. Criminal Liability A. The mail and wire fraud provisions are two of the most important federal provisions under which accountants can be held criminally liable. However, one cannot overlook the securities law, tax law, FCPA, and RICO criminal provisions.

XI. Record Retention, Destruction, and Tampering Statutes -- Motivated largely by Arthur Andersen's shredding of two tons' worth of documents as the SEC and the Department of Justice began looking into the Enron scandal, Congress included three criminal provisions related to document handling in Sarbanes-Oxley: A. Willful failure to retain audit and review work papers -- SOX created a new federal crime punishing a "knowing and willful" failure to retain audit or review work papers for a period of five years by up to 10 years in jail and a fine (Section 802, codified at 18 U.S.C. Section 1520). Because another provision of SOX required the PCAOB to establish rules that require auditors of public companies to maintain audit work papers for not less than seven years, that length of time remains quite important. B. Destruction of records -- SOX created a new federal crime that relates to destruction of records involved in any federal governmental matter or bankruptcy, making it a crime punishable by fine, imprisonment of up to 20 years, or both to "knowingly alter, destroy, mutilate, conceal, cover up, falsify, or make a false entry in any record, document, or tangible object with intent to impede, obstruct, or influence the investigation or proper administration of any matter within the jurisdiction of any department or agency of the United States or any case filed under the Bankruptcy Code." (Section 802, codified at 18 U.S.C. Section 1519). This provision was meant to eliminate any possible technical requirement in previous statutes that a subpoena already be issued or a grand jury indictment be issued before potential defendants were to stop shredding. Notice that it goes well beyond just audit-related documents. C. Corrupt tampering with documents to be used in an official proceeding -- SOX also created a new federal crime for tampering with documents to be used in an official proceeding, providing that any person who "corruptly" (1) alters, destroys, mutilates, or conceals a record, document or other object, or attempts to do so, with the intent to impair the object's integrity or availability for use in an official proceeding, or (2) otherwise obstructs, influences or impedes any official proceeding, or attempts to do so, shall be fined or imprisoned up to 20 years or both. The attempt to do these acts is also a crime. (Section 1102, codified at 18 U.S.C. Section 1512).

XII. Securities Fraud Statutes A. Although Section 10(b) of the 1934 Securities Exchange Act has long been used to punish criminal securities fraud, it is foundin the securities law title to the U.S. Code. Congress decided that a securities fraud provision should also be included in the U.S. Criminal Code. Therefore, it enacted 18 U.S.C. Section 1348, which appears to ease the prosecutor's burden. The Department of Justice need not prove as much to secure a criminal conviction under 1348 as under Section 10(b). Section 1348 punishes anyone who knowingly executes or attempts to execute a scheme or artifice (1) to defraud any person in connection with any security of a public company, or (2) to obtain, by means of false or fraudulent pretenses, representations or promises, any money or property in connection with a class of stock of a public company. The maximum term of imprisonment is 25 years. B. Prosecutors typically find it easier to convict defendants under a conspiracy statute than under an underlying substantive statute, and SOX contains a criminal provision that punishes conspiracy to commit securities fraud. XIII. Whistleblower Protection A. To encourage whistleblowing in the tradition of Sherron Watkins (Enron) and Cynthia Cooper (WorldCom), SOX contained two civil provisions (one granting rewards to whistleblowers and one giving them a civil cause of action to sue under certain circumstances). A related provision created a federal crime, punishing those who wrongfully retaliated against whistleblowers who provided truthful information to law enforcement about crimes. The provision is not restricted to securities fraud situations or to public companies.

I. Privileged Communications A. Introduction -- There are two broad types of privileges: 1. Testimonial privileges -- Classic privileged communications include attorney-client, doctor-patient, and priest-penitent. Where applicable, the protected party (client, patient, penitent) can prevent the party who received the protected communications (attorney, doctor, priest) from testifying. 2. Work product privilege -- This privilege typically prevents one party in a lawsuit from learning the other side's attorney's strategies for litigation. B. Accountant-client testimonial privilege -- 1. The federal courts have refused to recognize an accountant-client testimonial privilege. 2. The state courts have refused to recognize a common law accountant-client testimonial privilege. 3. Approximately 15 states have statutorily recognized an accountant-client privilege. In those states, remember: a. The privilege belongs to the client, not to the accountant b. The privilege can be waived by the client, either expressly or through voluntary and knowing disclosure of the relevant information c. Waiver of the privilege as to part of the communication is waiver as to all d. The privilege applies only in state court, where state procedural rules apply

C. The work product privilege and the "lawyer's umbrella" -- 1. Assume that a lawyer handling a case hires an accountant to help with complicated financial or accounting issues. The work product of the accountant would come under the umbrella of the lawyer's work product privilege and would be privileged from discovery by the other side. However, there is no freestanding work product privilege for accountants and their clients. 2. Similarly, the lawyer's testimonial privilege can shelter communications to an accountant when made by a client for purposes of the accountant assisting the attorney in preparing for litigation. D. The tax practitioners' privilege -- 1. Section 7525 of the Internal Revenue Code extends a modest testimonial privilege to clients of all tax advisers authorized to practice before the IRS, including accountants. However, the privilege has several exceptions and has been construed narrowly by the courts. 2. Exceptions -- The privilege does not apply to: a. Criminal matters b. Matters not before the IRS or federal courts in cases brought by or against the United States c. Tax advice on state or local matters d. Written advice in connection with promotion of a tax shelter 3. Construed narrowly -- Courts have not been uniform in their construction or application of the Section 7525 tax practitioners' privilege, but many have held that: a. It does not apply to information communicated to the practitioner solely for the purposes of facilitating tax return preparation b. It merely extends to tax practitioners the same privilege accorded in the attorney-client relationship c. Legal advice is protected, but not general accounting advice d. The exceptions to the privilege are to be broadly construed.

II. Confidential Communications A. General rule -- According to the AICPA Code of Professional Conduct, absent client consent, a CPA shall not disclose confidential information disclosed by clients. B. Exceptions -- Recognized exceptions include: 1. GAAP calls for disclosure 2. An enforceable subpoena or summons has been issued 3. An ethical examination is being conducted 4. A peer review requires disclosure 5. Disclosure is to other firm members on a "need to know" basis C. Miscellaneous rules -- 1. CPAs may utilize outside computer services to process tax returns, as long as there is no release of confidential information. 2. CPAs may reveal the names of clients without client consent, unless such disclosure releases confidential information. 3. In divorce proceedings, a member who has prepared joint returns for the couple should consider both of them to be clients for purposes of requests for confidential information relating to tax returns. If given conflicting instructions, the CPA should consider the legal implications of disclosure with an attorney. 4. New rules on outsourcing and offshoring place a responsibility upon the member who sends business, such as tax return preparation, to outside firms or to foreign shores (one million tax returns per year are prepared in India.) to ensure the confidentiality of clients' tax information.

D. Internal Revenue Code provisions -- As noted elsewhere in these materials, the IRC has several provisions dealing with confidentiality, including: 1. Section 6713, which imposes a civil penalty for each unauthorized disclosure or use of tax information by a tax return preparer; and 2. Section 7216, which imposes a criminal fine and potential imprisonment for knowingly or recklessly: a. Disclosing any information obtained in connection with the preparation of a return or b. Using such information for any purpose other than to prepare or assist in preparing a return E. Violations -- Violation of confidentiality obligations is also grounds for a civil malpractice lawsuit by a client.

A. Introduction -- In addition to the provisions referred to above, there are other privacy provisions relevant to the accountant-client relationship that should not be ignored. B. Generally accepted privacy principles -- 1. Management -- An accounting firm should define, document, communicate, and assign accountability for its privacy policies and procedures. 2. Notice -- An accounting firm should provide notice about its privacy policies and procedures and identify the purpose for which any personal information about clients is collected, used, retained, and disclosed. 3. Choice and consent -- An accounting firm should describe the choices available to clients and obtain implicit or explicit consent with respect to the collection, use, and disclosure of personal information. 4. Collection -- An accounting firm should collect personal information only for the purposes identified in the notice described above. 5. Use, retention, and disposal -- An accounting firm should limit the use of personal information to the purpose identified in the notice and for which the client has provided consent. 6. Access -- Firms should provide clients with access to their personal information for review and update. 7. Disclosure to third parties -- Accounting firms should disclose information to third parties only for the purposes identified in the notice and only with the client's implicit or explicit consent. 8. Security for privacy -- Accounting firms should protect personal information against unauthorized access, as identity theft is a growing problem. 9. Quality -- Accounting firms should maintain accurate, complete, and relevant personal information for the purposes identified in the notice. 10. Monitoring and enforcement -- The accounting firm should monitor compliance with its privacy policies and procedures and have procedures to address privacy-related inquiries, complaints, and disputes. C. E-mails -- At least two states require accountants to encrypt e-mails that contain clients' personally identifiable information and several other states are considering it. D. Reasonable measures -- Some states also have statutes requiring firms, such as accounting firms, which have possession of individuals' social security numbers to take reasonable measures to preserve the confidentiality of those numbers, including by taking precautions against identity theft.

E. Section 7216 -- As noted in the tax return preparer (TRP) discussion elsewhere in these materials, Section 7216 of the IRC imposes criminal penalties for unauthorized disclosure or use of taxpayer information. 1. This provision applies not just to TRPs, but to anyone who assists in preparing a return or provides auxiliary services in connection with return preparation regardless of whether they are paid. 2. The IRS does allow TRPs to use tax return information "for the purpose of providing other legal or accounting services to the taxpayer." For example, when the tax law changes, an accountant could use client tax return information to identify affected taxpayers for purposes of informing them about the change. 3. The IRS allows tax return preparers to use client information for purposes of sending newsletters to clients containing tax, general business, or economic information, but not for purposes of soliciting business other than tax return preparation services. 4. A TRP may generally disclose to its insurance carrier tax return information considered necessary for obtaining and maintaining a professional liability insurance policy.

F. Section 6713 -- As noted in the TRP materials, Section 6713 imposes civil fines for: 1. Disclosure of any information furnished in connection with preparation of a federal tax return and/or 2. Use of such information for any purpose other than to prepare the return G. Bank Secrecy Act and foreign bank accounts -- 1. Under the Bank Secrecy Act (BSA), taxpayers have an obligation to report foreign bank accounts (FBAR). 2. Evidence indicates that only about 30% of such accounts are currently being reported and the IRS has ratcheted up enforcement. 3. While FBAR penalties are aimed primarily at the taxpayer, a tax return preparer who, perhaps not fully understanding the FBAR rules, checked the "No" box in answering the question as to whether the client has a foreign financial account, might be punished under Internal Revenue Code provisions such as: a. Section 6694 (Understatement of a Taxpayer's Liability) b. Section 7201 (Criminal Attempt to Evade or Defeat Tax) c. Section 7206 (Criminal Fraud and Making False Statements)