Becker CPA Review – Regulation 7 Class Notes

REGULATION 7 CLASS NOTES

This lecture covers agency, bankruptcy, securities regulation, CPA legal liability and property insurance.
According to the AICPA's Content Specification Outline these items and the items found in R5 and R6
should make up between 20% and 25% of your Regulation examination.

AGENCY
I. Creation of an Agency
A. An agency is a legal relationship where the principal appoints an agent to act on his/her
behalf.
B. Principal must have capacity (not a minor).
D. Writing not generally required – unless to buy or sell land.
D. Agent – capacity not required – minor can be an agent.
E. Consideration not required to form an agency relationship.

II. Duties of Agent to Principal

A. Loyalty – agent must act solely in the principal's interest.
B. Obedience – agent must obey principal's reasonable instructions.
C. Reasonable care – agent must not act negligently.
D. If agent breaches the duties he owes the principal, then the principal can recover damages
from the agent including tort damages, contract damages, secret profits and even withhold
compensation.

III. Duties of Principal to Agent

A. Compensation – unless otherwise agreed.
B. Reimbursement/indemnification for all expenses in carrying out the agency relationship.
C. If the principal breaches her duties to the agent, then the agent can bring an action against
the principal for damages.

IV. Power to Terminate Relationship

A. Both parties generally have the power, but not necessarily the right, to terminate the
relationship at will. Can be held liable for damages if termination breaches contract.
B. Agency coupled with an interest – exception – principal cannot terminate – only the
agent can terminate.

V. Agent's Power to Bind the Principal

A. Principal is bound by agent's act if agent acted with authority. There are two kinds: Actual
and Apparent.
B. Actual authority.
1. Express – Principal specifically grants the power.
2. Implied – Authority necessary to run the business or carry out agency agreement.

1
© 2009 DeVry/Becker Educational Development Corp. All rights reserved.
 Becker CPA Review – Regulation 7 Class Notes

C. Apparent authority. This is the second way an Agent has the power to bind the Principal.
1. Title – position
2. Failure to give notice of agent's termination.
D. Ratification of previously unauthorized act can also bind principal in contract.
Requirements: The agent must have indicated that he was acting on behalf of the principal;
all material facts must be disclosed to the principal; and the principal must ratify the entire
transaction.
E. Disclosed Principal – the agent is not liable to third party under the contract.
F. Partially disclosed or undisclosed principal - the agent is liable under contract with the
third party along with the principal.

VI. Tort Liability

A. General rule – a principal is not liable for torts committed by agent.
B. Respondeat Superior – an employer can be held liable for an employee's torts committed
within the scope of the employment.
• Key difference between independent contractor and employee is that employer-
principal has right to control manner in which employee's work is performed.
C. Employer liable for independent contractor only if the employer authorized the tortious acts
or if the work involved an ultrahazardous activity.

BANKRUPTCY
I. Chapter 7 Liquidation and Chapter 11 Reorganization
A. Chapter 7 = Liquidation. Trustee is appointed and if the debtor is a business it ceases to
operate.
B. Chapter 11 = Reorganization. Trustee is not required. Debtor remains in possession of
his assets and a plan of reorganization is adopted. Business continues – assets are not
liquidated. Creditors are paid to the extent possible.
C. Chapter 7 and Chapter 11 – May be voluntary or involuntary.
D. Voluntary – Debtor files order of relief. The debtor need not be insolvent. All the debtor
needs is debt.
E. Involuntary – Unsecured creditors petition debtor into court. Must show debtor is not
paying debts as they become due. Fewer than 12 creditors – one or more creditors owed
at least $13,475 in aggregate unsecured debt may file a petition. 12 or more creditors – at
least 3 creditors who are owed in the aggregate at least $13,475 in unsecured debt may file
a petition.
F. Dismissal of a Chapter 7 Case – the Means or abuse tests – an individual consumer debtor
may be dismissed upon a finding that granting relief under Chapter 7 would constitute
abuse.

II. Common features of Chapters 7 and 11

A. Automatic Stay – stops the collection efforts.
B. Duties of debtor. After a petition is filed the debtor must file: list of creditors; schedule of
assets and liabilities; schedule of current income/expenses; etc.
C. Section 341 meeting – all interested parties, including creditors, the bankruptcy trustee and
the debtor must be given notice of the meeting.

2
© 2009 DeVry/Becker Educational Development Corp. All rights reserved.
 Becker CPA Review – Regulation 7 Class Notes

D. Property of the Bankruptcy estate – the debtor's estate; income generated from the
estate; and property the debtor receives from divorce, inheritance or insurance within 180
days after filing the petition.
E. Excluded property – post-petition earnings, spendthrift trusts, educational IRAs, state
tuition programs.
F. Exempt Property – homestead, motor vehicle, household goods, unmatured life
insurance, tools of trade, health aids, government benefits and alimony.
G. Preferential payment – a transfer for the benefit of a creditor on account of an antecedent
debt made within 90 days (one year for insiders) prior to filing the petition while the debtor
was insolvent and the creditor receives more than the creditor would have received under
the Bankruptcy Code.
H. Fraudulent transfers – any transfer for less than equivalent value made with the intent to
hinder, delay or defraud creditors. The trustee had the power to set aside fraudulent
transfers made within 2 years of the filing date.

III. Features of Chapter 7 Liquidation

A. Gives an honest debtor a "fresh start."
B. Objections to discharge – DRAWING – Discharge within 8 years, failure to keep Records,
failure to explain whereabouts of Assets, Willfully concealing assets, not an Individual,
Not obeying court orders and Guilty of a bankruptcy crime.
C. Exceptions to discharge: There are quiet a few exceptions to discharge. The ones that
generally appear on the exam are: WAFTED – debts arising from Willful and malicious
injury, Alimony, debts arising from Fraud, Educational loans, Taxes, and Debts
undisclosed at bankruptcy.
D. Reaffirmation of discharged debts – allowed if the agreement to reaffirm was made before
the granting of the discharge, the debtor has the right to rescind the agreement within 60
days of filing the agreement and the debtor's attorney informs the debtor that the
reaffirmation is not required by law.
E. Revocation of discharge – creditor or trustee may request where the debtor obtained the
discharge fraudulently, the debtor acquired property that would constitute property of the
estate and fraudulently failed to disclose, debtor failed to obey a court order, or debtor
could not explain why debtor failed to make documents available to auditor.
F. Distribution of debtor's estate. Three basic categories:
1. Secured claimants
2. Priority claimants, and
3. General creditors
G. Priority claimants: SAG-WEG-CTI
1. Support obligations to spouse and children
2. Administrative expenses
3. Involuntary case gap claims
4. Wage claims of each employee up to $10,950 earned within 180 days prior to
bankruptcy
5. Employee benefit plans contributions for each employee arising within 180 days prior
to bankruptcy, up to $10,950 reduced by wage claims
6. Grain farmers' and fishermen's claims against storage/processing facilities up to
$5,400

3
© 2009 DeVry/Becker Educational Development Corp. All rights reserved.
 Becker CPA Review – Regulation 7 Class Notes

7. Consumer deposits up to $2,425

8. Tax claims
9. Personal injury claims arising from intoxicated drivers

IV. Features of Chapter 11 Reorganization

A. Create a creditor's committee or a stockholder's committee.
B. Trustee generally is not appointed but can be appointed when there is fraud, dishonesty,
incompetence or gross mismanagement by the debtor.
C. Reorganization plan – unless a trustee is appointed, the debtor has an exclusive right to file
plan during the first 120 days after the order for relief is effective. Creditors may file a plan
if a trustee has been appointed; the debtor has not filed a plan within 120 days; or the
debtor has filed a plan but has not obtained acceptance of the plan by every impaired class
within 180 days of the entry of the order of relief.

SECURITIES REGULATION
I. Securities Act of 1933
Covers initial sales of investment contracts – practically any investment in which investor hopes
to be passive and make money from management of others.
A. Provide investors with sufficient information in which to make an informed decision.
B. Issuers, underwriters and dealers are required to register securities.
C. Registration Statement is made up of two parts; the Prospectus (written offer to sell
securities) and Part II the details (audited balance sheet and profit loss statement).
D. Registration is effective 20 days after filing.
E. Prefiling period – before registration – no sales activity allowed within 30 days of filing
registration.
F. Waiting period – after registration but before effectiveness – oral sales offers can be made;
tombstone ads can be used; preliminary prospectuses (red herring) can be sent and
summary prospectuses may be distributed. WKSIs can make written and oral offers and
sales.
G. Post-effective period – after the effective date – securities may be sold.
H. Special rules for WKSIs – may conduct sales activities at all times, use special shelf
registration, and use free writing prospectus.
I. Exemptions – Securities and Transaction.
J. Securities Exemption – never need to be registered. Banks, not-for-profits, government,
common-carriers, short-term commercial paper, insurance policies, etc.
K. Transaction Exemptions
1. Casual Sales – not an issuer, underwriting or dealer
2. Intrastate Sales
3. Regulation A – Partial Exemption – sales may not exceed $5 million in 12 months –
issuer files an offering statement.

4
© 2009 DeVry/Becker Educational Development Corp. All rights reserved.
 Becker CPA Review – Regulation 7 Class Notes

4. Regulation D – Private Offering Exemption. Rules for 504, 505, and 506.
(a) General conditions apply to Rules 504, 505, and 506. General solicitation
generally prohibited. Immediate resale prohibited. SEC must be informed
within 15 days of the first sale.
(b) 504 – Sales may not exceed $1,000,000 in 12 months.
(c) 505 – Sales may not exceed $5,000,000 in 12 months. May be sold to any
number of accredited investors and 35 or fewer unaccredited investors. If only
accredited investors – no disclosure required. Any nonaccredited, all investors
must be given audited financial statements.
(d) 506 – No dollar limit. May be sold to any number of accredited and 35 or fewer
unaccredited but sophisticated investors. If only accredited investors – no
disclosure required. Any nonaccredited, all investors must be given audited
financial statements.
(e) Accredited investor – an institutional investor, a bank or an individual investor
with $1,000,000 net worth or $200,000 annual income.
L. Liability provisions of the 1933 Act
1. Section 11 imposes civil liability for misstatements in registration statements.
2. A plaintiff need only prove a "material misstatement and damages." Not fraud or
reliance.
3. Anyone who signs the registration statements may be liable.
4. Due diligence defense – the defendant had reasonable grounds to believe the facts
in the registration statement were true and no material facts were omitted.

II. Securities Act of 1934

A. Reporting companies are required to report – 1) all companies who sell shares on a
national exchange or those with 500 or more shareholders in any class and $10 million or
more in assets, 2) any issuer that must register under the 1933 act.
B. Reporting requirements of the 1934 Act. 10K, 10Q and 8K reporting to the SEC. 5% or
more owners must report to SEC, Issuer and Exchange. Tender offers must be reported by
the person making the offer.
C. Insiders – officers, directors, more than 10% stockholders, accountants or attorneys of a
company – must file a report to the SEC disclosing their holdings.
D. Proxy solicitations and proxy statement must be reported.
E. Rule 10b-5 Antifraud Provisions.
1. Applies even if registration with the SEC is not required.
2. Prohibits fraud in connection with the purchase or sale of any security.
3. Scienter must be proven in a 10b-5 case. It means intent to deceive or reckless
disregard for the truth and is a popular term with the examiners.
4. Insider Trading under Rule 10b-5. It is illegal for a person to trade on the basis of
inside information if the person would breach a duty of trust owed to the issuer.

5
© 2009 DeVry/Becker Educational Development Corp. All rights reserved.
 Becker CPA Review – Regulation 7 Class Notes

CPA LEGAL LIABILITY

I. Breach of Contract
A. A CPA is liable to client and "intended third parties."
B. Harmed person is entitled to recover "compensatory" damages.

II. Tort
A. Negligence – duty, breach of duty, causation, damages
B. Fraud – misrepresentation of material fact, intent to deceive (scienter), actual and justifiable
reliance, intent to induce reliance, damages
C. Constructive Fraud – gross negligence, same elements as fraud but recklessness replaces
scienter
D. A CPA's liability for fraud and Constructive fraud is much broader than for negligence.
Negligence = the client and limited foreseeable class may sue the CPA compared to
Fraud/Constructive fraud = anyone who can prove the elements of fraud can sue.

III. CPA Statutory Liability

A. Section 11 of the 1933 Act – a material misstatement in the financial statements. Plaintiff
must prove they acquired the stock, suffered the loss and financial statements contained a
material misrepresentation.
B. Rule 10b-5 of the 1934 Act (Anti-fraud provision of the '34 act). Plaintiff must prove that
he/she suffered a loss and there was a material misstatement or omission. ALSO, plaintiff
must prove use of means of interstate commerce, the misrepresentation was made with
"scienter" or a reckless disregard for the truth and the plaintiff justifiably relied on the
misrepresentation.

IV. Sarbanes-Oxley Act

A. SOX makes it a "crime" to knowingly:
1. Destroy documents,
2. Fail to keep work papers for at least seven years,
3. Defraud the public in connection with any registered security.

V. Communication Privileges and Workpapers

A. Generally CPA has no accountant client privilege under federal and most states' law.
B. Workpapers belong to the CPA that prepares them. The General Rule is that the CPA is
prohibited from showing the workpapers to anyone except if subpoenaed by a court; a
surviving member of the accountant's firm; state CPA society voluntary quality review; to
defend a lawsuit; official investigation of the AICPA/state trial board; GAAP/GAAS
disclosure or a prospective purchaser of the CPA's firm who assures confidentiality (but a
purchaser may not be given workpapers without client's consent).

6
© 2009 DeVry/Becker Educational Development Corp. All rights reserved.
 Becker CPA Review – Regulation 7 Class Notes

PROPERTY INSURANCE
I. Insurable Interest
A. Must have an insurable interest to purchase insurance = any lawful and substantial
economic interest in property at the time of loss.

II. Types of Policies

A. Valued Policy – policy specifies the property value
B. Face Value Policy – limits the amount of recovery
C. Actual cash value at the time of loss.

III. Coinsurance Clause

A. Covers "partially" destroyed property.
B. Generally 80% of property value is insured.
C. Recovery = (Face value of policy/Coinsurance%*FMV of property) * loss
D. Pro rata clause – multiple policies
E. Subrogation is the right of the insurance company to recover amount paid from any third
party who's at fault.

There is REQUIRED HW READING on Antitrust law after the lecture text.

This topic is included and should be studied because it is within the scope of the Content Specifications
released by the AICPA and could appear on your exam.

We hope you find these tips helpful. Work hard and you will succeed. This concludes the
Regulation course. Please review the textbook material chapter by chapter. Please do a thorough
review and you will increase your chances of passing the Regulation exam. Become a CPA
sooner through a good study program. Best wishes to all on the Regulation exam.

7
© 2009 DeVry/Becker Educational Development Corp. All rights reserved.