The Concept of Agency and the Regulation Test of the CPA Exam

By Kenneth W. Boyd

The business law section of the Regulation (REG) test covers the agency-and-principal relationship. All companies have to work with the legal ramifications of hiring and managing employees. One set of rules that applies to the workplace is the concept of agency. Agency represents a legal relationship between an agent and a principal.

The agent is authorized to act on behalf of the principal. The agent is also authorized to create a legal relationship with third parties. To create the agency relationship, all that’s required is consent and a principal with capacity, the ability to do something. The relationship between agent and principal doesn’t need to be in writing.

Now consider what authority the agent has in his or her relationship with the principal. The REG test covers three types of authority in connection with the agency concept:

  • Actual authority: The principal’s words or actions cause the agent to reasonably believe that she has been authorized to act.

  • Apparent authority: The principal’s words or actions would lead a third party — who is a reasonable person — to believe that the agent has authority to act. This applies even if the principal and a potential agent never discussed an agency relationship.

  • Implied authority: If an agent can be reasonably expected to carry out certain duties as part of her express authority, the agent has implied authority to do them.

Agency liability issues

Some liability issues relate to the agency concept. First, consider situations in which agents may have liability to a third party:

  • Disclosure: If the agency is undisclosed or only partially disclosed — that is, if the relationship between the agent and principal isn’t quite clear to a third party — then both the agent and principal have liability to the third party.

  • Agent liable: If the agent doesn’t have actual, apparent, or implied authority, the agent has liability to the third party.

  • Agent not liable: If the agent has actual or apparent authority and the principal has been disclosed to the third party (along with the principal and agent relationship), the agent isn’t liable for acts performed within the scope of his or her authority.

Indemnity is defined as providing security against damage. When you indemnify people in a legal sense, you’re protecting them from loss or damages that relate to a potential legal liability. The following points relate to liability among agents, principals, and third parties:

  • Principal indemnified: If an agent acts with apparent authority but without actual authority, the principal is liable to third parties who work with the agent. In this situation, the agent is liable to indemnify the principal for any damages or losses due to the agent’s dealings with a third party.

  • Agentindemnified: If the agent acts with actual authority, the principal must indemnify the agent for any payments the agent makes while working in his or her role. This is true for payments that are expressly authorized or deemed necessary to promote the business.

  • Principal holds third party liable: A principal can hold a third party liable even if the third party’s identity or even existence isn’t disclosed to the principal.

The agent owes several types of duties to the principal, including a fiduciary duty (a duty of loyalty). The agent must act with reasonable care — that is, the agent shouldn’t act in a negligent manner. An agent should be obedient, meaning that the agent should follow the instructions that the principal provides. Finally, the agent must be loyal — an agent should act in the best interests of the principal.

If the agent acts without authority, the principal has a choice. One choice is ratification, which means that the principal can be bound by the transaction and accept any liability that results from the transaction. The principal could also choose not to be bound by the action of the agent. With ratification, the principal can choose to accept the third party’s offer or reject it.

Tort liability

A tort is defined as a wrongful act that results in injury to another person. That injury may be a physical injury, or it may be damage to a person’s property or reputation. A tort can lead to civil liability, as opposed to criminal liability. In civil cases, damages may be awarded.

The REG test asks questions about whether a principal is liable for an agent’s torts. A principal can be held liable for the torts of an agent if the agent is working as an employee. In some cases, both the employer (principal) and employee (agent) are held liable for a tort. A big factor in deciding on liability is the amount of control an employer has over a worker.

The IRS website has several publications that help companies determine whether a worker is an employee or an independent contractor for tax purposes. Just as with tort liability, the amount of control an employee has over a worker helps determine the proper classification. Employers are not held liable for the torts of independent contractors.

If the employer has the right to control an employee (agent), then the employer is liable for the torts of the agent. The employer who has liability for an agent’s torts has liability for only the torts arising from work performed for the employer (principal). The employer also isn’t liable for the following:

  • An intentional tort that the employer didn’t authorize: An intentional tort is a tort that was purposeful or intentional.

  • Criminal acts that the employer didn’t authorize: Say you manage a home healthcare business. An employee is assigned to help an elderly person with rehabilitation and to prepare meals. If the employee stole property without the employer’s knowledge or authorization, that’s simply a criminal act. The employer isn’t liable for the stolen property.

The REG test may ask a question about torts in relation to workers’ compensation. Typically, a state has a workers’ compensation fund to pay benefits to workers who are injured while employed. Employers in the state contribute to the fund based on the number of employees they have. When a worker is injured on the job, he or she applies for the workers’ compensation benefits.

Another employee benefit that may be on the REG test is the Family and Medical Leave Act. The act provides that a worker can take up to 12 weeks of unpaid leave to care for a spouse who has a serious health problem.