5 Agency and Principal Concepts on the REG TestWhen a CPA moves into management, he or she must hire, train, and manage employees and independent contractors. The Regulation (REG) CPA exam covers the concept of agency, which is a related legal issue that impacts both managers and workers.

Use this discussion to learn about agents, principals, and the concepts tested on the REG test. This way, you’ll be much more prepared to take your CPA exam and achieve a rewarding career!


1. Agents And Principals, Defined

The REG exam is one of four CPA exam sections. It defines agency as the legal relationship that exists between an agent and a principal. An agent is authorized to act on behalf of a principal.

Assume, for example, that Julie owns Standard Plumbing, and that Robert is a plumbing employee. In this case, Robert is the agent and Julie is a principal. Here are some important facts about their professional relationship:

  • Julie (principal) creates the agency relationship by giving Robert (agent) consent to do plumbing work. Julie also has the capacity to provide Robert a truck and plumbing equipment. The principal gives consent and has capacity.
  • Robert (agent) is authorized to create a legal relationship with third parties. For example, Robert is authorized to meet with prospects and customers, and to provide a work estimate for plumbing services.

Types Of Authority

2. Types Of Authority

If you’ve ever worked for someone else, you understand that every employee is given some level of authority. Agency includes several type of authority; these concepts are covered in detail on the REG test. You should be able to avoid any confusion on test day if you read these descriptions carefully:

  • Actual authority: The principal’s actions or words cause the agent to reasonably believe that he or she has the authorization to act. For example, Julie tells Robert that, given this knowledge and expertise, he can provide job estimates to customers.
  • Apparent authority: The focus here is on the third party, and what that third party believes about the agent. This term means that the actions or words of a principal can lead a third party to reasonably believe that there is authority for the agent to act. Even if the agent and principal never discussed the agency relationship, apparent authority still exists. If, for example, a customer believes that a Robert has the authority to handle time and date scheduling for a repair, that authority is apparent.
  • Implied authority: If an agent can reasonably expect to carry out a particular duty as part of an expressed authority, the agent has implied authority. For example, Robert collects damaged parts, pipes, and other plumbing items that he removes during a repair. He explains to the customer that the parts cannot be used and throws them away. This authority is implied.

Think about the last time you asked for help in a clothing store. A competent and professional salesperson most likely listened to your questions and brought you certain clothes to try on. You assumed that the salesperson was authorized to provide this service, since these services are commonly provided in a clothing store.

Pop quiz: Which of the following types of authority does the salesperson have in this scenario?

  1. Actual authority
  2. Apparent authority
  3. Implied authority

The answer is B: apparent authority. This is because the third party (you) believes that the agent (the salesperson) has the authority to perform these actions. This scenario can help you understand the types of authority explained above.


Liability Issues

3. Liability Issues

The interactions between agents, principals, and third parties may be complex, and legal liability may be a factor in an agency relationship. Here are three issues that impact an agent’s potential liability:

  • Disclosure: If an agent clearly discloses the agency relationship to third parties, the agent can reduce his or her personal liability. If Robert the plumber hands the customer a Standard Plumbing business card, it should be clear to the customer (third party) that Robert is acting on behalf of the plumbing company.
  • No authority: It should make logical sense that Robert can’t perform plumbing work for Standard Plumbing unless he has some form of authority. If an agent doesn’t have actual, apparent, or implied authority, the agent has legal liability to third parties. This rule protects principals from agents who present themselves as having authority, and harm third parties in some manner.
  • Agent not liable: If Julie asks Robert to perform plumbing work, and the relationship is disclosed to third parties, Robert (agent) does not have personal liability for work performed for customers. This assumes that Robert has actual or apparent authority.

If you become a CPA and move into management, it’s important to understand the legal liability related to agency relationships. That means that these concepts and terms are guaranteed to be on the test in some capacity!


Legal Protection: Indemnity

4. Legal Protection: Indemnity

Another REG test topic is indemnity, which is defined as protecting someone from legal liability. Indemnity can apply to agents, principals, or third parties.

Agents owe certain duties to principals, including a fiduciary duty. The agent has a duty of loyalty to the principal, because the agent is in a position of trust when representing the principal. In addition, agents must act with reasonable care by following instructions provided by the principal.

Note these different scenarios:

  • Principals: Robert (agent) may do plumbing work with a number of third parties using apparent authority. Say, for example, that Robert offers to take down a tree that is near a plumbing pipe, and Robert does damage to the house. The agent (Robert) is liable to indemnify the principal (Standard Plumbing) for the liability owed to the third party customer.
  • Ratification: When an agent acts without authority, a principal may decide to accept any potential liability that the transaction may create. This decision is referred to as ratification.
  • Agents: Assume, instead, that Robert has actual authority from Standard Plumbing to take down a tree that is near a plumbing pipe, and Robert does damage to the house. In this case, Julie the owner must indemnify the Robert for the liability owed to the third party customer.

To keep these concepts straight in your mind, think first about the authority given to the agent by the principal, if any. Once you know the type of authority, you can consider other details in the question.


Tort Liability

5. Tort Liability

An agent’s work may damage property owned by a third party. As in the example above, Robert removes a tree and damages the customer’s home.

A tort is defined as a wrongful act that injures another person, including physical injuries, damage to property, or damage to someone’s reputation. If an agent commits a tort, he or she may be subject to civil liability, criminal liability, or both.

The REG test asks questions about a principal’s liability for the actions of an agent working as an employee. Here are some important points to remember:

  • Control: An employer’s liability for an employee’s torts depends on the amount of control the employer has over the worker. For example, if a worker is classified as an independent contractor, the employer is generally not held liable for the worker’s torts. The IRS provides several publications that explain the differences between employees and independent contractors.
  • Work performed: If an employer (principal) controls the work of an employee (agent), the employer is liable for the employee’s torts that are work-related.
  • Unauthorized torts: An employer is not liable for criminal acts unauthorized by the employer. If, for example, Robert the plumber steals jewelry from a customer’s home, Standard Plumbing (the principal) is not held liable for the tort.

Hence, it’s reasonable to assume that an agent’s criminal acts are not within the control of the principal, and that the principal should not be held liable.


Understand The Players

Understand The Players

The key to this REG test topic is to understand the players involved. When you answer these questions, one way to keep things organized in your head is to create a simple diagram with an “A” (agent), “P” (principal), and so on. If an agent has a specific type of authority, write a word or phrase below the “A”. You can add other information, depending on the complexity of the question, but the most effective method is to keep this diagram as simple as possible.

If you understand each of the parties involved, you can master the agent and principal concepts on the REG test. Good luck!

Kenneth W. Boyd is a former Certified Public Accountant (CPA) and the author of several of the popular "For Dummies" books published by John Wiley & Sons including 'CPA Exam for Dummies' and 'Cost Accounting for Dummies'.

Ken has gained a wealth of business experience through his previous employment as a CPA, Auditor, Tax Preparer and College Professor. Today, Ken continues to use those finely tuned skills to educate students as a professional writer and teacher.