Exposure to the extracontractual.

An Illinois Supreme Court case may help change the long-standing interpretation of the 1971 case, 1136 Tenants' Corp. v. Max Rothenberg & Co. The result of 1136 Tenants' was that accountants might limit liability to client through the use of engagement letters. The Illinois case, Congregation of the Passion, Holy Cross Province v. Touche Ross & Co., makes it clear that engagement letters may not always be sufficient to define accountants' responsibilities to clients.

FACTS OF THE CONGREGATION CASE

The Congregation of the Passion, a Roman Catholic religious order, engaged the Chicago office of Touche Ross & Co. in 1973 to prepare unaudited financial statements. Trouble began in 1976 when the Congregation entrusted investment adviser Cranford D. Newell with $2 million and full discretionary authority over all investment decisions. Newell's leveraged arbitrage strategy greatly expanded the Congregation's potential liability and risk beyond the amount of cash invested.

The Congregation was fully informed about all aspects of the Newell investments. Every dealer through whom he conducted a transaction sent confirmations directly to the Congregation. Newell also regularly sent statements to the Congregation that identified the securities purchased or sold, coupon value, face value, market value, accrued interest on the bond or note, if any, and other information.

The CPA firm discovered the investment arrangement and the open arbitrage positions while preparing the unaudited financial statements for the period ended June 30, 1976. At this time, the Congregation was at risk for $22.25 million in short arbitrage positions and had an equal amount in long arbitrage (total position was $44.5 million). Touche Ross documented the investment arrangement in its working papers, showed the investments at their cost of $2,166,322, and footnoted that the investments were carried at cost rather than market value. The Congregation's unrealized loss of $214,802 was not disclosed.

By 1980, the CPA firm questioned the practice of reporting the investments at the cost of the net arbitrage position. Firm members contacted Newell to ascertain the investments' market values, which he never provided. By January 1981, the accountants learned from securities dealers that the market value of the net arbitrage position was $1,286,411. At this point, the Congregation had invested $3.6 million; thus the unrealized loss had at that point grown to approximately $2.3 million.

In February 1981, the CPA firm met with the Congregation to discuss the investments. There is conflicting testimony as to what was said, although the firm maintained it had informed the Congregation of the market value of the investments. In April, the Congregation forwarded $500,000 to Newell to cover a margin call made by a securities dealer. The CPA firm later that month sent the Congregation the final 1980 financial statements with the investments shown at market value, which required restating the 1978 and 1979 investment amounts from cost to market.

Shortly after receiving these financial statements, the Congregation closed its account with Newell. Because of the short positions Newell had taken on its behalf, the Congregation owed money to several securities dealers and faced an ultimate net loss of $3,819,352. The Congregation sued Touche Ross, first in federal court for violation of securities laws, then in Illinois state court for breach of contract and negligence. The federal court dismissed the suit, but the Illinois state court entered a judgment in favor of the Congregation, requiring the CPA firm to reimburse it for the full loss.

BACKGROUND: FACTS OF 1136 TENANTS'

The main issue in 1136 Tenants' was the scope of services agreed to by the accountant and the client. The accountant, Rothenberg, claimed he had an oral agreement to perform write-up services based on information furnished by the apartment cooperative's manager. When it was discovered that the manager had embezzled funds from the cooperative, the tenants sued Rothenberg for negligence and breach of contract.

Rothenberg claimed he had not been hired to perform an audit and had indicated in letters accompanying the financial statements that "we have reviewed and summarized the statements of your managing agent...." However, Rothenberg used the term "audit" in the financial statements and in the bill. Based on that terminology--and the fact that Rothenberg admitted to performing some audit procedures--the court held he had undertaken an audit and was negligent in its performance. The profession's response to the verdict was to recommend strongly that detailed engagement letters be used on all jobs--and their use has generally become standard practice. The assumption was that an accountant's responsibility would be restricted to what was in the letter.

IMPLICATIONS OF CONGREGATION

This case modifies 1136 Tenants' by specifying that an accountant's duty to the client is defined by both the contract (as set forth in the engagement letter) and by "extracontractual" responsibilities. Thus, an engagement letter is necessary but not always sufficient to establish the limits of an accountant's responsibility to the client. If the extracontractual responsibilities result in additional procedures, this will increase the costs of engagements. Because the responsibilities are extracontractual, these added costs cannot be reduced by agreement with the client even if formalized in the engagement letter.

The majority opinion did not include a definition of extracontractual responsibilities. In a blistering dissent, one justice asked: "What are these extracontractual duties? If these duties cannot be articulated in a contract, how is it that the client is able to articulate

RELATED ARTICLE: EXECUTIVE SUMMARY

* AN ILLINOIS SUPREME COURT CASE may help change the longstanding interpretation of 1136 Tenants' Corp. v. Max Rothenberg & Co. The result of 1136 Tenants' was that accountants could limit their liability to clients through the use of engagement letters.

* THIS CASE MODIFIES 1136 Tenants' by specifying that an accountant's to the client is defined by both the contract (as set forth in the engagement letter) and by "extracontractual" responsibilities. Thus, an engagement letter is necessary but may not be sufficient to establish the limits of an accountant's responsibility to a client.

* THERE MAY STILL BE A PERCEPTION that accountants are required to assume a wide range of responsibilities beyond the contract, including preventing a client's self-deception, in any area that affects the financial statements. Because the Illinois court has not defined extracontractual responsibilities, it is impossible to tell what they include or what affects them.

DEAN CRAWFORD, PhD, and DIANA FRANZ, PhD, are assistant professors of accounting, department of accounting, College of Business Administration, University of Toledo, Ohio. RAYMOND A. ZIMMERMANN, JD, PhD, is assistant professor of accounting, department of accounting, College of Business Administration, University of Texas at El Paso. PHILIP R. FINK, CPA, JD, is professor of accounting, department of accounting, College of Business Administration, University of Toledo. that they have been breached in a complaint?" These are excellent questions that remain unanswered. In addition, the Illinois court found the CPA firm owed its client the duty to prevent self-deception.

Accountants have grown accustomed to lawsuits by third parties alleging inadequate disclosure in financial statements when an investment goes bad. It is also common for new managers to bring lawsuits claiming the auditors did not adequately disclose prior managers' actions. In Congregation, however, the same management that undertook an extremely risky investment strategy sued its accountants for not disclosing that strategy fully in the financial statements.

The Congregation's suit was based on its claim that the CPAs were negligent in not reporting on the financial statements the market values of the Newell investments; therefore the Congregation claimed it maintained its accounts with Newell longer than it otherwise would have. The fallacy of this argument is that the Congregation had all the information it needed from periodic statements Newell provided. The Congregation claimed to have been misled by the omission from the financial statements of information that was already in its possession.

WHAT IT MEANS

In Illinois, the case sets precedent, although even there the final definition of extracontractual duties is far from settled. This year, an Illinois court applied the extracontractual responsibility doctrine to insurance brokers. The decision--which cites the Congregation case at length--applies this doctrine to all professional services and specifically mentions accountants. Outside the state, courts may or may not adopt the Illinois view of extracontractual responsibilities. The legal profession cites the Congregation case in American Law Reports, Annotated, which notes that a written contract is not sufficient to establish limits of professional liability. The perception may remain that accountants are required to assume a wide range of responsibilities beyond the contract, including preventing a client's self-deception, in any area that affects the financial statements.