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Reckless conduct sufficient to sustain fraud claim.

A U.S. district court ruled that an auditor's reckless conduct was sufficient reason to file a claim of securities law violations against the accounting firm. This case began when Coopers & Lybrand performed its 1992 fiscal year audit of Ferrofluidics. Ferro recognized revenue on delivery of its technology systems to its customers and improperly recognized revenue from two sales on or about June 27, 1992. In both cases, items included in the sales recognized by Ferro required substantial design and engineering changes after the sale.

After Ferro had delivered the systems, the firm asked it to obtain statements from the two customers that the sales had been accepted. Only one complied, and even in that case the customer could have returned the item within 30 days after delivery if the unit did not operate per specifications. Although the customer did keep the goods, some design changes were necessary. The firm nevertheless issued an unqualified opinion for fiscal year 1992 that included revenue from these sales, violating several Financial Accounting Standards Board and Accounting Principles Board standards. Subsequently, the financial statements had to be revised to delete these sales; the new statements, minus the two sales, showed a considerably less optimistic picture of the company. This triggered a severe stock market correction. Plaintiff shareholders then brought a class action lawsuit alleging violation of various securities laws.

The plaintiffs said "red flags" on the two sales should have alerted the firm:

1. Revenue from the two deals was recognized three days before the end of the fiscal year.

2. The equipment from these sales was visibly present on Ferro's floor during the audit.

3. Recognition of revenue front these transactions violated Ferro's own revenue recognition policy.

4. The customer's acceptance letter was not final.

5. The other customer refused to confirm acceptance.

Defendants argued that

1. The firm had reviewed the questionable sales and discussed them with management.

2. The two questionable transactions eventually were completed.

3. The firm ultimately had retracted its unqualified audit opinion by issuing revised financial statements.

4. The plaintiff could not supply a motive for the firm's alleged approval of Ferro's "slipshod accounting."

In ruling that the plaintiffs could proceed with their claim against the firm, the court said the plaintiffs' list of red flags made it dear that a reasonable auditor would have realized the disputed transactions demanded specific inquiry The retraction of the opinion did not absolve the auditor of responsibility for the opinion when it was issued. Plaintiffs' failure to show a motive for the firm's conduct could weaken its case but not to the point of dismissal.

This case allows securities violations claims based on reckless conduct. Previously, an indication of fraudulent conduct generally was required. (Van De Velde v. Coopers & Lybrand 899 E Supp. 73l) --Edited by Wayne Baliga, CPA, JD, CPCU, CFE, president of Aon Technical Insurance Services.
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Title Annotation:Van De Velde v. Coopers & Lybrand
Author:Baliga, Wayne
Publication:Journal of Accountancy
Date:Jul 1, 1996
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