Printer Friendly

The 3 faces of liability.

The 3 Faces of Liability

A California toy manufacturing company was formed in the mid-1980s to create sophisticated toys. The company was initially immensely sucessful marketing "Teddy Ruxpin" talking bears and "Laser Tag" toy guns. The success was short-lived, however, and the company filed for Chapter 11 bankruptcy protection. In 1988, the investors sued a number of parties including the accounting firm that had audited the financial records of the company. In 1989, the Supreme Court of Alabama decided a case where a bank sued two accounting firms for malpractice in the audits of a mortgage company which defaulted on loan obligations totaling $2.5 million. Cases like these two recent decisions are being decided throughout the United States.

For the last 60 years, our legal system has struggled with the problem of defining accountant malpractice liability toward third parties. To what extent should an accountant be held liable when providing an unqualified opinion of the financial statements of a company which subsequently collapses into bankruptcy? Potential users of audit reports and financial statements include owners, lenders, suppliers, potential investors, creditors, employees, management, directors, customers, financial analysts and advisers as well as the public in general. Third party users who did not hire the accountant are anxious to seek a recovery from a solvent accountant rather than having to write off the loss.

Determining the proper extent of liability is difficult because the public typically expects fraud or misrepresentation detection from all audits. Even though accountants are expected to provide the data and let an informed user of the information interpret the data, the public expects audited financial statements to be accurate and often concludes that negligence is present if the business subsequently fails.

From the accountant's perspective, broad liability threatens the viable existence of the profession. This difficult issue is all the more perplexing given the fact that the law varies greatly from state to state. Some states are protective of the accounting profession and some states are anxious to protect investors and creditors who have lost money as a result of a business failure. Courts in each state individually determine the extent of accountant liability to third parties.

The purposes of this article are to review the three basic approaches used by the courts in defining liability of accountants, to discuss reasons for expanding accountant liability, to discuss reasons for limiting accountant liability and to review recent cases highlighting the different approaches.

Basic Approaches

The three approaches to accountant legal liability are the Ultramares approach, the Restatement of Torts approach and the reasonably foreseeable user approach. These approaches are listed in order of increasing accountant responsibility.

Ultramares Approach

In the 1931 Ultramares v. Touche, the New York court held that an accountant was not liable for negligence to third parties unless the accountant and the third party were in privity of contract. The third party must have hired the accountant in order to sue the accountant for negligence. This case set a long-standing precedent. This decision was protective of the accounting profession and was supported by Justice Cardozo's famous quotation:

"If liability for negligence exists, a thoughtless slip or blunder, the failure to detect a theft or forgery beneath the cover of deceptive entries, may expose accountants to a liability in an indeterminate amount for an indeterminate time to an indeterminate class."

Under this approach, the only time an accountant can be held liable to a third party is if the third party is an intended third party beneficiary of the audit contract. For example, if an accounting firm is hired by a company to audit their financial records and to send the results to a bank, the auditor is liable to the bank for any negligence. In states which still follow the Ultramares approach, the accountant is not liable to investors or creditors who sue the accountant for negligence if the third parties lacked privity.

The New York courts have recently reaffirmed the Ultramares approach with some modifications, and at least eight states have reaffirmed the validity of the approach in recent case decisions: New York, Alabama, Colorado, Arkansas, Florida, Idaho, Indiana and Nebraska. Three of the states decided cases in 1989.

Some legal scholars have asserted that the Ultramares approach is overly protective of the accounting profession to the detriment of the general public interest, and some jurisdictions have adopted one of the following theories.

Restatement of Torts

The Restatement adopts a middle ground to accountant liability. This approach permits recovery for those who can be actually foreseen as parties who will rely upon the financial statements. Under this approach, an accountant who knows that the audit report or financial statements will be delivered to a particular creditor, financier or investor will be subject to negligence claims by these known third parties.

This approach subjects the accountant to greater potential liability than the Ultramares approach because the accountant may be held liable to a third party user even if there is no contract between the accountant and the third party. If the accountant is aware that the audit results or financial statements will be forwarded to a particular third party, the accountant can be sued by the third party for negligence even though there is no privity of contract.

At least 17 states have adopted the Restatement approach in recent case decisions. These states include Alaska, Georgia, Hawaii, Iowa, Kentucky, Michigan, Minnesota, Missouri, New Hampshire, North Carolina, Ohio, Pennsylvania, Rhode Island, Texas, Utah, Virginia and Washington. Some states have determined that this approach does not go far enough in protecting the public. These states have adopted the following approach.

The Reasonably Foreseeable User Approach

This approach subjects the accountant to the greatest liability potential. This approach goes beyond the Restatement approach and provides for potential liability toward all parties who are reasonably foreseeable recipients of financial statements for business purposes, provided the recipients rely on the accountant's statements.

This approach abandons the privity requirement altogether and has been adopted by courts in California, Wisconsin, Mississippi and New Jersey. The courts in these states have taken the approach that the accounting profession is required to act as a public watchdog against corporate fraud.

Why Expand Accountant Liability?

There are a number of arguments commonly asserted for expanding accountant liability. Most of the arguments for expanded accountant liability have a basic theme -- that the public expects and needs protection from deceptive financial information.

One argument is that if liability is broadened the profession will respond with audit practices which will detect fraud and misrepresentation. Innocent investors and creditors rely on financial statements in making business decisions and financial statements which are approved by auditors should be reliable.

Another argument often asserted is the spreading of the cost argument. This argument asserts that the accounting profession is better able to absorb the risk of loss of misstated financial information than investors and creditors. The absorption of the risk can be accomplished by the purchase of malpractice insurance and the spreading of the premium costs out over all clients as a cost of doing business. This approach is further supported by the fact that most public accounting firms are well-capitalized. Perhaps accountants are better able to cover the risk of loss than are innocent creditors or investors.

Accountants are arguably in the best position to detect corporate fraud. Private investors and creditors lack the expertise and access to information to protect themselves. In law, there is a public policy argument often made that a risk of loss should fall on the party who can best avoid the loss.

Reasons to Limit Accountant Liability

There are also many reasons which can be asserted for limiting the liability of accountants. First of all, auditing standards are not designed to be fraud or detectors. If auditing practices are changed to become fraud detectors, then all audit costs will increase dramatically. Since very few audits involve fraud, many audits will become unnecessarily expensive and many CPAs will not perform audits.

If accountant liability is limited and third parties who lack privity are not allowed to sue accountants for negligence, then these third parties will be forced to hire their own auditors if they wish to hold an accountant liable. The third party users would then be in privity of contract and would then have the right to sue their accountant for any negligence. Perhaps investors and creditors should themselves bear the risk of loss if they chose not to hire their own accountant. Many investors and creditors are reluctant to incur any costs, preferring to catch a "free ride" with audit costs incurred by the business entity. Perhaps these "free riders" should be precluded from suing accountants if they are unwilling to pay for an accountant's opinion.

Expanded liability is driving up malpractice insurance costs, and some insurers no longer issue coverage policies. Increased premiums drive up the cost of the audit and these costs are passed on to clients of the accounting firm, these costs are not passed on to third party users who are not under contract with the accountant. Perhaps it is unfair to have clients in effect subsidize third party users by having to pay increased audit fees to cover liability exposure to nonclients.

Recent Cases

It is interesting to compare third party user cases decided in different states. As stated above, some states are protective of accountants and some states are protective of third party users. Three recent cases will be discussed, one under each of the three basic approaches mentioned above. These cases were commenced by a bank, unsecured creditors and investors, respectively, and are representative of cases currently being decided across the country.

Colonial Bank v. Ridley & Schweigert, 551 So.2d 390 (Ala. 1989).

Leedy Mortgage Company, an Alabama firm, borrowed heavily from Colonial Bank of Alabama. Leedy employed two separate accounting firms between 1979 and 1983. One accounting firm performed annual audits from 1979 through 1981 and another firm performed the annual audits for 1982 and 1983. Between 1979 and 1983, Colonial Bank made substantial loans to Leedy. Leedy ended in Bankruptcy Court and Colonial Bank suffered a loss of approximately $2.5 million. Neither of the accounting firms forwarded copies of the audit to Colonial or anyone else. The accounting firms did provide multiple copies of each year's audit. Leedy supplied Colonial Bank with copies of each year's audit. The accounting firms both asserted that they were unaware that the audits would be used by the mortgage company to influence the Colonial Bank.

The bank naturally urged the court to adopt a reasonably foreseeable user test and argued that it was reasonably foreseeable to the accounting firms that the Leedy Mortgage Company would use the audits to influence the Colonial Bank. The accounting firms urged the court to adopt the Ultramares approach, asserting that there was no privity and that the accounting firms were not aware that the audits were to be used by Colonial Bank.

The Supreme Court of Alabama determined that the New York Ultramares approach was appropriate. Since Colonial Bank was not in privity with the accounting firms and there was no evidence that the accounting firms were aware that the audits were to be used to influence Colonial, Colonial could not recover from the accounting firms on a negligence theory. The accounting firms owed no duty toward Colonial Bank.

Raritan River Steel v. Cherry, Etc., 367 S.E.2d 609 (N.C. 1988).

In this case, Intercontinental Metals Corporation retained an accounting firm to audit their financial statements for 1980 and 1981. Two companies extended credit to Intercontinental in reliance on allegedly incorrect information in the audit report. The third party creditors contend that there was an incorrect overstatement of the company's net worth. The creditors asserted that they would not have extended unsecured credit to Intercontinental had they been aware of the true financial picture of the company.

In adopting the Restatement approach, the North Carolina court reviewed the Ultramares approach and the reasonably foreseeable use approach. The court rejected the Ultramares approach because it failed to protect the public given the important role played by accountants in the financial world. The court stated:

We reject the Ultramares |privity or near-privity' approach

. . . because it provides

inadequately for the central role

independent accountants play in the

financial world. Accountants'

audit opinions are increasingly

relied upon by the investing and

lending public in making

financial decisions. . . . Because of this

heavy public reliance on audited

financial information we believe

an approach that protects those

persons, or classes of persons,

whom an accountant knows will

rely on his audit opinion but who

may not otherwise be in privity

or near privity with him is desirable.

The North Carolina court declined to adopt the extensive liability which arises under the reasonably foreseeable user approach because liability under this approach was deemed more "expansive than an accountants should be expected to bear." The court noted that an accountant's liability should be limited for two main reasons: first, the accountant lacks control over the distribution of audit reports and financial statements; second, the auditor must rely upon the records of clients to prepare the reports and accountants cannot control their client's accounting records and processes.

The court concluded that the Restatement approach was the most appropriate, stating:

We conclude that the standard

set forth in the Restatement

(Second) of Torts represents the

soundest approach to accountants'

liability for negligent

misrepresentation. It constitutes a middle

ground between the restrictive

Ultramares approach advocated

by defendants and the expansive

reasonably foreseeable approach

advanced by plaintiffs. It

recognizes that liability should extend

not only to those with whom the

accountant is in privity or near

privity, but also to those persons,

or classes of persons, whom he

knows and intends will rely on

his opinion, or whom he knows

his client intends will so rely. On

the other hand, as the

commentary makes clear, it prevents

extension of liability in situations

where the accountant |merely

knows of the everpresent

possibility of repetition to anyone,

and the possibility of action in

reliance upon the audited

financial statements, on the part of

anyone to whom it may be

repeated. As such it balances more

so than the other standards, the

need to hold accountants to a

standard that accounts for their

contemporary role in the

financial world with the need to

protect them from liability that

unreasonably exceeds the bounds of

their real undertaking."

After determining that the Restatement approach to liability was applicable, the court concluded that the creditors claim should not be dismissed and should be submitted to trial.

Worlds of Wonder Securities Litigation, 694 F. Supp. 1427 (N.D.Cal.1988).

This case involved a California toy manufacturing company which ended in bankruptcy after being in existence for only two years. In June of 1987, the company issued a prospectus and registration statement which was allegedly materially false and misleading. Only seven months after issuing the registration statement, the company was in bankruptcy.

Investors alleged that the public accounting firm that audited the toy company knew the company was suffering business difficulties but concealed this from investors and gave the company a clean and unqualified opinion or report with respect to the financial statements. Investors also alleged that the accounting firm falsely represented that its financial examination was in accordance with generally accepted accounting principles. The accounting firm and various insiders were sued for securities law violations and for negligence.

In deciding the negligence claim against the accounting firm, the California court refused to dismiss the claims against the accountants and held that the accounting firm owed a duty to reasonably foreseeable plaintiffs who relied on the accounting firm's allegedly negligently prepared financial statements. Investors were deemed to be foreseeable users under the California approach.

Conclusion

Determining the proper extent of accountant malpractice liability is a difficult task. There are seemingly irreconcilable interests involved. The public has a desire to be free from unreliable information, but the accounting profession is unable to be an insurer of accurate information. With these competing interests involved, it appears that an approach at either extreme is not in the best interests of all parties concerned. The Ultramares approach is arguably too protective of the accounting profession, while the reasonably foreseeable user approach is overly protective of the public interest. The middle ground approach of the Restatement appears to be the best approach of the three. Perhaps that is why there appears to be a trend toward the adoption of this approach.

If an accountant is aware of the actual intended use of the product the accountant is creating, then the accountant should be accountable to the recipient of the information. The accountant should be willing to stand behind an assurance to the recipient that he or she has acted as a reasonably prudent professional in the preparation of the information. If the accounting firm can establish this fact, it can avoid liability on a negligence claim. If the firm cannot establish this, then it should be held accountable to foreseen users.

Randall K. Hanson is an associate professor of business law at the University of North Carolina in Wilmington. He received his BS and BA degrees from the University of North Dakota, his JD from the University of North Dakota Law School and his LLM from the Southern Methodist University Law School. He is a member of the American Bar Association, the American Business Law Association and the Bar associations of Minnesota and North Dakota. He has previously published in numerous professional publications. John W. Gillett is an associate professor of accounting at the University of North Dakota. He received his BS and MS degrees from the University of North Dakota and his PhD from North Texas State University. A CPA in the state of North Dakota, he is a member of the American Institute of Certified Public Accountants, the American Accounting Association and the North Dakota Society of Certified Public Accountants. His articles have previously been published in a number of professional publications.
COPYRIGHT 1991 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

Article Details
Printer friendly Cite/link Email Feedback
Title Annotation:accountant liability
Author:Hanson, Randall K.; Gillett, John W.
Publication:The National Public Accountant
Article Type:Cover Story
Date:Jun 1, 1991
Words:3000
Previous Article:Looking good: IRS takes steps to improve service.
Next Article:The split purchase option for small businesses.
Topics:


Related Articles
The erosion of the privity doctrine.
Professional liability insurance: go bare or not?
The need for expanding organizational options for CPAs.
What every accountant should know about securities law.
The liability crisis in the United States: impact on the accounting profession.
RICO: has the "ultimate weapon" been crushed?
IFAC releases position paper on the global implications of auditors' legal liability.
Exposure to the extracontractual.
Enhanced professional liability protection available.
Accountant liability from a state law perspective.

Terms of use | Copyright © 2017 Farlex, Inc. | Feedback | For webmasters