A STUDY OF THE AUDITOR'S CONTEMPORARY
LEGAL HAZARDS AND.REMEDIAL ACTION
by
JAMES EDWARD SAMSON, B.B.A.
A THESIS
IN
ACCOUNTING
Submitted to the Graduate Faculty
of Texas Tech University in
Partial Fulfillment of
the Requirements for
the Degree of
MASTER OF SCIENCE
IN
ACCOUNTING
Approved
May, 1970
rs /Jô.í^
ACKNOWLEDGMENTS
I am deeply indebted to Professor Doyle Z. Williams
for his direction of this thesis and to the other members
of my committee, Professors Bill J. Bishop and Arthur T.
Roberts, for their helpful criticism.
11
TABLE OF CONTENTS
ACKNOWLEDGMENTS
ii
TABLE
31
I.
INTRODUCTION
.
1
The Increasing Scope of the Auditor's
Liability
1
Statement of Purpose and Scope
3
Statement of Purpose
3
Statement of Scope
3
Limitations of Study
....
3
Definition of Terms
4
An Overview of the Study
II.
6
HISTORICAL PERSPECTIVES OF THE AUDITOR'S
LEGAL LIABILITY
8
Auditor's Liability to the Client
8.
Craig v. Anyon
9
National Surety Corporation v. Lybrand
.
11
Auditor's Liability to Third Parties
by Common Law
Landell v. Lybrand
12
: . . . .
13
Ultramares Corp. v. Touche
14
State Street Trust Co. v. Ernst
15
0 'Connor v. Ludlam
17
Gammel v. Ernst and Ernst
19
Auditor's Liability to Third Parties
by Statute
111
20
IV
The Federal Securities Act of 1933 . . . .
20
The Federal Securities Exchange
Act of 1934
22
Summary
III.
25
SELECTED RECENT CASES CONCERNING THE AUDITOR'S
LIABILITY
27
Escott V. BarChris
Facts Surrounding the BarChris Case
28
...
28
Materiality
30
Due Diligence Defense
32
Review of Subsequent Events
33
Inquiry Procedures
34
Due Professional Care
36
Qualifications of the Public Accountant
.
U.S. V. Simon
38
38
Facts Pertaining to the Case
39
Issues Pertaining to the Case
41
Fischer v. Kletz
47
Annual Report Liability
49
Interim Statement Liability
51
Investment Corporation of Florida v.
Buchman
52
Rusch Factors, Inc. v. Levin
54
Facts of the Case
IV.
THE AUDITOR'S LEGAL LIABILITY IN THE FUTURE
Should the Accountant be Liable for
Negligence?
55
. .
60
60
Reasons for Not Extending the Auditors'
Liability
61
Objections to Extending the Accountants'
Liability
64
Benefits that Would Accrue to the Auditor
V.
SOLUTIONS TO THE LIABILITY PROBLEM
66
72
Reports
73
Working Papers
76
Pronouncements by the Profession
VI.
.
. . . .
78
Professional Competence
80
Statutory Relief
81
Agreements
82
Clients
82
Education
83
Resistance
83
Insurance'
83
SUMMARY AND CONCLUSIONS
86
Summary
86
Craig v. Anyon
National Surety Corporation v. Lybrand
86
.
87
Landell v. Lybrand
88
Ultramares Corp. v. Touche
88
State Street Trust Co. v. Ernst
89
0 'Connor v. Ludlam
89
Gammel v. Ernst and Ernst
89
BarChris
90
VI
Continental Vending
91
Yale Express
91
Investment Corp. of Florida v. Buchman
Rusch Factors v. Levin
Conclusions
.
92
92
92
Advantages to Extending the Accountant's
Liability
93
Steps the Accountant Can Take to
Mitigate This Increased Liability . . . .
94
SELECTED BIBLIOGRAPHY
97
CHAPTER I
INTRODUCTION
Since the turn of the century the growth of American
business has been phenomenal.
Because of the dramatic in-
crease in the complexity of business enterprises, it has
become increasingly difficult for the accountant to attest
to the fairness of financial statements.
The Increasing Scope of the Auditor's Liability
Independent Certified Public Accountants, employed by
directors or stockholders, have the responsibility to determine if the financial statements portray fairly the operations of the business.
During the early part of this century
the public accountant's liability for negligence or fraud
in performing the attest function was limited mainly to the
client.
This responsibility has been established by several
court decisions over the years. Within the last ten years
the courts have expanded the auditor's liability for gross
negligence to include third parties.
Because of these recent
landmark decisions the liability of the public accountant to
third parties has attained new dimensions.
If the present
trend in court decisions continues, the auditor's legal lia-.
bility to third parties will likely be expanded to include
ordinary negligence,-
With the trend of court decisions has come an increased
number of liability suits against the public accountant.
In
19 66 it was estimated that there were approximately one hundred suits litigated.
These suits have caused several prob-
lems to the public accountant and his profession.
First,
even if the accountant is acquitted, his reputation suffers
heavily as well as the reputation of his firm.
Secondly,
these suits are causing a loss of confidence in the accounting profession, and unless the profession remedies this situation, its usefulness to society will be limited.
There are several reasons, for the flood of suits, which
are described aptly in the following quotation:
(1) The hope of banks and other financial institutions to make accounting firms a source of salvage
when credit losses occur; (2) the general growth of
the American economy and the related increase in
loss potential in the event of a business failure;
and (3) the publicity accompanying the six million
dollar law suit against Peat, Marwick, Mitchell &
Co., the nation's largest public accounting firm,
brought by the two largest banks in the United
States, the Bank of America and the Chase Manhattan
Bank.2
To summarize these causes, it can be said that third parties
are trying to find a source for relief from losses they have
suffered, and lately this source has been the public accountant.
Constantine N. Katsoris, "Accountants' Third Party Liability—How Far Do We Go?" Fordham Law Review, XXXVI (December, 1967), 191.
p
"Potential Liability of Accountants to Third Parties
for Negligence," St. John's Law Review, XXXXI (1967), 597.
Statement of Purpose and Scope
Statement of Purpose
The chief objective of this study is to analyze court
decisions relating to the auditor's liability for the purpose
of determining the impact of these decisions upon the traditional concepts of the auditor's liability to third parties.
An additional objective is to provide steps the auditôr can
take to mitigate his exposure to liability claims resulting
from the recently expanded concepts of liability.
Statement of Scope
The scope of this study will include an examination of
several recent cases which have defined the auditor's liability to third parties and some ramifications of these cases.
Second, this study will include an analysis of the reasons
for the accountant's liability and suggest some remedies
which may assist in protecting the public accountant from
liable suits.
This investigation will also include a review
of literature and official pronouncements of the American
Institute of Certified Public Accountants (AICPA) and other
bodies as appropriate.
Limitations of Study
The scope of this study will be limited to the legal
responsibilities of the public accountant for financial statements.
This study will not include a discussion of the
accountant's liability for taxation matters.
Second, this
investigation will be limited to rulings by United States
courts.
Third, this investigation will concentrate on recent
developments which have affected the auditor's legal liability.
Fourth, this study will include cases which pertain
directly to the public accountant and not decisions pertaining to other professions.
Finally, the investigation will
be limited to cases which are of significant impact to the
accounting profession to clearly establish precedent.
Definition of Terms
For this study selected relevant terms and phrases will
be used in accordance with the following definitions:
Auditor, accountant, pub1ic accountant, and Certified
Public Accountant as used in this paper will refer to a
Certified Public Accountant in public practice.
Financial statements refer to the income statement and
balance sheet as well as any other statements, certified by
the auditor, that are included in the annual report.
Auditor's report is a written statement by the auditor
expressing the nature and scope of his examination and his
opinion concerning the fairness of the financial statements.
Auditing standards as used herein refer to the auditor's
professional qualities and "the judgment exercised by him in
the performance of his examination and in his report."
Negligence is "the failure of an auditor to perform, or
report upon, a professional engagement with the care a reasonable prudent man would exercise in the circumstances."
Gross negligence is "a reckless or extreme departure
from the standard of care a reasonable, prudent auditor would
exercise under the circumstances."
Fraud is a deliberate deception by the auditor when
g
rendering an opinion on financial statements.
Privity of contract means "a mutual or successive relationship to the same rights of property legalized by contract."^
Third parties as used herein refers to any investors who
rely on the financial statements and any creditors of the
business entity.
3
American Institute of Certified Public Accountants,
"Auditing Standards and Procedures," Statements on Auditing
Procedure No. 33 (New York: American Institute of Certified
Public Accountants, 1963), p. 15.
Robert M. Trueblood, "Legal Liability--A View From the
States," Accountancy (Eng.), LXXVII (September, 19 67), 580.
c
Samuel Thurston Montgomery, "Accountants' Liability to
Third Parties" (unpublished Master's thesis, Texas Tech University, 19 69), p. 6.
R. F. Salmonson, "A Prophetic Analogy," The Accounting
Review, XXXVII (July, 1962), 502.
•7
Funk and Wagnalls Encyclopedic College Dictionary (New
York: Funk & Wagnalls, 1968), p. 1073.
6
Common law is the law developed by the courts which is
q
not covered by written law or the Constitution.
Statutory law includes written law, such as the Consti9
tution and laws passed by legislative bodies.
An Overview of the Study
In order to obtain a historical perspective, the study
will first examine several selected cases which have established the auditor's legal liability in previous years. This
examination will not include all cases which have been decided, but rather cases in which the courts have clearly
established the auditor's responsibility by a so-called landmark decision.
The second chapter will also contain a brief
discussion of the Securities Acts of 1933 and 1934 as they
have established the auditor's responsibility by statute.
The next section of the study, chapter three, will examine selected cases decided in the 1960's which in many
instances have redefined the auditor's liability.
There will
be a detailed review of these cases because of their extreme
importance in understanding the auditor's liability at
present.
Chapter four will include a discussion of the
^Essel R. Dillavau, et al., Principles of Business Law
(Englewood Cliffs, N.J.: Prentice-Hall, I n c , 1964), p. 105.
^lbid., p. 106.
^
implications of the recent court decisions and their effect
upon the accounting profession.
It will also include an
analysis of the benefits to be gained by an increased liability to both clients and third parties.
Based upon the foregoing analysis, the fifth chapter
will seek to distill the criteria for mitigating the auditor's
liability.
The last chapter will summarize the important court
decisions reached in this decade and review the future implications of these decisions.
In conclusion, the study will
present the steps the Certified Public Accountant may take
to minimize the risk associated with performing work of an
auditing nature.
CHAPTER II
HISTORICAL PERSPECTIVES OF THE AUDITOR'S
LEGAL LIABILITY
Historically, auditors have been held liable to clients
and third parties by both common and statutory law.
The
common or court decided law has evolved for several centuries.
This chapter will be concerned with United States cases from
the turn of the century to 19 60.
f
The common law liability
of the auditor has been divided into two categories, liability to clients and liability to third parties.
This division
has been made because of the significant difference in the
responsibility the accountant has to these parties.
The third section of this chapter consists of the auditor's liability to third parties by statute.
The examinatiop/'
has been limited to the sections of the Securities Acts of
19 33 and 19 34 which pertain to the auditor's liability and
does not contain a discussion of any cases based on the
Securities Laws.
Because of their recent origin, cases in-
volving the Securities Laws will be investigated in the next
chapter.
Auditor's Liability tothe Client
/
V
The auditor's liability to his client is founded on a
contractual relationship which may be written or oral.
8
This
contract does not assure the client that the audit will uncover defalcations, but rather that the audit will be performed with reasonable care and diligence.
The accountant
is liable to his client "for negligence, bad faith or dishonesty, but not for losses consequent upon mere errors of
judgment."
A review of several cases as decided by the
courts may be helpful in understanding more fully the CPA's
responsibility to his client.
Craig v. Anyon
In this case the plaintiffs were members of a firm of
brokers in stocks and commodities.
The defendants were en-
gaged to audit the company's books quarterly from 1913 to
1917.
In May 1917 it was discovered that an employee in
charge of their commodities department had swindled over one
million dollars.
The plaintiffs alleged that the auditor was
negligent and had he not been, the fraud would have been
discovered.
The auditor was found guilty of negligence and assessed
a fine of $2,000, the amount paid as compensation for the
accountant's services.
The principal issue to be decided
was whether the accountant's negligence was the cause of the
"^^illiam L. Prosser, Prosser or Torts (St. Paul:
Publishing Co., 1941), p. 673.
West
•'•-'•Craig v. Anyon, 212 App. Div. 55, 208 N.Y. Supp. 259
(1926).
10
loss or whether the client was responsible because of contributory negligence.
To answer this question the court
considered the auditor's examination.
The auditor had not
confirmed the accounts receivable nor had he made any attempt
to determine the status of the open accounts.
In considering the client's negligence the court found
that the books for the commodities department were maintained
by the head of the department, Mr. Moore.
This procedure
was objected to by the auditor because of the lack of internal control.
In reaching a decision the court stated the
following:
We think the damages cannot be said to flow naturally and directly from defendants' negligence or
breach of contract. Plaintiffs should not be allowed to recover for losses which they could have
avoided by the exercise of reasonable care. . . .
The plaintiffs in effect contend that defendants
are chargeable with negligence because of failure
to detect Moore's wrongdoing, wholly overlooking
the fact that, although they were closely affiliated with Moore, who was constantly under their
supervision, they were negligent in failing properly to supervise his acts or to learn the true
condition of their own business and to detect his
wrongdoing.1^
The court also said that public accountants are expected
to use "such skill in the performance of their agreements as
reasonably prudent, skillful accountants would use under the
„13
circumstances.
Ibid., p. 57.
13
Ibid., p. 58.
11
In conclusion, the court followed the theory that the
auditor was liable to the extent of compensation he received.
The client is liable for any loss in excess of the auditor's
fee because of his own negligence.
However, this theory is
not always applied as demonstrated in the National Surety
Corporation case which follows.
National Surety Corporation v. Lybrand
The plaintiff in this case was a surety company which
had refunded Hable and Streglitz, a brokerage firm, for
losses sustained through thefts by the cashier in the main
office.
The defendants were three different public account-
ing firms who had audited the brokerage firm from 19 28 to
1933.
The plaintiff charged that the accountants were guilty
of "negligence in the conduct of their audit and fraud in the
alleged misrepresentation of material facts in their reports."
In the trial court's decision the judge dismissed the
case on the grounds that "the Court is unable to discover
anything in the testimony indicating a violation of the obligations of an expert accountant" and that "the principle laid
16
down in Craig v. Anyon is the one to be applied here."
•^"^National Surety Corporation v. Lybrand, 256 App. Div.
226, 9 N.Y. S. 2d 554 (1939).
•'•^lbid. , p. 228.
•'•^lbid. , p. 229.
12
The principle the judge referred to is "that the loss incurred could not be said to flow naturally and directly from
the defendants' negligence" because of the contributory negligence of the brokerage firm.
This decision was appealed and reversed and a new trial
ordered.
On reaching the decision to reverse the trial court
decision, the appellate court considered the question of contributory negligence at length.
The appellate court had the
following to say concerning contributory negligence:
Accountants, as we know, are commonly employed for
the very purpose of detecting defalcations which
the employer's negligence has made possible. Accordingly, we see no reason to hold that the accountant is not liable to his employer in such cases.
Negligence of the employer is a defense only when it
has contributed to the accountant's failure to perform his contract and to report the truth.-^^
Thus, it can be said that the accountant will be held
responsible to his employer in most cases.
Only in extreme
circumstances where the contributory negligence of the employer has led directly to misrepresentations by the accountant, will the accountant be released of his liability.
Auditor's Liability to Third Parties
*^
by Common Law
The accountant's liability to third parties has been
limited mainly to fraud because of the lack of a contractual.
•^'^lbid. , p. 230.
^^lbid., p. 233.
13
relationship.
However, in some cases where the auditor has
known in advance that a third party would rely upon his
opinion the court has held him responsible for negligence.
In order to understand more fully the accountant's liability
to third parties several cases will be discussed.
19
Landell v. Lybrand
This case is concerned with a suit brought against a
certified public accounting firm by a third party which had
relied on the financial statements.
The plaintiff alleged
that the financial statements were misleading and that he
relied on them when making his investment.
He also charged
that the auditors were negligent in the perfonnance of their
duties and consequently liable for the loss he sustained.
The courts found for the accountants stating the following:
There were no contractual relations between the
plaintiff and defendants, and, if there is any
liability from them to him, it must arise out of
some breach of duty, for there is no averment that
they made the report with intent to deceive him.
The averment in the statement of claim is that the
defendants were careless and negligent in making
their report; but the plaintiff was a stranger to
them and to it, and, as no duty rested upon them
to him, they cannot be quilty of any negligence of
which he can complain.20
19Landell v. Lybrand, 264 Pa. 406, 107 A. 783, 8 A.L.R.'
461 (1919).
^^John H. Myers, Auditing Cases (Chicago, Illinois:
Northwestern University Press, 1964), p. 15.
14
Ultramares Corp. v. Touche^-*In this case the Certified Public Accountants audited
the books of Fred Stern and Company and prepared thirty-two
copies of the balance sheet.
The auditors were aware that
the certified balance sheet was to be presented to several
banks and other creditors.
The plaintiff claimed that he
had relied on the balance sheet and had loaned substantial
amounts of money to Fred Stern and Company.
The plaintiff's
case was based on the failure of the auditor to discover an
overstatement of the accounts receivable by $950,000 and an
understatement of accounts payable by $300,000. Because the
auditor had failed to discover these mistakes the plaintiff
charged that he was guilty of fraud and negligence.
The Court of Appeals found that the accountant was
guilty of negligence,' but because of the lack of a specific
contract between the plaintiff and the defendant there did
not exist any liability on the accountant's part.
The court
stated the following in its opinion:
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. The hazards of a business
conducted on these terms are so extreme as to
21
Ultramares Corporation v. Touche, 255 N.Y. 170, 174
N.E. 441 (1931).
15
enkindle doubt whether a flaw may not exist in
the implication of a duty that exposes to these
consequences.22
However, the court went on to discuss how the act of
fraud might be inferred from a negligence act:
Our holding does not emancipate accountants from
the consequences of fraud. It does not relieve
them if their audit has been so negligent as to
justify a finding that they had no genuine belief
in its adequacy, for this again is fraud. It
does no more than say that, if less than this is
proved, if there has been neither reckless misstatement nor insincere profession of an opinion,
but only honest blunder, the ensuing liability
/
for negligence is one that is bounded by the con-tract, and is to be enforced between the parties
by whom the contract has been m.ade. We doubt
whether the average business man receiving a
certificate without paying for it, and receiving
it merely as one among a multitude of possible
investors, v/ould look for anything more.23
From the Ultramares Case several conclusions can be
drawn:
(1) that ordinary negligence on the part of the ac-
countant will not result in a liability to third parties,
and (2) that gross negligence (reckless misstatement or insincere profession of an opinion) can be inferred as fraud
and hence the accountant would be liable.
^24
State Street Trust Co. v. Ernst
In this case the accountant had audited the PelzGreenstein Company for 1928.
Pelz-Greenstein was engaged in
^^lbid., p. 444.
^^lbid., p. 445.
24State Street Trust Co. v. Ernst, 278 N.Y. 104, 15
N.E. 2d 416 (1938).
16
the factoring business and their working capital was supplied
by seventeen banks to whom an amount of $4,275,000 was owed
on December 31, 1928.
The plaintiff in this case was one of
the banks and claimed that he had relied on the financial
statements prepared by the accountant when making the loan
to Pelz-Greenstein.
He further claimed that the auditor was
grossly negligent in the performance of his audit because of
an inadequate review of the allowance for doubtful accounts.
The facts surrounding the case are as follows:
1.
The accountant prepared eleven copies of the PelzGreenstein financial statements of which ten copies
were to be used to obtain credit.
The standard
short form report was attached to each.
2.
Thirty days later the accountants issued a long form
report which was submitted to only the client.
3.
The plaintiff alleged that the long form report contained material information which should have been
revealed to the creditors.
4.
The accountants had accepted the client's word that
the provision for bad debts was sufficient and had
not investigated the account.
The actual loss on
doubtful accounts amounted to $215,000.
In deciding this case the Courts of Appeals cited the
Ultramares decision:
We have held that in the absence of a contractual
relationship or its equivalent, accountants cannot
17
be held liable for ordinary negligence in preparing a certified balance sheet even though they are
aware that the balance sheet will be used to obtain credit (Ultramares Corp. v. Touche, 255 N.Y.
170). Accountants, however, may be liable to third
parties, even where there is lacking deliberate or
active fraud. A representation certified as true
to the knowledge of the accountant when knowledge
there is none, a reckless misstatement, or an opinion based on grounds so flimsy as to lead to the
conclusion that there was no genuine belief in its
truth, are all sufficient upon which to base liability. A refusal to see the obvious, a failure •
to investigate the doubtful, if sufficiently gross,
may furnish evidence leading to an inference of
fraud so as to impose liability for losses suffered
by those who rely on the balance sheet.25
^^
The court further stated that because the accountant failed
to inform the creditors of the long form report and failed
to investigate the doubtful accounts, he was guilty of gross
negligence.
26
O'Connor v. Ludlam
This case was brought by a group of stockholders who
had purchased the preferred stock of G. L. Miller and Company.
The plaintiff purchased the stock during 1925 and 1926 and
the corporation was adjudicated bankrupt in 1926.
This suit
did not come to trial until 1934, following the final decision in the Ultramares case.
The plaintiff brought suit
against the accountant for fraud instead of negligence because
25State Street TrustCo. v. Ernst, op. cit., p. 111.
^^O'Connor v. Ludlam, 92 F. 2d 50 (2d Cir.), certiorari
denied, 302 U.S. 758 (1937).
18
of the Ultramares decision.
The Circuit Court of Appeals
upheld the trial court decision in finding for the defendant
and certiorari was denied by the Supreme Court of the United
States.
The prominent issues on which the plaintiff based his
case were:
1.
2.
3.
4.
The audit and balance sheet were claimed to be
"intentionally fraudulent in not adequately disclosing the amount of cash held in trust."
Payments made by Miller & Company to complete
the construction of mortgaged buildings were
falsely shown in the balance sheet to be
"Secured."
Miller & Company itself guaranteed to bondholders
the completion of buildings under construction,
and the balance sheet made no mention of such contingent liabilities.
The defendants made a false certificate as to the
earnings of Miller & Company.27
In commenting on the definition of fraud when applied to the
accountant the Circuit Court stated the following:
. . . fraud may be established by showing that.a
false representation has been made, either knowingly, or without belief in its truth, or in reckless disregard of whether it be true or false; and
that the issue was whether the defendants had an
honest belief that the statements made by them were
true. "If they did have that honest belief, whether
reasonably or unreasonably, they are not liable. If
they did not have an honest belief in the truth of
their statements, then they are liable, so far as
this third element [scienter] is concerned."28
Saul Levy, Accountant's Legal Responsibility (New York:
American Institute of Accountants, 1954), p. 41.
28O'Connor v. Ludlam, op. cit., p. 53.
19
The Circuit Court concluded that the jury had been properly
instructed and that the verdict for the accountant should
not be reversed.
Gammel v. Ernst and Ernst
The plaintiff in this case, President of Midway Creamery
Corporation, entered into agreement with Sanitary Farm Dairy
to merge the two corporations.
437 shares of common stock.
The plaintiff was to receive
The newly formed corporation
was to pay the plaintiff a sum equal to "twelve times the
net earnings per share of said common stock for the preceding
30
twelve months."
In the event the parties could not agree
on the net earnings per share, an independent auditor was to
be hired to determine the earnings.
In June of 19 4 6 the auditors completed their review and
determined that the reported earnings for 1944 were
$180,602.90 before taxes. On August 6, 1946, the plaintiff
filed suit against the auditors "for bias, gross mistake,
31
and fraud."
The court found that the audit by Ernst and
Ernst contained fraud and the actual earnings for 1944 were
$227,475.15.
In reaching a decision the court stated that
the accountant could not be classified as a quasi arbitrator
29 Gammel v. Ernst and Ernst, 54 ALR 2d 316 (1955).
-^^lbid., p. 319.
^•'•Ibid., p. 320.
20
immune from liability.
The court went on to say that the
standards of reasonable care which apply to lawyers, doctors,
architects, and engineers in furnishing skilled services for
compensation apply to the public accountant.
Auditor's Liability to Third Parties by Statute
In addition to liability by common law, the auditor has
a civil and criminal liability to third parties by statutory
law.
The auditor's liability to third parties by statute is
derived mainly from the Federal Securities Act of 1933 and
the Federal Securities Exchange Act of 1934. The passage of
these Acts was brought about primarily by the stock market
crash of 1929.
Many of the listed companies had written up
their assets and distorted earnings in an effort to present
a favorable financial picture.
The Securities Acts were passed with the intention of
providing the general public with reliable financial information.
To enforce these Acts the Securities Exchange Commis-
sion was established to review the financial information
published by publicly listed companies.
32
The Federal Securities Act of 1933
The primary purpose of the Federal Securities Act of
1933 was to provide full and fair disclosure of securities
^^Federal Securities Act of 1933, 48 Stat. 74 (1933), as
amended, 15 U.S.C. ## 77a-77aa (1964).
21
issued to the public by companies in interstate and foreign
commerce.
To achieve this purpose the Securities and Ex-
change Commission (SEC) requires the filing of a Registration
Statement with the issuance of securities.
The Registration
Statement contains both historical and financial inform.ation
about the corporation.
Any material fact concerning the
corporation must be disclosed within the Registration Statement or the accountant can be held liable to the public.
The concept of materiality is defined as follows by the SEC:
"The information required to those matters as to which an
average prudent investor ought reasonably to be informed
33
before purchasing the security."
The Securities Act of 1933 creates a responsibility for
the auditor to the investing public, but does not provide
the creditors of the company protection.
Section 11(a)
establishes the auditor's liability to the public as follows:
In case any part of the registration statement,
when such part became effective, contained an
untrue statement of a material fact or (which has)
omitted to state a material fact required to be
stated therein or necessary to make the statements therein not misleading, any person acquiring such security . . . may, either at law or in
equitv, in any court of competent jurisdiction,
sue.^^
^•^Louis H. Rappaport, SEC Accounting Practice and Procedure, Revised Printing (New York: The Ronald Press Company, 1959), p. 212.
^"^Federal Securities Act of 1933, op. cit., 82 #77K(a).
22
The auditor, as a defense, must prove that he had reasonable
grounds to believe that the financial statements were true
and that there were no omissions of material facts which
would have affected the investor's judgment.
The Securities Act of 1933 has significantly expanded
the auditor's liability to third parties and in so doing
has negated the common law decisions which have protected
the accountant.
Secondly, the burden of proof has been
placed upon the auditor rather than the plaintiff.
Thirdly,
the accountant must prove that the loss sustained by the
plaintiff was not caused by the omission of material facts
within the financial statements.
Under common law the
plaintiff is required to show that he relied upon the financial statements and that they were the proximate cause of
his loss.
Finally, the public accountant is liable "not
only as of the date of the financial statements, but beyond
that, as of the time when the Registration Statement becomes
effective."^^
The Federal Securities Exchange
Act of 1934^^
The Securities Act of 1934 was passed to extend the
coverage of the 1933 Act.
The 1934 Act provides for the
Levy, op. cit., p. 47.
^^Federal Securities Exchange Act of 1934, 48 Stat. 881
(1934) as amended, 15 U.S.C. ##78a-78bb (1964).
23
regulation of the national exchanges and over-the-counter
markets.
It requires companies listed on the national ex-
changes to file annual reports with the SEC.
Prior to the
passage of the Securities Exchange Act of 1934 the Federal
Trade Commission enforced the Securities Act of 19 33.
The
19 34 Securities Act established the Securities and Exchange
Commission for the purpose of enforcing the provisions of
the 1933 and 1934 Securities Acts.
Section 18 of the 1934 Act protects the public from
misleading statements certified by the auditor.
The section
states that:
Any person who shall make or cause to be made any
statement in any application, report, or document
filed pursuant to this chapter or any rule or regulation thereunder . . . which statement was at the
time and in the light of the circumstances under
which it was made false or misleading with respect
to any material f'act, shall be liable to any person (not knowing that such statement was false or
misleading) who, in reliance upon such statement,
shall have purchased or sold a security at a price
which was affected by such statement, for damages
caused by such reliance, unless the person sued
shall prove that he acted in good faith and had no
knowledge that such statement was false or misleading.^'
There are several significant differences between the
1933 Act and the 1934 Act.
First, the 1933 Act protects
only the buyer of the securities, whereas the 1934 Act
^"^Federal Securities Exchange Act of 1934, 48 Stat. 881
(1934), as amended, 15 U.S.C. ##78a-78hh (1934), pp. 897-98,
78r(a) .
24
protects both the buyer and the seller.
Second, under the
19 34 Act the accountant is not obligated to extend his examination beyond the completion date of the audit.
The 19 34 Act requires that the Registration Statement
be accurate and not misleading "at the time and in the light
of the circumstances under which it was made."^^ Therefore,
the accountant cannot be held liable for events subsequent
to the signing of the Registration Statement.
Third, the 1934 Act provides that the plaintiff must
prove that he relied upon the financial statements and that
they were the proximate cause of his injury.
Under the 1933
Act the accountant had to prove that the loss by the plaintiff was not caused by the omission of material facts within
the financial statements.
Fourth, under the 19 34 Act the plaintiff does not have
to prove negligence or fraud by the auditor.
The auditor may
use as a defense the fact that he "acted in good faith and
had no knowledge that such statements were false or misleading."
Therefore, it would seem that the accountant would
not be liable for negligence provided he had acted in good
faith.
^^Spencer Gordon, "Liability of Accountants Under Securities Exchange Act of 1934," The Journal of Accountancy, LVIII
(October, 1934), 257.
Levy, op. cit., p. 50.
25
Summary
In summarizing the historical respects of the accountant's liability the following major points should be noted.
The auditor is responsible to his client to perform the
audit with the ordinary care a reasonable, prudent accountant
would use under the circumstances.
Should the auditor fail
to perform the audit in this manner he will be liable to the
client for negligence or fraud.
In cases where contributory
negligence by the client has led directly to misrepresentations by the accountant, the auditor will be responsible only
to the extent of the audit fee.
The auditor, because of the lack of a contractual relationship, will not be held liable to third parties for ordinary negligence.
Only in cases where the accountant has made
a reckless misstatemerit or an insincere profession of an
opinion will he be liable to third parties.
Thus, the ac-
countant will be responsible to third parties when.the negligences is sufficiently gross as to infer fraud.
As a defense
the auditors must prove that they "had an honest belief that
40
the statements made by them were true."
Also, it should
be noted that the auditor is subject to the same standards as
doctors, lawyers, architects, and engineers.
The Securities Act of 1933 places responsibility on the'
O'Connor v. Ludlam, op. cit., p. 53.
26
accountant for an untrue statement of a material fact or
omission of a material fact.
The 1933 Act also extends the
auditor's responsibility to the effective date of the Registration Statement.
Under the Securities Exchange Act of 1934 the accountant is liable to any person that relied upon his statements
when purchasing or selling securities.
As a defense the
auditor must prove that "he acted in good faith and had no
knowledge that such statements were false or misleading. "'^-'The 1934 Act also releases the auditor of liability subsequent to completion of his examination.
Federal Securities Exchange Act of 1934, op. cit.,
pp. 897-98, 78r(a).
CHAPTER III
SELECTED RECENT CASES CONCERNING
THE AUDITOR'S LIABILITY
Within the decade of the sixties the accountant's responsibility for financial statements was expanded in almost
every conceivable direction.
First, accountants were found
guilty of negligence under the Securities Act of 1933 and
the judge elaborated upon the concept of materiality.
Second,
accountants were convicted of fraud under the Securities Exchange Act of 1934 for preparing financial statments which
were false and misleading.
Third, the auditor's responsi-
bility may be expanded to include a perpetual liability for
the financial statements.
Another inroad was made on the
auditor's legal responsibility when a State Supreme Court
ruled that accountants can be liable to third parties that
they knew would rely upon the financial statements. This
decision was based on common law rather than statutory law
as in the preceding cases.
In another case the extent of
the auditor's liability to knov/n third parties was defined.^
The court stated that the accountant is liable for damages
which the third party suffered when relying on the financial
statements.
Thus, it is evident that a thorough investiga-
tion of these precedent setting cases is necessary to
27
28
ascertain the present extent of public accountants' liability for financial statements.
Escott V. BarChris"^^
The BarChris case was one of the most significant cases
ever tried under the Securities Act of 1933.
This case was
the first to be brought under Section 11 of the Securities
Act of 1933.
Judge McLean's opinion established new standards
for materiality, subsequent period events, qualifications of
the auditor, and extended the auditor's liability to include
negligence to third parties.
Facts Surrounding the BarChris Case
The BarChris Construction Company was primarily engaged
in the construction of bowling alleys and participated in the
bowling alley boom frôm 1956 to 1960. Sometime between 1961
and 19 62 the market became saturated and BarChris, because
of over-expansion, was forced to declare bankruptcy.
To finance construction of the bowling alleys, BarChris
accepted notes for the balance.
The notes were normally dis-
counted to a bank, thus becoming a contingent liability on
BarChris's balance sheet.
To help finance operations BarChris
made a public offering of common stock and later an offering
42 cott V. BarChris Construction Corporation, 283 F.
Es
Supp. 643 (1968)
29
of debentures.
In October 19 62 BarChris defaulted on the
interest payment to tlie debenture holders and on October 25,
19 62, the plaintiffs filed suit alleging:
. . . that the registration statement with respect
to these debentures filed with the Securities and
Exchange Commission, which became effective on
May 16, 19 61, contained material false statements
and material omissions.43
Judge McLean made an extensive review of the registration statement and concluded it contained false and misleading statements.
In reaching his decision the judge placed
particular emphasis on the matter in v/hich the proceeds of
the debentures were employed.
The net proceeds of the debentures which amounted to
$3,202,298.85 were deposited in a new account at the Irving
Trust Company.
The purpose of the sale of the debentures
was to finance the construction of a new plant and to develop a new equipment line.
Shortly after depositing the
proceeds, withdrawals totaling $1,379,000 were made.
The
purpose of the v/ithdrawals was to repay loans from the officers of the company and construction costs incurred in preceding months.
It v/as also discovered that as of May 19 61
BarChris had borrowed $600,00 0 and held up payments to creditors totaling $400,000.
These factors were not mentioned in
the prospectus, nor was the fact that approximately 60
^"^lbid., p. 644.
30
percent of the net proceeds from the debentures would be used
"in paying prior debts incurred as a result of alley construction already undertaken. "^"^ Because of these and other
factors, the judge concluded that the BarChris prospectus
was misleading.
However, for accountants to be held respon-
sible for negligence under the 19 33 Securities Act, the misstatements must be of a material amount.
Materiality
Judge McLean's decisions concerning materiality are of
importance because "they present difficult judgments on
actual dollar amounts and, more significantly, because the
judge expanded the criteria for determining materiality." 45
The judge considered each issue separately to determine
its significance.
Table 1 presents the relevant figures on
which Judge McLean based his decision.
In considering the question of materiality the court
relied.on a definition from an earlier case:
. . . a fact which if it had been correctly stated
or disclosed would have deterred or tended to deter the average prudent investor from purchasing
the securities in question.46
^"^lbid., p. 657.
^^Douglas R. Carmichael, "The Auditor's Statutory Liability to Third Parties," The Texas Certified Public Accountant, XXXVIII (October, 1968), 5.
"^^lbid., p. 8.
31
TABLE 1
RELEVANT FIGURES FROM BARCHRIS'S FINANCIAL STATEMENTS
BALANCE SHEET (19 60)
Current Assets
Current Liabilities
Current Ratio
INCOME STATEMENT (19 60)
Sales
Net Operating Income
Earnings Per Share
CORPORATIVE EARNINGS (19 59)
Sales
Net Operating Income
Earnings Per Share
Source:
REPORTED
ACTUAL
$4,524,021
2,413,867
1.9
$3,924,000
2,478,000
1.6
$9,165,320
1,742,801
75 cents
$8,511,420
1,496,196
65 cents
$3,320,121
441,103
33 cents
Douglas R. Carmichael, "The Auditor's Statutory
Liability to Third Parties," The Texas Certified
Public Accountant, XXXVIII (October, 1968), 5.
The judge realized that the definition was actually indeterminate.
Since no one knows what moves or does not move the
mythical "average prudent investor," it comes down
to a question of judgment, to be exercised by the
trier of the fact as best he can in the light of
all the circumstances.47
The court ruled that the misstatements within the income
statement were not misleading.
In so finding Judge McLean
reasoned as follows:
These debentures were rated "B" by the investment
rating services. They were thus characterized as
"^"^lbid.
32
speculative, as any prudent investor must have
realized. It would seem that anyone interested in
buying these convertible debentures v/ould have
been attracted primarily by the conversion feature,
by the growth potential of the stock. The growth
which the company enjoyed in 19 60 over prior years
was striking even on the corrected figures. It is
hard to see how a prospective purchaser of this
type of investment would have been deterred from
buying if he had been advised of these comparatively minor errors in reporting 19 60 sales and
earnings.48
However, the judge ruled that the over-statement of the current assets and the under-statement of the current liabilities was of a material amount even though the securities
were presumed to be growth oriented.
There are several significant features of Judge McLean's
decision concerning materiality.
1.
In determining the significance of a misstatement
the amount is not the only determinate factor.
2.
The court placed considerable weight on the purpose
for which the investor purchased the securities.
Due Diligence Defense
Under the Securities Act of 1933 the auditor is liable
for negligence provided he cannot establish his innocencé by
use of the due diligence defense.
To sustain this defense
the auditor must prove that he made a reasonable investigation and that there were no material omissions from the
Ibid.
33
registration statement.
In considering the auditor's defense
the court contemplated several technical auditing questions.
Review of Subsequent Events
The auditor is required by statutory law to make a review of events which have taken place between the date of
the financial statements and the effective date of the registration statement.
The purpose of this review is:
. . . to ascertain whether any material change has
occurred in the company's financial position which
should be disclosed in order to prevent the balance
sheet figures from being misleading. The scope of
such review, under generally accepted auditing standards, is limited. It does not amount to a complete audit.49
The court found that Peat, Marwick, Mitchell & Co.'s
(PMM) program conformed to generally accepted auditing standards and included the following:
1. Review minutes of stockholders, directors
and c o m m i t t e e s . . . .
2. Review latest interim financial statements
and compare with corresponding statements of preceding year. Inquire regarding significant variations and changes.
4. Review the more important financial records
and inquire regarding material transactions not in
the ordinary course of business and any other significant items.
' e'. 'lnquire as to changes in material contracts....
^^lbid., p. 9.
34
^^rnÍn;^-.^?'^''^^^ ^^ ^° ^""^ significant bad debts or
been Sade
^''^^''^^
^^^ ^^^^h provision has not
Kni^í- ^''^V^^^ as to . ; ; Aewly discôvêr^d'liabilities, direct or contingent. . . .50
Judge McLean concluded that the auditor had failed to carry
out the steps required by the S-1 review.
The accountants
had failed to read the prospectus, read any contract documents, read the minutes of executive committee meetings, or
éxamine financial records other than the trial balance.^^
The judge also stated that there were sufficient danger signals within the documents the auditor examined to require
further investigation.
Another auditing question which the
court considered at length was the inquiry procedures employed by the auditor.
Inquiry Procedures
The court criticized the auditor for being too easily
satisfied with the ansv/ers he received to questions regarding
the subsequent period events.
The judge stated:
He [the auditor] asked questions, he got answers
which he considered satisfactory, and he did
nothing to verify them.
. . . He was too easily satisfied with glib answers
to his inquiries.
It is not always sufficient merely to ask questions.52
50
p. 658. Escott V. BarChris Construction Company, op. cit..
51Carmichael, op. cit., p. 10.
Escott V. Barchris Construction Company, op. cit..
659.
35
An accountant is required by the third standard of
field work to obtain
. . . sufficient competent evidential matter
through inspection, observation, inquiries and
confirmations to afford reasonable basis for an
opinion regarding the financial statements under
examination.53
Judge McLean stated that for the public accountant to
merely ask questions is not sufficient.
The auditor must be
able to verify, or test the answer so as to have a basis for
an opinion.
There are several examples of insufficient verification
in the BarChris case.
One instance was when the auditor in-
quired about a certain Capital Lanes.
The auditor testified
that he was told that Capital Lanes was not yet in existence,
but was the site of a prospective location.
In actuality
Capital Lanes existed, but under the name of Heavenly Lanes.
The court stated that the accountant should have been aware
to this misstatement because of insurance payments which
were being made on Capital Lanes.
By this maneuver the offi-
cers of BarChris were able to include the sales and profits
of this alley in the income statement and not include the
liability on the balance sheet.
In reaching a conclusion concerning the accountant's
inquiry procedures, the court stated that "Accountants should
^^American Institute of Certified Public Accountants,
"Auditing Standards and Procedures," op« cit., p. 34.
36
not be held to a standard higher than that recognized in
their profession.
I do not do so here."^"^ The judge ruled
that the inquiry was inadequate and the accountant liable
for the misstatements.
Due Professional Care
The auditor, under generally accepted auditing standards
is required to exercise "due professional care . . . in the
performance of the examination and the preparation of the
report." 55 This standard requires the auditor to extend his
examination if his suspicions are aroused during his investigation.
In the BarChris case an example is given of the criteria
used to determine whether the auditor exercised due professional care.
A factoring institution made a temporary loan
in December 19 60 to BarChris to increase their cash balance
on the December 31, 19 60, financial statements. Although
extended auditing procedures by PMM would have revealed the
payment v/as conditional, the court held that "it would be
contrary to reason to require the auditor to examine all of
^"^Escott V. BarChris Construction Company, op. cit.,
p. 665.
^^American Institute of Certified Public Accountants,
"Auditing Standards and Procedures," op. cit., p. 15.
^
/
37
BarChris's correspondence files when he had no reason to
suspect any irregularity."^^
Due profession care by the auditor is required in the
^
preparation of the working papers as well as the performance
of the examination.
The work papers should contain sufficient
documentation to "support the auditor's opinion and his representation as to compliance with auditing standards."^^
When reviewing PMM's work papers Judge McLean found
several instances in which there was insufficient documentation to support an opinion by the accountant.
In one in-
stance the auditor testified that he had based his computation of BarChris's contingent liability on an agreement
between BarChris and the factor.
The court ruled that the
computation of the liability was incorrect and found no evidence of any agreement between the factor and BarChris
within the working papers.
This example displays vividly
the importance of complete and accurate working papers which
are necessary to limit the auditor's responsibilities to
third parties.
Escott V. BarChris Construction Company, op. cit..
p. 666.
57American Institute of Certified Public Accountants,
"Auditing Standards and Procedures," op. cit., p. 23.
38
Qualifications of the
Public Accountant
Generally accepted auditing standards require that the
audit "is to be performed by a person or persons having
adequate technical training and proficiency as an auditor."^^
In reviewing the auditor's qualifications Judge McLean
stated the following:
He was not yet a C.P.A. He had no previous experience with the bowling industry. This was his
first job as a senior accountant. He could hardly
have been given a more difficult assignment.59
Clearly, the court was less than satisfied with the qualifications of the senior accountant and the supervision displayed by the manager and partner.
In conclusion, it should be noted that where clear, concise auditing standards exist, the court will rely on them
in making a decision.
When no standards exist, or if they
lack clarity and contain ambiguity, the court will supplement these with standards it feels are required of a prudent
auditor.
60
U.S. V. Simon
Up to this point this study has concentrated on civil
^^lbid., p. 18.
^^Escott V. BarChris Construction Company, op. cit.,
p. 669.
U.S. V. Simon, U.S. Court of Appeals, Second Circuit
(1969), p. 3817.
39
suits involving the CPA.
The case of U.S. v. Simon concerns
the accountant's liability for criminal fraud.
To establish
criminal fraud the Government must prove that "the financial
statements were false or misleading in a material respect
and the defendants knew it to be and deliberately sought to
mislead."
The indictment was brought against three members pf a
prominent public accounting firm, Simon, Kaiser and Fishman,
for violations of the U.S.C. and the Securities Exchange Act
of 1934.
Section 32 of the 1934 Act "renders criminal the
willful and knowingly making of a statement in any required
report which was false or misleading with respect to any
material fact."
In June 19 68 the U.S. District Court found the defendants guilty of fraud'and fines were assessed to Simon for
$7,000 and Kaiser and Fishman $5,000 each.
The defendants
appealed the decision to the U.S. Court of Appeals.
The
Court of Appeals affirmed the District Court's decision on
November 12, 19 69.
Facts Pertaining to the Case
This case involves the published financial statements
of Continental Vending Machine Corporation (Continental)
^•^lbid., p. 3819.
^^lbid.
40
for 19 62 as well as events preceding and subsequent to this
date.
The accounting firm of Lybrand, Ross Brothers and
Montgomery began auditing Continental in 1956 and continued
until the corporation was declared bankrupt in February 1963.
Continental had as an affiliate the Valley Commercial
Corporation (Valley) which was engaged in lending money to
Continental and other companies in the vending machine. business.
The president of Continental was Harold Roth who also
had controlling interest in Valley.
Continental was in the
practice of issuing negotiable notes to Valley, who would in
turn discount these to a bank and transfer the proceeds to
Continental.
As of the 19 62 financial statements the payable
to Valley amounted to $1,029,4 75.
Another practice, which was common between these companies, was loans from Continental to Valley and then loans
from Valley to Roth.
Roth used the money to finance stock
market transactions from 19 57 to 19 62.
Because of these
transactions the Continental financial statements contained
both a Valley payable and a Valley receivable.
These amounts
could not be offset because the notes from Continental had
been discounted.
At the end of 19 62 the Valley receivable
amounted to $3.5 million, and by February 19 63 it had risen
to $3.9 million.
The majority of this receivable consisted
of loans to Roth to finance his stock market transactions.
In December 19 62 the auditors learned that Valley was not
41
able to repay the debt and required that collateral be posted.
To accomplish this Roth posted his equity in certain securities as collateral for his loan from Valley and hence secured
the loan from Valley to Continental.
The securities which
were posted consisted of approximately 80 percent Continental stock and convertible debentures.
In a footnote to the 19 62 Continental balance sheet the
auditors stated that the Valley receivable was secured by
certain marketable securities which as of February 15, 19 63,
exceeded the net receivable.
The Government had two objec-
tions to the footnote:
(1) A statement should have been made informing the
stockholders that the payable could not be netted
against the receivable.
(2) The nature of the collateral should have been disclosed.
The Government also contested the valuation of the marketable
securities.
They contended that the securities should have
been valued at $1,978,000 rather than $2,978,000 because of
liens against the securities.
Issues Pertaining to the Case
The prosecution's case was based on two central issues.
First, the financial statements failed to disclose that
loans made to Valley were of approximately the same amount
as the loans from Valley to Continental's president, Harold
42
Roth.
Second, the auditors failed to disclose that "a sub-
stantial part of the collateral securing the Valley receivable
consisted of common stock of Continental principally owned by
Roth."^^
In defense of these issues the auditors contended that
disclosure of this nature was not required by generally accepted auditing standards.
To prove their contention the
defendants called eight expert accountants to testify in
their behalf.
The expert testimony verified the auditors'
contentions except for the netting of the Valley receivable
against the Continental payable.
The expert witnesses testi-
fied that:
. . . neither generally accepted accounting principles nor generally accepted auditing standards
required disclosure of the make-up of the collateral or of the increase of the receivable after
the closing date of the balance sheet, although
three of the eight stated that in light of hindsight they would have preferred that the make-up
of the collateral be disclosed.64
The witnesses also testified that disclosure of the loan
from Valley to Roth was not required under generally accepted
auditing standards.
In justifying this view the witnesses
stated that to
. . . reveal what Valley had done v/ith the money
would be to put into the balance sheet things that
did not properly belong there; moreover, it would
^-^lbid. , p. 3826.
^"^lbid., p. 3832.
43
create a precedent which would imply that it was
the duty of an auditor to investigate each loan to
an affiliate to determine whether the money had
found its way into the pockets of an officer of
the company under audit, an investigation that
would ordinarily be unduly wasteful of time and
money."5
The Government called several accounting witnesses, including the SEC chief accountant.
Most all of these wit-
nesses took a contrary view and stated that for adequate
disclosure it would have been necessary for the auditors to
reveal the loans from Valley to Roth and the makeup of the
collateral.
In reaching a decision the judge stated that the
. . . critical test was whether the financial
statements as a whole fairly presented the financial position of Continental as of September 30,
19 62, and whether it accurately reported the operations for fiscal 1962. If they did not, the
basic issue became whether defendants acted in
good faith. Proof of compliance with generally
accepted standards was evidence which may be very
persuasive but not necessarily conclusive that he
acted in good faith, and that the facts as certified were not materially false or misleading.^^
Thus, it is evident that the court placed more weight on the
fairness of the financial statements rather than their compliance with generally accepted auditing standards.
The judge agreed with the defendants that advances by a
company to an affiliate do not impose a duty on the
^^lbid.
^^lbid., p. 3833.
44
accountant under ordinary circumstances.
But, the court
went on to state:
. . . it simply cannot be true that an accountant
is under no duty to disclose what he knows when
he has reason to believe that, to a material extent, a corporation is being operated not to carry
out its business in the interest of all the stock-^
holders but for the private benefit of its president.
For a court to say that all this is immaterial as
a matter of law if only such loans are thought to
be collectible would be to say that independent •
accountants have no responsibility to reveal known
dishonesty by a high corporate officer. If certification does not at least imply that the corporation has not been looted by insiders so far as the
accountants know, or, if it has been, that the
diversion has been made good beyond peradventure
(or adequately reserved against) and effective
steps taken to prevent a recurrence, it would mean
nothing, and the reliance placed on it by the public would be a snare and a delusion.^'
In evaluating the application of generally accepted
auditing standards to this instance the court said that the
accountant is to use these standards as guides in the usual
case.
If, as a result of his investigation, the accoun-
tant's suspicions are aroused, he is to make full disclosure
of all relevant facts.
Another issue the court considered was the failure of
the auditor to describe the collateral used to secure the
note from Roth to Valley.
As previously mentioned, the
auditors had required that collateral be posted to ensure
the collectibility of the Valley receivable.
^"^lbid.
The court
45
questioned the auditor's judgment when they accepted the Continental stock as security for the debt owed by Valley.
Since Continental itself was experiencing major financial
difficulties the auditors could hardly have been justified
in accepting this as collateral.
An issue that was questioned by the defense counsel was
the lack of motivation for the defendants to perpetrate such
fraud.
The court agreed that in most cases the motivation
was much clearer than in this case.
The defendants were not
guilty of accepting any bribes nor was the Continental account so large as to influence their judgment.
The Govern-
ment contended:
. . . that the defendants in the course of their
audits of Continental in the years preceding 19 62
also had had an obligation to inquire into the
affairs of Valley (and to disclose Roth's borrowings, which would have been revealed by such inquiry); and that their failure to make such inquiry
gave them a reason to falsify the 19 62 balance
sheet—namely, concealment of their earlier failure to inquire.68
In reaching a decision concerning the criminal intent
of the defendants, the judge stated:
Even if there were no satisfactory showing of motive, we think the Government produced sufficient
evidence of criminal intent. Its burden was not
to show that defendants were wicked men with designs on anyone's purse, which they obviously were
^^American Institute of Certified Public Accountants,
"The Continental Vending Case," The Journal of Accountancy,
CXXVI (November, 19 68), 55.
46
not, but rather that they had certified a statement knowing it to be false.69
The American Institute of Certified Public Accountants
(AICPA) filed a memorandum with the Court of Appeals in an
effort to obtain an acquittal for the defendants.
The ef-
fort was unsuccessful, but the memorandum contained several
statements relevant to this study.
The Institute found that
the Continental case was
. . . a unique case: the first in which an accountant has been charged with criminal responsibility
for financial statements alleged to be false and
misleading by reason of failure to make disclosure
asserted to be required by professional standards.70
The Institute also pointed out that the defendants were
charged with having knowledge of a professional standard
which "could be found in no places more accessible than the
71
minds of some accountants."
Because of the lack of gen-
eral support for the existence of auditing standards requiring disclosure of this nature the AICPA questioned the
validity of convicting the accountants by hindsight.
The
Institute stated the following:
The essential vice of allowing a finding of guilty
knowledge regarding a professional standard upon
a record as thin and doubtful as that presented
here is that it exposes a professional person to
the risk of criminal liability for the exercise of
69U.S. V. Simon, op. cit., p. 3840.
^^American Institute of Certified Public Accountants,
"The Continental Vending Case," op. cit., p. 57.
'^-^lbid., p. 60.
47
his honest professional judgment, for it allows
his judgment to be tested by the hindsight judgment
of other members of the profession without any real
assurance that he knew at the time what that other
judgment might be.72
An important conclusion which can be drawn from the
Continental case is that accountants are required by law to
disclose all pertinent information.
In areas where gener-
ally accepted auditing standards are lacking or lack clarity
concerning disclosure the accountant should place primary
interest upon the fair presentation of the facts.
Fischer v. Kletz'^'^
In this case the plaintiff sought action against the
defendant under Section lOb and lOb-5 of the Securities
Exchange Act.
The plaintiff alleged that the accounting
firm of Peat, Marwick, Mitchell & Co. (PMM) had certified
financial statements which were materially false and that
the accountant failed to disclose information acquired subsequent to the certification.
This case is significant
. . . both for its expansion of the traditional
duties of independent accountants to responsibility for non-disclosure and for its unique application of the federal securities anti-fraud provisions, incorporated in rule lOb-5, to a case
^.
"^^lbid.
"^-^Fischer v. Kletz, 266 F. Supp. 180 (S.D.N.Y. 1967).
48
involving neither a corporate insider, a brokerdealer, a corporate issuer nor a party to a
securities transaction.74
Early in 19 64 PMM undertook the annual audit of Yale
Express System (Yale).
The audit was completed and a certif-
icate was issued for the December 31, 1963, financial statements on March 31, 19 64.
On or about June 29, 19 64, the
annual report Form lOK was filed with the SEC.
In May 19 64 the auditors were engaged by Yale to conduct
a "special study of Yale's current income and expenses."^^
The study was concluded May 5, 19 65, at which time PMM disclosed its findings to Yale, the SEC, and the exchange on
which the securities were traded.
During the course of the special study the auditors
were informed by Yale of their intention to issue interim
statements.
The auditors advised Yale that the figures
derived from the special study could not be used for the
interim statements, and suggested that Yale use figures from
their own internal accounting records.
None of the interim
statements issued by Yale were certified or prepared by the
auditors.
As later discovered, the Form lOK, the annual
New York University School of Law, "Securities—Rule *
lOb-5," New York University Law Review, LXVII (March, 1968),
209.
75
Fischer v. Kletz, op. cit., p. 183.
49
report, and the interim statement "were materially false
76
and misleading."
The plaintiff asserted that PMM was liable because of
their failure to report conditions which they undercovered
during their special study.
In defense of their actions PMM
stated that when conducting the special study they were engaged not as independent public accountants, but rather as
dependent accountants and therefore were not required to disclose the findings of the study.
In ruling on this case the
judge separated his opinion into two sections:
annual report
liability and interim statement liability.
Annual Report Liability
The plaintiff's claim was based on the common law action of deceit citing the defendant for nondisclosure or
silence.
The court supported its position in the following
manner:
Plaintiffs' claim is grounded in the common law
action of deceit, albeit an unusual type in that
most cases of deceit involve an affirmative misrepresentation by the defendant. Here, however,
plaintiffs attack PMM's nondisclosure or silence.77
PMM contended that such a duty exists only to parties
of a business transaction and thus was not applicable to an
independent auditor.
^^lbid., p. 183.
"^"^lbid., p. 185.
In reply the judge stated:
50
One party to a business transaction is under a
duty to exercise reasonable care to disclose to
the other before the transaction is consummated.
Any subsequently acquired information which he
recognizes as making untrue or misleading a previous representation which v/hen made was true or
believed to be so.78
To answer the question of the defendant's intent the
court recognized the theory of continuing representation.
An explanation of the theory follows:
A representation is deemed repeated at each successive moment during the period in which it is
relied upon. Therefore, unless the representor
corrects or modifies the misrepresentation at
any time during such intervals, he is deemed to
intend the results which flow from such misrepresentation.79
The judge further stated that under common law a person
who makes a representation and later finds the representation
to be false is under a duty to correct the misrepresentation.
In conclusion the court was quick to realize some of the
potential problems inherent in such a decision.
How long, for instance, does the duty to disclose
after-acquired information last? To whom and how
should disclosure be made? Does liability exist
if the after-acquired knowledge is obtained from
a source other than the original supplier of information? Is there a duty to disclose if an associate or employee of the accounting firm discovers that the financial statements are false
but fails to report it to the firm members?^^
"^^lbid., p. 186.
^ New York University School of Law, "Securities—
Rule lOb-5," op. cit., p. 214.
^^Fischer v. Kletz, op. cit., p. 189.
51
In ruling on this portion of the case the court stated
the following:
Proper reconciliation of these interests or policy
considerations, however, can only be m.ade after
full development of the facts of this case during
the discovery process and at trial.81
Interim Statement Liability
The plaintiff alleged that the auditors aided and abetted
Yale "by remaining silent when it was known that the interim
statements were false and, second, by recommending the issuance of the reports."
Judge Tyler, when commenting on PMM's silence, stated
that there existed no special relationship between the auditors and the plaintiff.
He based his decision on the fact
that PMM was not engaged as independent public accountants
for the special study.
When determining the accountant's liability for recommending the release of the interim statements, the judge
stated the following standard:
"For harm resulting to a third person form the
tortious conduct of another, a person is liable
if he. . . .
(b) knows that the other's conduct constitutes a
breach of duty and gives substantial assistance
^^lbid.
^^lbid., p. 195.
52
or encouragement to the other so to conduct himself.
. . . " (Restatement, Torts i 876 (1939).^3
In reference to the preceding the judge proposed that it
would be difficult to characterize PMM's actions as assistance or encouragement.
In conclusion the court decided that it would be inappropriate to make a determination on the preceding issues
at the present time.
84
Investment Corporation of Florida v. Buchman
In this case the public accountants had prepared the
financial statements of Belcher-Young Company in 19 63.
At
the time of the audit the defendants were aware that the
statements were to be distributed to the plaintiff.
The
plaintiff was to purchase stock of the Belcher-Young Company
provided the financial statements depicted favorable operations.
Upon examining the statements the plaintiff decided
to purchase the Belcher-Young stock.
In November 19 64
Belcher-Young failed financially and plaintiff filed suit.
As a third party beneficiary the plaintiff brought suit
against the accountants for fraud and failure to exercise
due care in the certification of the financial statements.
^-^lbid., p. 197.
^"^lnvestment Corporation of Florida v. Buchman, 208
So. 2d 291 (1967).
53
The judge permitted the case to go to the jury only on the
theory of fraud.
When instructing the jury the judge stated;
. . . if they (the jury) found that defendants
were grossly negligent in preparing the financial
statements then the jurors could infer fraud on
the part of the defendants.85
The jury found for the defendant and plaintiff appealed the
verdict.
On appeal, the plaintiff asserted that the trial court
was in error because it dismissed the issue of negligence.
In considering this case the appellate judge cited the.
Ultramares and State Street decisions.
The judge also cited
a case decided by the Florida Supreme Court that involved a
title abstractor's liability to third parties.
In reaching
a decision the Florida Supreme Court stated the following
rule of law:
The weight of authority is that an abstractor does
not render himself liable to any and every person
who may be injured by reason of his negligence,
ignorance, or want of skill in preparing abstracts,
but that such liability exists only in favor of
the person employing him or those in privity with
him. The negligence or unskillfulness of an abstractor does not render him liable to the alienee,
devisee, or other successor in interest employing
him, or other persons with whom there is no privity •
of contract. Sickler v. Indian River Abstract &
Guaranty Co., 142 Fla. 528 (1940).«b
—
^^lbid., p. 292.
^^lbid., p. 294.
54
The plaintiff predicated his appeal upon Section 552
of the Restatement of Torts.
One who in the course of his business or profession
supplies information for the guidance of others in
their business transactions is subject to liability
for harm caused to them by their reliance upon the
information if
(a) he fails to exercise that care and competence
in obtaining and communicating the information
which its recipient is justified in expecting, and
(b) The harm is suffered
(i) by the person or one of the class of persons
for whose guidance the information was supplied, and
(ii) because of his justifiable reliance upon it in
a transaction in which it was intended to influence
his conduct or in a transaction substantially identical therewith.87
In conclusion, Judge Liles stated that although Section 552 appeared to be in conflict with State Street Trust
and Sickler he was obligated to follow the rules of law
established by these cases.
Thus, under Florida law the
public accountant wili most likely be relieved of liability
to third party beneficiaries.
88
Rusch Factors, Inc. v. Levin
The plaintiff in this case was a New York commercial
banking and factoring corporation.
A certified public ac-
countant from Rhode Island was the defendant.
^^lbid., p. 295.
88Rusch Factors, Inc. v. Levin, 284 F. Supp. 85 (1968).
55
Facts of the Case
In 19 63 a Rhode Island corporation asked the plaintiff
for financing.
The plaintiff stipulated that certified fi-
nancial statements would be necessary to ascertain the company's solvency.
The defendant prepared the statements and
submitted them to the plaintiff on February 10, 1964. Plaintiff judged the company to be solvent on the basis of the
financial statement and subsequently loaned the corporation
$337,000.
Shortly afterwards the corporation went into re-
ceivership and the plaintiff was able to recover only a
portion of the loan.
Plaintiff alleged that he
. . . had been injured in an amount in excess of
$121,000 as a result of its reliance upon the
fraudulent or negligent misrepresentations in the
financial statements certified by the defendant
accountant.89
The defendant moved for dismissal on the grounds that lack
of privity of contract between the third party and himself
was a complete defense.
In considering the question of privity of contract as
a defense for fraudulent action the judge cited Ultramares:
Neither actual knowledge by the accountant of the
third person's reliance nor quantitative limitation
of the class of reliant persons is requisite to recovery for fraud. . . . The same broad perimeter
prevails if the misrepresenter's conduct is heedless
enough to permit an inference of fraud. . . .
Ultramares v. Touche & Co., 255 N.Y. 170, 174 N.E.
441, 74 A.L.R. 1139 (1931).90
^^lbid.
90^,
..
Ibid.
56
Judge Pettine in explaining the reasons of liability
for fraudulent misrepresentations stated the following:
First, liability should extend at least as far in
fraud, an intentional tort, as it does in negligence cases resulting in personal injury or property damage. Second, the risk of loss for intentional wrongdoing should invariably be placed on
the wrongdoer who caused the harm, rather than on
the innocent victim of the harm. Finally, a broad
rule of liability may deter future misconduct. . . .^1
The judge concluded that public accountants could be
liable for fraud to third parties even though there was no
contractual relationship.
When considering if privity of contract was a complete
defense for negligent acts, Judge Pettine stated that no
court had held accountants liable to third parties for negligence.
The rationale for this is founded on the idea that
the social utility of.the public's accountant's services
should release him from obligations to third parties.
Judge Pettine cited the Ultramares case as a precedent
and questioned the wisdom of the decision.
Concerning this
decision the judge stated:
Why should an innocent reliant party be forced to
carry the weighty burden of an accountant's professional malpractice? Isn't the risk of loss
more easily distributed and fairly spread by imposing it on the accounting profession, which can
pass the cost of insuring against the risk onto
its customers, who can in turn pass the cost onto
the entire consuming public? Finally, wouldn't
^^lbid., p. 86.
57
a rule of foreseeability elevate the cautionary
techniques of the accounting profession?92
The court further stated that this case would not overrule the Ultramares decision because they were "quantita93
tively distinguishable."
Plaintiffs in Ultramares were
remote lenders of an unlimited class víhereas in the immediate case the plaintiff is a "single party whose reliance was
actually foreseen by the defendant." 94
The court also considered the case of Glanzer v.
95
Shephard
at bar.
stating that it more closely resembled the case
In Glanzer a professional weigher certified the
weight of a shipment of beans.
the buyer sued.
The weight was incorrect and
Judge Cardozo held for the plaintiff even
though no contract existed between the buyer and the weigher,
Judge Pettine next considered the Investment Corp. of
Florida v. Buchman case.
He stated that the Florida appel-
late court failed to perceive the difference between Ultramares and Glanzer cases.
Furthermore, the appellate court
was confined because of the Florida Supreme Court's decision in Sickler.
^^lbid., p. 88.
^•^lbid. , p. 89.
Q4
^^lbid., p. 91.
95Glanzer v. Shephard, 233 N.Y. 236, 135 N.E. 275,
23 A.L.R. 1425 (1933) .
58
In conclusion the court held "that an accountant should
be liable in negligence for careless financial misrepresentations relied upon by actually foreseen and limited classes
96
of persons."
The judge did not define the extent of accountant's liability pending further developments in the
trial.
As a concluding note, an lowa Supreme Court relied upon
the Rusch decision in finding accountants legally responsible
for negligence to known third parties. Of significance in
this case, Ryan v. Kanne, is the judge's determination of
the extent of the auditor's liability.
The judge stated:
If the statement of account was incorrect and untrue, and the known third party relying thereon
sustained a loss resulting from the issued statement of account, the accountant must be held to
respond in damages and such damages should be those
caused by the negligent act and which were reasonably contemplated by the parties and directly connected with it, similar to other third party interest situations. No other measure of damage would
appear adequate or just.
In conclusion, we hold those parties who were
timely identified as reliants on a certified public accountant's statement of accounts are entitled to the same measure of damages that apply
to those in privity of contract.97
In review, no doubt the decade of the sixties contained
more significant developments in the public accountant's
legal liability than ahy preceding period.
The accountant's
liability was extended to include responsibility to third
96Rusch Factors v. Levin, op. cit., p. 92.
^"^Ryan v. Kanne, 170 N.W. 2nd 395 (1969).
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CHAPTER IV
THE AUDITOR'S LEGAL LIABILITY IN THE FUTURE
The accounting profession is probably more troubled
about what their liability will be in the future than their
present legal responsibility.
After some of the preceding
cases in litigation have been settled there will likely be
new precedents which will extend the auditor's responsibilities.
Hopefully the ambiguity concerning the accountant's
liability to third parties will be clearer.
Whatever the
outcome, at least the auditor should have a better idea of
his responsibilities to third parties.
The preceding chapters have illustrated the premises on
which the accountant will be liable for gross negligence and
fraud at common and statutory law.
The purpose for the chap-
ter is to present the arguments for and against expanding the
auditor's liability to include negligent acts to third parji^.
ties.
In so doing this investigation will seek to highlight
objectively the logic behind both sides of the argument.
This investigation will also review some of the benefits to
be gained by an expansion of the auditor's present liability
to include negligence.
Should the Accountant be Liable for Negligence?
The public accounting profession has several peculiarities associated with it that are not common among either the
60
61
law or medical profession.
First, accountants are at a "dis-
advantage in that the numbers of people who might rely on an
auditor's opinion, and the amounts involved, are virtually
98
unlimited."
Another disadvantage is that auditors are
subjected to review by laymen who are unfamiliar with auditing procedures.
The auditor is subjected to another dis-
advantage because the jury has the use of hindsight when
reviewing the audit work.
A fourth disadvantage is that few
laymen understand that
Audits are based on testing, sampling and reliance
on internal control; that collusion on the part of
management can sometimes conceal material information; and that judgment and estimate inevitably
enter into inventory valuation, size of bad-debt
reserves and similar items.99
Another disadvantage is that most of the public is under the
illusion that the CPA .insures the accuracy of the financial
statements where in actuality he merely gives his opinion as
to the fairness of the statements.
Finally, the accountant
is placed in an awkward position because he is hired by management and is responsible to report his findings to the
public.
Reasons for Not Extending the
Auditors' Liability
There are several reasons why the public accountant
^^Editorial, "The Specter of Auditor's Liability," The
Journal of Accountancy, CXX (September, 1965), 33.
^^lbid.
62
should be released from liability for negligence to third
parties.
With the increasing number of law suits, the cost
of obtaining liability insurance has climbed to a point
where the accountant must pass most of the cost on to the
client.
Should this trend continue there will be some point
where the cost of obtaining the accountant's services will
become prohibitive.
A second argument is that accountants
may become reluctant to express their professional opinions
if they are liable for mere negligence.
"They may have to
revise the form of their reports so as to obtain greater
protection for themselves against legal liabilities."
Certainly it would not be in the public interest for the
accountant to restrict either the scope or opinion of his
report.
Opponents have given a number of reasons why the accountant should be responsible to third parties for negligent
acts.
First, such a doctrine seems to be in accord with
the desires and needs of a majority of the investing public.
An example of this support was the passage of the Securities
/
Act of 19 33 which imposes liability for negligence on the
accountant.
lO^Ibid.
There are numerous examples in history "wherein
63
statutes were enacted because society thought the common law
failed to provide proper redress."
Second, it is neither equitable nor fair for the public
accountant not to be held accountable for his actions.
Under
existed law it is possible for the accountant to be the
direct cause of losses sustained by third parties, yet he
will not suffer the consequences of his actions.
Thus, the
accountant has a moral duty to assume responsibility for
mistakes he has committed.
Third, the trend in common law indicates that before
long the accountant will be responsible to third parties for
ordinary negligence.
In several of the preceding cases the
accountant has been held liable for negligence if his opinion
was intended primarily for the use of a third party.
In an-
other instance accountants were liable for negligence which
was so gross as to lead to the inference of fraud.
Finally, as more people rely on the accountant's opinion because of the complexity of business, the courts "will
need more clearly stated and defined professional standards
and rules against which to compare an accountant's conduct
102
and opinion."
The accountant's professional conduct
"'"^•'"R. F. Salmonson, "CPA's Negligence, Third Parties
and the Future," The Accounting Review, XXXIV (January, 19 59),
93.
102jbid.
64
should not be judged by laymen's standards.
This should re-
sult in greater reliance by the courts upon generally accepted auditing standards and generally accepted accounting
principles.
As greater weight is placed on professional
standards the difference between ordinary negligence and
gross negligence will tend to disappear.
The crucial test
to determine whether a public accountant is guilty of negligence would be whether he adhered to the "professional standards of care."
Objections to Extending the
Åccountants' Liability
Accountants have raised several objections to the extention of their liability to include ordinary negligence to
third parties.
One of the reasons for not extending the lia-
bility is that such a doctrine would allow third parties to
reap the benefits of a contract without having to pay for it.
Opponents agree with this but state that this condition already exists under the fraud doctrine and that one of the
accountant's responsibilities is to report to the public on
the findings of his investigation.
A second objection to holding accountants responsible
for negligence is that a thoughtless slip or blunder may
subject them to a ruinous liability.
i"ibid.
The validity of the
65
argument is questioned by opponents because the accountant
has been subject to liability for fraud to clients and third
parties for sometime.
Moreover, under present laws there
exists the possibility "that what an accountant would call
mere blunder a jury will call gross negligence, infer an
intent to deceive therefrom, and impose a ruinous liability
for fraud."^^"^
A final objection to holding accountants responsible
for negligence acts is that should this burden be imposed it
would require the accountant to increase his fees to such an
extent that his services v/ould become financially prohibitive.
If this were to happen the need for the accounting
profession v/ould diminish solely to tax and management services work.
It is further alleged that the public accoun-
tant will of necessity have to restrict the scope and opinion
of his report.
In rebuttal to these arguments it should be noted that
the same objections were raised prior to the passage of the
Securities Act of 1933.
Subsequent to the passage of this
act the accounting profession has expanded manyfold.
Actu-
ally the passage of the Securities Act of 1933 has been of
more benefit to the accountant than harm.
The public has
placed more reliance on the financial statements and
i'^^ibid.
66
consequently the auditor's status in financial circles has
been elevated.
The Securities Act of 1933 has also required
the accounting profession to culminate more definite standards which in turn has placed the accounting profession on
an equal level with the law and medical profession.
There-
fore, it would seem logical to assume that requiring the
auditor to be responsible for negligence acts would further
elevate his stature in the eyes of the investing public.
This liability would only require the public accountant to
perform his investigation in accordance with generally accepted auditing standárds, which is one of present requirements to which the auditor must conform.
Thus, it seems reasonable to conclude that although
there are several reasons why liability to third parties for
negligence should not be imposed upon the accountant, the
burden of responsibility can be more properly placed upon
the accountant than on the investing public.
Also, accoun-
tants as professional men should accept the moral responsibility of presenting fair and equitable financial information
to the public.
Benefits that Would Accrue to the Auditor
Accountants who have objected to extending their liability to include negligence to third parties have failed to
consider the benefits that would accrue to the profession
67
and to society in general.
There are a number of benefits
which should be considered before making a final judgment
on this issue.
One of the advantages of such a doctrine would be the
willingness of third parties to place more reliance on the
public accountant's report.
Since third parties would have
a greater likelihood of recovering for negligence acts by
accountants, they would be more willing to accept statements
the auditor has prepared.
Thus, the accountant's services
"would become more valuable and sought than before." 105
Another advantage that would accrue to the auditor from
extended liability would be the "acceptance by the courts of
the accounting profession's standards as guides to accept10 6
able conduct in trying actions coming before them."
Such
an acceptance would increase the prestige of the profession
and the authority of its standards. An example of the benefits to be gained by such legislation is the SEC's requirement that the auditor must maintain an independent mental
attitude.
The acceptance by the accountant of a responsi-
bility to third parties would "assert an even greater degree
of independence."
^Q^Ibid., p. 95
IQ^Ibid.
lO^ibid.
Acceptance by the courts of a body of
68
profession standards would eliminate the need for two sets
of guidelines:
one for SEC reporting and another for finan-
cial statements.
The acceptance of the auditor's professional standards
by the court would alleviate much of the subjective judgment
by juries.
Under existing common law the jury is required
to make a judgment on the accountant's inferred intent to
deceive.
By the adoption of "standards of care to which
accountants must adhere . . . the possibility of an accountant
being liable for fraud for what he thinks is negligence . . .
V70uld be eliminated."-'-^^
The existing common law imposes liability for "albeit
109
gross negligence traveling under the guise of fraud."
If
the negligence doctrine were adopted, the accountant would
be liable for acts which lacked due professional care.
Under
the present law accountants might be responsible fo.r fraudulent representations for the very same conduct.
"Certainly
it is far less damaging to the reputation to be called a
blunderer than a defrauder."
Common law, at present, requires that the jury "must
find negligence so gross that an intent to deceive is
"^ibid.
"^ibid.
llOlbid.
69
evident."
Such a doctrine requires a very subjective
judgment on the part of the jury.
Thus, there is a possi-
bility that a jury may infer an intent to deceive when the
practice in question is actually a generally accepted auditing standard.
The doctrine advocated would eliminate much
of the subjective judgment because the jury would be required
to apply the standards established by the profession. Although auditing standards "are not ideally set forth, they
are not as vague as the intent to deceive v/hich juries must
112
presently find in the accountant's conduct."
The acceptance by accountants of a responsibility to
third parties for negligent acts "should eventually bring
about a uniform, high degree of quality to the services
113
rendered by accountants."
It is a well known fact that third parties which use
audited financial statements as a basis for making loans are
greatly influenced by the certified public accounting firm
that performed the examination.
The knowledge by third
parties that accountants have a legal obligation to adhere
to professional standards "should help to eliminate the
•^•^ Montgomery, op. cit., p. 65.
Ibid.
ll-^Salmonson, "CPA's Negligence, Third Parties and the
Future," op. cit., p. 96.
70
mental reservations concerning the reliability of the opinions of some firms."
Reliance by the courts on auditing standards as a basis
for judging the accountant's actions should prompt the accounting profession to constantly' re-examine existing standards and practices.
Acceptance of this doctrine should make
accountants more cognizant of their responsibility to report
information accurately to third parties.
Because of a lia-
bility to third parties for negligence, accountants will of
necessity have to continually question the adequacy of profession standards or risk the chance of a liable suit.
This
constant appraisal of professional standards
. . . cannot help but result in the formulation
of new and better standards and practices, which
in turn would result in even more informative and
useful reports to the public at large, upon which
the accounting profession depends so heavily for
its existence.H^
In conclusion, from examination of cases in the preceding chapter, it appears that at some point in the future the
accountant will be responsible to third parties for acts of
ordinary negligence.
Many accountants feel this will be the
demise of the accounting profession.
However, there are
many valid benefits to be attained from such liability.
countants should be quick to realize the necessity of
ll^Ibid.
ll^ibid.
Ac-
y
71
maintaining and enhancing their public image.
If the pub-
lic loses confidence in the public accountant, his profession is doomed to failure and the investing public will be
at a loss for reliable financial information.
CHAPTER V
SOLUTIONS TO THE LIABILITY PROBLEM
Within the decade of the sixties the accountant has
been exposed to a vastly increased legal liability.
The
question arises as to what steps can the accountant take
to mitigate this increased liability.
The purpose of this
chapter is to suggest possible solutions to the liability
problem.
Singularly none of these actions will prevent a
liable suit, but adherence to the following preventive measures should minimize the possibility of legal action.
The proposal of these remedial actions does not deny a
legal responsibility to clients and third parties.
The ac-
countant's legal liability
. . . is an assurance to the public that the profession may be relied on. It is a fundamental
principle of law that in work requiring peculiar
skill a person who offers his services is understood to be holding himself out to the public as
possessing the degree of skill commonly possessed
by others in the same calling.H^
If the scope of the auditor's legal liability were more
clearly defined, many of the measures would not be necessary
The CPA may be subject to a ruinous liability merely because
neither the common or statutory law provides sufficient
•^•'•^John L. Carey, The CPA Plans for the Future (New
York: American Institute of Certified Public Accountants,
1965), p. 414.
72
73
clarity.
Clearly, the accounting profession is confronted
with one of the gravest problems in its history.
Several
y
authors believe that the liability to which the auditor is
subject is substantially out of proportion to the fees he
charges.
An auditor
. . . who honestly performs an audit for a fee
of a thousand dollars, and conforms to generally
accepted auditing standards, should not be held
liable for perhaps hundreds of thousands of dollars to third parties with whom he has no contractual relationships, simply because years later a
jury decides that if he had taken steps which he
did not take the plaintiff's loss would not have
occurred.117
The theory of law that the punishment should fit the crime
has been totally ignored by the courts.
Until many of the
ambiguities of the existing law are more clearly defined
accountants in public practice should give particular attention to the following'measures.
Reports
The auditor's investigation culminates with a written
report of his findings.
Within the report the scope of the
auditor's investigation is defined and an opinion is expressed
concerning the fairness of the statements.
port is the basis for most liable suits.
The auditor's re-
There have been
many suggestions that the auditors should qualify either the
^-^"^lbid., p. 415.
(
74
scope or opinion of his report.
Certainly, these measures
are to be advocated for undoubtedly they can limit the auditor's legal liability.
As was mentioned in the previous
chapter, actions of this nature tend to discredit the accounting profession and it is questionable whether the resulting effects upon society are desirable.
Perhaps a better solution would be a revision of the
standard short-form report.
Some authors advocate a simpli-
fication of the existing terminology.
This should enable
the average reader to ascertain more easily the findings of
the auditor's investigation.
From a legal point of view
this action could be disastrous to the accounting profession,
The auditor should strive to make his report as complete and
the language as exacting as possible.
When there is any doubt whether an explanation is
needed or whether additional information would be
helpful to the reader, the explanation should be
given or the information supplied. Otherwise, the
price of readability may become liability as a result of the omission.ll^
Several authors have advanced the idea that the shortform report should be rewritten.
The opinion paragraph
should contain more explicit statements of the auditor's
findings.
That is, the reference to generally accepted
auditing standards should make it clear that the
^^Salter J. Coakley, "Accountant's Legal Liability,"
The Journal of Accountancy, CXXVI (July, 1968), 60.
75
standards are those established by the accounting
profession. It should be made clear that the content of the statements and, indeed, the figures
"^ representing earnings per share are not immutable
truths resulting from the application of fixed
formulae but, rather, are the result of professional judgments applied on the varying factual
situations. Finally, it should be made clear that
the public accountant is not a guarantor of accuracy nor is he a surety for the integrity of the
management.ll^
The major disadvantage to this suggestion is that such
a major revision would require several years for approval by
the AICPA, SEC, and the investing public.
At the present,
the auditor can gain sufficient protection by adhering to
guides established by the AICPA for report writing.
The auditor should be cautious when issuing a long-form
report subsequent to a short-form report. As the case of
State Street Trust Co. v. Ernst
illustrated,when material
information is not conveyed to the public the accountant
will be responsible for any subsequent losses.
Statements
on Auditing Procedure No. 33 contains a detailed discussion
of precautions the auditor should take under these circumstances and should be referred to prior to issuing a second
report.
In summary, the accountant should always be conscious
that the third party reading the report is a layman and
•'•''•^Thomas W. Hill, "The Public Accountant's Legal Liability to Clients and Others," The New York Certified Public
Accountant, XXXVIII (January, 1968), 21.
76
therefore the auditor should strive for clarity and completeness at all times.
Working Papers
In most cases the court, through the use of hindsight,
can find procedures or techniques which if followed would
have disclosed material mistakes or misrepresentations.
To
rebut such conclusions the accountant can produce working
papers to demonstrate the use of reasonableness and due care
in the audit.
The public accountant should be constantly
aware of the need for completeness in preparing working
papers.
The plaintiff will have access to the working papers
and will search for:
. . . provocative questions not resolved, items
listed for investigation not cleared, results of
tests which disclose a high incidence of error or
exception with no indication of follow-up or extended procedure, check lists with items unanswered or marked "not done," internal control
reviews without modification of audit programs
for weaknesses disclosed, opinions revised with
inadequate explanation in a situation where later
events supported the original tentative opinion,
and similar damming evidence.^^O
Therefore, the CPA should strive to include within the working papers all communications with clients and steps taken
in his investigation.
Ralph E. Kent, "Liability of Auditors," The Journal
of Accountancy, CVI (September, 1958), 65.
77
The auditor's work papers should be meaningful to third
parties as well as himself.
Several large firms adhere to
the practice of having work papers reviewed by supervisory
personnel not connected with the audit.
This practice aids
in assuring that the work papers will be complete and also
meaningful.
A sense of balance should be maintained within the working papers so as to negate possible negligence.
Items of
importance should command considerably more investigation
than items of insignificance.
Finally, the auditor's work-
ing papers should present an organized review of the client's
operations.
In most instances where the working papers are
well organized, the court will conclude that the investigation was well planned and not haphazardly conducted.
Well
organized work papers will also assist the auditor in determining the completeness of his investigation and illustrate
areas where weakness exists.
"A good job of organization in
and of itself tends to rebut the charge of a negligently per121
formed job and . . . vice versa."
Thus, work papers form
the auditor's first line of defense and their completeness,
balance and organization should coramand considerable attention.
121
Coakley, loc. cit.
78
Pronouncements by the Profession
If the accountant's legal liability is to become clearly
defined, the accounting profession must clarify its principles and standards.
At present courts and juries have diffi-
culty in determining whether a practice is generally accepted.
The Continental Vending case is a good example of
how laymen determine the general acceptance of a practice.
Therefore, it seems evident that the accounting profession,
through the use of official pronouncements, has the ability
to protect itself from ruinous liability.
As Saul Levy
stated:
Only through well-established professional standards and criteria can accountants assure themselves of judgment by their peers. The legal
liability of accountants should be confined within
the framev/ork of professional standards and criteria. If that framev7ork is not constructed by
the profession itself, it will be rudely fashioned
for us by juries of laymen out of the unfortunate
material presented to them in the extreme situations which are occasionally litigated.122
There are several steps the profession can take that
would help'solve the liability problem.
First, the account-
ing profession often uses the word "responsibility" as the
equivalent of "legal liability."
This practice should be
discouraged because laymen and the courts rely to a great
extent on the profession to define the care which is required of the auditor when making his investigation.
•'"^^Levy, loc. cit.
79
Second, in several instances the accounting profession
has failed to indicate the purpose of their pronouncements.
Some of the pronouncements seem
. . . designed to define accounting skill which
the profession should seek to attain. Others
represent codifications of accounting principles
or procedures that have already become "generally
accepted."123
There should alv/ays be a clear distinction betv/een these two
because the accountant will be held legally responsible for
failure to conform to generally accepted practices.
Third, the accounting profession, when establishihg
objectives for future attainment, should be practical.
They
should not establish "standards that the average skilled
accountant cannot reasonably comply with in his conduct of
a normal audit."124
Finally, the accôunting profession should make a careful study of widely published financial mishaps prior to the
issuance of a pronouncement.
The profession should take
action
. . . only after careful study, and taken in such
a way as to make very clear that the standards or
procedures established represent a change from
what was theretofore generally accepted practice.
It may not be sufficient merely to say that the
action is not intended to be retroactive.125
1 23
Coakley, loc. cit
124ibid.
^^^lbid.
80
Professional Competence
The auditor must maintain a high degree of professional
competence to protect himself from the possibility of a liable suit.
To maintain a high degree of competence the audi-
tor must have absolute integrity.
The auditor must be honest
at all times and be aware of biases that may exist in his
judgments.
Should the accountant fail to be absolutely
honest, he may find himself charged with criminal or civil
suits.
The public accountant must also maintain an attitude of
independence.
In order for third parties to place reliance
upon the auditor's opinion, they must be assured that the
accountant has not submitted to pressures from clients.
John Carey stated:
It is most important that the CPA not only shall
refuse to subordinate his judgment to that of
others but that he be independent of any selfinterest which might warp his judgment even subconsciously in reporting whether or not the
financial position and net income are fairly presented. Independence in this context means objectivity or lack of bias in forming delicate judgments.126
Besides maintaining integrity and independence the auditor is
expected to exercise due care in performing his audit.
Fail-
ure by the public accountant to adhere to a reasonable standard of care may result in a liability for negligence which
if sufficiently gross can be inferred as fraud.
126Carey, op. cit., p. 416.
81
The auditor, to insure professional competence, must
stay abreast of current developments within the accounting
profession.
The auditor should place particular emphasis on
publications by the AICPA.
Many of these pronouncements
establish new standards to which the auditor must adhere in
order to minimize his legal liability.
Thus, it is evident
that for the auditor to maintain professional competence he
must constantly review his actions and those of the accounting profession.
Statutory Relief
Several authors have advocated the need for clarification of existing statutory laws.
Because of the recent
extensions of the accountant's legal responsibilities it may
be possible for the accounting profession to persuade Congress that a revision of the Securities laws is necessary.
Constantine Katsoris has suggested:
One solution would be to integrate into one composite statute all the rules concerning the accountants' duties and liabilities arising out of
the certification of SEC financials. It is within
such a framework that reporting principles could
be formulated which would not only be more meaningful to the average investor, but would also
help to narrow the incidents of accountants' liability.127
•'•^^Constantine N. Katsoris, "Public Liability. Exposure, "
The New York Certified Public Accountant, XXXX (January,
T9TO) , 37.
"
~~
82
Serious consideration should be given to these suggestions
as they would provide a satisfactory solution to the auditor's liability problem.
Agreements
In the past the accounting profession has made agreements with surety companies whereby a group of impartial
observers would consider the accountant's actions.
In cases
where gross negligence or fraud appeared evident the observers would recommend legal action.
This approach has the
advantage of limiting damaging publicity that can result
from unfounded law suits. Accounting firms facing liable
suits should consider the possibility of arbitration prior
to the filing of suits.
Clients
The CPA should exercise caution when accepting clients.
He should make a thorough investigation of the company as
well as the company officers to insure the integrity of
clients.
The accountant should also exercise care in formu-
lating agreements with the client.
All contracts should be
in writing and the writing should be as explicit as possible
The accountant should make every effort to spell out exactly
the extent of his investigation.
83
Education
The accountant should seek to educate society as to the
purpose of his investigation.
Third parties have long been
under the impression that the accountant is an insurer of
the financial statements.
The accounting prdfession would
do well to dispel this belief.
Second, the accounting pro-
fession should inforra
. . . the public and the judiciary of the harm
which society may suffer if unreasonable liabilities are imposed on professional men merely for
honest errors. The result can only be to inhibit
the free exercise of professional judgment, to
hedge professional opinions with disclaimers, to
avoid cases involving risks, and thus to deprive
the public of skilled advice and service on which
it can rely with confidence.128
Resistance
When possible accountants should carry questionable law
suits to the highest court.
This would help establish useful
precedents and hopefully clarify some of the ambiguities
which exist within the present lav/.
Insurance
Liability insurance is'by no means a solution to the
auditor's problem, but it does offer partial protection.
In
most cases the insurance policy will cover the legal cost of
defending claims.
However, insurance will not compensate
Carey, op. cit., p. 415.
84
the firm for time of partners and staff required to participate in the defense.
An insurance policy will not offset
the damaging publicity which arises from liable suits.
Finally, liability insurance will not protect accountants
"against the nervous and mental strain involved in defending
an action in vv'hich the honor and reputation of the f irm are
129
involved."
Although the cost of insurance coverage has
risen considerably over the past few years, "it is safer to
have too much too soon than too little too late." 130
Saul Levy has compared the auditor's liability insurance with the use of liability insurance when operating an
automobile.
It would be untliinkable for an automobile owner
to operate his car without carrying liability
insurance. Such insurance cannot reduce the
physical hazards to life and limb, and careful
driving remains the all-important safeguard.
But the incidental financial hazards are substantially reduced at a moderate cost.l^l
As a concluding note, the auditor should have an intimate knowledge of pertinent cases and statutes and their
possible implications.
They
. . . will do more than anything else to develop
a technique of imaginative thinking and alertness
129iMd.
•^ Kent, op. cit., p. 65.
"''^ Saul Levy, "Legal Hazards in Public Accounting,"
The Journal of Accountancy, LXXXXIX (May, 1955), 37.
85
in our work and an awareness of the importance of
complying with our own standards. All of which
will enable us to minimize whatever hazards of
legal responsibility may be inherent in the practice of public accountancy.132
^^^lbid., p. 39.
CHAPTER VI
SUMMARY AND CONCLUSIONS
Historically, auditors have been liable to clients and
third parties by both common and statutory law.
tor's liability can be divided into three parts:
The audiliability
to the client by common law, liability to third parties by
common law, and liability to third parties by statute.
This
division should be made because of the significant difference in the accountant's responsibilities to these parties.
Summary
The auditor's liability to his client is founded on a
contractual relationship which may be written or oral.
The
accountant is liable to his client for negligence and fraud
133
"but not for losses consequent upon mere error of judgment."
To summarize this study, the second chapter contains a review
of several cases that are helpful in understanding the CPA's
responsibility to his client and third parties.
Craig v. Anyon
The principle issue to be decided in this case was
whether the accountant's negligence was the cause of the
loss or whether the client was responsible because of
133
Prosser, loc. cit.
86
87
contributory negligence.
The auditor was found guilty of
negligence and fined $2,000, the amount of his audit fee.
In reaching a decision the court stated:
"Plaintiffs should
not be allowed to recover for losses which they could have
avoided by the exercise of reasonable care. . . ."1"^^
The
court followed the theory that the auditor was liable to the
extent of compensation he received and the client is liable
for any loss in excess of the auditor's fee.
National Surety Corporation
V. Lybrand
The plaintiff alleged that the accountant was guilty of
negligence for failure to discover thefts by the cashier.
The accountant contended that the client was guilty of contributory negligence.
The court stated:
"Negligence of the
employer is a defense only when it has contributed to the
accountant's failure to perform his contract and to report
the truth."135 In summary, the accountant will be held
liable to his employer in most cases, and only in cases where
the contributory negligence of the employer has led directly
to misrepresentations by the accountant will the accountant
be released of his liability.
The accountant's liability to third parties has been
134
.
•.
cn
Craig v. Anyon, op. cit., p. b/.
•'••^^National Surety Corp. v. Lybrand, op. cit., p. 226.
88
limited mainly to fraud because of the lack of a contractual
relationship.
However, in cases where the auditor has known
in advance that a third party would rely upon his opinion
the court has held him responsible for negligence.
Landell v. Lybrand
In this case the plaintiff alleged that the financial
statements were misleading and that the auditors were negligent in the performance of their duties and liable for the
loss sustained.
Thé court found for the accountant stating
that because there was no contractual relationship between
the auditor and the plaintiff the auditor could not be found
guilty of negligence.
Ultramares Corp. v. Touche
The plaintiff claimed that the auditor had failed to
discover material misstatements within the accounts and because he was a known third party the auditor could be found
guilty of fraud and negligence.
The court found that the
accountant was guilty of negligence, but because of the lack
of a specific contract there did not exist any liability on
the accountant's part.
However, the court discussed how
gross negligence could be inferred as fraud from a reckless
misstatement or insincere profession of an opinion.
89
State Street Trust Co. v. Ernst
The plaintiff claimed that he had relied on the financial statements and that the auditor was grossly negligent
in the performance of his audit.
The court followed the
gross negligence concept established in Ultramares and
found the accountant guilty for failure to inform the creditors of the long form report and failure to investigate the
doubtful accounts.
O'Connor v. Ludlam
In this case the plaintiff brought suit against the
accountant for fraud instead of negligence because of the
Ultramares decision.
The court found the accountant guilty
and stated the following definition of fraud:
. . . fraud may be established by showing that a
false representation has been made, either knowingly, or without belief in its truth, or in reckless disregard of whether it be true or false.l-^o
Gammel v. Ernst and Ernst
The plaintiff in this case filed suit against the auditors for gross mistake and fraud.
The court found for the
plaintiff and stated that the standards of reasonable care
which apply to lawyers, doctors, architects, and engineers
apply to the public accountant.
•'•"^^O'Connor v. Ludlam, op. cit., p. 53.
90
Besides a liability by common law the auditor has a
civil and criminal liability to third parties by statutory
law.
Acts.
This liability is derived mainly from the Securities
The Securities Act of 1933 creates a responsibility
by the auditor to the investing public for an "untrue state137
ment of a material fact"
fact.
or the omission of a material
The Securities Exchange Act of 19 34 protects the pub-
lic from false or misleading statements of a material amount.
The 1934 Act protects both the buyer and seller of securities.
As a defense the auditor must prove that "he acted
in good faith and had no knowledge that such statements
138
were false or misleading."
Within the decade of the sixties the accountant's responsibility for financial statements was expanded, in
almost every conceivable direction.
The BarChris case was
one of the most significant examples.
BarChris
The plaintiff filed suit alleging that the registration
statement contained material false statements and omissions.
Judge McLean concluded that the statements were misleading
and false and in a material amount.
Judge McLean's decision
-^•^'^Federal Securitíes Act of 1933, op. cit. , 82 #77K(a)
•^^^Federal Securities Exchange Act of 1934, op. cit.,
pp. 897-98, 78r(a).
91
also included comments on the S-1 review, inquiry procedures,
and the qualifications of the auditor.
The judge's opinion
in the BarChris case represents a landmark decision because
this was the first time an auditor was held liable for ordinary negligence under the Securities laws.
Continental Vending
In this case the plaintiff sought action against the
defendant for deliberately making false or misleading statement of a material amount.
In defense of these allegations
the auditor contended that generally accepted auditing standards did not require disclosure of the makeup of collateral
securing loans.
In reaching a decision the court concluded
that the fairness of the financial statement would have
precedence over generally accepted auditing standards.
Yale Express
The plaintiff alleged that the auditor had certified
financial statements which were materially false and had
failed to disclose information acquired subsequent to the
certification.
This case has yet to be settled, but in a
ruling on a motion for dismissal the judge reasoned that the
auditor's liability could be extended to include events subsequent to effective date of the registration statement.
92
Investment Corp. of Florida
V. Buchman
The plaintiff brought suit against the auditor for
failure to exercise due care in the certification of the
financial statements.
At the time of the audit the defen-
dants were aware that the statements were to be distributed
to the plaintiff.
Judge Liles ruled that accountants would
not be liable to third party beneficiaries.
Rusch Factors v. Levin
The plaintiff contended that the financial statements
139
contained "fraudulent and negligent misrepresentations."
Judge Pettine concluded that public accountants could be
liable for fraud to third parties even though there was not
a contractual relationship.
The judge also ruled that ac-
countants could be liable for negligence to "actually foreseen and limited classes of persons."
(^The court did not
define the extent of accountant's liability pending further
developments in the trial.y
Conclusions
Thus, it is evident that the public accountant's legal
responsibility is in a state of flux.
However, accountants
are probably more troubled about what their liability will
•^•^^Rusch Factors v. Levin, op. cit., p. 85.
-'•'^^lbid., p. 92.
93
be in the future than their present legal responsibility.
It is possible that the accountant's liability will be extended to include an unlimited class of third parties at common law in the near future.
Many accountants believe that
such an extension of the present liability concept could
subject them to a ruinous liability.
this argument is invalid because:
Opponents state that
(1) the accountant has
been subject to a liability for fraud to third parties for
some time,and (2) under present law there exists the possibility of a jury construing mere negligence as fraud.
Advantages to Extending the
Accountant's Liability
There are numerous advantages to extending the accountant's liability to include negligence to third parties.
One of the advantages of such a doctrine would be the willingness of third parties to place more reliance on the public
accountant's report.
Another advantage that would accrue to
the auditor would be the "acceptance by the courts of the
accounting profession's standards as guides to acceptable
141
conduct in trying action coming before them"
Reliance
by the courts on auditing standards as a basis for judging
the accountant's actions should prompt the accounting profession to constantly re-examine existing standards and
•'"^•'•Salmonson, "CPA's Negligence, Third Parties and the
Future," op. cit., p. 95.
94
practices.
Accountants should be quick to realize the neces-
sity of maintaining and enhancing their public image.
If
the public loses confidence in the public accountant, his
profession is doomed to failure and the investing public
will be at a loss for reliable financial information.
Steps the Accountant Can Take to
Mitigate This Increased Liability
The question arises as to what steps can the accountant
take to mitigate this increased liability.
The following
measures are suggested for the public accountant to minimize
the possibility of a liable suit.
This list has been de-
rived from the preceding penetrating analysis of cases,
statutes, and extrapolations into the future.
Reports.—The accountant should always be conscious
that the third party reading the report is a layman and
therefore, the auditor should strive for clarity and completeness at all times.
Working Papers.--Work papers form the auditor's first
line of defense and th^ir completeness, balance and organization should command considerable attention.
Pronouncements by the Profession.—The standards to
which accountants must adhere should not be established by
juries or the courts, but by the accounting profession and
the AICPA.
95
Professional Competence.—If the auditor is to maintain
professional competence he must constantly review his integrity, independence and professional development.
Statutory Relief.--Accountants should seek to minimize
their liability by revision of existing laws.
Agreements.--Accounting firms facing liable suitsshould consider the possibility of arbitration prior to the
filing of suits.
Clients.--The CPA should exercise caution when accepting clients and in formulating contracts with them.
Education.--Accountants should seek to educate society
as to the purpose of their investigation and tlie meaning of
generally accepted auditing standards.
Insurance.—Liability insurance is by no means a solution to the auditor's problem, but it does offer partial
protection.
Insurance will not, however, compensate for
lost time, damaging publicity or mental strain involved in
defending liable suits.
A general conclusion can be drawn from this study that
the investing public and the courts are demanding more reliable financial information from the public accountant. Therefore, the burden is placed on the accounting profession to
96
expand the scope of their examinations.
Such a burden should
not be looked upon as a detriment, but rather as an enhancement of the auditor's position within the financial world.
SELECTED BIBLIOGRAPHY
Periodicals
"Accounting Court of Appeals Proposed for Discussion." The
Journal of Accountancy, CXXI (January, 1966), 8-10.
American Institute of Certified Public Accountants. "The
Continental Vending Case." The Journal of Accountancy,
CXXVI (November, 1968), 55-64.
"Bank Directors Sue Peat, Marwick, Mitchell & Co." The
Journal of Accountancy, CXXII (November, 1966), 24-25.
"Banks Sue Accounting Firm for Six Million Dollars."
Journal of Accountancy, CXIX (June, 1965), 20.
Blough, Carman G. "Responsibility to Third Parties."
Journal of Accountancy, CIX (May, 1960), 58-65.
The
The
Bradley, Edwin J. "Auditor's Liability and the Need for
Increased Accounting Uniformity." Law and Contemporary
Problems, XXX (1965), 898-922.
Carmichael, Douglas R. "The Auditor's Statutory Liability
'll
to Third Parties." The Texas Certified Public Accoun/ /
tant, XXXVIII (October, 1968), 5-12.
JL
i"
i
Å
Coakley, Walter J. "Accountants' Legal Liability." The •
Journal of Accountancy, CXXVI (July, 1968), 58-61.
C^l mbia University School of Law. "Accountants' Liabilities
for False and Misleading Financial Statements." Columbia
Law Review, LXVII (December, 1967), 1436-1469.
"CPA's Indicted for Fraud." The Journal of Accountancy, CXXII
(December, 1966), 20, 22.
Daus, Edward J. "Accountants' Liability Today." The New
York Certified Public Accountant, XXXVII (November,
1967), 835-43.
Goldberg, Joseph, and Kelly, Walter F., Jr. "Accountants'
Liabilities to Third Parties Under Common Law and Federal Securities Law." Boston College Industrial and
Commercial Law Review, IX (Fall, 1967), 137-61.
97
98
Gordon, Spencer. "Accountants and the Securities Act." The
Journal of Accountancy, LVI (December, 1933) , 438-51":
"Liability of Accountants Under Securities Exchange Act of 1934 (Including Amendm.ents to Securities
Act of 1933)." The Journal of Accountancy, LVIII (October, 1934), 251-57.
~~
Hill, Thomas W., Jr. "Accountants' Legal Liability." The
New York Certified Public Accountant, XXIX (March,
1959), 177-89.
:
"The Public Accountants' Legal Liability to
Clients and Others." The New York Certified Public
Accountant, XXXVIII (January, 1968), 21-31.
Katsoris, Constantine N. "Accountants' Third Party Liability
How Far Do We Go?" Fordham Law Review, XXXVI (December,
1967), 191-234.
"Public Liability Exposure." The New York Certified Public Accountant, XXXX (January, 1970), 36-41.
Kent, Ralph E. "Liability of Auditors." The Journal of
Accountancy, CVI (September, 1958), 61-66.
"Landmark Decision on Liability." The Journal of Accountancy, CXXV (June, 1968), 20.
"Lawsuits Test Extent of CPA Liability."
XXXIV (June, 1966), 10, 68.
Financial Executive,
Levy, Saul. "Legal Hazards in Public Accounting." The
Journal of Accountancy, LXXXXIX (May, 1955), 37-39.
New York University School of Law. "Securities—Rule lOb-5."
New York University Lav; Review, LXVII (March, 1968) ,
209-18.
Richardson, Mark E. "Professional Maturity and Responsibility." The New York Certified Public Accountant,
XXXIII (January, 1963), 19-20.
Salmonson, R. F. "A Prophetic Analogy." The Accounting
Reyiew, XXXVII (July, 1962), 502-05.
"CPA's Negligence, Third Parties and the Future."
Thê Accountinq Review, XXXIV (January, 1959), 91-96.
99
• "Third Party Actions Against Accountants."
Accounting Review, XXXII (July, 1957), 389-94.
The
St. John's University School of Law. "Potential Liability
of Accountants to Third Parties for Negligence." St.
John's Law Review, XXXXI (1967), 588-601.
"The Specter of Auditor's Liability." Editorial, The Journal of Accountancy, CXX (September, 1965), 33-34.
Books
American Institute of Certified Public Accountants. "Auditing Standards and Procedures." Statements on Auditing
Procedure No. 33. New York: American Institute of
Certified Public Accountants, 19 63.
Carey, John L. The CPA Plans for the Future. New York:
American Institute of Certified Public Accountants,
1965.
Dickerson, R. W. V. Accountants and the Law of Negligence.
Ontario, Canada: Canadian Institute of Chartered Accountants, 19 65.
Levy, Saul. Accountants' Legal Responsibility.
American Institute of Accountants, 1954.
Myers, John H. Auditing Cases.
University Press, 19 64.
Chicago:
Prosser, William L. Prosser on Torts.
West Publishing Company, 1941.
New York:
Northwestern
St. Paul, Minnesota:
Rappaport, Louis H. SEC Accounting Practice and Procedure.
Revised printing. New York: The Ronald Press Company,
19 59.
Rich, Wiley Daniel. Leqal Responsibilities and Rights of
Public Accountants. New York: American Institute
Publishing Co., Inc., 1935.
Newspaper Articles
Berton, Lee. "CPA's Under Fire: Auditor's Critics Seek
Wider, Faster Action in Reform of Practices." Wall
Street Journal, November 15, 19 66.
100
Kaplan, Morris. "Three Lybrand Aides are Found Guilty."
New York Times, June 22, 1968.
Metz, Robert. "Accounting Profession, Vexed by Lawsuits,
Weighs Responsibility to Shareholders." New York Times,
November 20, 19 66.
Silberman, Lee. "Embattled CPA's: They Fret Over Rise in
Lawsuits, Domination by Big Firms." Wall Street Journal, May 24, 1965.
(Staff Reporter). "Three Members of Lybrand-Ross are Convicted." Wall Street Journal, June 24, 19 68.
Cases
Craig v. Anyon, 212 App. Div. 55, 208 N.Y. Supp. 259 (1926).
Escott V. BarChris Construction Corporation, 283 F. Supp. 643
(1968).
Fischer V. Kletz, 266 F. Supp. 180 (S.D.N.Y. 1967).
Gammel v. Ernst and Ernst, 54 ALR 2d 316 (1955).
Glanzer V. Shepard, 233 N.Y. 236, 135 N.E. 275 (1920).
Investment Corporation of Florida v. Buchman, 208 So. 2d
291 (1967).
Landell v. Lybrand, 264 Pa. 406, 107 A. 783, 8 A.L.R. 461
(1919).
National Surety Corporation v. Lybrand, 256 App. Div. 226,
9 N.Y. S. 2d 554 (1939).
O'Connor v. Ludlam, 92 F. 2d 50 (2d Cir.), certiorari denied,
302" U.S. 758 (1937).
Rusch Factors, Inc. v. Levin, 284 F. Supp. 85 (1968).
Ryan V. Kanne, 170 N.W. 2nd 395 (1969).
State Street Trust Company v. Ernst and Ernst, 278 N.Y. 104,
15 N.E. 2d 416 (1938).
Ultramares Corporation v. Touche, 255 N.Y. 170, 174 N.E. 441
•
(1931).
101
U.S. V. Simon, U.S. Court of Appeals, Second Circuit (1969),
p. 3817.
Wharton v. Lybrand, Ross Bros. & Montgomery, No. 65 Civ. 664
(E.D.N.Y. 1967).
Miscellaneous Publications
Federal Securities Act of 19 33, 48 Stat. 74 (1933), as
amended, 15 U.S.C. ## 77a-77aa (1964).
Federal Securities Exchange Act of 1934, 48 Stat. 881 (1934),
as amended, 15 U.S.C. ## 78a-78hh (1964).
Montgomery, Samuel Thurston. "Accountants' Liability to
Third Parties." Unpublished Master's thesis, Texas
Tech University, 19 69.
The 1964 Federal Securities Act, 78 Stat. 565 (1964).
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