The 3 Faces of Liability

By Hanson, Randall K.; Gillett, John W. | The National Public Accountant, June 1991 | Go to article overview

The 3 Faces of Liability


Hanson, Randall K., Gillett, John W., The National Public Accountant


The 3 Faces of Liability

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

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

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

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

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

Basic Approaches

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

Ultramares Approach

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

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

Under this approach, the only time an accountant can be held liable to a third party is if the third party is an intended third party beneficiary of the audit contract. For example, if an accounting firm is hired by a company to audit their financial records and to send the results to a bank, the auditor is liable to the bank for any negligence. …

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