Cook & Thomas LLC

ISSUES IN ACCOUNTING EDUCATION American Accounting Association Vol. 32, No. 1 DOI: 10.2308/iace-51318 February 2017 pp. 17–32

Cook and Thomas, LLC: Balancing Auditor Liability, Client Confidentiality, and the Public Interest

Kelsey R. Brasel Ball State University

Brian E. Daugherty University of Wisconsin–Milwaukee

ABSTRACT: In this case students are asked to assume the role of Alex Trifold, CPA, an audit partner for the public accounting firm, Cook and Thomas, LLC, who holds going concern information about an audit client that may impact other entities audited by Cook and Thomas. The case study illustrates how adherence to auditing standards may place auditors in a difficult situation when balancing the auditor’s risk of litigation, the clients’ rights to confidentiality, and the auditor’s duty to the public. Additionally, the case provides exposure to prior litigation cases against auditors with unfavorable outcomes when auditors chose to protect their client’s confidentiality, and, conversely, in cases where auditors chose to protect the greater public interest. The case requires students to engage in critical thinking by providing their viewpoints as to the optimal balance of limiting auditor liability, adhering to client confidentiality requirements, and simultaneously serving the public interest. The case study is appropriate for both undergraduate and graduate auditing courses.

Keywords: auditor liability; client confidentiality; auditors’ duty to the public; Public Company Accounting Oversight Board; AICPA code of conduct; Regulation Fair Disclosure.

INTRODUCTION

I n this case you will assume the role of Alex Trifold, CPA, an audit partner for the public accounting frm, Cook and

Thomas, LLC. As you will learn in the case, Alex Trifold holds potential going concern information about a client that

may impact other entities audited by Cook and Thomas. This case is concerned with client confdentiality within a frm in

terms of whether information pertaining to one audit client can be shared with the engagement teams of other clients of the frm.

The requirements of client confdentiality between the audit client and an external party are clearly set forth by regulations (e.g.,

AICPA 1992, 1988). However, the way in which an audit partner considers client confdentiality in practice may not always be

clear and straightforward, particularly when the external parties are other engagement teams, in differing locations, of the

auditor’s frm. Therefore, this case focuses on the way in which an audit partner considers client confdentiality in practice

within a frm that has common inter-dependent clients.

According to regulations, a CPA is not permitted to disclose confdential client information to others in the frm who are

not connected to the audit engagement. However, with respect to auditor liability, historical legal opinions have been mixed on

matters pertaining to auditor clients’ confdentiality rights and the auditor’s duty to the public. Auditors have previously

suffered negative litigation consequences when adhering to client confdentiality rules and when acting in a manner that

demonstrates a concern for the broader public interest. As you will discover as you work through the case, the potential

conficts remain an unresolved issue nearly 50 years after the rendering of certain legal opinions involving confdentiality

litigation against auditors.

We thank Lori Holder-Webb (editor), an anonymous associate editor, and two anonymous reviewers for their constructive comments and feedback on earlier versions of the manuscript. We are grateful to Kyle Peel for administrating the case and appreciate the undergraduate and graduate students participating in the case for their feedback used for case validation purposes.

Editor’s note: Accepted by Lori Holder-Webb.

Submitted: January 2013 Accepted: October 2015

Published Online: October 2015

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The remainder of the case presents information on a hypothetical audit client of Cook and Thomas, LLC. The case

provides general background information on auditors’ duties to the public, auditors’ client confdentiality requirements, and

auditors’ litigation risk (Cashell and Fuerman 1995). At the end of the case you will fnd case questions to complete.

COOK AND THOMAS, LLC

As a partner for the international public accounting frm Cook and Thomas, LLC, you are comfortable with complex

problems and situations, but the current engagement of Fine Furniture Manufacturing is particularly challenging. Since joining

Cook and Thomas, LLC out of college you have been located in the Chicago, Illinois offce. For the past two years, you have

been assigned as engagement partner on the annual fnancial statement audit of Fine Furniture Manufacturing. Fine Furniture

has been a client of the frm for 12 years out of the Chicago offce and has traditionally been an uneventful audit. You and your

audit engagement team are currently completing the year-end audit of Fine Furniture Manufacturing for the year ended

December 31, 2014.

Fine Furniture Manufacturing is a medium-sized publicly held corporation established in 1982. The company specializes in

manufacturing wood furniture including park benches, patio furniture, and rocking chairs. Nearly all of the furniture produced

by Fine Furniture Manufacturing is constructed using a revolutionary and proprietary product called paple that is supplied by

Paple Lumber Supply in Atlanta, Georgia. Since its founding in 1991, Paple Lumber Supply has revolutionized the lumber

industry by creating a hybrid wood product that is a cross between pine and maple (hence, paple). Paple has the economic

benefts of pine lumber with the sturdiness and longevity of maple wood. Paple Lumber Supply is the only company of its kind

to manufacture paple lumber. Paple Lumber Supply’s largest customer is Fine Furniture Manufacturing. Paple Lumber Supply

is also a publicly held corporation and is audited by the Atlanta offce of your frm, Cook and Thomas, LLC.

As a manufacturer of wood furniture, Fine Furniture Manufacturing sells its products wholesale to retail stores. Fine

Furniture Manufacturing’s largest customer is Front Porch Furniture in St. Louis, Missouri. Front Porch Furniture is audited by

the St. Louis offce of your frm, Cook and Thomas, LLC. Front Porch Furniture is a publicly held corporation established in

1985 specializing in high-quality outdoor furniture. Front Porch Furniture’s largest supplier of inventory is Fine Furniture

Manufacturing and a majority of its sales are derived from Fine Furniture Manufacturing’s products. Front Porch Furniture has

multiple store locations throughout the Midwest and advertises that it specializes in bringing you the best of southern living.

Over the past fve years, Front Porch Furniture has experienced continued growth in sales of furniture manufactured by

Fine Furniture Manufacturing. Due to the increased sales, Front Porch Furniture plans to expand its store locations into the

Colorado region by opening eight new store locations in the next year. Front Porch Furniture is currently in the process of

securing a ten-year, 6 percent note payable in the amount of $30 million from Mutual Trust Bank for the expansion. One large

factor in the bank’s consideration of the note is an analysis of Front Porch Furniture’s 2014 fnancial statements. Mutual Trust

Bank will provide fnal approval on the note after it reviews the audited 2014 fnancial statements.

The Chicago offce of Cook and Thomas, LLC has an uneventful history with Fine Furniture Manufacturing and has issued

unmodifed (clean) audit opinions every year since it began auditing the company. Fine Furniture has been historically

proftable and its fnancial performance has generally been in line with that of its competitors. The client is not followed by a

large number of analysts given its niche as a mid-market, publicly held company and thus does not face the scrutiny or pressure

of larger public companies that have a large analyst following and consensus analyst forecasts. The fnancial performance

during the frst three quarters of the current year has been relatively consistent with prior year’s results and those of its peers.

However, during the fourth quarter of the current fscal year under audit, Fine Furniture Manufacturing experienced

drastically increased costs of production relating to two unforeseen factors that occurred during the last two months of the year.

Specifcally, the company experienced material and uninsured damages to the company’s custom manufacturing equipment.

Additionally, the company was unable to favorably negotiate its union contract and has experienced increased pension

expenses that are material to the company. Therefore, the Fine Furniture Manufacturing engagement team believes these factors

raise substantial doubt about the ability of Fine Furniture to continue as a going concern. Under current standards, the going

concern decision requires the auditor to consider whether there is substantial doubt about the ability of the client to remain a

going concern through the next fscal year-end.1

1 In August 2014, the Financial Accounting Standards Board (FASB) issued an updated standard, Accounting Standards Update No. 2014-15, that will explicitly require management to assess an entity’s ability to continue as a going concern, and to provide footnote disclosures in certain circumstances. The updated standard is effective for entities with fscal years ending after December 15, 2016. The standard continues to use a substantial doubt framework, but extends the forward-looking period to within one year after the audit report issuance date. See the FASB website for additional detail. In September 2014 the Public Company Accounting Oversight Board (PCAOB) issued a practice alert reminding auditors of their responsibilities in a going concern context, and indicated that a new auditing standard may be proposed to align with the FASB’s updated standard. See the PCAOB website for additional information.

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During the audit, you have discussed Fine Furniture Manufacturing’s ability to continue as a going concern with its

management. Despite the conversations, the client will not agree to provide consent to disclose (prior to the release of the audit

opinion) the audit frm’s substantial doubt about its ability to continue as a going concern to either its primary supplier (Paple

Lumber Supply) or its primary customer (Front Porch Furniture). The client refuses to provide consent because both

management and the audit committee believe Fine Furniture Manufacturing can navigate the issues giving rise to the going

concern opinion, and further believes the company will remain a viable concern for years to come. As noted by management,

auditors in general have a relatively poor track record for issuing going concern opinions in the year prior to a client fling for

bankruptcy. Fine Furniture has appropriately disclosed its plans to address the relevant factors causing Cook and Thomas’

substantial doubt about its ability to continue as a going concern in the footnotes to the fnancial statements to be fled soon with

the Securities and Exchange Commission (SEC). Regardless of the client’s beliefs and footnote disclosure, you and your audit

team believe there is substantial doubt the company can continue as a going concern and have determined the audit report must

include a going concern paragraph. Fine Furniture Manufacturing, Paple Lumber Supply, and Front Porch Furniture all have

December 31 fscal year-ends and similar expected audit opinion dates on or about February 25, 2015.2 All three companies are

audited by different offces, engagement partners, and audit engagement teams of Cook and Thomas, LLC.

As partner of the audit engagement, you are concerned about Fine Furniture’s ability to continue as a going concern and

the implications regarding the audits of Paple Lumber Supply and Front Porch Furniture. You are especially concerned with the

audit report to be issued for Front Porch Furniture since the audit report will be relied upon by Mutual Trust Bank before

approving a note payable. As the auditor of the Fine Furniture Manufacturing, do you have a duty to inform the engagement

teams of Paple Lumber Supply and Front Porch Furniture that your client has a going concern issue? Or do you have a duty to

uphold your client’s right to confdentiality and withhold the information from the other engagement teams until Fine

Furniture’s audited fnancial statements are fled with the SEC?

Suppose both engagement teams for Paple Lumber Supply and Front Porch Furniture issue unmodifed opinions for their

respective clients. If Fine Furniture Manufacturing were to become insolvent, and Paple Lumber Company and/or Front Porch

Furniture were unable to locate alternative customers or wholesale product sources, respectively, then Cook and Thomas would

likely face litigation if Paple Lumber Company and/or Front Porch Furniture were to fle for bankruptcy shortly after receiving

clean unmodifed audit opinions. Alternatively, the frm may face litigation, under client confdentiality rules, from Fine

Furniture Manufacturing if the pending going concern opinion is disclosed to the Paple Lumber Company and/or Front Porch

Furniture engagement team(s) prior to public release of the opinion.

The Cook and Thomas’ policy regarding potential going concern issues requires you to consult with the national offce of

the frm. The national offce has expertise regarding technical and subjective issues including going concern situations, and is

able to assist engagement partners in making more diffcult decisions. Your consultation with the national offce is just a few

days away. In preparation for your meeting with the national offce, you decide to refresh your understanding of the issues by

researching an auditor’s duty to the public, client confdentiality, and legal liability.

Auditor’s Duty to the Public

You decide to begin your reading with the American Institute of Certifed Public Accountants’ (AICPA) Code of

Professional Conduct. The AICPA emphasizes the auditor’s duty to the public in its Code of Professional Conduct by stating,

Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and

demonstrate commitment to the profession (AICPA 1988, § 53).

The Code of Professional Conduct acknowledges potential conficting pressures from various stakeholder groups and

states, In resolving those conficts, members should act with integrity, guided by the precept that when members fulfll their

responsibility to the public, clients’ and employers’ interests are best served (AICPA 1988, § 53.02). Additionally, the Code of

Professional Conduct states, Those who rely on certifed public accountants expect them to discharge their responsibilities

with integrity, objectivity, due professional care, and a genuine interest in serving the public. They are expected to provide

quality services, enter into fee arrangements, and offer a range of services—all in a manner that demonstrates a level of

professionalism consistent with these Principles of the Code of Professional Conduct (AICPA 1988, § 53.03).

A fundamental understanding of the term public interest is essential to following the AICPA’s Code of Professional

Conduct. The International Federation of Accountants (IFAC 2012) defnes the public interest in a recent policy position.

The IFAC defnes the public interest as the net benefts derived for, and procedural rigor employed on behalf of, all society in

relation to any action, decision, and policy. The broadness of the defnition comes from the IFAC’s very broad defnition of

the public. According to the IFAC, the public includes all individuals and groups because accountants directly and indirectly

2 The Sarbanes-Oxley Act of 2002 now requires most public companies to fle audited fnancial statements with the Securities and Exchange Commission within 60 days of their fscal year-end.

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affect all levels of society. Therefore, the public includes investors, shareholders, and business owners; consumers and

suppliers; and taxpayers, electorates, and citizens (IFAC 2012).

During your reading, you come across four publications that discuss the auditor’s duty to the public. In the frst article, the

authors adopt a common good defnition of the public interest by focusing on the advancement of the good of institutions,

communities, and individuals. This defnition identifes both mutual interests of society and private interests of individuals

(Shapiro and Naughton 2013). In the second article, the author argues the AICPA’s Code of Professional Conduct should

explicitly state that the interest of the public outweighs client confdentiality when there is a confict of interest between the two

(Bowie 1986). However, the author also observes when the confict is not obvious, the Certifed Public Accountant (CPA) may

not even know the public good is threatened (Bowie 1986). A third article suggests the public interest is clearly dominant, in

contrast to the interests of both auditors and clients (Waples and Shaub 1991). In the fourth article, the authors view the

AICPA’s Code of Professional Conduct as a transitional document, suggesting that the profession should always be searching

for the changes that will improve the level of professional service to the public we are commissioned to serve (Collins and

Schultz 1995, 40).

These observations regarding public interest are notable in that they are silent with respect to the degree that negative impacts

on the accounting frm may indirectly have on the greater public good. Consider for example the impact that negative litigation

outcomes against auditors on matters regarding client confdentiality and the public interest may have. The annual audit client

acceptance and retention requirements of the profession, by defnition, involve risk and reward judgments by auditors. To the

extent litigation risks are perceived to be increased, whether by virtue of client characteristics or by auditing and accounting

standards, fees can be expected to rise to counter this risk. You note that this may or may not serve the greater public interest.

While the AICPA’s Code of Professional Conduct and the views of others who have published on the matter of the

auditor’s duty to the greater public interest seem to suggest this outweighs client confdentiality matters, you feel that, in order

to cover all the bases, you would be well suited to review the authoritative requirements insofar as they relate to confdentiality.

Auditor’s Client Confidentiality Responsibilities

In addition to your duty to the public as an auditor, you also hold client confdentiality responsibilities. Rule 301 of the

AICPA’s Code of Professional Conduct addresses client confdentiality by stating a member in public practice shall not

disclose any confdential client information without the specifc consent of the client (AICPA 1992). Therefore, Rule 301

suggests that client confdentiality is necessary regardless of the auditor’s motivation to protect the public good.

You value the service that you as an audit partner provide to the profession, its clients, and the capital markets. You also

know that you cannot provide these services if you are not a CPA and are becoming increasingly concerned that resolving the

Fine Furniture issues may place you into an uncomfortable position, even to the point of potentially committing an act that is

discreditable to the auditing profession. This is of great concern to you personally as this could result in the loss of your CPA

credential and other disciplinary outcomes.

In addition to considering the requirements of Rule 301, you also realize that compliance with the SEC’s Regulation Fair

Disclosure (Reg FD) is necessary. Reg FD was implemented to level the playing feld and requires any material client

information to be disseminated to all potential stakeholders concurrently to minimize the advantage that one stakeholder group

might have over another.

During your reading you fnd an interesting article concerning client confdentiality Werner (2009). In the article, Werner

describes a factual case in which an honest client of a frm (Dallas offce) sold a material amount of product on credit to a

dishonest client of the same frm (Los Angeles offce). Neither clients’ audited fnancial statements had yet been issued, nor was

the dishonest client’s audit team aware that the honest client’s accounts receivable balance was not collectible. The Los Angeles

audit team also recognized that Rule 301 of the AICPA’s Code of Professional Conduct precluded informing the Dallas audit

team. Leadership of the frm was equally aware that the Dallas audit engagement team could not sign their audit opinion unless

the receivable balance (from the dishonest client) was fully reserved.3 Werner (2009) also describes two hypothetical scenarios

an auditor might encounter regarding client confdentiality as follows:

(i ) The CPA learns during the current audit that the client has not properly accounted for a transaction, but the CPA’s

knowledge was obtained during work for another client; and

(ii ) The CPA frm has material information from the audit of another client that would cause the engagement partner on a

current audit to take exception or give an adverse opinion on the current audit client’s fnancial statements.

3 Ultimately, the press reported an SEC investigation of the Los Angeles client, thus allowing the Dallas offce to use that public information in fnalizing its opinion on the appropriate application of GAAP for its client (Werner 2009).

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In the frst scenario, Werner (2009) indicates that the CPA should consult legal counsel and attempt to develop audit

evidence and support from the current client’s books and records, without revealing the confdential information obtained from

the second client. Absent the ability to independently develop information from the current client, the auditor should consider

resigning because the issuance of a known incorrect audit opinion is not a viable option. In the second circumstance, the CPA

frm is not expected to act on the information if it is unable to connect an issue discovered on one audit with the fnancial

statements under audit at another client (Werner 2009).4

You consider again the two scenarios set forth by Werner (2009). In the frst case, the professional literature is silent and

the CPA’s legal counsel might advise that legal obligations to disclose certain information override Rule 301, especially if the

client is a publicly traded entity (Werner 2009). In the second scenario, the professional literature is again silent and Werner

(2009, 66) concludes there appears to be no duty to search for information on one client’s audit that may be relevant to another

client. However, you know from the popular press that frms have experienced negative litigation outcomes when choosing to

protect the public interest and when preserving client confdentiality. You next turn your attention to client confdentiality

litigation involving auditors.

Selected Client Confidentiality Litigation

In your search for client confdentiality litigation, you come across a number of interesting and, potentially, applicable

cases. To organize your thoughts you create a table to provide a summary of selected client confdentiality litigation against

auditors (see Exhibit 1).5

As detailed in the cases in Exhibit 1, the courts have produced mixed conclusions regarding the balance between the

auditor’s duty to the public and client confdentiality. For example, Peat Marwick Mitchell (PMM) became aware—through a

consulting contract with an audit client—that previously issued audited (unqualifed opinion)6 and interim (though not

reviewed) fnancial statements were materially misstated. PMM was subsequently sued, related to the misstated fnancials. The

frm remained silent, citing client confdentiality rules, and the court ruled the frm had no obligation related to the interim

fnancial information as a review report was not issued. However, PMM’s motion to dismiss the suit was denied by the court

with respect to the audited fnancial statements (Cashell and Fuerman 1995).7 Conversely, Alexander Grant was sued and found

guilty of negligence and breach of contract involving the revelation of confdential information about one client in an effort to

protect other clients and the greater public interest (Beach 1984).

Several months after issuing an unqualifed audit opinion on a privately held audit client (American Fuel & Supply

Company, Inc.), Touche Ross (Touche) discovered a material misstatement in the audited fnancial statements (Knapp 2010).

Touche advised the client of its intent to withdraw the audit opinion and notify all parties known to be relying on the fnancial

statements.8 The client’s counsel threatened legal action against Touche for violating client confdentiality. In an apparent

compromise, Touche notifed the client’s only secured creditor—but none of the unsecured creditors. Touche was subsequently

sued by an unsecured creditor and found negligent in failing to notify the plaintiff of the opinion withdrawal (Knapp 2010).

Arthur Andersen lost a litigation case in which the frm did not reveal confdential information about one client to another

client, and was sued by the uninformed client (Beach 1984). The court held: Assuming that the duty of confdentiality applies

in this instance, when an auditor fnds its independence in question, or a confict of interest developing, there is testimony that it

may (1) strongly encourage one client to make the necessary disclosure; (2) disclose that it has relevant information not

available to the other client; or (3) resign from one account. Arthur Andersen did none of these (Werner 2009, 63; emphasis

added).

Arthur Young refused an IRS summons for the tax accrual workpapers of a client citing accountant-client privilege, which

was upheld by an appeals court. However, the U.S. Supreme Court overturned the appellate decision, indicating that a CPA’s

4 The frst scenario described by Werner (2009) implies that the auditor becomes aware of an error in the application of Generally Accepted Accounting Principles (GAAP). The second scenario simply discusses the auditor’s knowledge of material information obtained from another audit client that might impact another audit opinion and is more analogous to the hypothetical setting we use in this case.

5 It is important to note that the court cases cited in Exhibit 1 comprise state and federal cases. This case represents a hypothetical case with clients located in three separate states and thus the results could differ based on jurisdiction. However, a number of the cases cited (and other litigation involving auditors) rely, in part, on common law (versus statutory law), and the ultimate outcomes of future cases may, or may not, draw from prior legal rulings.

6 Currently referred to as an unmodifed opinion. 7 Werner (2009) documents that the AICPA changed its auditing standards subsequent to the PMM case, requiring auditors to withdraw their opinion in

such a circumstance unless the client has already publicly disclosed the issue. 8 Note that in practice it is more diffcult to determine parties known to be relying on audited fnancial statements for privately held clients as the auditor,

under professional standards, may not restrict distribution of the audit opinion and does not know with certainty all entities that may have received such fnancial statements. For a public company audit, the auditor presumes every potential stakeholder may be relying on materially misstated fnancial statements, and the notifcation process is accomplished through the client’s fling of a Form 8-K with the SEC.

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EXHIBIT 1

Summary of Selected Client Confidentiality Litigation Against Auditors

Defendant Citation Summary

Alexander Grant (AG) &

Company (now Grant

Thornton)

Wagenheim v. Alexander Grant & Co., 19 Ohio

App 3rd 7, 482 N.E.

2d 955 (1982)

AG was the auditor of Consolidata Data Services, Inc. (CDS). AG notifed

clients of CDS that funds purportedly on deposit with CDS for payment of

payroll taxes were being used to fund CDS’s operations. AG warned their

own clients to stop doing business with CDS as CDS was having fnancial

diffculty. The court ruled against AG citing that AG did not uphold client

confdentiality. However, the court indicated the actions might be justifed

if CDS intended fraud by not disclosing its insolvency or did not intend to

fulfll its contractual obligations to clients. Although the court ruled against

AG, it stated that overriding public interest may exist to which

confdentiality must yield.

Arthur Andersen (AA) Fund of Funds Limited, et al. v. Arthur Andersen & Co., 545

F. Supp. 1314,

S.D.N.Y. (1982)

AA was the auditor of Fund of Funds, Ltd. Fund of Funds purchased

investments from King Resources Corp., another AA client. AA knew from

the audit of King Resources that the investments were worth substantially

less than that paid by Fund of Funds. Therefore, Fund of Funds sued AA

for not disclosing this information to them. A federal jury found AA liable

based on breach of contract and fraud. The court indicated when duty of

confdentiality applies, in this situation the auditor may (i ) encourage the

selling client to make the necessary disclosure, (ii ) disclose that it has

information relevant (but not disclosable) to the other client, or (iii ) resign

from one account. The court noted AA did none of the above. Therefore,

even though AA upheld client confdentiality, it was liable because it did

not take appropriate action as detailed by the courts.

Arthur Young (AY) (now

Ernst & Young)

United States v. Arthur Young, 104 S. Ct. 1495

(1984)

AY (now EY) refused an IRS summons for tax accrual workpapers of a

client. AY cited accountant-client privilege as the reason for not providing

the client’s workpapers. An appellate court refused to enforce the

summons. The Supreme Court overturned the lower court, ruling that

implying an auditor’s duty to the public is a higher priority than client

confdentiality. The court argued that an independent CPA performs a

different role than an attorney and the CPA’s public responsibility

transcends any client employment relationship. The court also said an

independent auditor’s obligation to serve the public interest assures that

integrity will be preserved without the need for work-product immunity.

Touche Ross (TR) (now

Deloitte & Touche)

Chevron Chemical v. Deloitte & Touche, 483

N. W. 2d 314 Wis.

App. (1992)

TR detected a material misstatement subsequent to issuing an unqualifed

opinion on audited fnancial statements of a client. TR notifed the client of

its intent to withdraw the opinion and notify all parties known to be relying

on the audited fnancial statements. The client threatened TR with litigation

under client confdentiality requirements. TR then informed the client’s

only secured creditor, but none of the unsecured creditors. TR was sued by

an unsecured creditor and found negligent for failing to notify the plaintiff

of the opinion withdrawal. Therefore, the courts held that the auditor

should have disregarded client confdentiality and informed all parties

known to be relying on the audited fnancial statements.

Peat Marwick Mitchell

(PMM) & Co. (now

KPMG)

Fischer v. Kletz, 266 F

Supp. 180, S.D.N.Y.

(1967)

PMM issued an unqualifed opinion on the fnancial statements of Yale

Express. Subsequently, PMM discovered in a consulting engagement with

Yale that substantial amounts of their accounts payable were omitted from

the audited fnancial statements. PMM did not withdraw the unqualifed

opinion due to the client confdentiality rule. The court ruled PMM’s

failure to withdraw the opinion exposed Yale to litigation by investors who

relied on the opinion. Therefore, the courts decided in favor of an

accountant’s duty to the public over client confdentiality.

(continued on next page)

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responsibility to the public transcends client relationships. The Supreme Court further stated an independent auditor’s

obligation to serve the public interest assures that integrity will be preserved without the need for work-product immunity

(Collins and Schultz 1995).

In a recent case occurring after the implementation of Reg FD, Cast Art Industries brought a case against KPMG LLC

alleging that after Cast Art’s merger with KMPG’s client, Papal Giftware, Cast Art found out that Papal had accounting

irregularities that KPMG failed to detect. KPMG argued, and the courts agreed, that KPMG could not be held liable to third-

parties unless the accountant knew at the time of the engagement that third-parties would rely on its report.

As previously discussed, Cook and Thomas, LLC could experience litigation claims, depending on its decision to share the

Fine Furniture going concern information (prior to report issuance) with the engagement teams of Paple Lumber Supply and/or

Front Porch Furniture. First, suppose both engagement teams for Paple Lumber Supply and Front Porch Furniture were not

informed of Fine Furniture Manufacturing’s going concern opinion prior to the release of the audit report. Both Paple Lumber

Supply and Front Porch Furniture would issue unmodifed opinions on their respective clients. If Fine Furniture Manufacturing

were to go bankrupt, and Paple Lumber Company and/or Front Porch Furniture were unable to locate alternative customers or

wholesale product sources, respectively, then Cook and Thomas would likely face litigation if Paple Lumber Company and/or

Front Porch Furniture were to fle for bankruptcy shortly after receiving clean unmodifed audit opinions. The Fine Furniture

Manufacturing engagement team has acknowledged the interdependent relationships with Paple Lumber Supply and Front

Porch Furniture in its audit-planning documents, and has identifed these companies as primary users of Fine Furniture

Manufacturing’s fnancial statements.

While litigation could be initiated by stockholders of either company, it would be especially likely that Cook and Thomas

would face litigation from Mutual Trust Bank that indicated they would rely on the Front Porch Furniture fnancial statements

before extending the $30 million note to Front Porch Furniture. The potential plaintiff, Mutual Trust Bank, would likely argue

that the company was a foreseen user of Front Porch Furniture’s fnancial statements, and that those fnancial statements should

have disclosed the fact that its primary supplier, Fine Furniture Manufacturing, was issued a going concern opinion. Mutual

Trust Bank’s success in its litigation claim would be contingent on its ability to show that its lending decision would have been

different had the fnancial statements forewarned users that the company’s primary supplier may discontinue operations.

Alternatively the frm may face litigation, under client confdentiality rules and Reg FD, from Fine Furniture

Manufacturing if the pending going concern opinion was disclosed to the Paple Lumber Company and/or Front Porch Furniture

engagement team(s) prior to public release of the opinion. Fine Furniture Manufacturing could initiate litigation against the frm

for breaching client confdentiality as defned in Rule 301 of the AICPA’s Code of Professional Conduct. Conversely, Cook

and Thomas, LLC may argue that it was acting in such a way as to serve the public interest, consistent with the AICPA’s Code

of Professional Conduct.

CONCLUSION

After considering the balance between auditor liability, client confdentiality, and an auditor’s duty to the public, you

realize you have much to discuss with the national offce during your consultation. After all of this deliberation, it has occurred

to you that it would be so much simpler if there were a safe-harbor rule that would provide protection from litigation in cases in

which the auditor was genuinely attempting to fulfll his or her duty to the public interest. The safe-harbor rule could provide

EXHIBIT 1 (continued)

Defendant Citation Summary

KPMG LLP Cast Art Industries, LLC v. KPMG LLC, 416

N.J.Super. 76 (2010)

Cast Art Industries merged with Papal Giftware, which was audited by

KPMG. Cast Art obtained a loan from PNC Bank to complete the merger

with Papal. The loan was conditioned on review of Papal’s audited

fnancial statements. Cast Art alleged that after the merger it found out

Papal had accounting irregularities that KPMG failed to detect. KPMG

defended the suit claiming that it could not be held liable for Cast Art’s

losses because KPMG did not know the audit report would be used by a

third-party. KPMG argued that it did not have a public duty to a third-party

and the court agreed (New Jersey Supreme Court), holding that an

accountant cannot be liable to third-parties unless the accountant knew at

the time of the engagement that third-parties would rely on the report.

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