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Third Party Liability

George Hanson was the owner of JustPrinting or JP, a printing supply and press repair business. In 1997, Hanson retired because of his failing health. At that time, he relinquished his ownership interest in the company to his three children, giving each a one third interest, and passed control of the company to his son-in-law, Philip Katz. After his retirement, Philip, now CEO, retained Walter, Stern and Bailey (WS & B) as JP's accounting firm. WS & B's dual undertaking through its contract was to perform annual audits of JP's financial statements as well as prepare unaudited reports for the company every six months. Under the engagement, it audited JP's annual year-end financial statements for 1999, 2000, 2001 and 2002.

Hanson also entered into several transactions with JP after his retirement. In 2000, he loaned the company $450,000 and then in 2002, he pledged $150,000 to JP. After a June, 2003 independent audit found that reported accounts receivable had been inflated by JP, the Bank of the East, JP's principal lender, called in its $2 million loan. As a result, JP was forced to cease operations, and the Bank took possession of the company's premises and liquidated most of its assets.

Hanson sued WS & B on a theory of negligent misrepresentation for the $600,000 in losses he suffered as a result of the accounting error that led to JP's collapse. According to Hanson, JP's overstatement of its accounts receivable was a result of a mathematical error that went undetected for years. The effect of the error was the overstating of assets by approximately 10 times. Hanson claimed that WS & B failed to obtain, as it should have, independent confirmation of the receivables from the debtors, separate and apart from the input of JP. WS & B maintained that Hanson's damages were the result of a embezzlement scheme perpetrated by Buck Henry, the company's bookkeeper. It pointed out that Henry served a two year sentence in the federal penitentiary for that scheme.

WS & B moved to have the case dismissed. It argued that Hanson could not establish that WS & B owed him a duty of care in the conduct of the audit. WS & B asserted that no duty ran to Hanson from its contract with JP for the performance and preparation of audits and reports. In support of its motion, WS & B submitted the affidavit of Tracy M. Patrick, which stated that WS & B was not asked to express an opinion on the advisability of Hanson lending money to JP. Furthermore, WS & B argued that Hanson was not, and could not show that he was a third party beneficiary to the contract between JP and WS & B.

In response, Hanson emphasized the contacts he had with WS & B. Hanson had several discussions with WS & B personnel regarding the audits and reports of WS & B prior to making the loans to JP. Sometime between November 1, 1999 and February 1, 2000, Phillip Katz, Patrick and Hanson met at WS & B's office to discuss the loans. During that meeting, Mr. Patrick presented a cash flow analysis and a projected profit and loss statement for JP's coming year. Hanson was also given a copy of the 1999 audit report. Based on these reports and information presented by WS & B, Hanson agreed to make the loans and commitments to JP.

JP also sued WS & B for its failure to uncover the accounting error and its failure to uncover the fraud by Henry. WS & B argued that JP was contributorily negligent by failing to oversee Henry and by failing to have sufficient internal controls in place. JP argued that neither contributory negligence nor comparative negligence should be a defense since JP's negligence did not interfere with WS & B's ability to perform the audit and uncover the truth. WS & B argued that the court should allow the modern defense of comparative negligence.

Analyze the issues presented in this case scenario. The relevant law is contained in Chapters 8 and 44. You will also want to review material that explains accountants' liability that is posted on Blackboard in the Articles section. My power points are also available for your review as well as an article on the contributory negligence defense (see the Articles section of the course site). In making your analysis, answer the following questions:

1. Explain how the third party liability or duty issue will be resolved under the three different tests that have been developed by the courts: the primary-benefit test, the foreseen class of users test, and the foreseeable users test.

2. Explain what the plaintiffs will have to establish to prove negligence on the part of WS & B. Will the undetected mathematical error be sufficient to establish a lack of due care? If the case goes to trial, what will be WS & B's strongest argument relating to the negligent misrepresentation claim?

3. Explain the likely outcome of the contributory negligence issue. Consider how the issue would be resolved under the traditional and modern approaches to the contributory negligence defense in auditor liability cases. See the above article for a discussion of those approaches.

Solution Preview

1. Explain how the third party liability or duty issue will be resolved under the three different tests that have been developed by the courts: the primary-benefit test, the foreseen class of users test, and the foreseeable users test.

Courts adopt three different tests to determine whether a nonclient may sue a professional for negligence. Under the Primary Benefit Test, a professional's duty of care extends only to those intended to receive the primary benefit of the professional audits or prepares financial reports and documents. Under the Foreseen Class of Users Test, a professional's duty of care extends to those who a ...

Solution Summary

Third party liability is discussed.

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