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Audit Case on Common Law Constructive Fraud and Negligence

Astor Inc. purchased the assets of Bell Corp. A condition of the purchase agreement required Bell to retain a CPA to audit Bell's financial statements. The purpose of the audit was to determine whether the unaudited financial statements furnished to Astor fairly presented Bell's financial position. Bell retained Winston & Co., CPA's, to perform the audit.

While performing the audit, Winston discovered that bell's bookkeeper had embezzled $500. Winston had some evidence of other embezzlements by the bookkeeper. However, Winston decided that the $500 was immaterial and that the other suspected embezzlements did not require further investigation. Winston did not discuss the matter with Bell's management. Unknown to Winston, the bookkeeper had, in fact, embezzled large sums of cash from Bell. In addition, the accounts receivable were significantly overstated. Winston did not detect the overstatement because of Winston's inadvertent failure to follow its audit program.
Despite the foregoing, Winston issued an unqualified opinion on Bell's financial statements and furnished a copy of the audited financial statements to Astor. Unknown to Winston, Astor required financing to purchase Bell's assets and furnished a copy of Bell's audited financial statements to City Bank to obtain approval of the loan. Based on Bell's audited financial statements, City loaned Astor $600,000.

Astor paid Bell $750,000 to purchase Bell's assets. Within six months, Astor began experiencing financial difficulties resulting from the undiscovered embezzlement and overstated accounts receivable. Astor later defaulted on the City loan.

City has commenced a lawsuit against Winston based on the following causes of action:

â?¢ Constructive fraud
â?¢ Negligence

Required:

In separate paragraphs, discuss whether City is likely to prevail on the causes of action it has raised, setting forth reasons for each conclusion.

Solution Preview

Hello Student,

Before you tackle this case, the first thing you may want to note is - in order for a client or any other individual to establish common law liability against an auditor based on negligence, that client or individual must prove that:

1) The auditor had the duty to exercise due care.
2) The auditor/accountant breached the duty of due care.
3) Damage or loss was suffered by the client.
4) A causal relationship exists between the fault of the auditor/accountant and the resulting damage.

Also, in order to establish a cause of action against an auditor based on constructive fraud, the client must prove that:

1) The auditor made a materially false statement of fact.
2) The auditor lacked a reasonable ground for belief that the statement was true. Constructive fraud may be inferred from evidence of gross negligence or recklessness.
3) The auditor intended another to rely on the false statement.
4) The client justifiably relied on the false statement.
5) Such reliance resulted in damages or injury.

Within the case, you will also find the matter of privity of contract was brought ...

Solution Summary

This solution includes a response to an audit case related to common law constructive fraud and negligence. This response tells which company is likely to prevail and gives reasons.

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