Articles: CPA Has No Liability to Third Parties for Review of Financial Statements

Originally published in California Civil Litigation Reporter, by Farley J. Neuman.

In only the third California appellate decision to address accountants’ liability to third parties, the Second District Court of Appeal in Union Bank v Ernst & Whinney (1991) 227 CA3d 1389, 278 CR 490, held that a certified public accountant has no duty to third parties who claim to have relied on a review report of financial statements. The other two cases (Bily v Arthur Young Co. (review granted Oct. 18, 1990, SO17199, former opinion at 222 CA3d 289 (advance reports), 271 CR 470, reported at 12 CEB Civ LR 256 (Sept. 1990)) and International Mortgage Co. v John P. Butler Accountancy Corp. (1986) 177 CA3d 806, 223 CR 218, reported at 8 CEB Civ LR 95 (Apr. 1986)) involved audits of financial statements, not reviews.

Essential to understanding this case is recognition of the distinction between a review and an audit. A review is a level of service lower than an audit of financial statements. After conducting a review, the CPA cannot express an opinion based on generally accepted auditing standards, because many of the significant auditing procedures are not required by a review. Accordingly, the standard form for an accountant’s report on a review of financial statements states that an audit was not conducted, that a review is substantially less in scope than an audit, and that the CPA does not express an opinion regarding the financial statements taken as a whole. (Statement on Standards for Accounting and Review Services, American Institute of Certified Public Accountants (AICPA) Professional Standards AR § 100.32 (1983).)

In Union Bank, the trial court sustained the demurrer of defendant Ernst & Whinney to the second amended complaint of plaintiff Union Bank which alleged causes of action for fraud, conspiracy to defraud, negligent misrepresentation, and professional negligence. The complaint essentially alleged that Ernst & Whinney was retained by ZZZZ Best Co. (Z Best) to perform a review of Z Best’s interim financial statements for the quarter ending July 31, 1986. Union Bank claimed that it lent $7 million to Z Best in December 1986 in reliance on certain oral representations made to it by Ernst & Whinney and on a preliminary prospectus that included an unsigned draft of a review report by Ernest & Whinney. The review report included the following language:

[A review report] is substantially less in scope than an examination in accordance with generally accepted auditing standards, which will be performed for the full year with the objective of expressing an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

227 CA3d at 1394, 278 CR at 493.

The court of appeal affirmed the judgment against Union Bank for a variety of reasons. Most significantly, the court held that the accountant owed no duty to the bank because a review report differs substantially from an auditor’s opinion rendered after a full audit. The court intertwined its analysis of duty and reliance seemingly to bolster its conclusion that no duty existed. The court found that reliance on the review report was unreasonable as a matter of law. Because of the disclaimer in the review report, and a warning in the prospectus that the accountants did not audit the financial statements, the court stated that “it is inherently unreasonable for the Bank, as an experienced user of financial statements, to rely on the E & Y review report as an assurance that Z Best was financially sound.” 227 CA3d at 1405, 278 CR at 499.

The court also concluded that there was no actual reliance by the bank because the complaint set forth facts indicating that the bank conducted its own investigation and relied on other representations and conditions for the loan. As a third basis for its holding, the court concluded that all of the bank’s claims were barred by the statute of frauds set forth in CCP § 1974 which prohibits evidence “to charge a person upon a representation as to the credit of a third person, unless such representation, or some memorandum thereof, be in writing, and either subscribed by or in the handwriting of the party to be charged.” Not only was the review report unsigned, but the preliminary prospectus in which it was contained was also unsigned. In addition, the court found that because of Ernst & Whinney’s disclaimer language, the review report did not make any representation regarding Z Best’s creditworthiness.

Justice Johnson, concurring and dissenting, agreed that Union Bank could not base any cause of action on oral representations by the accountants under CCP § 1974, but concluded that the complaint did properly state causes of action related to the written review report. His principal argument was that the lack of an audit report should eliminate the accountant’s duty. The same standard of care should apply to the accountant’s work product whether that work product is an audit report or an unaudited interim financial review. However, if an accountant agrees to perform a service less than a full certified audit, there is no liability for omissions that would only appear in a full certified audit. Justice Johnson concluded that the auditor had a duty to conduct the review in accordance with applicable professional standards and that it was reasonable for the third party to believe the review was conducted in this manner and to rely on that fact.

Comment: The implications of Union Bank are far reaching because banks and investors routinely rely on unaudited financial information such as quarterly financial reviews. Yet this case says that it is unreasonable to rely on such information. Reading Union Bank broadly, it seems to have eliminated any duty by accountants to third parties for anything other than an audit regardless of the circumstances. Plaintiffs will certainly argue that Union Bank‘s holding is limited to situations involving sophisticated users of financial statements, such as banks.

From the accountant’s perspective, Union Bank represents long-awaited relief. Reviews are often conducted because the client does not want to pay the cost of a full audit. Given the limited scope of the accountant’s work and reduced fee, it would be unreasonable to subject accountants to nearly unlimited liability to third parties for reviews. On the other hand, a more compelling argument can be made for imposing liability when the accountant fraudulently fails to disclose in a review report errors or problems with the financial statements.