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By James N. Kinney, CPA,Lopez Edwards Frank & Company LLP

The story begins with a partner in a West Coast office of a multi-national accounting firm. For purposes of this story, I will call the partner, John Smith. Mr. Smith is a conscientious CPA--hardworking, dedicated, bright. Smith is a credit to his

Mr. Smith's firm is auditing the financial statements of a medical transportation company. Smith, the partner-in-charge on the account, obtains the requisite engagement letter, thereby allowing his firm to proceed with the audit. During numerous contacts with the client, Smith learns of management's need to report improved financial results in order to obtain additional equity funding. Indeed, the unaudited financial statements reflected those much needed financial results by showing a handsome profit. However, as a result of the audit, Smith proposed adjusting entries that would turn this profit into a substantial loss.

As with any client, Smith decides to present management with his proposed adjusting entries. Unfortunately, management refuses, and proceeds to threaten Smith, should he insist on their acceptance of his suggested adjusting entries. Undaunted, Smith allows his client every opportunity to either accept his adjustments or provide additional evidentiary information to refute his proposed entries. Not only did management fail to provide the additional evidence, but they further admonish Smith by once more issuing a threat. Smith, having been left with no other choice, informs management of his decision to resign from the engagement, Whereupon, the client brings suit against Smith and his firm, alleging breach of contract for not issuing an audit report.

Sounds like a script taken from the back lots of Hollywood? Who would believe this story--a client, intentionally misstating their own financial statements? The auditors discover the errors but the client refuses to change the financials. The auditors resign when the client threatens them and then the client sues the auditors for breach of contract. The sad part about this screenplay is that it's all true. As preposterous as this story sounds, except for the names, the events as stated above actually occurred. What makes this story even worse is that the accountants were found liable and the client was awarded a judgment of $10 million.

The auditors eventually appealed the decision in the State of California's Court of Appeals. The decision of the higher court is pending at the time of this writing. The California Society of CPAs as well as the AICPA filed friend of the court briefs in favor of the auditors. The brief filed by lawyers for the AICPA further disclosed that, after engaging three additional firms, the client finally agreed to the issuance of an audit report on financial statements reflecting a loss of $480,000. The client eventually accepted virtually all of the adjustments originally proposed by our Mr. Smith. While this is a moral victory for the auditors, it is not an absolute victory since the lower court's decision stands, unless reversed on appeal.

One could argue that what transpired was another example of our society's litigious appetite. I believe there is more to this story. What is so troublesome about the events described above is that the auditors did everything right. They followed generally accepted auditing standards. They performed their audit consistent with their firm's quality control policies; and they adhered to the ethical standards that set apart our profession from all the others. Finally, at the moment their independence was compromised and at the moment their objectivity became so impaired that to continue would violate the very essence of our auditing framework; they did the only thing they could have done. They resigned. Their reward: The auditors are currently fighting a multimillion dollar judgment. *

Editor's note: James N. Kinney is president of the Nassau Chapter of the NYSSCPAs. This article first appeared in his chapter newsletter and is based upon a talk to the chapter by Michael R. Young, one of the attorneys handling the case. Samuel B. Traum, CPA, of the chapter arranged for the talk and has been following the case. Common sense would say that the auditors will be successful upon appeal. But common sense does not always prevail. But Sam Traum, would advise that CPAs should include provisions in their engagement letters clearly stating the conditions under which they have the right to resign. Language to use in the letters may be available from your insurance carrier.

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