What the courts are saying about financial forecast engagements.by Pallais, Don M.
The author raises several questions concerning financial forecast engagements and indicates how courts have responded. Often the signals are decidedly mixed. The best advice is to pay close attention to professional standards and know your client.
The legal system permeates every facet of commercial life in the U.S. Therefore, knowing the courts' views of accountants' responsibilities may affect how you deliver services.
The AICPA standards on financial forecasts and projections establish professional requirements for accountants. Generally, courts have accepted the AICPA standards as relevant, and often, sufficient in judging accountants' performance. But sometimes courts go beyond those standards. In those instances, the practitioner may face risks not ordinarily considered.
The good news is courts generally view prospective reporting realistically. They usually recognize financial forecasts and projections are softer, and therefore less reliable, than historical information. At the same time, they acknowledge users sometimes rely on prospective information to make financial decisions. Thus, they try to find a middle ground that balances these two conflicting concerns. Court opinions indicate where judges believe that middle ground lies. Although most court opinions represent large amounts of money and public interest, it's reasonable to assume the same principles would apply to cases involving less money and interest.
Beware: sometimes actual performance is irrelevant to whether a suit is filed against the accountant. Mere involvement with a client that fails may be reason enough to precipitate a lawsuit.
While it's true a plaintiff must prove its case to prevail, even if the accountant wins, the financial and emotional costs of a lawsuit can be tremendous. To practice defensively, it's good to have an idea of the current legal landscape.
Who's Responsible for the Financial Statements?
A basic tenet of financial reporting is the client is responsible for the content of the financial statements. The accountant's responsibility is for the report and the work that underlies it. This distinction is especially important in prospective reporting situations. Forecasts quantify management's expectations; they don't represent the accountant's predictions.
Although plaintiffs sometimes try to blur the differences in responsibilities, the courts have generally recognized the contrast. In one case, Zupnick v. Thompson Parking Partners, the judge specifically discussed this distinction, noting the client acknowledged its responsibility in a signed representation letter. He used this as the basis, in part, for his finding in favor of the accountant. Thus, representation letters are important. Besides being required by the AICPA forecasts and projections standards, courts view them as evidence of responsibility for financial statements.
Should You Take On A New Client?
New client acceptance poses some unique risks to the accountant. Often, an accountant's biggest mistake is involvement with the wrong clients. Some clients simply present higher risks than others. To reduce the likelihood of being sued, the accountant can try to identify factors (such as questions about the client's integrity and high-risk industries) that increase risk in prospective reporting engagements. Then the accountant can try to avoid clients that present inordinate risks.
The AICPA standards require the accountant to establish a clear understanding with the client about the nature of the engagement. It recommends using an engagement letter to document that understanding. When questions arise about the extent of the accountant's responsibility, the engagement letter can provide protection. For example, in Alexanders Laing & Cruikshank v. Goldfield, the judge looked to the engagement letter to determine that the accountant had no responsibility to evaluate the reasonableness of assumptions.
Generally, the more limited the accountant's service, the more important it is to have an engagement letter that specifies the limited nature. This makes it harder for plaintiffs to argue the accountant was engaged to perform a higher level of service and take more responsibility than was actually agreed.
Who Can Sue You?
Generally, only the accountant's client and persons who relied on the report have standing to initiate a suit on a forecast or projection engagement. But anyone with a lawyer can sue. Sometimes courts allow cases to proceed even when an accountant did not expect third-party reliance on the report. Therefore, it's a good idea to consider who will use the prospective financial statements.
In Dalton v. Alston & Bird, the accountant helped develop a financial forecast, but his report did not appear in the offering materials used to solicit investments. The accountant argued that since the investors were unaware of his report, they couldn't have relied on it. While the judge acknowledged this argument, he nonetheless refused to dismiss the claim and allowed it to go to a jury. Thus, the accountant was exposed to risks not envisioned when the engagement was accepted. (Published opinions are generally limited to matters of law. They don't include jury decisions, which resolve questions of fact. By letting a case go to a jury, a judge has decided the law could support the plaintiff if the jury decides the facts warrant it. Anytime a matter goes to a jury, there's the potential for the accountant to lose the case.)
In another case, Griffen v. McNiff, an accountant was engaged after the completion of the offering; the offering materials contained prospective financial statements reported on by another accountant. This accountant's role was merely to prepare the K-1s for the partnership. Yet the investors sued him for purported misstatements in the offering materials. In this case the court realized the investors could not have relied on him since he wasn't even engaged until after the fact. The claims were dismissed against him, but he still had to endure the hardship of a lawsuit.
A point to remember is that involvement with forecasts used by third parties carries some inherent risk to the accountant. The AICPA standards call for a report when the accountant assembles and submits statements expected to be used by third parties. A client's promise not to disseminate the report may mitigate the accountant's risk but doesn't eliminate it entirely.
Is a Compilation Safe?
Courts generally recognize that the accountant provides no assurance in a compilation and have limited plaintiffs' claims in compilations more than in examinations.
A series of cases indicates the accountant's disclaimer in a compilation can limit the types of claims that can be made. Generally courts have found the compiling accountant doesn't have a duty to seek support for assumptions. When assumptions later turn out to have been unsupported, the wording of the limitation on the accountant's service has stood up as a good defense.
Limiting the service to a compilation, however, doesn't eliminate all legal liability. The accountant still has to read the prospective statements and consider whether, based on his knowledge of the client and the industry, they are materially misstated. In some instances, judges allowed cases to proceed even though the accountants only compiled the prospective financial statements.
For example, in Sperber Adams v. JEM Management, the accountants argued that since their service consisted only of a compilation, they should not be liable for misstatements in the prospective financial statements. The judge rejected such a broad limitation, and allowed the case to go forward.
Plaintiffs took a novel approach in Boley v. Pinelock Associates. They acknowledged the accountants' service provided no assurance on the prospective financial statements. But they claimed the accountants had a duty to provide such a service even though they were not engaged to do so. They further claimed that had the accountants examined the statements, they would have determined the assumptions to be unreasonable. The judge rejected this argument and dismissed the case.
Did You Provide Other Accounting Services?
Some courts have indicated that the accountant's responsibility might change if he or she is also the client's continuing accountant. Often an accountant who provides services on a client's forecasts or projections also audits, reviews, or compiles that client's historical financial statements.
No case reviewed here has ruled against an accountant for performing services on both historical and prospective financial statements. But courts have considered whether knowledge gained from one service might bear on the other. Further, they seemed prepared to hold the accountant responsible for that knowledge.
In Latimer v. Hall, the accountant both audited a series of limited partnerships' historical financial statements and reported on their forecasts in private placement memorandums. The plaintiffs claimed that, because of the knowledge gained from the audits, the accountant should have been aware of negative information about the forecasts and should not have reported on them. The judge accepted the concept, but dismissed the claim primarily because the plaintiffs could not demonstrate what the accountant was supposed to have known that would have caused him to refuse to report on the forecasts.
In Haberkamp v. Steele, the judge rejected all the plaintiffs' claims. But in so doing, he opened the door to some other possible bases for claims against the accountant. One was whether the accountant was the continuing accountant. Thus, if the accountant had been the continuing accountant (in that case he was not), he might have been held to a different standard.
Do You Know the Industry?
Professional standards recognize the importance of adequate industry knowledge. The accountant needs sufficient knowledge of the client's industry to identify material misstatements in the prospective financial statements. The courts also recognize this. For example, in Eisenberg v. Gagnon, the court expected the accountant to have enough industry knowledge to recognize an obvious misstatement in an engineer's report on coal reserves.
This doesn't mean, however, the accountant must have this knowledge before accepting the engagement. It can be acquired during the engagement. In Zupnick v. Thompson Parking Partners, the court concluded that the accountant, who admittedly had no experience in the client's industry, had appropriately informed himself of the relevant industry practices by the time he reported on the statements.
Are the Assumptions Good?
Assumptions are key to prospective financial statements. Many lawsuits deal with whether inappropriate assumptions were used in the statements and whether the accountants should have rejected them.
Problems occur because many assumptions simply don't come true. They fail to materialize either because there was no basis for them in the first place or because, although they were suitable when made, events and circumstances didn't turn out as anticipated. Although the accountant's report explicitly warns the actual results will probably differ from the prospective results, this warning, in-and-of itself, is generally not enough. The courts try to determine whether the assumptions that fail to come true were appropriate when made.
In determining fault, courts consider what information was available at the time the statements were prepared. This is considered in light of what the accountants knew and what courts believe they were responsible to find out. The standard caveat on achievability doesn't provide protection when the court believes accountants should have known assumptions were inappropriate.
In the case of Longden v. Sunderman, for example, plaintiffs alleged the statements were unrealistic and the accountants should have known that when the statements were prepared because the client's similar projects were failing. The judge said the warning that actual results will probably differ from the prospective results doesn't necessarily protect the accountant when the unfavorable events have already occurred. He let the case against the accountants proceed.
The case of Herskowitz v. NutriSystem sends a similar message, although it did not concern an accountant. In that case, a bank issued a letter roughly analogous to a report on a forecast. The bank's opinion was based on the then-existing tax rates (46%) with a disclosure that Congress was considering lowering the rates. The plaintiffs argued that, because some knowledgeable observers at the time believed the lower rate would ultimately be instituted, the lower rate should have been used. They claimed mere disclosure was insufficient. The judge allowed the case against the bank to go forward.
In McInnis v. Merrill Lynch Pierce Fenner & Smith, plaintiffs claimed projected profits were the result of aggressive assumptions about inflation rates. In this case, the rates used were three to four times the rate of inflation. The accountants pointed to caveats about uncertainties in the statements, but the judge didn't believe such language overcame the questions about the inflation rates assumed. He let the case proceed.
Finally, in O'Brien v. National Property Analysts, plaintiffs claimed prospective financial statements were developed by starting with net income and working backwards to arrive at the assumptions. The case was dismissed because the statute of limitations expired. But it raised an issue regarding preparation and revision of draft statements. Often prospective statements are developed and revised during the engagement. That's a normal chain of events, but the accountant should be concerned when the client appears to be revising assumptions to arrive at a predetermined result.
Can You Rely on Specialists?
The accountant who performs services on forecasts and projections sometimes relies on the work of a specialist. Errors or misstatements made by specialists can cause misstatements in the prospective financial statements and accountants are sometimes sued as a result.
The AICPA forecasts and projections standards permit reliance on specialists as does the auditing literature. In an examination, the accountant does not have to reanalyze a specialist's conclusions, but needs to consider whether they appear to be unreasonable. In a compilation, the accountant is not required to explicitly consider the specialist's report (except for tax opinions as required by Treasury Circular 230) but needs to consider whether the assumptions that derive from it are obviously inappropriate, incomplete, or otherwise misleading.
The courts' views are generally consistent with AICPA standards. Thus, the accountant needs to consider whether the specialist's conclusions are unreasonable, but need not affirmatively determine that they are reasonable.
An independent appraisal was used in Friedman v. Arizona World Nurseries. Plaintiffs claimed the appraisal was misleading. But the court found there was no reason for the accountants to believe it was misleading and found for them. The accountants compiled the statements in this case. It's unclear whether the judge would have come to the same conclusion if it had been an examination.
Eisenberg v. Gagnon, however, led to a different result. In that case, the accountant who examined the prospective statements relied on an engineer's report on coal reserves. The trial judge found for the accountant but was reversed on appeal. The appeals court believed there were sufficient problems in the report for the accountant to have been skeptical of it. The appellate court directed that a jury be allowed to decide the issue.
Is Disclosure Adequate?
Adequacy of disclosure is an issue that comes up frequently in litigation. As a general rule, required disclosures are those specified in the AICPA presentation guidelines (contained in the AICPA Guide for Prospective Financial Statements). However, those guidelines are necessarily general and courts often impose their own standards in this area.
Some cases deal with disclosures that bear directly on the prospective financial statements. In O'Brien v. National Property Analysts, for instance, plaintiffs claimed disclosures were misleading. But, in dismissing the claim, the judge noted disclosures in the prospective financial statements explicitly disclosed information plaintiffs sought. Thus, the adequacy of disclosure was crucial in defeating the claim.
Many of the disputed disclosures, however, don't bear directly on the prospective financial statements but other information disseminated about the proposed transaction or its principals. Courts sometimes fail to distinguish between disclosures made within and outside prospective financial statements. As a result, the message sent by the courts is not always clear.
The AICPA standards require the accountant to consider whether the statements are presented in conformity with presentation guidelines. It also imposes a responsibility regarding disclosures elsewhere in a document that contains the statements. The accountant has to read that information to see if it either conflicts with the statements or contains a material misstatement of fact. The accountant generally does not have a professional responsibility for completeness of those disclosures or to verify the information contained in them. The courts' messages, however, have been less clear.
In Schumate v. McNiff, some matters plaintiffs alleged should have been disclosed by the accountants included: the principals were insolvent, the principals dealt with allegedly shady characters, and a previous accountant had withdrawn his report on the statements. The judge was not convinced there was any duty to disclose such matters and dismissed the case.
Similarly, in Gilmore v. Berg, plaintiffs alleged the accountants should have made sure the following were disclosed: the property was purchased out of bankruptcy, the sales price was stepped up, the principal's roles with related parties, and the accountant's assessment of the principal as an aggressive syndicator. The judge determined the accountant had no duty to disclose these matters as part of the forecast engagement.
But the judge in Duke v. Touche Ross took a different view. Plaintiffs claimed the accountant should have disclosed, among other things, that the promoter was on the IRS watch list and a similar deal was under IRS investigation. In this case, the judge let the matter proceed. It is evident that different courts may come to different conclusions about the adequacy of disclosure.
Must You Update the Report?
The standard accountant's report on prospective financial statements states the accountant has no responsibility to update the report for events and circumstances occurring after the report date. This means the accountant has no responsibility to notify users of the report when actual results start to diverge from the forecast. Not only does the accountant have no responsibility to track the actual results, he or she has no responsibility to notify users if he or she happens to find out actual results diverged from the forecast. In fact, the report says they probably will.
The courts seem to have accepted this concept. In Morin v. Trupin for example, the accountant who reported on the prospective statements later audited the company. When the actual results didn't agree with the projections, plaintiffs argued he should have disclosed that the projections had proved to be invalid. The allegation was dismissed.
Similarly, plaintiffs in Alexanders Laing & Cruikshank v. Goldfield claimed the accountant breached his responsibility to report to them that actual sales were less than forecasted. The court determined the accountant had no responsibility to report on actual sales and dismissed the claim.
The limitation on updating is different than correcting the report for errors that occurred at the time of the engagement. The standards require the accountant to consider notifying users if he or she later finds a mistake was made at the time of the engagement. Presumably the courts would agree.
Do the Standard Caveats Help?
Many cases discuss the standard accountant's warning that prospective results will likely not be achieved. In some cases the warning was very helpful to the accountant's case. Courts say investors should be wary when relying on a document that "bespeaks caution." The existence of standard caveats help shift the burden to the plaintiffs. But they don't let the accountant off the hook if he or she missed a material misstatement.
The weight judges give to the caveats varies significantly. In Stevens v. Equidyne Extractive Industries, for example, the judge placed substantial weight on the warning language and dismissed plaintiffs' claims. In Longden v. Sunderman, however, the judge concluded cautionary statements were not effective and let the case proceed.
Can You Get Sued for Anything Else?
Accountants are sued for reasons other than purported substandard work on the prospective financial statements. Often accountants are characterized as insiders, promoters, or sellers of the securities, which attaches different responsibilities to their actions.
In a number of cases, courts summarily dismissed the notion an accountant who merely reports on forecasts or projections for a fee takes on the additional liability of a seller or promoter. In Friedman v. Arizona World Nurseries, for instance, the judge concluded the accountant was not a seller of securities since the accountant received no commissions, finder's fees, or similar financial gain from the transaction. In Dawe v. Main Street Management, the court stated plainly that an accountant performing ordinary services for a fee is not a seller of securities.
A different set of problems emerges when an accountant reports on prospective financial statements and recommends the investment to clients. In such circumstances, the accountant might receive commissions for sales to these clients. Complaints against an accountant in these circumstances are even stronger when the investor clients are ignorant of the commissions the accountant receives on the sales.
The court recognized in Schwartz v. Michaels that when the commissions were undisclosed, the accountant's advice appears to be neutral when, in fact, he has a personal interest in the client's investment decision. The judge let the case against this accountant proceed.
A Word to the Wise
Conformity to professional standards generally satisfies the standard of care demanded by courts. But in some cases, courts using 20/20 hindsight have required more. It's helpful to know what else the courts think should be done.
SUMMARY OF OBSERVATIONS AND RECOMMENDATIONS
* Courts generally recognize the client is responsible for the financial statements. A signed representation letter in which the client specifically acknowledges those responsibilities is important.
* The more limited the accountant's services, the more important it is to have an engagement letter that describes the engagement's limited nature.
* Although a compilation presents less risk to the accountant than an examination, it doesn't eliminate liability. The compiling accountant must read the prospective financial statements to consider, based on a knowledge of the entity and its industry, if they're materially misstated.
* Accountants who provide accounting services in addition to reporting on the prospective financial statements may have more responsibility than those who don't. When reporting on prospectives, accountants should also consider information that comes to their (or their partners') attention when performing other services.
* Although the report warns users actual results will probably differ from prospective results, the warning may not be enough if the court believes the accountant should have known the assumptions were inappropriate.
Don M. Pallais, CPA, has his own practice in Richmond, Virginia. A former member of the Auditing Standards Board, he currently serves on the ASB's Financial Forecasts and Projections Task Force and the Accounting and Review Services Committee. This article is adapted from a chapter in Guide to Forecasts and Projections (Practitioner's Publishing Co., 1993) by Don Pallais and Stephen Holton.
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