Question

Superior Wholesale Corporation planned to purchase Regal Furniture, Inc., and wished to deter-mine Regal’s net worth. Superior hired Lynette Shuebke, of the accounting firm Shuebke Delgado, to review an audit that had been prepared by Norman Chase, the accountant for Regal. Shuebke advised Superior that Chase had performed a high-quality audit and that Regal’s inventory on the audit dates was stated accurately on the general ledger. As a result of these representations, Superior went forward with its purchase of Regal.

After the purchase, Superior discovered that the audit by Chase had been materially inaccurate and misleading, primarily because the inventory had been grossly overstated on the balance sheet. Later, a former Regal employee who had begun working for Superior exposed an e-mail exchange between Chase and former Regal chief executive officer Buddy Gantry. The exchange revealed that Chase had cooperated in overstating the inventory and understating Regal’s tax liability. Using the information presented in the chapter, answer the following questions.

1. If Shuebke’s review was conducted in good faith and conformed to generally accepted accounting principles, could Superior hold Shuebke Delgado liable for negligently failing to detect material omissions in Chase’s audit? Why or why not?
2. According to the rule adopted by the majority of courts to determine accountants’ liability to third parties, could Chase be liable to Superior? Explain.
3. Generally, what requirements must be met before Superior can recover damages under Sec-tion 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5? Can Superior meet these requirements?
4. Suppose that a court determined that Chase had aided Regal in willfully understating its tax liability. What is the maximum penalty that could be imposed on Chase?

Debate This:

Only the largest publicly held companies should be subject to the Sarbanes-Oxley Act.

Answer 1

Requirement 1

What establishes slackness may differ according to legal verdict and state decrees, but fulfilling with GAAP and acting in good faith are lines only to a prima facie case and do not justify obligation in every case. Shuebke could contend that her error was not due to carelessness, and a court might or might not agree with her, yet in compliance to GAAP and acting in good faith are not fail safe suspicions.

Requirement 2

The majority of courts apply the ideologies set out in the Restatement (Second) of Torts, which hold an bookkeeper accountable for careless acts that detriment a third party if the bookkeeper knew the third party would use the bookkeeper’s statements. It does not necessitate that the third party be in privity of contract with the bookkeeper. Chase ostensibly envisioned to manipulate Regal’s financial position, in abuse of GAAP and GAAS, which would specify carelessness. On this philosophy, the question is whether Chase set the audit, knowing that Superior would eventually depend on on it. If so, Chase could be accountable under the Restatement rule.

Requirement 3

To be accountable for deception under the 1934 act and Rule 10b-5, a bookkeeper must make incorrect reports or errors of material facts that condense financial statements ambiguous in association with a acquisition or sale of securities. Chase evidently did this, failing to adapt to GAAP and making a report that was materially ambiguous. The 1934 act also needs that the petitioners prove intent (scienter) to commit the duplicitous or misleading act. Superior is able to do this, having come into possession of an email exchange between Chase and Regal CEO Buddy Gantry. Therefore, Superior meets all the requirements and can recover damages under the Securities Exchange Act of 1934.

Requirement 4

Helping or supporting in the groundwork of a false tax return is a offense bookable by a fine of up to $100,000 in the case of an individual ($500,000 in the case of a corporation) and imprisonment of up to three years. A penalty of $250 per return may be considered for careless underestimation of tax liability. For a willful underestimation, the penalty may be $1,000. Extra penalties of up to $10,000 may apply for helping and supporting an underestimation.