A CPA firm was engaged to examine the financial statements ofGotham Manufacturin

Question

A CPA firm was engaged to examine the financial statements ofGotham Manufacturing Corporation for the year ending December 31. Gotham needed cash to continue its operations and agreed to sell its common stock investment in a subsidiary through a private placement. The buyers insisted that the proceeds be placed in escrow due to a poss from a govermment claim that is pending against the subsidiary. The payment in escrow was complete in late November. The president of Gotham told the audit partner that the proceeds from the sale of the subsidiary's common stock, held in escrow, should be sl an unrestricted current account receivable. Th was groundless, and that Gotham needed an "uncluttered balance sheet and a "clean" auditor's opinion to obtain additional working capital from lenders. The audit partner agreed with the president and issued an unqualified opinion on the Gotham financial statements which did not refer to the contingent liability and did not properly describe the escrow arrangement ible major contingent tax liability that might result e president's opinion was that the government's claim The government's claim proved to be valid, and pursuant to the agreement with the buyers, the purchase price of the subsidiary was reduced by $500,000, the amount of the tax settlement. This adverse development forced Gotham into bankruptcy. The CPA firm is being sued for deceit (fraud) by several of Gotham's unpaid creditors who extended credit to Gotham, relying on the CPA firm's unqualified opinion on Gotham's financial statements. REQUIRED: (1) (2) (3) What type of negligence or fraud (deceit) do you believe the creditors are claiming? case? Is the lack of privity between the CPA firm and the creditors important in this Do you believe the CPA firm is liable to the creditors? Explain.

Explanation / Answer

With Respect to Gotham Manufacturing Corporation:

Q1. Answer:

Creditors are claiming "Financial Statement Fraud" to the CPA firm. Because creditors believe that this bankruptcy situation arises due to release of Gotham's Financial Statement which was of course prepared by that CPA firm.

Q2. Answer:

Yes, lack of privity between CPA firm and Gotham's creditors are important in this case. Since there was no contractual agreement executed between both the parties as what should be the liability or who should be liable in case of any adverse event arising post preparation of financial statement, neither the parties should be in position to file a claim against each other.

Q3. Answer:

Yes. Looking at the scenario above, I believe the CPA firm is liable to creditors.

Being an independent audit firm, it was moral and business ethics which CPA firm violated by agreeing to the opinion of President of Gotham Manufacturing to include the deal which was not carried out in truthful manner. The ideal job of CPA firm was to prepare financial statement based on the true facts/transactions available in the company’s account book. You are not supposed to include misleading information favoring someone from audited organization. Hence in my opinion CPA firm is liable to pay to creditors.

Answeres with Respect to Pogo Entrepreied:

1. True.

Reason: In the light of failure to exercise due professional care or applicable standards", both clients and third parties can sue CPAs for the negligence. Hence Churchy can recover her loses if she was able to prove that neglogence was caused at Kelly and Walt end.

2. True.

Reason: Gross negligence is the lack of concern for the likelihood that finacial injuries will result. This is one aspect of professional negligence for which suit can be filed by Churchy which used finacial statement prerpared by Kelly and Walt.

3. True.

Reason: Privity of contract happened only between Kelly & Walt AND Pogo Enterprises Inc. Churchy is just a third part beneficiary.

4. True.

Reason: Yes. Churchy will have to prove that Kelly and Walt has done this fraud intentionally. If she can't prove, she won't be able to recover her loses. Also one important point is that there should exist privity of contract.

5. True.

Reason: Yes. Churchy is third party beneficiary here since privity of contract executed between Pogo Enterprises and Kelly & Walt.

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