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Who is Responsible?
On August 21, 2007, Comfi Beds and Furniture, Inc. planned to purchase Sleep
Ezy Corporation, and hired the accounting firm of Loosy and Goosy LLP, to review the
audit that had been prepared by Billy Bob and Brothers, CPAs, the accountant for Sleep
Ezy, as of the fiscal year-end July 31, 2007. Loosy and Goosy advised Comfi Beds that
Billy Bob had performed a high-quality audit and that Sleep Ezy’s inventory was stated
fairly on the general ledger and balance sheet as of the audit date. As a result of these
representations, Comfi Beds went forward with the purchase of Sleep Ezy.
Several months after the purchase, Comfi Beds discovered that the audit by Billy
Bob had been materially inaccurate and misleading, primarily because the inventory had
been grossly overstated on the balance sheet. Subsequent to the discovery, a former
Sleep Ezy employee who had begun working for Comfi Beds exposed an e-mail
exchange between Billy Bob and the former CEO of Sleep Ezy. The exchange revealed
that Billy Bob had cooperated in overstating the inventory on the books of Sleep Ezy.
This case discusses the legal liability of an auditor when a company is purchasing another
company.
Ethical Issues
This case looks at the legal liability of an auditor when one company is purchasing
another company. It poses the questions of who is the third party to the audit; who has
privity; if the CPA colluded is that scienter; is CPA negligence the same as fraud?
Questions
1. If Loosy and Goosy’s review was conducted in good faith and conformed to
GAAP, could Comfi Beds hold Loosy and Goosy liable for negligently failing
to detect the inventory overstatement in Billy Bob’s audit? Why or why not?
Loosy and Goosy has a contract with Comfi Beds for the audit of Sleep Ezy. Thus,
Loosy and Goosy have privity and are liable for negligence to Comfi Beds. Loosy
and Goosy were clearly negligent in their failure to detect management fraud of
2. Review the various principles discussed in the chapter that have been
adopted by the courts and the accountants’ legal liability. Based on your
review and analysis, could Billy Bob have been liable to Comfi Beds?
Billy Bob has as defense that they did not know of sale or seller so it would seem that
Billy Bob is not liable to Comfi Beds. Ultamares, Rusch and Restatement of Torts
(552) supports Billy Bob as the sale was not contemplated when Billy Bob was
auditing Sleep Ezy. Comfi Beds was not anticipated as third party beneficiary, and
3. What is scienter? To what extent does scienter exist with respect to any
potential legal liability of Billy Bob? How about Loosy and Goosy?
Scienter is the intent to deceive, mislead or manipulate. Hochfelder considers gross
negligence for inference about intention. If a sound audit would have found and
revealed the overstatement, it may be argued that the audit was intentionally flawed.
4. Generally, what requirements must be met before Comfi Beds can recover
damages under Section 10(b) of the Securities and Exchange Act of 1934 and
SEC Rule 10b-5? Could Comfi Beds meet these requirements?
Under the 1934 Securities and Exchange Act, Comfi Beds must prove damages or
loss; that the financial statements were misleading; that they relied on the misleading
statements and that the misleading statement were the direct cause of the loss for
damages under Section 10(b). For damages under Section 10(b)-5, Comfi Beds must
