Case 6- 8
Kay
& Lee LLP
Kay and Lee LLP has just been retained as the auditor for Holligan Industries to audit the financial statements required
by a bank, Second National Bank & Trust, as a prerequisite to extending a loan to the client. The auditor knows the
bank is the client’s principal lender and is aware of the bank’s reliance on the financial statements, particularly the
valuation of inventory and accounts receivable. Additionally, the bank and auditor have direct oral and written
communication during the lending period and even meet to discuss the client’s financial statements.
After the audit report is issued, the bank discovers that the client’s inventory and accounts receivable were
overstated. The client subsequently goes bankrupt and defaults on the loan. The bank alleges that the auditor failed to
communicate about the inadequacy of the client’s internal recordkeeping and inventory control.
Questions
1. What would the bank have to do prove to successfully bring a lawsuit against Kay & Lee for ordinary
negligence? Use legal principles to support your answer.
Second National Bank & Trust would be considered a known user so that the auditor could be liable for ordinary
negligence. The bank would have to prove that there was a false representation by Kay & Lee, that the firm had
The principle of auditor liability for ordinary negligence to third parties is expanded by the American Law Institute’s
Second Restatement of the Law of Torts. Restatements of law are compilations of the majority view of the common law
of the states on various topics such as contracts and torts and are meant to serve as guides for judges when they are
2. Changing the facts of the case, assume the client hired Kay & Lee to audit the financial statements,
explaining that the purpose of the audit is to negotiate a loan. The name of the bank is unknown to the
auditors. Under which legal principle could the auditors be held legally liable for the ordinary
negligence? Which case(s) in the book support your opinion?
Now we have a reasonably foreseeable third-party user and under the Rosenblum ruling that provides that auditors can
be held liable for ordinary negligence to all reasonably foreseeable third parties who are recipients of the financial
statements for business purposes. Kay & Lee knew the financials would be used as the basis for a loan even though the
specific bank was not identified. In the precedent of Credit Alliance, the auditors might held to near-privity
relationship and liable for ordinary negligence, since the auditors knew that the purpose of the audit was to negotiate a
3. From an ethical perspective why is it important for an auditor to properly audit inventory and
accounts receivable when it knows a bank may rely on the audited financial statements?
The auditors have an obligation of due care and competence in the audit of inventory and accounts receivable so that
they are properly valued, owned and classified. This is particularly true when the client plans to apply for a bank loan.