By Anne Rosivach

In a unanimous decision, the New Jersey Supreme Court on February 16 reversed an Appellate Court decision in a case brought by a third party that found KPMG LLP guilty of negligence for failing to uncover accounting fraud by a former client, Papel Entities.

The decision by the state's highest court upheld the privity requirements of New Jersey's Accountant's Liability Act which states that third-party suits against accountants can only be brought by those third parties that have established privity with the accountant.

Two parties who have a direct contractual relationship, such as a CPA and a client, are said to be in privity. As a result of this relationship, the client has the right to bring a lawsuit for negligent or fraudulent actions. The requirement of privity for third-party suits is not present in all case law, the Supreme Court said, but it is clearly defined in the New Jersey Statute.

Papel was acquired by the plaintiffs, Cast Art Industries, in 2000. When Cast Art Industries closed in 2003, it filed suit against KPMG for negligence and damages. Lawyers for the plaintiffs have filed a "motion for reconsideration", requesting that the Supreme Court reconsider several elements of its decision. The Court's response is pending.

"This is an important win for the accounting profession in New Jersey, with implications around the country, as more and more CPA firms are facing suits from third parties for perceived liability", said New Jersey Society of CPAs (NJSCPA) Executive Director Ralph Albert Thomas, in an interview with AccountingWEB.

"The Court's unanimous decision that privity was not established in this case was solid and clear. It upheld the requirements of New Jersey's Accountant's Liability Act, which defines what a third party has to do if they are to have a relationship - prove a formal acknowledgement between the CPA and the third party as to the utilization or reliance on financial statements. We believe those requirements make New Jersey's Accountant's Liability Act the best liability statute in the country."

Under the New Jersey Accountants Liability Act, the preconditions to imposing liability on an accountant to a non-client third party are that the accountant: "(a) knew at the time of the engagement by the client, or agreed with the client after the time of the engagement", that the accountant's services would be provided to that specific third party for a specific transaction; (b) knew the third party intended to rely on those services; and (c) expressed to the third party the accountant's understanding of that reliance.

In the initial trial, a jury had found KPMG guilty of negligence because it had signed off on financial audits of Papel Entities in 1998, 1999, and 2000 without discovering inflated revenue numbers. The plaintiffs argued that these numbers influenced their decision to buy Papel for $34.4 million in December 2000. The jury awarded Cast Art $31.8 million in damages. The Appellate Court affirmed KPMG's liability but remanded for a new trial on damages.

The Supreme Court ruled that "KPMG did not know in November 1999, when it agreed to perform the audit, that its work could play a role in a subsequent merger because its agreement predated by several months Cast Art's interest in Papel."

The Court quoted KPMG's audit report in their decision. The audit report states clearly that "Absolute assurance is not attainable because of the nature of audit evidence and the characteristics of fraud. Therefore, there is a risk that material errors, fraud (including fraud that may be an illegal act), and other illegal acts may exist and not be detected by an audit performed in accordance with generally accepted auditing standards."

"The public does not understand the scope of an audit of financial statements", Thomas said. "The audit is a statement about the company's financial condition or position at a particular time. But there is an 'expectation gap.' The public expects the audit to go well beyond its stated scope, for example, to identify fraud and attest to the quality and effectiveness of internal controls. Chief executive officers and chief financial officers attest to internal controls. Evaluating internal controls would be a separate engagement. The audit reviews a sampling of financial transactions. The audit is not going to find out everything that goes on."

Although the negligence charges were deemed moot since privity was not established, the Supreme Court challenged the Appellate Court's conclusions regarding both privity and negligence.

In its decision the Supreme Court said that "KPMG also asserts that the trial court erred in its charge to the jury when it instructed the panel that it could, in determining whether KPMG departed from the appropriate standard of care, look not only to generally accepted auditing standards but to the training materials KPMG used for its own staff, which stressed the importance of "seek(ing) out fraud."

The decision quoted the amicus brief filed by the American Institute of CPAs (AICPA) and the NJSCPA in which they argued that the Appellate Court "erred when it concluded that the trial court's reference to internal training materials as part of its instructions to the jury with respect to the standard of care governing KPMG's conduct was harmless error." The brief urged the Supreme Court "to reject this approach because it will discourage accountants from developing or following internal initiatives for the detection of fraud."

The NJSCPA, working collaboratively with the AICPA, submitted the amicus brief to the Supreme Court urging it to uphold the New Jersey statute, which also defines the manner in which a third party can be considered to have established privity and limits privity to a specified transaction.

"We participated in this case, as in a 2005 privity case before the Supreme Court, on behalf of the profession, not on behalf of an individual or a firm. A decision in favor of the plaintiff could have opened up a floodgate of suits and had an enormous impact on liability insurance", Thomas said.

"Liability issues will continue to be a focus for the NJSCPA", Thomas said. "The NJSCPA is continuing to readjust and realign tort reform in New Jersey. We are currently working to level the playing field for businesses and CPAs by establishing an appeal bond cap. The appeal bond can be the amount of the award as well as legal fees, and in New Jersey where we have professional services firms and pharmaceutical companies with intellectual assets, for example, that can be an obstacle to their ability to mount an appeal."

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