ACCT 511 Week 4 Research Project 1 Example

From Ultramares to Bily: How Far an Accountant's Duty to Third Parties Reaches, and Why the Law Keeps Drawing the Line Closer

Introduction

A regional bank lends $6 million to a manufacturer after reviewing its audited financial statements. A year later the manufacturer collapses, and it emerges that inventory was overstated by $4 million, an error a competent audit should have caught. The bank was not the audit firm's client and signed nothing with it. Can it recover its loss from the auditors? The answer depends on the state in which the case is brought, because American courts have adopted at least four different rules on how far an accountant's duty of care reaches beyond the client. This paper argues that the law has moved steadily toward narrower liability since the 1980s, and that the movement reflects both a long-standing fear of indeterminate liability and evidence that broad liability does not reliably improve audit quality. The paper first examines each approach through its leading case, then considers statutes and the fraud exception that survives every rule, then turns to accounting research on litigation and audit quality, and finally applies the competing rules to the bank's claim. Throughout, the focus is negligence liability under state common law; federal securities liability, which follows different rules, is reserved for the second research project.

The Privity Rule: Ultramares

The starting point is Ultramares Corp. v. Touche (1931). Accountants had certified a balance sheet for a client they knew would show it to lenders, and a lender relied on it. Writing for the New York Court of Appeals, Judge Cardozo held that the accountants were not liable for negligence to the lender because there was no contract between them. Extending liability for negligence to everyone who might rely on a report, he wrote, would expose accountants to liability in an indeterminate amount for an indeterminate time to an indeterminate class. The court left open liability for fraud, including reckless disregard of the truth, so a third party could still recover if the audit was so careless as to amount to fraud. Pacini et al. (2000b) describe Ultramares as the foundation on which every later American approach builds, whether by following it or departing from it.

Near Privity: Credit Alliance

For half a century, New York refined rather than abandoned Ultramares. Decided in 1985, Credit Alliance Corp. v. Arthur Andersen & Co. (1985) set out three conditions for a non-client to recover in negligence: the accountants must have known that their reports would be used for a particular purpose, in furtherance of which a known party was intended to rely, and there must have been some conduct by the accountants linking them to that party that shows their understanding of the reliance. A bank that met with the auditors, or to which the auditors sent the report directly at the client's request, can satisfy the test. A bank that merely received the statements from the borrower usually cannot.

The Restatement Approach

Most states follow a middle path drawn from Section 552 of the Restatement (Second) of Torts (American Law Institute, 1977). It extends liability for negligent misrepresentation to a limited group of persons for whose benefit and guidance the accountant intends to supply the information, or knows that the client intends to supply it, in a transaction the accountant intends or knows the information will influence. Under this rule, the accountant need not know the identity of the specific lender, but must know that the statements will be given to a lender, or a class of lenders, for a loan of the kind actually made. The Restatement is broader than near privity and narrower than foreseeability, which helps explain its popularity. It gives auditors a rule they can apply when they accept an engagement, since the relevant facts are what they know about intended users at that point. The Restatement's own illustrations make the line concrete: an accountant who audits a company knowing that the client will use the statements to obtain a bank loan is liable to the bank that makes the loan, but not to a supplier who later extends trade credit after seeing the same statements, because the accountant neither intended nor knew of that use. The rule therefore turns on the accountant's knowledge at the time of the engagement, which is why engagement documents and communications with lenders matter so much in litigation.

Foreseeability and Its Retreat

In Rosenblum v. Adler (1983), the New Jersey Supreme Court went further, holding that auditors owe a duty to all reasonably foreseeable users of audited statements who obtain them from the client for proper business purposes. The court reasoned that auditors are well placed to insure against the risk and spread its cost, and that broad liability would encourage careful audits. The foreseeability approach never won wide acceptance, and New Jersey itself later replaced it by statute with a test resembling near privity. Pacini et al. (2000a) found the same pattern across the United Kingdom, Canada, Australia, New Zealand and the United States: litigation pressure on accountants rose, and courts and legislatures responded by limiting third-party liability.

California's Synthesis: Bily

The most influential modern decision is Bily v. Arthur Young & Co. (1992). The California Supreme Court rejected foreseeability, explaining that auditors do not control the client's statements, that sophisticated users can protect themselves by contracting directly with auditors or investigating on their own, and that broad liability would raise the cost of audits without a matching improvement in their accuracy. The court limited general negligence claims to the client, adopted the Restatement rule for negligent misrepresentation and preserved liability for intentional fraud to anyone who relied.

Statutes and the Fraud Exception

Several legislatures have codified a narrow rule. Illinois, for example, limits a licensed accountant's liability for negligence to clients unless the accountant committed fraud or intentional misrepresentation, or knew that a primary intent of the client was for the work to benefit or influence a particular third party and identified that party in writing, and other states have adopted similar privity statutes as part of the trend Pacini et al. (2000b) describe. Statutes of this kind give firms a way to define their exposure in advance, since a written identification of intended users is within their control. Under every approach, however, one route remains open to any third party who relied on audited statements: fraud. Ultramares itself held that an audit performed with such recklessness that it amounts to a pretense of knowledge can support a fraud claim, and later courts have treated gross negligence in the same way. The practical effect is that the difference between the approaches matters most for ordinary negligence. An audit firm that ignores obvious warning signs cannot rely on privity, because a court may describe the same conduct as reckless rather than merely careless. Bily turned the question from whether reliance was foreseeable into whether it was invited.

What Research Suggests About Liability and Audit Quality

The courts' competing rationales rest on empirical claims, and accounting research tests some of them. Rosenblum assumed that broad liability improves audits. Palmrose (1988) found that litigation against auditors was not random: firms outside the Big Eight faced proportionally more audit-related litigation than Big Eight firms, consistent with litigation activity reflecting differences in audit quality. Lys and Watts (1994) studied lawsuits against auditors and examined which client and audit characteristics were associated with being sued, evidence that litigation responds to observable risk factors as well as to audit failures. Those findings suggest liability does carry information about quality, which supports some exposure to suit.

Other research supports the Bily court's caution. Kadous (2000) found in an experiment that jurors held auditors to higher standards of care when the consequences of an audit failure were more severe, even when audit quality was held constant. If jurors judge an audit by the size of the loss rather than the quality of the work, broad liability may punish bad outcomes more than bad audits. Porter (1993) showed that a substantial part of the gap between what the public expects of auditors and what they deliver comes from unreasonable expectations rather than deficient performance, which helps explain why plaintiffs and juries may see failure where standards were met. Honigsberg et al. (2020) document how auditors' liability exposure has changed over recent decades, and Chung et al. (2010) compare how several countries reformed auditor liability after the Sarbanes-Oxley Act, generally pairing limits on private liability with stronger public oversight. Taken together, the research suggests that a narrower private liability rule, combined with regulatory inspection, may protect users without the distortions of foreseeability liability.

Application to the Bank's Claim

Return to the bank. Under Ultramares, it cannot recover for negligence, only for fraud or reckless disregard. Under Credit Alliance, it can recover only if the auditors knew the statements would be used for this loan, knew the bank would rely on them and did something linking themselves to the bank, such as meeting with its loan officer or sending it the report directly. Under the Restatement, it can recover if the auditors knew the statements would be supplied to a lender for this kind of financing, even without knowing the bank's name. Under a pure foreseeability rule, it could likely recover simply because lending is a foreseeable use of audited statements. For an audit firm, the practical lesson is that its own conduct, such as agreeing to discuss the audit with a lender or addressing a comfort letter to one, can expand its duty under the narrower tests. Engagement letters that state the intended users of the report, and declining to communicate with third parties without a written understanding, are sensible precautions in every state. If the bank's loan officer had called the audit partner to ask about inventory and received reassurance, the bank's position would be much stronger under Credit Alliance and the Restatement, because that conversation is precisely the linking conduct the tests look for. Firms therefore train partners to refer such inquiries to the client or to respond only under a written agreement that defines the scope of what is being represented. Those habits cost little and narrow the firm's exposure in any jurisdiction.

A Biblical Perspective

When a lawyer asked Jesus, "And who is my neighbor?", Jesus answered with the parable of the Good Samaritan, in which a stranger becomes a neighbor by acting with mercy (Luke 10:29-37; English Standard Version Bible, 2001/2016). The law of accountants' liability asks a narrower version of the same question: to whom does an accountant owe a duty of care? The parable suggests that the moral duty of a Christian accountant is broader than the legal one. Even where the law protects an auditor from a lender's suit, the lender, the employees and the investors who rely on the statements are neighbors whose welfare the audit affects. A firm that performs each audit as though every reader could sue honors the parable, whatever the governing rule.

Conclusion

American law has moved from Ultramares's privity rule through near privity and the Restatement to a brief experiment with foreseeability, and back toward the narrower rules in Bily and in legislation. The courts that narrowed liability worried about indeterminate exposure and doubted that broad liability would improve audits, and research on litigation and juror judgment gives those doubts some support while confirming that liability carries real information about audit quality. For CPAs, the rule in their state, and their own conduct toward third parties, will decide how far their duty reaches. For Christian CPAs, the question of who counts as a neighbor reaches further still. The narrowing of the law should not be read as permission to care less about third parties. It reflects judgments about who should bear losses in a commercial system, not about the importance of honest, careful work. The best protection a firm has under any rule remains an audit performed to the standards, documented well and communicated honestly to the people the firm knows will rely on it.

References

American Law Institute. (1977). Restatement (second) of torts § 552.

Bily v. Arthur Young & Co., 3 Cal. 4th 370, 834 P.2d 745 (1992).

Chung, J., Farrar, J., Puri, P., & Thorne, L. (2010). Auditor liability to third parties after Sarbanes-Oxley: An international comparison of regulatory and legal reforms. Journal of International Accounting, Auditing and Taxation, 19(1), 66-78. https://doi.org/10.1016/j.intaccaudtax.2009.12.005

Credit Alliance Corp. v. Arthur Andersen & Co., 65 N.Y.2d 536, 483 N.E.2d 110 (1985).

English Standard Version Bible. (2016). Crossway. (Original work published 2001)

Honigsberg, C., Rajgopal, S., & Srinivasan, S. (2020). The changing landscape of auditors' liability. The Journal of Law and Economics, 63(2), 367-410. https://doi.org/10.1086/707238

Kadous, K. (2000). The effects of audit quality and consequence severity on juror evaluations of auditor responsibility for plaintiff losses. The Accounting Review, 75(3), 327-341. https://doi.org/10.2308/accr.2000.75.3.327

Lys, T., & Watts, R. L. (1994). Lawsuits against auditors. Journal of Accounting Research, 32(Suppl.), 65-93. https://doi.org/10.2307/2491440

Pacini, C., Hillison, W., & Sinason, D. (2000a). Auditor liability to third parties: An international focus. Managerial Auditing Journal, 15(8), 394-407. https://doi.org/10.1108/02686900010353980

Pacini, C., Martin, M. J., & Hamilton, L. (2000b). At the interface of law and accounting: An examination of a trend toward a reduction in the scope of auditor liability to third parties in the common law countries. American Business Law Journal, 37(2), 171-236. https://doi.org/10.1111/j.1744-1714.2000.tb00271.x

Palmrose, Z.-V. (1988). An analysis of auditor litigation and audit service quality. The Accounting Review, 63(1), 55-73. https://doi.org/10.2308/tar-4482234

Porter, B. (1993). An empirical study of the audit expectation-performance gap. Accounting and Business Research, 24(93), 49-68. https://doi.org/10.1080/00014788.1993.9729463

Rosenblum v. Adler, 93 N.J. 324, 461 A.2d 138 (1983).

Ultramares Corp. v. Touche, 255 N.Y. 170, 174 N.E. 441 (1931).