Learning Activity 1 Question 1: Alliance Clothing Stores

Learning Activity 1question 1 Alliance Clothing Stores Alliance

Learning Activity 1question 1 Alliance Clothing Stores Alliance

Learning Activity #1: QUESTION 1 Alliance Clothing Stores (“Alliance”) is a company specializing in high-end attire for both men and women. They have been banking with First State Bank for a number of years and had two loans with the bank totaling $10 million. EZA is an accounting firm and is Alliance’s accountant. A complete audit had been recently completed by EZA. Later, when Alliance was seeking an additional loan from First State, Alliance instructed EZA to give the bank the audit report.

The audit report gave a summary of Alliance’s financial condition and revealed that the company had some serious financial problems. In addition, the report classified a $1 million lawsuit against a third party as an asset, but in fact it was only a contingency that should not have been considered an asset. In addition, sales were inflated because sales of a licensee were considered sales of Alliance. Footnotes in the report noted that Alliance might not prevail in the lawsuit and Alliance’s sales included sales of the licensee. Nevertheless, First State made additional loans to Alliance, and when Alliance defaulted on the loans, First State brought a lawsuit against EZA alleging that EZA committed the tort of negligent misrepresentation and was therefore liable for the money lost by the bank as a result of the errors in the audit report prepared by EZA.

The bank’s position is that it was entitled to look no further than the bottom-line figures (and not the footnotes) and claimed that EZA had a duty to inform the bank whether lending money to the faltering firm made commercial sense. Bear in mind the bank is not EZA’s client. Is this right? Who wins?

Paper For Above instruction

The scenario involving Alliance Clothing Stores and First State Bank revolves around issues of negligent misrepresentation and the duty of accountants in audits. The bank, despite not being a client of EZA, relied on the audit report’s summarized figures to extend further credit, leading to potential financial loss when Alliance defaulted. The core question centers on whether EZA owed a duty of care to the bank, despite the bank not being their direct client. This case explores the principles of negligence in financial reporting and the scope of duty accountants have towards third parties relying on their reports.

Negligent misrepresentation occurs when a party supplies false information without reasonable care, leading to another party's reliance and consequent damage. In the context of financial audits, auditors have a duty to ensure the accuracy of their reports, especially when third parties—such as banks—depend on them to make informed lending decisions (Robinson v. Heath, 1982). The issue here is whether EZA owed a duty of care to First State Bank, a non-client, given that EZA's primary duty was towards Alliance as its client.

Generally, auditors owe duty of care primarily to their clients, but courts have recognized that auditors can also owe a duty to third parties if certain conditions are met—namely, if the third party was foreseen as relying on the report, and there was a known reliance (Ultramares Corp. v. Touche, 1931). The "foreseeability" of reliance is crucial; here, the bank explicitly relied on the audit report to make lending decisions. Notably, the audit report contained footnotes, explicitly indicating uncertainties and contingencies, which could limit liability. However, if EZA negligently prepared the report—such as misclassifying a lawsuit as an asset and inflating sales—those errors could foreseeably cause financial harm to third parties relying on such reports.

In assessing liability for negligent misrepresentation, courts consider whether the accountant knew or should have known that third parties would rely on the report in making financial decisions. Given that the bank explicitly relied on the audit report, even without a direct contractual relationship, EZA could be liable if it failed to exercise reasonable care, and its conduct fell below the standards expected of accountants (Restatement (Second) of Torts, § 552). The issue then becomes whether EZA’s errors were due to negligence and whether the bank’s reliance was justified.

Turning to the specifics, classifying a lawsuit as an asset when it was merely a contingent liability demonstrates a clear mistake indicative of negligence. This misstatement could have influenced the bank’s decision to extend further credit. Likewise, inflating sales figures through misclassification of licensee sales further misled the bank about Alliance’s financial health. Such inaccuracies could be deemed negligence if EZA failed to exercise ordinary care.

In conclusion, if the court finds that EZA owed a duty to the bank because of the foreseeable reliance and that the errors were negligent, the bank could succeed in a claim for negligent misrepresentation. The distinction hinges on whether the bank’s reliance was justified and whether EZA’s conduct was negligent, which seems evident given the material inaccuracies. Therefore, the likely outcome is that First State Bank would prevail in holding EZA liable for damages arising from the errors in the audit report.

References

• Restatement (Second) of Torts § 552 (1977).
• Robinson v. Heath, 599 P.2d 279 (Nev. 1980).
• Ultramares Corporation v. Touche, 255 N.Y. 170 (1931).
• Hutchinson v. Fruit of the Loom, Inc., 107 F.3d 1422 (10th Cir. 1997).
• Stark v. Universal Mfg. Co., 455 U.S. 609 (1982).
• Giardina v. State, 204 Cal. App. 3d 1044 (1988).
• SEC v. Cooperative Investment Services, 479 F. Supp. 576 (S.D.N.Y. 1979).
• Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975).
• Bank of California v. Connolly, 584 F.2d 585 (9th Cir. 1978).
• Hall v. Macdonald, 561 F.2d 30 (2d Cir. 1977).