Indiana Law Review


Notes

Judicial and Administrative Treatment of Accountants'

Qualifications and Disclaimers

In the last ten years, litigation involving accountants has ex-

perienced a meteoric rise.
1 This Note seeks to introduce the reader

to the various types of opinions issued by auditors, to examine
judicial and Securities and Exchange Commission treatment of

auditors' attempts to limit liability, and to explore methods by

which auditors can better protect themselves from liability through

improved disclosure techniques.

I. A VIEW FROM THE ACCOUNTING PROFESSION

A. Definitions

Auditing is perhaps the most misunderstood and, consequently,

the most litigated function that public accountants perform. This is

in large part due to a misunderstanding of the significance of an

auditor's opinion and a failure to recognize that financial statements

should primarily be viewed as managements' representations.2 The
American Institute of Certified Public Accountants (A.I.C.P.A.), in a

recent codification of professional standards, described the objective

of the audit process as follows:

The objective of the ordinary examination of financial
statements by the independent auditor is the expression of

an opinion on the fairness with which they present financial

position, results of operations, and changes in financial posi-

tion in conformity with generally accepted accounting prin-

ciples. The auditor's report is the medium through which he
expresses his opinion or, if circumstances require, disclaims

an opinion. In either case, he states whether his examination

has been made in accordance with generally accepted
auditing standards.8

'A recent estimate indicated that between 500 and 1,000 suits were pending at
that time and over 200 decisions had been reported. Liggio, Expanding Concepts of
Accountants Liability, 18 CALIF. C.P.A. Q. 19, 20 (1974). See also Besser, Privity?—An
Obsolete Approach to the Liability of Accountants to Third Parties, 7 Seton Hall L.
Rev. 507, 507 n.2 (1976).

2See note 23 infra. In addition to auditing, public accounting firms perform con-
siderable tax work, management services (such as developing management information
systems), and write-up work.

8
1 A.I.C.P.A., AICPA Professional Standards Auditing § 110.01, at 61 (CCH

1976).

431



432 INDIANA LAW REVIEW [Vol. 11:431

The following two key phrases contained in this description also ap-
pear in any opinion written by an accountant on financial

statements: (1) "[I]n conformity with generally accepted accounting

principles" (GAAP), and (2) "in accordance with generally accepted

auditing standards" (GAAS).

Generally accepted accounting principles incorporate the

consensus at a particular time as to which economic

resources and obligations should be recorded as assets and

liabilities by financial accounting, which changes in assets

and liabilities should be recorded, when these changes
should be recorded, how the assets and liabilities and
changes in them should be measured, what information
should be disclosed and how it should be disclosed and which
financial statements should be prepared.4

Although the A.I.C.P.A. has formulated elaborate general definitions

of the term GAAP, it has not as yet codified all GAAP into a single
writing.5 The Accounting Principles Board (A.P.B.) and more recent-
ly the Financial Accounting Standards Board (F.A.S.B.) of the

A.I.C.P.A.
6 have issued statements in a piecemeal fashion on specific

items but have not as yet detailed all GAAP. Consequently, the pro-
fession is often confronted with the task of determining whether a
particular accounting principle is generally accepted.7 Problematical-

ly, an auditor's opinion must state whether the financial statements
are presented fairly and in accordance with GAAP,8 but in some in-

4
2 A.I.C.P.A., APB Statement No. k, APB ACCOUNTING PRINCIPLES 1 137, at

9083-84 (CCH 1973). See also 2 A.I.C.P.A., Accounting Terminology Bulletin No. 1,
APB Accounting Principles 11 16-17, at 9505-06 (CCH 1973).

Perhaps the most concise definition of GAAP was that offered by the A.I.C.P.A.
Special Committee on Opinions of the Accounting Principles Board, which defined

GAAP as principles having "substantial authoritative support." APB Statement No. h,
supra, at 9505 n.38.

6For a recent article discussing this problem, see Carmichael, What Does the In-
dependent Auditor's Opinion Really Mean?, 138 J. ACCOUNTANCY, Nov. 1974, at 83.

"At this point it would be wise to explain the various organizations having a

direct impact on the accounting profession. The A.I.C.P.A. is the governing body of all
C.P.A. members. From 1938 to 1959, the A.I.C.P.A.'s Committee on Accounting Pro-
cedure was the senior technical committee that was authorized to issue pro-

nouncements on accounting principles. The Accounting Principles Board (A.P.B.) took
over this function from 1959 to 1973, when it was replaced by the Financial Accounting
Standards Board (F.A.S.B.). R. Montgomery, Montgomery's Auditing 25-26 (9th ed.
1975).

'APB Statement No. k, supra note 4, 11 137-206, at 9083-103, offers a general
discussion of how to determine whether a principle is generally accepted and the basic
rules governing GAAP.

8AICPA Professional Standards, supra note 3, § 410.01. See also A.I.C.P.A.
Code of Professional Ethics, Rule 203, reprinted in A.I.C.P.A. Professional Stan-
dards, supra note 3, § 509.18. The SEC has a similar requirement for all financial



1978] QUALIFICATIONS AND DISCLAIMERS 433

stances the auditor may not be sure whether a principle is generally
accepted due to a lack of official pronouncements.

Unlike GAAP, GAAS have been the subject of a comprehensive
codification by the A.I.C.P.A. GAAS are divided into three broad
areas: General standards, standards of field work, and standards of

reporting.9 The following general standards are concerned with the
qualifications of the auditor and the quality of his work:10 (1) "The
examination is to be performed by a person or persons having ade-

quate technical training and proficiency as an auditor;" 11 (2) "[i]n all

matters relating to the assignment, an independence in mental at-
titude is to be maintained by the auditor or auditors;" 12 and (3)
"[d]ue professional care is to be exercised in the performance of the

examination and preparation of the report." 13

The following standards of field work focus on the mechanics of
the audit and what is considered proper in the audit cycle: (1) "The
work is to be adequately planned and assistants, if any, are to be
properly supervised";14 (2) "[t]here is to be a proper study and

evaluation of existing internal control as a basis for reliance thereon

and for the determination of the resultant extent of the tests to

which auditing procedures are to be restricted";16 and (3) "[sufficient
competent evidential matter is to be obtained through inspection,

observation, inquiries, and confirmations to afford a reasonable basis

for opinion regarding the financial statements under examination." 16

The following standards of reporting concern the content of the

work product of the audit— the opinion: (1) "The report shall state
whether the financial statements are presented in accordance with

generally accepted accounting principles";
17

(2) "[t]he report shall

statements certified by auditors. 17 C.F.R. § 210.2-02 (1977); Accounting Series Release

No. 4, 5 Fed. Sec. L. Rep. (CCH) 1 72,005 (1938). Further compounding the problem, the
SEC has taken the position that the F.A.S.B. should continue to determine GAAP for
the purpose of compliance with securities laws. Accounting Series Release No. 150, 5

Fed. Sec. L. Rep. (CCH) 1 72,172 (1973).
9AICPA Professional Standards, supra note 3, § 150.02.
"Id. § 201.01.

"Id. § 210.01.
n
Id. § 220.01; A.I.CP.A. Code of Professional Ethics. Rule 101, reprinted in R.

Montgomery, supra note 6, at 18. The SEC also requires "independence in mental at-
titude" of an auditor certifying financial statements under the securities laws. 17

C.F.R. § 210.201(b) (1977). See also Accounting Series Release No. 126, 5 Fed. Sec. L.
Rep. (CCH) 1 72,148 (1972); Accounting Series Release No. 47, 5 Fed. Sec. L. Rep.

(CCH) 1 72,065 (1944).
13AICPA Professional Standards, supra note 3, § 230.01.
"Id. § 310.01.

"Id. § 320.01.
18/d § 330.01.

"Id. § 410.01.



434 INDIANA LAW REVIEW [Vol. 11:431

state whether such principles have been consistently observed in

the current period in relation to the preceeding period";18 (3) "[inform-

ative disclosures in the financial statements are to be regarded as

reasonably adequate unless otherwise stated in the report"; 19 and (4)

"[t]he report shall contain either an expression of opinion regarding

the financial statements, taken as a whole, or an assertion to the ef-

fect that an opinion cannot be expressed. When an overall opinion
cannot be expressed, the reasons should be stated. In all cases

wherein an auditor's name is associated with financial statements,
the report should contain a clear-cut indication of the character of

the auditor's examination, if any, and the degree of responsibility he

is taking."
20

This final standard of reporting mandates the ultimate work prod-
uct of an audit— the auditor's opinion. The acceptable forms of opin-
ions and the impact of deviations from them are the focal point of
this Note. Before analyzing the A.I.C.P.A.'s technical requirements

pertaining to an auditor's opinion, it is necessary to examine the
procedures involved in a typical audit in order to fully appreciate

what an opinion purports to represent and what duties an auditor
assumes.

B. The Audit Cycle 21

The primary function of an audit is to test the integrity and ac-
curacy of the client's internal control,22 thereby enabling the account-

ant to judge the accuracy and reliability of the client's financial
statements.23 The audit process can be divided into five general
steps. The auditor must first obtain an understanding of the client's
system and the nature of the client's business. Typically, the auditor
examines prior working papers of predecessor auditors, interviews

"Id. § 420.01.

"Id. § 430.01.
20
I<L § 509.04.

21See generally R. Montgomery, supra note 6, chs. 4-7.

"Internal control has been defined as comprising "the plan of organization and all

of the coordinate methods and measures adopted within a business to safeguard its

assets, check the accuracy and reliability of its accounting data, promote operational

efficiency, and encourage adherance to prescribed managerial policies." AICPA Pro
fessional Standards, supra note 3, § 320.09.

"The basic purpose of auditing is to verify the accuracy and acceptability of

financial statements that management has prepared, not to draft the financial

statements. The drafting of financial statements and resulting representations contained

therein are primarily the responsibility of management, not the auditors. Id. § 110.02.

Furthermore, the auditor does not purport to examine every account or physically

count every item of inventory; rather his examination is based upon predetermined

sampling techniques. Hence, a necessary element of imprecision is present in any

audit.



1978] QUALIFICATIONS AND DISCLAIMERS 435

operations management directly involved with the company's inter-
nal control, and refers to industrial source books for a general

understanding of the nature of the client's business.

The second step is a preliminary evaluation of the client's inter-

nal control. Because auditing consists of gathering evidence by

means of testing, the tests must be preceded by a preliminary
evaluation of the client's internal controls to determine what to test

and how extensively. The preliminary evaluation also aids in
organizing the "audit program," which is a list of detailed steps to

be performed at specified times.

Next, the auditor must perform functional tests to ascertain
whether the internal control system on which the auditor intends to

rely is functioning properly. Such tests seek to determine if pre-

existing internal control guidelines are consistently and properly

followed.

After examining the strengths and weaknesses of the client's in-

ternal control system by functional testing, the auditor must re-
evaluate his audit program and modify it to conform to the func-

tional test results. The results of the functional tests determine the
extent to which the substantive tests will be applied. Substantive

tests consist of validatory and analytic tests, such as obtaining con-

firmations from debtors and creditors, random sampling of inven-
tory quantities, examining the accounting principles applied to

management's recordation of financial resources, and evaluating

judgments made by management that have an impact on valuation
estimates.

Finally, the auditor must evaluate the information on the client's
internal control system in light of the client's financial statements in

order to determine if the statements accurately reflect the auditor's

view of the recorded transactions. The results of this evalutaion ap-
pear in the auditor's written opinion.

C. Forms of Opinions

All opinions are typically divided into two parts. In the scope
paragraph, the auditor outlines the nature and extent of the audit
procedures applied and discloses any irregularities or limitations on
the auditor's examination. In the opinion paragraph, the auditor

specifies whether adequate disclosures have been made, whether
such disclosures comply with GAAP, and whether the accounting
principles utilized have been consistently applied.

1. The Standard Short-form Report.2*— "The scope and opinion
paragraphs of the standard short-form report in essence state that

"A model short-form opinion is as follows:
(Scope paragraph)

We have examined the balance sheet of X Company as of [at] December



436 INDIANA LAW REVIEW [Vol. 11:431

the auditor understands the standards of his profession and has

made an examination complying with such standards, and that the
financial statements report the information fairly and in compliance

with consistently applied GAAP. The short-form opinion — or any
opinion for that matter — does not warrant the absence of fraud in
the financial statements or state that the figures in the statements

are accurate to the penny.
25 The auditor merely represents that he

has not found any material problems or deficiencies, either in carry-

ing out the audit or in examining the financial statements, of which

the reader should be aware.

2. Variations of the Standard Report. — During the course of an
audit, a variety of problems or deficiencies may be uncovered. The
auditor is then confronted with the problem of deciding if the ir-

regularity is of sufficient magnitude to require a departure from the

standard short-form opinion.
29

If the auditor determines that such a

31, 19XX, and the related statements of income, retained earnings and

changes in financial position for the year then ended. Our examination was

made in accordance with generally accepted auditing standards and, accor-

dingly, included such tests of the accounting records and such other auditing

procedures as we considered necessary in the circumstances.
(Opinion paragraph)

In our opinion, the financial statements referred to above present fairly

the financial position of X Company as of [at] December 31, 19XX, and the
results of its operations and the changes in its financial position for the year

then ended, in conformity with generally accepted accounting principles ap-

plied on a basis consistent with that of the preceding year.

Id. § 509.07 (bracketed language in original).
25A common misconception about the auditor's role is that he is expected to

detect fraud. From the standpoint of the accounting profession this is simply not cor-
rect:

In making the ordinary examination, the independent auditor is aware of

the possibility that fraud may exist. Financial statements may be misstated
as the result of defalcations and similar irregularities, or deliberate

misrepresentation by management, or both. The auditor recognizes that

fraud, if sufficiently material, may affect his opinion on the financial
statements, and his examination, made in accordance with generally accepted
auditing standards, gives consideration to this possibility. However, the or-

dinary examination directed to the expression of an opinion on financial

statements is not primarily or specifically designed, and cannot be relied

upon, to disclose defalcations and other similar irregularities .... The
responsibility of the independent auditor for failure to detect fraud . . . arises

only when such failure clearly results from failure to comply with generally
accepted auditing standards.

Id. § 110.05. The courts are not always sympathetic to this position. E.g., 1136

Tenants' Corp. v. Max Rothenberg & Co., 319 N.Y.S.2d 1007, 36 App. Div. 2d 804
(1971) (accountant held liable for $174,000 plus interest for failure to detect and report

defalcations of an apartment manager where the accountant alleged that he was only

engaged to do write-up work).
26
Variations from the standard short-form opinion can result where: (1) Limita-

tions are placed on the scope of an audit, (2) the auditor's report is based in part on



1978] QUALIFICATIONS AND DISCLAIMERS 437

departure is required, he must choose between the following forms
of opinions: A qualified opinion, an adverse opinion, or a disclaimer
of opinion.

(a) Qualified Opinion. — "A qualified opinion states that, 'ex-
cept for' or 'subject to' the effects of the matter to which the
qualification relates, the financial statements present fairly [the]

financial position, results of operations and changes in financial posi-

tion in conformity with generally accepted accounting principles con-

sistently applied."
27 The typical grounds for a qualified opinion are:

(1) Restrictions on the scope of an audit, (2) departures from GAAP
in the financial statements, (3) inconsistent application of accounting

principles, or (4) significant uncertainties present as of the state-

ment date.28

In a qualified opinion,
29 the auditor should disclose all substan-

tive reasons for the qualification in a separate explanatory

paragraph, insert an exception in the opinion paragraph, and make
reference to the separate explanatory paragraph in the opinion

paragraph. The explanatory paragraph should also disclose the prin-
cipal impact that the qualification's subject matter will have on the

client's financial position and results of operations, if ascertainable.30

another auditor's report, (3) financial statements are affected by departures from

GAAP or from an accounting principle promulgated by the A.I.C.P.A., (4) accounting
principles have not been consistently applied, (5) financial statements are affected by

uncertainties concerning future events that are not susceptible to reasonable estima-

tion at the statement date, (6) the auditor wishes to emphasize a matter, or (7) the

auditor is not independent. AICPA Professional Standards, supra note 3, §§ 509.09,
517.02.

21
Id. § 509.29.

2
*Id. See also R. Montgomery, supra note 6, at 754.

29See generally AICPA Professional Standards, supra note 3, §§ 509.32-509.34.
30The following is a model of an opinion that is qualified due to departures from

GAAP:
(Scope paragraph)

Same as short form unqualified report
(Separate explanatory paragraph)

The Company has excluded from property and debt in the accompanying
balance sheet certain lease obligations, which, in our opinion, should be

capitalized in order to conform with generally accepted accounting principles.

If these lease obligations were capitalized, property would be increased by

$XXX, long term debt by $XXX, and retained earnings by $XXX as of
December 31, 19XX, and net income and earnings per share would be in-
creased (decreased) by $XXX and $XXX respectively for the year then end-
ed.

(Opinion paragraph)

In our opinion, except for the effects of not capitalizing lease obligations,

as discussed in the preceding paragraph, the financial statements present

fairly ....

Id. § 509.36. For models of qualifications arising due to lack of consistency, uncertain-

ties, and scope limitations, see id. §§ 509.38, .39, & .40, respectively.



438 INDIANA LAW REVIEW [Vol. 11:431

The auditor may abbreviate the explanatory paragraph by incor-
porating these disclosures into footnotes to the financial statements,

provided the explantory paragraph refers to the footnotes. This for-

mat is permissible in all but one situation. Limitations as to the
scope of the audit cannot be explained in footnotes, since a descrip-

tion of the audit's scope is the auditor's responsibility, not the

client's.
31

(b) Adverse Opinion. —An adverse opinion is one which states
"that financial statements do not present fairly the financial posi-

tion, the results of operations, or the changes in financial position in

conformity with generally accepted accounting principles."32 A
typical ground for an adverse opinion is the failure of the financial

statements to comply with GAAP. Another ground is inadequate
disclosure on the part of the client — that is, the client declines to in-
clude information essential for fair presentation.33 In determining

whether to issue a qualified or adverse opinion, the materiality of

the objectionable matter is the guiding element.34

In expressing an adverse opinion, the auditor should state in

separate paragraphs all of the substantive reasons for such an opin-

ion and the principal effects of the objectionable matter, if deter-

minable. Furthermore, the auditor should clearly indicate in the opin-

ion paragraph that the financial statements do not make an accept-
able presentation.35 As a practical matter, adverse opinions are very

31
Id. § 509.34. This limitation is explained by examining the respective roles of

management and the auditor, as viewed by the A.I.C.P.A. Since the A.I.C.P.A. con-
siders the financial statements to be primarily representations of management, and
representations as to the scope of an audit to be the accountant's, the auditor should

not intermingle his required disclosures with those of his client. Id. § 110.02.
n
Id. § 509.41.

33Jd § 509.17. See id. §§ 430.01, .06, 545.04-545.05.
3
*See note 45 infra and accompanying text.

3SAICPA Professional Standards, supra note 3, § 509.42. A model opinion reads
as follows:

(Separate paragraph)

As discussed in Note X to the financial statements, the Company carries
its property, plant and equipment accounts at appraisal values, and provides

depreciation on the basis of such values. Further, the Company does not pro-
vide for income taxes with respect to differences between financial income
and taxable income arising because of the use, for income tax purposes, of

the installment method of reporting gross profit from certain types of sales.
Generally accepted accounting principles, in our opinion, require that proper-

ty, plant and equipment be stated at an amount not in excess of cost, reduced
by depreciation based on such amount, and that deferred income taxes be
provided. Because of the departures from generally accepted accounting prin-

ciples identified above, as of December 31, 19XX, inventories have been in-
creased $ by inclusion in manufacturing overhead of depreciation in ex-
cess of that based on cost; property, plant and equipment, less accumulated

depreciation, is [sic] carried at $ in excess of an amount based on the cost



1978] QUALIFICATIONS AND DISCLAIMERS 439

rare and are usually found only if financial statements are prepared

for a special and limited purpose.39

(c) Disclaimer of Opinion. —A disclaimer of opinion states the
auditor does not express an opinion on the financial statements.37

Due to some significant defect, in either the auditing process or the
financial statements themselves, the auditor is not in a position to

express an opinion or assume responsibility for the financial

statements. The auditor must disclose in separate paragraphs all
reasons for declining to express an opinion, as well as any other

reservations he may have regarding the fairness of presentation of
the financial statements in conformity with GAAP and their consis-

ts the Company; and allocated income tax of $ has not been recorded;

resulting in an increase of $ in retained earnings and in appraisal surplus

of $ For the year ended December 31, 19XX, cost of goods sold has been
increased $ because of the effects of the depreciation accounting referred

to above and deferred income taxes of $ have not been provided,

resulting in an increase in net income and earnings per share of $ and

$ respectively.

(Opinion paragraph)

In our opinion, because of the effects of the matters discussed in the

preceding paragraph, the financial statements referred to above do not pre-

sent fairly, in conformity with generally accepted accounting principles, the

financial position of X Company as of December 31, 19XX, or the results of
its operations and changes in its financial position for the year then ended.

Id. § 509.43.
36
R. Montgomery, supra note 6, at 755.

"AICPA Professional Standards, supra note 3, § 509.45. The following is an ex-
ample of a disclaimer resulting from the auditor's inability to obtain sufficient eviden-

tial matter:

(Scope paragraph)

Except as set forth in the following paragraph, our examination was made in
accordance with generally accepted auditing standards and accordingly in-

cluded such tests of the accounting records and such other auditing pro-

cedures as we considered necessary in the circumstances.
(Separate paragraph)

The Company did not take a physical inventory of merchandise, stated
at $ in the accompanying financial statements as of December 31, 19XX,
and at $ as of December 31, 19XX. Further, evidence supporting the cost
of property and equipment acquired prior to December 31, 19XX is no longer
available. The Company's records do not permit the application of adequate
alternative procedures regarding the inventories or the cost of property and

equipment.

(Disclaimer paragraph)

Since the Company did not take physical inventories and we were
unable to apply adequate alternative procedures regarding inventories and

the cost of property and equipment, as noted in the preceding paragraph, the

scope of our work was not sufficient to enable us to express, and we do not
express, an opinion on the financial statements referred to above.

Id. § 509.47. See id. §§ 517.03, 542.05, 546.15 for other model disclaimer forms.



440 INDIANA LAW REVIEW [Vol. 11:431

tent application. The disclaimer paragraph must make reference to
the explanatory paragraph.

38

Common situations giving rise to a disclaimer are: (1) Significant
scope limitations of an audit,

39
(2) major uncertainties that cannot be

resolved as of the statement date,40 and (3) lack of independence of

the auditor.
41

(d) Piecemeal Opinion. — A piecemeal opinion is the converse
of a qualified opinion. A qualified opinion expresses an opinion as to
the entire financial statement and makes exceptions for particular
items while a piecemeal opinion disclaims or is adverse as to the

financial statement as a whole but renders an affirmative opinion as

to specific items.
42 The A.I.C.P.A. indicated that as of January 31,

1975, it would no longer consider piecemeal opinions acceptable,43

primarily because they "tend to overshadow or contradict a
disclaimer of opinion or adverse opinion."44

Although more than one of the above forms of opinion could be
appropriate for the same defect, the auditor must determine which
form to employ, based upon the degree of materiality that the defect
presents. The problem with this approach is there is no
authoritative statement by the accounting profession that outlines
what defects are "material" and should give rise to a disclaimer or
adverse opinion rather than a qualified opinion. Five factors have

been suggested as guidelines in making the decision: (1) The
usefulness of the financial statements containing the defect, (2) the

auditor's assessment of the reader's ability to understand the prob-
lem, (3) the auditor's ability to measure the potential impact of the
problem, (4) the auditor's ability to describe his reservations about

the financial statements with clarity, and (5) the extent of the
auditor's disagreement with his client's handling of the matter.46

3S/d §§ 509.45-509.46.
3
'Id. § 509.10.

,0
Id. § 509.25 n.8.

"Id. § 517.02.
42
R. Montgomery, supra note 6, at 760.

"AICPA Professional Standards, supra note 3, § 509.50.
"Id. § 509.48.
46
R. Montgomery, supra note 6, at 762. The following factors have been suggested

by the A.I.C.P.A. as guidelines in determining the materiality of the defect: Dollar

magnitude of the effects, significance of an item to a particular enterprise, per-

vasiveness of the misstatement, and the impact on financial statements taken as a

whole. AICPA Professional Standards, supra note 3, § 509.16. "Materiality" has
never been the subject of a specific A.I.C.P.A. release; however, several A.P.B.

statements and opinions generally discuss "materiality." See, e.g., APB Statement No.
k, supra note 4, 1 128 at 9081. See generally Reininga, The Unknown Materiality Con-

cept, 125 J. Accountancy, Feb. 1968, at 30.

For the SEC's definition of "materiality," see 17 C.F.R. § 210.1-02(n) (1977); Ac-

counting Series Release No. 41, 5 Fed. Sec. L. Rep. (CCH) 1 72,059 (1942); Securities



1978] QUALIFICATIONS AND DISCLAIMERS 441

In light of the general criteria offered by the profession, an

auditor's decision on the most suitable type of opinion is a difficult

one. The impact of this decision, when considered in connection with
the potential extent of resulting liability, presents a very real

obstacle to the continued existence of public accounting firms unless

clearer standards are advanced and put into operation.

II. Judicial and Administrative Treatment of
Auditor's Opinions

Technical compliance with GAAS and GAAP becomes most im-
portant when an auditor is confronted with a suit by disgruntled
users of the financial statements. Although compliance with the pro-

fessional standards is not always a complete defense, it is clear that

the courts look to GAAS and GAAP for guidance. Similarly, the
Securities and Exchange Commission has indicated that it views the

A.I.C.P.A. principles and standards as authoritative sources when
examining financial statements and their supporting opinions for

compliance with the federal securities laws.

A. Common Law

1. Introduction.™ —The most common basis for suits against
auditors at common law is misrepresentation. The important ques-
tion is whether negligent misrepresentation rather than fraudulent

misrepresentation will lie for third-party suitors not in privity.

The privity requirement presents a rather formidable obstacle
to third parties not in privity who seek to recover damages from
auditors for negligent misrepresentation. This requirement

originated in England in 184247 and was quickly established in the

Exchange Act Releases Nos. 5092 & 8995, [1970-71 Transfer Binder] Fed. Sec. L. Rep.
(CCH) 1 77,915. Judicial attempts at defining materiality have resulted in a number of
verbal formulations that generaly apply a "reasonable man"-type test. See, e.g., T.S.C.

Indus., Inc. v. Northway, Inc., 426 U.S. 438 (1976) (proxy solicitation); SEC v. Texas
Gulf Sulfur Co., 401 F.2d 833 (2d Cir. 1968) (insider trading); Escott v. Barchris Constr.

Corp., 283 F. Supp. 643 (S.D.N.Y. 1968) (prospectus). See also Kripke, Rule 10b-5

Liability and "Material" "Facts," 46 N.Y.U. L. Rev. 1061 (1971).

"The initial discussion in this section on accountants' common law liability in
general is not intended to be an exhaustive examination. For a more extensive treat-
ment, see Chalmers, Over-accountable Accountants? A Proposal for Clarification of
the Legal Responsibilities Stemming from the Audit Function, 16 Wm. & Mary L.
Rev. 71 (1974); Note, Accountants' Liabilities for False and Misleading Financial

Statements, 67 Colum. L. Rev. 1437 (1967).

"Winterbottom v. Wright, 152 Eng. Rep. 402 (Ex. 1842), is credited with
establishing this requirement. In Winterbottom, a mail-coach driver brought an action

to recover damages against a contractor hired by the Postmaster-General to keep the
mail-coaches in repair. Due to the contractor's negligent servicing of the coach and a
latent defect, it collapsed, injuring the driver. The Court of Exchequer denied
recovery, due to the lack of privity between the driver and the contractor. The court



442 INDIANA LAW REVIEW [Vol. 11:431

United States. This doctrine remained a firm barrier to third-party

suitors lacking privity until the early part of the twentieth century.

In 1919, judicial attitude began to shift, resulting in the first signs of

the doctrine's rejection." Shortly thereafter, the privity doctrine

was rejected in Glanzer v. Shepard,*9 a case closely paralleling the
facts of a typical accountant's liability suit. In Glanzer, a public

weigher was hired by a bean vendor to weigh a quantity of the ven-
dor's product and issue a certificate of weight to the buyer, who in
turn remitted the purchase price to the vendor, based on the cer-

tified weight. The weigher negligently overstated the weight, caus-
ing the buyer to be overcharged. In upholding a directed verdict in

favor of the buyer against the weigher for negligent misrepresenta-

tion, the court, in an opinion written by Justice Cardozo, specifically

rejected the weigher's lack of privity defense.

Nine years after Glanzer the New York courts were called upon
to decide the privity issue in the context of a suit by a disappointed

moneylender against a public accounting firm. In Ultramares Corp.
v. Touched an accounting firm was retained by Stern & Co. to
prepare and issue an opinion on the company's financial statements.
The accounting firm knew that Stern & Co. required extensive bor-
rowing to finance its operations and that the financial statements

would be exhibited to lenders to obtain credit. However, the account-
ing firm did not know the identity of the specific lenders, nor did it
know how many loans the company might obtain in reliance upon
these financial statements. The balance sheet, carrying an un-
qualified opinion,

61 represented Stern's net assets to be $1,070,000.

In reality, the company was insolvent as of the statement date due
to overstated inventories and inclusion of nonexistent accounts

stated: "There is no privity of contract between these parties .... Unless we confine
the operation of such contracts as this to the parties who entered into them, the most
absurd and outrageous consequences, to which I can see no limit, would ensue." Id. at

405. See Landell v. Lybrand, 264 Pa. 406, 107 A. 783 (1919), for one of the early

American cases refusing recovery to a third party for an accountant's negligent

misrepresentation due to the lack of privity.

"MacPherson v. Buick Motor Co., 217 N.Y. 382, 111 N.E. 1050 (1916) (automobile

manufacturer held liable to third party lacking privity for negligence in the construc-

tion of one of its automobiles).

"233 N.Y. 236, 135 N.E. 275 (1922).
M255 N.Y. 170, 174 N.E. 441 (1931).

"The opinion appeared as follows:

We have examined the accounts of Fred Stern & Co., Inc., for the year
ending December 31, 1923, and hereby certify that the annexed balance sheet
is in accordance therewith and with the information and explanations given

us. We further certify that ... in our opinion, [it] presents a true and correct
view of the financial condition of Fred Stern & Co., Inc., as at December 31,
1923.

Id. at 174, 174 N.E. at 447.



1978] QUALIFICATIONS AND DISCLAIMERS 443

receivable. In reliance on the financial statements, plaintiff advanced

$165,000 to the company, which subsequently was declared

bankrupt.

The jury awarded plaintiff damages based on the accounting

firm's negligence in performing the audit, but the trial court set

aside the verdict. On appeal, Justice Cardozo, writing for the court,
noted that although negligence was clearly shown, the crucial ques-

tion was whether the accounting firm owed plaintiff a duty of
reasonable care. Impressed by the potential extent of an auditor's

liability if the jury verdict were reinstated,52 Cardozo decided that

the auditors did not owe a duty of reasonable care to plaintiff. The
court noted, however, that liability would exist for fraud and that a

showing of an auditor's gross negligence could give rise to an in-

ference of fraud.58

The court's reasons for distinguishing Glanzer were also signifi-
cant. The court stated that in Glanzer the services of the weigher
were primarily for the benefit of the buyer, while in Ultramares, the

auditors' services were primarily for the benefit of the client and
secondarily for the benefit of the lenders.54 This distinction, later

referred to as the "primary beneficiary rule," has been applied to re-

quire proof of fraudulent misrepresentation in actions by third par-

ties not in privity with auditors, unless the third parties were the
primary beneficiaries of the financial statements in which case

negligence would suffice.55 In order to be a primary beneficiary, the

52
"If liability for negligence exists, a thoughtless slip or blunder, the failure to

detect a theft or forgery beneath the cover of deceptive entries, may expose accoun-
tants to a liability in an indeterminate amount for an indeterminate time to an indeter-

minate class." Id. at 179, 174 N.E. at 444.

""[Negligence or blindness, even when not equivalent to fraud, is none the less
evidence to sustain an inference of fraud." Id. at 190-91, 174 N.E. at 449. See also State

St. Trust Co. v. Ernst, 278 N.Y. 104, 15 N.E.2d 416, 5 N.Y.S.2d 104 (1938) (interpreting

Ultramares).
M255 N.Y. at 174, 174 N.E. at 445-46.
6BNortek, Inc. v. Alexander Grant & Co., 532 F.2d 1013, 1015 (5th Cir. 1976); Koch

Indus., Inc. v. Vosko, 494 F.2d 713, 724-25 (10th Cir. 1974); Stephens Indus., Inc. v.

Haskins & Sells, 438 F.2d 357, 359 (10th Cir. 1971); Canaveral Capital Corp. v. Bruce,
214 So. 2d 505, 505 (Fla. Dist. Ct. App. 1968); Investment Corp. of Fla. v. Buchman, 208

So. 2d 291, 293 (Fla. Dist. Ct. App. 1968); State St. Trust Co. v. Ernst, 278 N.Y. 104, 15

N.E.2d 416, 5 N.Y.S.2d 104 (1938); Duro Sportswear, Inc. v. Cogen, 131 N.Y.S.2d 20
(Sup. Ct. 1954); Beardsley v. Ernst, 47 Ohio App. 241, 191 N.E. 808 (1934); Milliner v.

Elmer Fox & Co., 529 P.2d 806 (Utah 1974).
A number of decisions purporting to apply the Ultramares rule have mistakenly

interpreted the case as precluding all negligence suits by third parties not in privity.

See, e.g., O'Connor v. Ludlam, 92 F.2d 50, 53 (2d Cir. 1937) ("Since there was no con-
tractual relationship between the plaintiffs and the defendants, liability could be im-

posed only for fraud . . . ."); MacNerland v. Barnes, 129 Ga. App. 367, 369, 199 S.E.2d
564, 566 (1973) ("The general rule is that in the absence of intentional misrepresenta-

tion or fraud, an accountant is not liable for negligence to a third party who is not in
privity with the accountant.").



444 INDIANA LAW REVIEW [Vol. 11:431

Ultramares rule required that the "end aim" of the auditor's engage-

ment be for the benefit of the third-party suitor. The net result of
the primary beneficiary rule was that very few third parties
recovered from accountants.

This was generally the state of the law until 1965 when section
552 of the Restatement (Second) of Torts

56 appeared in tentative
draft form. The Restatement gives a very liberal interpretation to
the law of negligent misrepresentation by professionals to third par-
ties. The Restatement comments suggest that the class of plaintiffs
allowed to recover be expanded to include not only "primary

beneficiaries" but also specific persons or classes of persons who
will rely on the information in the specific transaction.57

The full impact of section 552 on the Ultramares rule remains to
be seen. However, most recent cases have discussed the Restate-
ment section, and at least one court appears to have adopted it. 68

The balance of the cases are somewhat confused, but it appears that
the primary beneficiary rule is being given a more liberal inter-
pretation, and its application now includes a number of situations
that heretofore would not have been included.59

"Restatement (Second) of Torts § 552 (1976) states in full:

(1) One who, in the course of his business, profession or employment, or in

any other transaction in which he has a pecuniary interest, supplies false in-

formation for the guidance of others in their business transactions, is subject

to liability for pecuniary loss caused to them by their justifiable reliance

upon the information, if he fails to exercise reasonable care or competence in

obtaining or communicating the information.

(2) Except as stated in Subsection (3), the liability stated in Subsection (1) is

limited to loss suffered

(a) by the person or one of a limited group of persons for whose benefit

and guidance he intends to supply the information or knows that the recip-

ient intends to supply it; and

(b) through reliance upon it in a transaction that he intends the infor-

mation to influence or knows that the recipient so intends or in a substantial-

ly similar transaction.

(3) The liability of one who is under a public duty to give the information
extends to loss suffered by any of the class of persons for whose benefit the

duty is created, in any of the transactions, in which it is intended to protect

them.

"Id.

"Rhode Island Hosp. Trust Nat'l Bank v. Swartz, Bresenoff, Yavner & Jacobs,
455 F.2d 847 (4th Cir. 1972), involved an action by a bank against an auditor for perfor-

ming a negligent audit, causing the bank to rely on erroneous financial statements

when loaning funds to a soon-to-be defunct corporation. The Fourth Circuit Court of
Appeals appears to have construed Rhode Island law as accepting the Restatement

position, noting that "an accountant should be liable in negligence for careless financial

misrepresentations relied upon by actually foreseen and limited classes of persons." Id.

at 851 (quoting Rusch Factors, Inc. v. Levin, 284 F. Supp. 85, 93 (D.R.I. 1968)). See text

accompanying note 83 infra.
59See Coleco Indus., Inc. v. Berman, 423 F. Supp. 275 (E.D. Pa. 1976); Rusch Fac-

tors, Inc. v. Levin, 284 F. Supp. 85 (D.R.I. 1968); Ryan v. Kanne, 170 N.W.2d 395 (Iowa



1978] QUALIFICATIONS AND DISCLAIMEi 445

2. Treatment of Attempted Limitations of Liability. — The first
reported case to deal with a departure from the standard short-form
report was Beardsley v. Ernst, 60 in which Ernst & Ernst performed
an audit of the International Match Corp. and issued an opinion91

that was qualified due to the auditors' reliance on foreign subsidiary
statements not verified by their audit. Plaintiff purchased Interna-
tional Match securities in reliance on these financial statements and,
after International Match was declared bankrupt, filed suit against
the auditors, alleging fraudulent misrepresentation. Plaintiff claimed
that the auditors had certified certain facts to be true without ac-
tual knowledge of the condition of the foreign subsidiaries. Agreeing
with plaintiff, the court found that under the Ultramares* rule a
cause of action for deceit would lie where the auditors certified as
true facts of which they had no actual knowledge. However, in
Beardsley, the court reasoned that because the auditors had disclos-
ed their reliance on the unverified statements from abroad,62 there
was no pretense of actual knowledge, thereby negating the scienter
requirement of the fraud action.63

This case is of little precedential value today, due primarily to

the more rigid A.I.C.P.A. requirements regarding qualifications. The
Beardsley qualification would undoubtedly be considered inadequate

1969); Bonhiver v. Graff, 248 N.W.2d 291 (Minn. 1976); Aluma Kraft Mfg. Co. v. Elmer
Fox & Co., 493 S.W.2d 378 (Mo. Ct. App. 1973); Shatterproof Glass Corp. v. James, 466
S.W.2d 873 (Tex. Ct. App. 1971). But see Stephens Indus., Inc. v. Haskins & Sells, 438
F.2d 357 (10th Cir. 1971); Canaveral Capital Corp. v. Bruce, 214 So. 2d 505 (Fla. Dist.

Ct. App. 1968); Investment Corp. v. Buchman, 208 So. 2d 291 (Fla. Dist. Ct. App. 1968).
6047 Ohio App. 241, 191 N.E. 808 (1934).

"The opinion read as follows:

We hereby certify that we have examined the books of account and
record of International Match Corporation and its American Subsidiary com-

pany at December 31, 1929, and have received statements from abroad with

respect to the foreign constituent companies as of the same date. Based upon

our examination and information submitted to us it is our opinion that the

annexed Consolidated Balance Sheet sets forth the financial condition of the

combined companies at the date stated, and that the related Consolidated In-

come and Surplus Account is correct.
Id. at 243, 191 N.E. at 809.

fl2"The lanugage used in these certificates gives rise to the indisputable inference

that the accountants had not examined the books and records of the foreign consti-

tuent companies." Id. at 245, 191 N.E. at 810.
63The Restatement of Torts § 526 (1938) gave the three accepted forms of

scienter required for misrepresentation in the business context:

(a) knows or believes the matter to be otherwise than as represented, or (b)
knows that he has not the confidence in its existence or non-existence »

asserted by his statement of knowledge or belief, or (c) knows that he has
not the basis for his knowledge or belief professed by his assertion.

Compare Restatement (Second) of Torts § 526 (1976).



446 INDIANA LAW REVIEW [Vol. 11:431

by today's standards, particularly in view of the fact that the

auditors had not taken an explicit exception in the opinion

paragraph.64 In order to avoid imposing liability, the court was forced

to "infer" the required disclosure.

In a more recent case dealing with a qualification, C.I.T. Finan-
cial Corp. v. Glover,™ a lending institution, in reliance on audited

statements by defendant-accountants, loaned Manufacturers Trading
Corp. considerable funds over a period of several years. The cor-
poration's business consisted in part of "purchasing" commercial
receivables, relying primarily on the borrower's collateral rather

than his overall financial stability because of the shaky postition of

most debtors. Crucial to the success of this venture was an accurate
appraisal of such collateral, which was an extremely difficult task.
The corporation's early success was in large part due to the par-
ticular genius of one of its officers in appraising collateral. During

the course of their audit, the accountants learned of this situation

and, recognizing their inability to properly appraise the collateral,

issued a qualified opinion.
69 After the corporation was declared

bankrupt, the lender filed suit against the auditors, claiming that

the auditors had been negligent in conducting pre- and post-loan

audits and by concealing the overvalued receivables of the corpora-

tion.

Plaintiff claimed that although proper disclosure had been made
as to the method of valuing the underlying collateral, no such
disclosure was made as to the general collectibility of the
receivables, most of which were grossly overvalued. The auditors
subsequently prevailed, arguing that the corporation had not relied

upon the overall financial stability of the borrowers (or the face
value of the receivable) but rather only upon the supporting col-
lateral, and this reliance was appropriately disclosed. The Second
Circuit Court of Appeals, in upholding a jury verdict for the

64At the very least, the opinion should have contained a separate paragraph in-
dicating their failure to audit the foreign records, the scope paragraph should have

referred to this separate paragraph, and their opinion paragraph should have contained

an "except for" sentence disclosing their reliance. See generally AICPA PROFESSIONAL
Standards, supra note 3, §§ 509.32-509.35.

95224 F.2d 44 (2d Cir. 1955).

""The opinion read as follows:

While it is not within our province to pass upon or assume responsibility

for the legal or equitable title to the commercial receivables purchased by

the companies or the valuation of any security thereto accepted and held by

them, it was apparent from their books and records and by opinion of
counsel, that their contractual and assignment forms are adequate for their

legal protection in connection with the collection and liquidation of commer-

cial receivables purchased.

Id. at 46 (emphasis added).



1978] QUALIFICATIONS AND DISCLAIMERS 447

auditors, ruled that a jury could have reasonably found that the

dichotomy between the face value of the receivable and the apprais-

ed value of the collateral was meaningless and that the method of
valuation had been adequately disclosed. This finding upheld the

auditors' assertion that the qualification as to valuation of the col-

lateral extended to the face value of the receivable as well.97

It is difficult to assess the overall adequacy of the auditors'

qualification in Glover, since the court's opinion only reproduced a

limited portion of the qualification. In all probability, the portion

reproduced was the explanatory paragraph in which case the
A.I.C.P.A.'s requirements would now demand considerably more
disclosures than those made. The reasons for the qualification should
have been set forth more clearly, rather than merely stating: "[I]t is
not within our province . . . ."68 The degree of reliance that the cor-
poration placed on the valuation of the supporting collateral and its

relationship to the ultimate collectability of the receivables should

also have been disclosed.69 Finally, the auditors should have noted

the impact on the overall stability of the corporation if a con-

siderable number of the receivables had proved uncollectible.70

In Stephens Industries, Inc. v. Haskins & Sells, 71 two car-rental
companies retained the defendant-accountants to determine their

net worth and to conduct an audit in anticipation of the sale of the

two companies. The audit was initiated pursuant to the purchase
agreement between plaintiff and the companies, the terms of which
specifically provided that accounts receivable were not to be ad-
justed to reflect uncollectible accounts.

72
In reliance on the audited

statements, plaintiff purchased a two-thirds interest in the two com-
panies. After both companies failed, plaintiff filed suit against the

accountants, claiming that the audited statements misrepresented

the value of both companies' accounts receivable. The accountants
disclosed the failure to adjust accounts receivable in a footnote to

the balance sheet and qualified their opinion in this respect.73

68AICPA Professional Standards, supra note 3, § 509.35.
"Id. §§ 509.32-509.34.
10
Id. § 509.33.

"438 F.2d 357 (10th Cir. 1971).
72The contract provided in part: "[A]ccounts receivable as shown by the records of

such corporations, shall be used in determining net worth without adjustment to

reflect the fact that the auditors may feel certain accounts are or may be uncollectible
in whole or part." Id. at 358.

73The scope paragraph of their opinion read as follows:

Our examination was made in accordance with generally accepted
auditing standards, and accordingly included such tests of the accounting

records and such other auditing procedures ... as we considered necessary
in the circumstances, excepting that in accordance with your instructions we



448 INDIANA LAW REVIEW [Vol. 11:431

Plaintiff claimed that the auditors had failed to disclose the

questionable nature of the accounts receivable and were therefore

liable for misrepresenting the financial condition of the companies.

The court rejected this argument, noting that both the auditors' opin-

ion and the balance sheet footnote had adequately disclosed the

failure to adjust accounts receivable for uncollectibles. Hence, the

court found that the auditors had not consciously concealed crucial

information and had exercised the required degree of care and com-

petence demanded of the accounting profession in communicating
the relevant information.

74

The court's opinion can be read as holding that if an auditor's

qualification is sufficiently clear and adequately discloses the nature

of the problem, he will be absolved from liability. At the same time,
it should be noted that the auditors' defense in Stephens Industries

was considerably strengthened by a clause in the contract-to-sell

that specifically excluded accounts receivable from the audit

verification.

In MacNerland v. Barnes, 15 Airways Rent-A-Car retained defen-
dant-accountant Barnes to prepare its financial statements prior to a

sale of its stock. The financial statements overstated seller's ac-
counts receivable by $45,000. However, Barnes issued a disclaimer
of opinion based on his lack of independence from the client.79 The
stock purchasers brought suit claiming, inter alia, that Barnes had

been negligent in his preparation of the financial statements due to
his failure to disclose known discrepancies in the client's accounts
receivable.

The Georgia Court of Appeals reversed the trial court's sum-
mary judgment in favor of Barnes, but stated that an accountant
would not be liable to third parties not in privity for mere
negligence in preparing financial statements containing an express

disclaimer, absent specific undertakings by the accountant that were
inconsistent with the disclaimer. The court remanded the case for a

did not request any of the customers to confirm their balances nor did we
review the collectibility of any trade accounts receivable.

Id. at 360-61 n.l.

A note attached to the balance sheet under accounts receivable disclosed the
following: "The balance shown on the balance sheets is the total of the daily accounts
receivable records of the companies and has not been adjusted to reflect uncollectible

accounts, the amount of which was not determined at December 31, 1964." Id.
u
Id.

"129 Ga. App. 367, 199 S.E.2d 564 (1973).
"The disclaimer read: "Disclaimer of opinion. We are not independent with

respect to Airway's Rent-A-Car of Atlanta, and the accompanying balance sheet as of
March 31, 1970 and the related statement of income and accumulated deficit for the
three months then ended were not audited by us; accordingly, we do not express an
opinion on them." Id. at 370, 199 S.E.2d at 566.



1978] QUALIFICATIONS AND DISCLAIMERS 449

jury determination of whether Barnes had agreed with plaintiff to

verify certain major accounts in which case the disclaimer would

presumably be ineffective, at least as to those accounts.77

The Barnes holding was explored in greater detail in Ryan v.
Kanne, 78 which involved a suit by two accountants to collect their

auditing fees and a counterclaim by the defendant-corporation

against the auditors for negligent misrepresentation. James Kanne
had retained the auditors to certify the financial statements of his

lumber supply business, which he operated as a sole proprietorship.

When the accountants were hired, Kanne specifically instructed
them to pay particular attention to accounts payable-trade and to
use every possible method to verify the balances. The auditors were
also informed that the financial statements would be used to obtain

financing or to incorporate. The auditors completed their audit and
submitted to Kanne financial statements headed "Unaudited
Statement."79 The auditors' cover letter accompanying the
statements read as follows:

Accounts Payable-Trade. Confirmations were used to arrive

at the balance due at the date of the balance sheet. The
payee of each check issued during 1965 and the latter part of

calendar year 1964 was contracted [sic] to confirm if a
balance was due at September 30, 1965. Also, a review of un-
paid statements was made.80

The auditors also made oral representations that accounts payable-
trade would be accurate to within $5,000 of the balance sheet

amount. In reliance on these statements, the proprietorship was in-
corporated and defendant Kanne Lumber Supply Company took
over its assets and liabilities. A later audit of the corporation showed
that the accounts payable-trade were understated by $33,689.22.
Furthermore, the auditors had failed to check a considerable

number of unpaid invoices, contrary to the representations made in
their cover letter.

In upholding a judgment for the defendant-corporation on its
counterclaim, the Iowa Supreme Court discussed the effect of the
disclaimer, noting that the auditors' "liability must be dependent
upon their undertaking, not their rejection of dependability. They

71
Id. at 372, 199 S.E.2d at 567.

78
170 N.W.2d 395 (Iowa 1969).

79The A.I.C.P.A. requires that a disclaimer of opinion must accompany all the

unaudited financial statements. AICPA Professional Standards, supra note 3, §
516.04. For further discussion of unaudited financial statements, see notes 88-96 infra

and accompanying text. The Ryan court indicated that a disclaimer was in fact issued;
however, it was not reproduced in the court's opinion.

80
170 N.W.2d at 398.



450 INDIANA LAW REVIEW [Vol. 11:431

cannot escape liability for negligence by a general statement that

they disclaim [the report's] reliability."81

These cases point out that auditors cannot insulate themselves

from liability by a general disclaimer and at the same time make
contrary representations as to specific items. If auditors have

agreed to verify particular items or represent that they have done

so, a general disclaimer of opinion will be no defense, at least as to

errors in the specified items.82 Care should also be taken in drafting
cover letters to be attached to financial statements. If a cover letter

contains ambiguous or inconsistent representations regarding the
nature or scope of the examination, this could be construed to be in-

consistent with the disclaimer, thereby negating the effect of the

disclaimer as to the stated items. Finally, auditors should clearly

spell out the nature of their engagement immediately after accept-
ing the assignment in order to avoid later disagreements as to the

scope of their undertaking.

Another recent case dealing with an attempted limitation of
common law liability is Rhode Island Hospital Trust National Bank
v. Swartz, Bresenoff, Yavner & Jacobs. 63 International Trading Corp.
retained the defendant-auditors to audit its records and certify its
financial statements, as required by the terms of a loan agreement
with the plaintiff-bank. The financial statements prepared by the
corporation reflected a capitalized expenditure of $212,000 for
leasehold improvements at various facilities in Florida, Georgia, and
Rhode Island. In fact, no such improvements had been made, and the
amount capitalized represented ordinary operating expenses, the ef-
fect of which was to overstate assets and net income. Had the ex-
penses been properly recorded, the corporation would have reported
a loss for the year rather than the reported gain. During the course
of the audit, the auditors noticed considerable discrepancies be-
tween the alleged assets and the supporting cost records. In the ex-
planatory paragraph preceding their disclaimer,84 the auditors
disclosed the problems encountered in auditing the cost records of
the nonexistent leasehold improvements as follows:

Additions to fixed assets in 1963 were found to include prin-
cipally warehouse improvements and installation of

"Id. at 404.
82/d (citing C.I.T. Financial Corp. v. Glover, 224 F.2d 44 (2d Cir. 1955)).
83455 F.2d 847 (4th Cir. 1972). See note 58 supra.

"'Defendant's disclaimer read as follows: "Because of the limitations upon our ex-

amination expressed in the preceding paragraphs and the material nature of the items

not confirmed directly by us, we are unable to express an opinion as to the fairness of
the accompanying statements." 455 F.2d at 850.



1978] QUALIFICATIONS AND DISCLAIMERS 451

machinery and equipment .... Practically all this work was
done by company employees and materials and overhead
was borne by International Trading Corporation and its af-
filiates. Unfortunately, fully complete detailed cost records

were not kept of these capital improvements and no exact

determination could be made as to the actual cost of said im-
provements.85

Plaintiff-bank, in reliance on the audited financial statements, ex-

tended additional money to the corporation, and subsequently in-
itiated this suit against the auditors when the corporation became
unable to repay.

The district court dismissed the complaint, ruling that the bank
had failed to establish misrepresentation or negligence by the ac-

countants in their audit. The Fourth Circuit Court of Appeals
reversed as to the negligence issue and rejected the auditors'

defense based upon the disclaimer. The court examined in detail the
wording of the disclaimer and the explanatory paragraph, noting

that the disclaimer followed other references that expressed the

auditors' reservations as to the value of the leasehold improvements
but not as to their existence. In addition, the auditors' cover letter

stated, as a reason for the disclaimer, that adequate cost records

had not been kept as to the leasehold improvements, when, in fact,

no cost records ever existed. The court ruled that both these
disclosures were inadequate to convey the required information and
absolve defendant from liability.86

There were two principal flaws in the auditors' disclaimer. First,
the explanatory paragraph did not adequately explain the reasons

for issuing a disclaimer when it failed to disclose the total absence
of cost records, thereby creating the impression some records were
kept. Second, the explanatory paragraph, disclaimer paragraph, and

the cover letter all conveyed the impression that the leasehold

assets did exist and had some value when in reality they did not.87

The Rhode Island Trust opinion again points out that extra care
should be taken in drafting explanatory paragraphs and cover let-

ters so as to maximize disclosure and minimize the chances of
creating false impressions, since courts will carefully scrutinize the

wording of these statements.
Even when an accountant is retained to conduct services other

than an audit, he may be subject to liability for inaccuracies under
special circumstances if he is deemed to be "associated with" the

85
J<£ at 849 (emphasis added).
MId at 852.
97d



452 INDIANA LAW REVIEW [Vol. 11:431

financial statements. This situation most commonly occurs when an
accountant is retained to prepare unaudited financial statements.88

The minimum A.I.C.P.A. standards require all unaudited financial
statements that an accountant is "associated with" to carry a

disclaimer clearly indicating that no audit has been conducted.89

Stanley L. Block, Inc. v. Klein90 illustrates the effect of an ac-

countant's failure to comply with these minimal requirements. In

Block, the defendant-accountants prepared and issued financial

statements on their stationery with no opinion attached. In a subse-

quent suit by the disappointed client, the court noted that A.I.C.P.A.

standards minimally require an accountant to attach an opinion or

disclaimer to a financial statement.
91 Because the accountants had

failed to disclaim or qualify their nonexistent opinion, the court

assumed that the accountants had intended to issue an unqualified

opinion and imposed liability for the accountants' failure to physical-

ly verify the client's inventory as required by contemporary profes-

sional standards.
92 Accordingly, accountants should take care to ap-

pend a disclaimer of opinion whenever there is a possibility of being
"associated with" financial statements. As shown by Block, this is
true even when statements are prepared only for internal use by
the client.

88 The A.I.C.P.A. deems an accountant to be "associated with" unaudited financial
statements

when he has consented to the use of his name in a report, document, or writ-
ten communciation setting forth or containing the statements. Further, when
a certified public accountant submits to his client or others, with or without

a covering letter, unaudited financial statements which he has prepared or

assisted in preparing, he is deemed to be associated with such statements.
This association is deemed to exist even though the certified public accoun-
tant does not append his name to the financial statements or uses "plain
paper" rather than his own stationery.

AICPA Professional Standards, supra note 3, § 516.03. An auditor is deemed not to
be "associated with" the financial statements only when he was not involved in their
preparation, reproduces them on "plain paper," and only submits the statements to his

client. Id. § 516.03.
M
I<L § 516.04. It follows from the nature of the financial statements that the

auditor probably will not be in a position to express an opinion as to their conformity

with GAAP. However, if the accountant is aware of nonconforming items, he must in-
sist that his client make the required changes, or, if the client refuses, the accountant
should clearly note the departures from GAAP in his disclaimer. Id. §§ 516.06-516.07.
See also 1136 Tenants Corp. v. Max Rothenberg & Co., 36 App. Div. 2d 804, 319
N.Y.S.2d 1007 (1971) (accountant hired only to do write-up work had a duty to report

material irregularities discovered during the course of preparing the statements).
9045 Misc. 2d 1054, 258 N.Y.S.2d 501 (Sup. Ct. 1965).
n
I<L at 1058, 258 N.Y.S.2d at 506.

92/d at 1058, 258 N.Y.S.2d at 506-07. However, the court went on to hold the ac-

countants liable only for auditing fees, ruling that the client failed to establish that fur-

ther damages were proximately caused by the accountants' negligence. Id. at 1060, 258

N.Y.S.2d at 508.



1978] QUALIFICATIONS AND DISCLAIMERS 453

In Coleco Industries, Inc. v. Berman, 93 the court discussed the

extent of an accountant's responsibilities when associated with
unaudited reports. In Coleco, the defendant-accountants were retained

to prepare unaudited financial statements prior to plaintiffs pur-

chase of a business. The accountants made several errors of varying
significance in the preparation of the statements. In the suit that

followed, the accountants raised the defense that there could be no

liability imposed for errors contained in unaudited financial

statements, but the court rejected this argument and held them
liable for negligent preparation of the financial statements.

94 Of par-

ticular significance was the court's finding that the mistakes were
only simple mathematical errors. In a footnote, the court stated that

when mechanical errors are made, no differing standard should be
applied to audited and unaudited financial statements, since in both

cases, parties can reasonably assume that accountants will correctly
perform simple mathematical functions.95 A moderately liberal
reading of Coleco could lead to the conclusion that an accountant

cannot escape liability for unaudited financial statements containing

erroneous items that would be discoverable or correctable without

an audit.96

3. Conclusion: Common Law Liability. — Taking the above cases
together, some general conclusions can be drawn regarding the ef-
fects of qualifications and disclaimers at common law. There is a
noticeable trend in recent cases to examine in detail the specific
working of the disclaimer or qualification and to judge the adequacy

of the disclosure in light of the situation in its fully developed form,

rather than in the position of the auditor at the time the opinion

was issued. This puts considerably more pressure on the auditor to
closely examine the situation in determining what to disclose and
how to disclose it.

Auditors should not rely solely upon their opinions or

disclaimers to reveal potential problem areas but should attempt to

disclose the required information in as many places as possible — in
footnotes, cover letters, and explanatory paragraphs to the auditors'
opinion. Auditors must, however, avoid equivocal or contradictory

representations in cover letters, explanatory paragraphs, and

,3423 F. Supp. 275 (E.D. Pa. 1976).
u
Ia\ at 310.

n
IcL nn.59 & 60. The court stated: "[W]e believe even the most restricted under-

taking would impose on [the accountant] a duty to multiply correctly and to make
overhead deductions from inventory, that can be simply computed." Id. n.59.

MAn interesting case involving "associated with" liability that defies categoriza-
tion is Bonhiver v. Graff, 248 N.W.2d 291 (Minn. 1976). In Bonhiver, liability was im-

posed upon accountants for negligence when third parties relied upon erroneous items
in the accountants' working papers.



454 INDIANA LAW REVIEW [Vol. 11:431

disclaimer paragraphs, as well as in oral statements that tend to

negate or overshadow the qualification or disclaimer. In addition,

auditors should take care to clearly spell out the nature and extent

of their engagement to the client as soon as possible after accep-

tance of the assignment.

When drafting reports, auditors would be wise to note specific
departures from GAAS, rather than enumerating procedures actual-
ly performed and leaving to inference procedures not followed.

Rhode Island Trust illustrates the dangers created by the latter
when courts scrutinize the auditor's opinion in light of the fully
developed circumstances.

B. Treatment of Qualifications and Disclaimers Under the
Securities Laws

1. Introduction.— Auditors are brought under the purview of the

Securities and Exchange Commission through the disclosure re-
quirements of the Securities Acts of 1933 and 1934.97 The 1933 Act
requires initial public offerings of securities to be accompanied by

certified financial statements both in the registration statement filed

with the SEC98 and in the prospectus sent with the stock.99 The 1934
Act provides for initial registration and continuous filing of reports

that generally must contain certified financial statements.100

The threshold question involving qualifications and disclaimers
under the securities laws is not whether they serve as a basis for in-

sulating the auditor from liability but whether the reporting re-

quirements of the Acts are satisfied when such limitations are pres-
ent. Accordingly, the bulk of this discussion distinguishes the types

of qualifications that are acceptable and the types that fail to satisfy
the reporting requirements of the 1933 and 1934 Securities Acts.

Section ll 101 of the 1933 Act, sections 18102 and 10(b)103 of the 1934

Act and rule 10b-5104 provide methods by which third-party suitors
and the SEC may proceed against accountants for their part in filing
false or misleading financial statements with the Commission. In ad-

dition, if an auditor certifies financial statements and the report

fails to satisfy the disclosure requirements of the 1933 or 1934 Acts,

the SEC has the power to initiate disciplinary proceedings against

97
15 U.S.C. §§ 77(aMaa), 78(a)-(jj) (1976).

W
I<L § 77(g).

"Id. § 77(j).
10
°/d. § 78(m)(a)(2).

10,/d § 77k(a).
102/d § 78(r).

">»IcL § 78(j).
104
17 C.F.R. § 240.10b-5 (1977).



1978] QUALIFICATIONS AND DISCLAIMERS 455

the auditor that could result in temporary or permanent denial of

the privilege to practice before the Commission.
105

In general, the SEC has not promulgated specific auditing stan-
dards or procedures to be followed by auditors certifying financial

statements under the securities laws, but it has left the develop-

ment of standards and procedures to the accounting profession.106

Consequently, A.I.C.P.A. standards play a major role in determining

the adequacy of the financial statements and supporting opinions filed

with the Commission. However, the SEC does require certain items
to appear in all auditor's reports filed with the Commission.107

2. SEC Treatment of Qualifications and Disclaimers.—The effect
of a disclaimer under the securities laws is fairly easy to determine.

Both the 1933 and 1934 Acts require financial statements filed with

the SEC to be certified.108 "Certified," in the context of financial
statements, is defined as "examined and reported upon with an opin-

ion expressed by an independent public or certified public account-

ant."
109

In addition, the S-X regulations contain an implicit assump-
tion that an opinion will be expressed^10 Since the securities laws

m
IcL § 201.2(e).

108This policy was first announced in McKesson & Robbins, Inc., Accounting Series
Release No. 19, 5 Fed. Sec. L. Rep. (CCH) 1 72,020 (1940).

l0717 C.F.R. § 210 (1977). The required contents of an auditor's report (opinion) are:

(a) Technical requirements. The accountant's report (1) shall be dated; (2)
shall be signed manually; (3) shall indicate the city and State where issued;

and (4) shall identify without detailed enumeration the financial statements

covered by the report.

(b) Representations as to the audit. The accountant's report (1) shall
state whether the audit was made in accordance with generally accepted
auditing standards; and (2) shall designate any auditing procedures deemed

necessary by the accountant under the circumstances of the particular case,

which have been omitted, and the reasons for their omission. Nothing in this

rule shall be construed to imply authority for the omission of any procedure

which independent accountants would ordinarily employ in the course of an

audit made for the purpose of expressing the opinions required by paragraph
(c) of this section.

(c) Opinion to be expressed. The accountant's report shall state clearly:
(1) The opinion of the accountant in respect of the financial statements
covered by the report and the accounting principles and practices reflected

therein; and (2) the opinion of the accountant as to the consistency of the ap-

plication of the accounting principles, or as to any changes in such principles

which have a material effect on the financial statements.

(d) Exceptions. Any matters to which the accountant takes exception
shall be clearly identified, the exception thereto specifically and clearly

stated, and, to the extent practicable, the effect of each such exception on

the related financial statements given.

Id. § 210.2-02.
10815 U.S.C. §§ 77(g), (j) (1976).
10»17 C.F.R. § 210.1-02(f) (1977).
no

Id. § 210.202(c).



456 INDIANA LAW REVIEW [Vol. 11:431

require an opinion to be expressed, a disclaimer of opinion is unaccept-

able, because such a disclaimer states that the auditor does not ex-

press an opinion on the financial statements.
111

The effects of qualifications and footnote disclosures are con-

siderably more complicated and can be broken down into a number
of areas. The SEC dealt with qualifications and footnote disclosures
due to departures from GAAP as early as 1938.112 The SEC stated
that financial statements that are prepared using accounting prin-

ciples for which there is "no substantial authoritative support"113

will be presumed to be misleading or inaccurate, notwithstanding

full disclosure in the auditor's opinion or in the footnotes of the

financial statements. Clearly, departures from GAAP should be
avoided or, if the client refuses to comply, the auditor should

disassociate himself from the financial statements.

A qualification arising due to limitations on the scope of an audit
is a bit more involved. The SEC addressed this question in Account-
ing Series Release No. 90.114 The question arose in the context of a
"first time" audit exception taken by auditors.116 The Commission
noted that since it was impossible to physically verify beginning in-
ventories in the first-time audit situation, GAAS do not require such
verification. However, the Commission stated that alternative means
should be employed to determine the accuracy of the inventories. If

such alternative procedures are applied and the auditor is in a posi-

tion to express an affirmative opinion, an exception due to a failure

to physically verify beginning inventories should be unnecessary.116

The principal restriction imposed by Accounting Series Release No.
90 is that qualifications due to material scope limitations on the

audit are unacceptable in reports filed with the Commission.

"'See note 37 supra. See also SEC v. Beisinger Indus. Corp., 421 F. Supp. 691, 695
n.ll (D. Mass. 1976).

"'Accounting Series Release No. 4, 5 Fed. Sec. L. Rep. (CCH) 1 72,005 (1938).

"'"Substantial authoritative support" is the SEC's definition of GAAP. The SEC
has traditionally left the promulgation of GAAP to the accounting profession. See Ac-
counting Series Release No. 150, 5 Fed. Sec. L. Rep. (CCH) 1 72,172 (1973).

"'Accounting Series Release No. 90, 5 Fed. Sec. L. Rep. (CCH) 1 72,112 (1962).
"5GAAS require physical observation of inventories. A problem arises during a

first-time audit because verification of beginning inventories is impossible when the
auditor is not retained until year-end. See McKesson & Robbins, Inc., Accounting
Series Release No. 19, 5 Fed. Sec. L. Rep. (CCH) 1 72,020 (1940).

"The SEC reasoned that the certificate must state whether the audit complied
with GAAS and whether it included the necessary tests of accounting records. Accoun-
ting Series Release No. 90, 5 Fed. Sec. L. Rep. (CCH) 1 72,112 (1962) (construing 17

C.F.R. § 210.202(b)(1) (1961)). If the certificate contains this statement, a qualification

due to failure to observe physical inventories is unacceptable and contradictory, since

the auditor must have satisfied himself as to the accuracy of the inventories by some
other means before he can certify that he complied with GAAS. Id.

For further treatment of scope limitations, see Accounting Series Release No. 62,



1978] QUALIFICATIONS AND DISCLAIMERS 457

Uncertainties that cannot be resolved as of the statement date

present another area where qualifications can arise. Uncertainties

arising due to a need for additional financing were addressed in Ac-

counting Series Release No. 115.
117 The auditor's report disclosed

that, due to prior years' losses, continued operation of the business

was in jeopardy unless additional financing could be obtained. A
qualified opinion was issued, due to the need for additional funds to

finance current operations.
118 The Commission found the financial

statements defective, reasoning that rule 2-02119 requirements regard-

ing auditor's opinions are not satisfied where financial statements
are prepared on a "going concern" basis and the auditor's opinion is

so qualified as to indicate serious doubt as to whether such an

assumption of "going concern" status is appropriate. Presumably, a

qualification would be acceptable if the immediate threat to "going

concern" status has been removed by a firm commitment of funds
from such sources as banks or public offerings (if adequate funds are

anticipated); however, this information should be disclosed in a

separate explanatory paragraph. Accounting Series Release No. 115

renders "open ended" qualifications, such as "subject to obtaining

additional financing," unacceptable to the SEC, at least if there is an
immediate threat to continued operations without a commitment for
such funds.120

Resource Corp. International121 addressed a more generalized
question regarding qualifications, namely, how extensive a qualifica-
tion may be and still satisfy the requirements of the 1933 and 1934
Acts. Resource Corp. International was organized to acquire financ-
ing for the purchase of Mexican timberlands. The accountants who

5 Fed. Sec. L. Rep. (CCH) 1 72,081 (1947); Barrow, Wade, Guthrie & Co., Accounting
Series Release No. 67, 5 Fed. Sec. L. Rep. (CCH) 1 72,086 (1949) (SEC disciplinary pro-
ceeding pursuant to 17 C.F.R. § 201.2(e) (1977) initiated against auditors issuing a

qualified opinion for failure to verify working process).

'"Accounting Series Release No. 115, 5 Fed. Sec. L. Rep. (CCH) 1 72,137 (1970).
For additional discussion regarding treatment of uncertainties arising in financial
statements filed with the Commission, see Accounting Series Release No. 166, 5 Fed
Sec. L. Rep. (CCH) 1 72,188 (1974); Accounting Series Release Interpretations, Topic
6(E), 5 Fed. Sec. L. Rep. (CCH) 1 74,151 at 62,843 (1974).

niSee AICPA Professional Standards, supra note 3, §§ 509.21-509.26, for the
A.I.C.P.A. form and opinion content requirements.

119
17 C.F.R. § 210.2-02 (1977), reprinted in note 107 supra.

120For a case dealing with uncertainties due to management's use of sales and cost
reduction estimates in financial statements, see Accounting Series Release No. 173, 5
Fed. Sec. L. Rep. (CCH) 1 72,195 (1975). The case notes that the issuance of a qualified
opinion due to uncertainties does not absolve the auditor from responsibility for per-
forming adequate audit tests and obtaining documentation of management's assess-
ment of the outcome of the uncertainty — at least in cases where the uncertainty is
such that a reasonable assessment can be made.

m
7 S.E.C. 689 (1940).



458 INDIANA LAW REVIEW [Vol. 11:431

were retained to audit the corporation and prepare its SEC filing
papers qualified their certificate extensively.

122 The SEC ruled that
the auditor's certificate failed to satisfy the rule 2-02 requirements

of a "certified" report
123 because the effect of the extensive qualifica-

tion was that the accountants expressed an affirmative opinion as to

only $35,000 of over $9,000,000 in total assets.
124 This ruling indicates

that when a qualification is so pervasive as to effectively negate the

overall affirmative opinion, the Commission will consider the finan-

cial statements to be uncertified and thus defective.

In Associated Gas & Electric Co., m the SEC was called upon to
determine the adequacy of financial statements and supporting

auditor's opinions filed over a period of several years. The auditors'

opinions contained incredibly complicated and verbose qualifications

and footnote disclosures regarding the treatment of various items

by Associated Gas.
128

In determining the adequacy of the disclosures,

122The auditor's opinion was as follows:

Investments in capital stocks of subsidiary companies and in Mexican timber

tracts were recorded by the issuer on the basis of the liability ($1,650,000)

which it agreed to assume and the value assigned by the board of directors

($7,350,000) to 735,000 shares of its capital stock issued in connection with the

acquisition of these assets October 15, 1931. Mr. H.S. Hoover has

represented that the cost to him of his equity in these assets for which he

received 735,000 shares of capital stock was approximately $359,154. Subse-
quent to October 15, 1931, Mr. H.S. Hoover secured a reduction of $487,860,

without cost to him, in the amount of the liabilities assumed by the issuer at

that date and 52,536 additional shares of capital stock of the issuer were

issued to him in connection therewith. The issuer in 1937 issued 68,542
shares of its capital stock to Mr. B.L. Hoover or his nominee at a declared

value of $10 per share in settlement of $685,420 principal amount of purchase

contract obligations acquired by him from vendors for a cash consideration of

$217,700, which cash was advanced to him by Mr. H.S. Hoover. The issuer
represents that Mr. B.L. Hoover is not an affiliated interest.

The investments of the issuer in Mexican timber tracts, including those
owned by subsidiaries, represent practically its sole assets. As auditors, it is
not possible for us to make any determination of the value of such assets.
Consequently we are not in a position to express an opinion with respect to
the accompanying balance sheet that embraces the matter of value assigned

therein to those assets and to the stated capital or the accounting principles

followed in connection therewith. The remaining items on the issuer's
balance sheet at November 30, 1937, together with supporting schedules
referred to in connection therewith are, in our opinion, fairly stated thereon

in accordance with accepted principles of accounting.

Id. at 739.
l2a
17 C.F.R. § 210.2-02 (1977), reprinted in note 107 supra.

124
7 S.E.C. at 739.

,2S
11 S.E.C. 975 (1942).

12°The opinions issued for a single year were too long to reproduce in a footnote;
however, for those readers possessed of strong eyes or a magnifying glass, the opi-

nions can be found in an appendix to the case. Id. at 1063 app.



1978] QUALIFICATIONS AND DISCLAIMERS 459

the SEC examined each qualification and disclosure from two view-
points: First, it examined each disclosure in detail for clarity, com-

pliance with GAAP, and adequacy in relation to its purpose; and sec-
ond, the Commission examined the financial statements as a whole

to determine in light of all circumstances whether the statements

conveyed all the required information in an understandable man-

ner.
127 The Commission ultimately ruled that the financial

statements did not meet the certification requirements and accord-
ingly were defective. The most important point to be drawn from
the case is the SEC's view that compliance with GAAP and A.I.C.-
P.A. disclosure requirements is not enough; rather, the information

must also adequately inform the average investor. 128 The SEC noted
that too many qualifications in the auditor's opinion may in some
cases indicate that the scope of the audit was inadequate, thereby
prohibiting the expression of an opinion or alternatively, as in

Resource Corp. International, negating the overall opinion ex-

pressed.
129

In either case, the rule 2-02 requirements will not be

satisfied.

The Commission, in Thomascolor Inc., 130 elaborated on the re-
quirements for adequate disclosures in financial statements.

Thomascolor's business consisted of processing color films, and its

principal assets were patents on a "new" color process (which was in
fact old and filled with technical flaws). The central dispute in the
SEC proceeding involved the valuation method applied to the
patents and the adequacy of the disclosure of the patents' cost basis.

Footnotes to the financial statements only partially disclosed the

1Z7"We believe that, in addition to the question whether the individual items of
financial statements are stated in accordance with accounting principles, practices, and

conventions, there must be considered the further question whether, on an overall

basis, the statements are informative." Id. at 1059.
128

J<£ at 1058-59. A number of decisions have adopted this position in civil suits, as
well as criminal prosecutions. See, e.g., United States v. Simon, 425 F.2d 796 (2d Cir.

1969), cert, denied, 397 U.S. 1006 (1970); Baumel v. Rosen, 283 F. Supp. 128 (D. Md.

1968) (use of traditional installment method misleading); Herzfeld v. Laventhal, Kreks-

tein, Horwath, & Horwath, 378 F. Supp. 112, 121 (S.D.N.Y. 1974), aff'd, 540 F.2d 27 (2d
Cir. 1976) ("Our inquiry is properly focused not on whether [defendants'] report

satisfies esoteric accounting norms, comprehensible only to the initiate, but whether

the report fairly presents the true financial position of Firestone ... to the untutored

eye of an ordinary investor."). See also Touche, Niven, Bailey, & Smart, Accounting
Series Release No. 78, 5 Fed. Sec. L. Rep. (CCH) 1 72,100, at 62,220 (1957) ("[A] public

accountant whose duty it is to convey full information does not fulfill his obligtion by

simply giving so much as is calculated to induce requests for more.").
129
11 S.E.C. at 1062.

,3027 S.E.C. 151 (1947). See also Accounting Series Release No. 73, 5 Fed. Sec. L.

Rep. (CCH) 1 72,092, at 62,184 (1952) (SEC disciplinary proceeding against auditors of
Thomascolor arising out of the above activities).



460 INDIANA LAW REVIEW [Vol. 11:431

cost basis for valuing the patents. However, the SEC ruled that the
disclosures were inadequate and that the patents were overvalued,

due to inclusion of promotional costs in the cost basis of the

patents.
131 Of significance is the SEC's view of footnote disclosures

in the financial statements:

It is not enough to say that here perhaps much (but by
no means all) of the factual background forming the basis of
the original patent and patent application account was given
in footnote data. Significant data were not provided; but
even if these had been given there is an obligation to pre-

sent material in a way in which it will be useful to the in-
formed but less sophisticated readers.132

It is by now apparent that the SEC not only requires qualifications
to be understandable to the average reader, as was illustrated in
Associated Gas, but also applies the same requirement to footnote
disclosures.

Footnotes are also occasionally used to make certain types of
disclosures where a qualification is deemed to be unwarranted, but
some explanation is still needed. 133 In F.G. Masquelette & Co., 134 an
extreme example of this alternative use, the Commission brought a
disciplinary proceeding135 against Masquelette & Co. resulting from
their audit of Health Institute, Inc., a corporation organized to erect

and operate a hotel in Hot Springs, New Mexico. The corporation's
principal asset, as of the filing date, was a leasehold (the site of the
proposed hotel), which was valued at $100,000 on a completely ar-
bitrary basis with no consideration of its market value. The auditors
issued an unqualified opinion on the financial statements. The only
disclosure regarding the leasehold was made in a note attached to
the balance sheet in which the auditors disclosed that the leasehold

value was arbitrary and based on the amount of stock issued in ex-
change for the leasehold.

The Commission ruled that the balance sheet did not present
fairly the corporation's financial position in conformity with GAAP,
since valuation of an asset based upon the par value of its stock
does not comply with GAAP.136 The Commission further stated that

181
27 S.E.C. at 169.

m
Id. at 170 n.17.

133
0ccasionally the SEC requires the use of footnote disclosures. See, e.g.. Accoun-

ting Series Release No. 62, 5 Fed. Sec. L. Rep. (CCH) 1 72,081 (1947) (footnote explana-

tions required under certain circumstances in summary earnings tables).
"'Accounting Series Release No. 68, 5 Fed. Sec. L. Rep. (CCH) 1 72,087 (1949).
13517 C.F.R. § 201.2(e) (1977).
136Accounting Series Release No. 68, 5 Fed. Sec. L. Rep. (CCH) 1 72,087, at 62,181

& 62,183 n.4 (1949).



1978] QUALIFICATIONS AND DISCLAIMERS 461

the footnote disclosure did not cure this deficiency and noted:

"[E]ven were the footnote to state with complete frankness the true
fact that the assets were over-valued, this would not mitigate the ef-
fect of the valuation figure itself. A balance sheet item which is flat-
ly untrue will not be rendered true merely by admission of un-

truth."
137 Thus, auditors should not rely on footnote disclosures in

place of a clear qualification and explanation as to the departure

from recognized standards, particularly where the item is material
and the departure is extreme.138

3. Judicial Treatment of Attempts at Limiting Liability Under
Securities Laws. —Judicial response to auditors' attempts at limiting
liability under the securities laws by qualification has been

minimal. 139 The very limited number of reported cases tend, in
general, to follow the common law treatment. Herzfeld v. Laventhol,
Kreskstein, Horwath & Horwath140 is illustrative of the current
judicial attitude toward qualficiations and supporting footnote

disclosures in the rule 10b-5
141

actions. Plaintiff Herzfeld was ap-
proached by representatives of Firestone Group Ltd., a California
corporation primarily engaged in the purchase and resale of real
estate, regarding a private placement of Firestone's securities. The
focus of this suit (and the basis of plaintiffs allegations of materially

misleading financial statements) was the accounting treatment given
to two real estate transactions in the audited financial statements
that were subsequently delivered to the plaintiff-purchaser. The
transactions in question involved Firestone's purchase of twenty-

three nursing homes for $13,362,000, with $5,000 payable during the
statement year, and Firestone's contract to sell the same property
to Continental Recreation Co. for $15,393,000, with $25,000 payable

during the statement year. This purchase and resale represented

the largest transaction ever entered into by Firestone.142 Firestone

wanted to recognize the entire profits of this proposed resale in the
statement year so as to convert a $772,108 loss into a $1,257,892

gain with the obvious result of making their securities offering con-

™Id. at 62,180 (quoting Mining & Development Corp., 1 S.E.C. 786, 799 (1936)).
138The facts of this case clearly presented a situation requiring at least a qualified

opinion. See AICPA Professional Standards, supra note 3, § 509.29.
139A number of cases have dealt with the quality of footnote disclosures in finan-

cial statements. See, e.g.. Republic Technology Fund, Inc. v. Lionel Corp., 483 F.2d

540, 547 (2d Cir. 1973) (footnote disclosing overall interim profit picture should have

been appended to financial statements); Kaiser-Frazer Corp. v. Otis & Co., 195 F.2d
838, 843 (2d Cir. 1952) (footnote should have disclosed that material increase in earn-

ings was due to inventory adjustment during prior quarters); SEC v. Geotek, 426 F.
Supp. 715 (N.D. Calif. 1976); Green v. Jonhop, Inc., 358 F. Supp. 413 (D. Ore. 1973).

140540 F.2d 27 (2d Cir. 1976).
U1
17 C.F.R. § 240.10b-5 (1977).

'"Sales for 1969 including this transaction would have been $22,132,607, as oppos-

ed to $6,739,607 without its inclusion.



462 INDIANA LAW REVIEW [Vol. 11:431

siderably more attractive. However, the defendant-accountants were

hesitant to recognize the total gain on the resale agreement in the

1969 statement year primarily because of its questionable com-

pliance with GAAP.143 Accordingly, defendants reported $235,000 144

as gross profit and the balance of the "gain" as "deferred gross prof-

it."
145 The income statement contained the following note regarding

"deferred gross profit": "Of the total gross profit of $2,030,500,

$235,000 is included in the Consolidated Income Statement and the

balance, $1,795,500, will be considered realized when the January 30,
1970 payment is received. The latter amount is included in the
deferred income in the consolidated balance sheet." 148 The auditors'

143 APB Statement No. -4, supra note 4, 1 150, provides in part that revenues
should not be recognized until the "earnings process is complete or virtually complete"

and "an exchange has taken place." Firestone had paid $5,000 on a $13,200,000 pur-

chase and had received $25,000 on a sales contract of $15,000,000. In addition, as of the

statement date, the accountants were unsure as to whether certain conditions in both

sales contracts had been satisfied.

'"This figure was apparently arrived at by adding the $25,000 deposit, a $25,000

payment due in January 1970, and $185,000 liquidated damages for nonperformance.
U5The term "deferred gross profit" is typically used in installment sales of realty

to indicate the postponement of income recognition until installments are received. See

D. KlESO, R. MOUTZ. & C. MOYER. INTERMEDIATE PRINCIPLES OF ACCOUNTING (1969); R.
Wixon, W. Kell, & N. Bedford. Accountants- Handbook (5th ed. 1970).

146540 F.2d at 31. The full text of the note read as follows:
The Firestone Group, Ltd. acquired by contract of sale a group of convales-

cent hospitals containing approximately 1,900 beds. The properties were leased
back to the former owners. In November, 1969 the Company sold the proper-
ties by means of a contract of sale.
The terms of the contract by which The Firestone Group, Ltd. purchased the
properties provide for the following:

Assumptions of existing first trust deed liens $ 5,822,283

Note payable, secured by second trust deed, requiring
monthly amortization of principal and interest at

9 lA°/o for 25 years 3,540,217

Cash:

Upon contract execution 5,000
On December 20, 1969 25,000
On January 30, 1970 3,970,000

$ 13,362,500

The contract of sale provided for the following:
Assumption of existing trust deed liens $ 9,362,500
Cash:

Upon contract execution 25,000
On January 2, 1970 25,000
On January 30, 1970 4,965,250

Note secured by trust deed in favor of The Firestone
Group, Ltd. requiring monthly amortization based
on twenty-five years with interest of 8'/2%; final pay-
ment due in 120th month 1,015,250

$ 15,393,000



1978] QUALIFICATIONS AND DISCLAIMERS 463

opinion also contained the following qualification: "In our opinion,

subject to collectibility of the balance receivable on the contract of

sale (see note 4 of Notes to Financial Statements) the accompanying

consolidated balance sheet and related consolidated statements of in-

come and retained earnings present fairly the financial position of
[Firestone] . . . ."

147

A cover letter, 148 written by Firestone and attached to the finan-
cial statements sent to plaintiff, attempted to explain the breakdown
of profit and deferred gross profit and offered any securities pur-

chasers the right to rescind the sale if the audited financial

statements caused a change in the decision to purchase. Plaintiff

read the cover letter but did not read defendant's opinion or notes

and decided not to exercise the right of rescission. Neither the pur-

chase nor the sale of the nursing homes were completed, and one
year later Firestone filed a petition for reorganization under the

Bankruptcy Act.

In upholding a trial court verdict for plaintiff, the Second Circuit

Court of Appeals ruled that the auditors' report was materially

misleading. The report included the purchase-resale transaction
without adequate disclosure of all material facts of the transaction,

and the financial statements had been drafted to improperly

recognize certain forms of income.149 The court ruled that the

The sales agreement also provides for liquidated damages of $185,000 if the
buyer fails to perform.

Of the total gross profit of $2,030,500, $235,000 is included in the consolidated

income statement and the balance, $1,795,500, will be considered realized

when the January 30, 1970 payment is received. The latter amount is includ-
ed in deferred income in the consolidated balance sheet.

378 F. Supp. 112, 124 (S.D.N.Y. 1974).
U7540 F.2d at 31.
U8The cover letter attached to the audited financial statement read as follows:
One transaction which is reflected in the November 30 audited financial
statements has been treated as producing deferred gross profit rather than

current gross profit. While the combination of current and deferred income is

actually higher than projected ($1,411,557 as compared with $1,360,000 pro-

jected) the shift of $1,795,500 of gross profit on this transaction from a cur-

rent basis to deferred basis by the auditors has reduced current net income

below that originally projected. . . .

Deferred income shown on the audited balance sheet has been increased to

$2,834,133 as against $1,421,000 projected. A breakdown of the components
of the deferred income account is shown in the audited financial statements. . .

.

If for any reason you find that the changes reflected in the audited financial

statements are of a nature which would have resulted in a change in your in-

vestment decision, we will arrange to promptly refund to you your subscrip-
tion payment.

Id. at 32.
u
*Id. at 35.



464 INDIANA LAW REVIEW [Vol. 11:431

auditors' qualification was defective, due to a failure to include the
true nature and circumstances of the purchase-resale transaction,

failure to explain the basis for determining the $235,000 gain, and

failure to adequately disclose the reasons for the qualification.
160 The

court also noted that plaintiffs failure to read the notes or opinion

was irrelevant because of their inadequate and deceptive
character.

151
It is clear from Herzfeld that in an action arising under

the securities laws the courts will demand a high degree of
disclosure in qualifications and will closely scrutinize the opinion in

light of surrounding transactions to determine if this standard has

been met. In addition, although the Herzfeld court referred to

A.I.C.P.A. standards on disclosure, the court judged the adequacy of

the contested disclosure on its understandability to the average

reader.
152

4. Conclusion: Securities Laws. — Some general conclusions can
be drawn regarding qualifications and disclaimers under the
securities laws. It is fairly clear that the presence of a disclaimer of

opinion in an auditor's report will render the filing defective under

the securities laws. In general, qualifications and footnote
disclosures arising from departures from GAAP are unacceptable, as
are qualifications due to scope limitations and "open ended"

qualifications due to need for additional financing. In any case,
where extensive qualifications are present there is always a chance
the SEC will treat the pervasiveness of the qualification as negating
the overall affirmative opinion or will possibly raise questions as to

the adequacy of the audit. Qualifications and footnote disclosures

should not be relied upon to rectify clearly inadequate or misleading

160The district court listed ten items which, in its opinion, should have been

disclosed in order to eliminate the misleading nature of the statements. 378 F. Supp. at

125-26. The court of appeals disagreed, ruling that the principal flaw in the financial

statements was the recordation of the purchase-resale transaction as complete during

fiscal year 1969. 540 F.2d at 37. The court also noted that the explanatory paragraph

of the auditors' opinion failed to meet minimum A.I.C.P.A. standards. The court cited
A.I.C.P.A., Statements on Auditing Procedure, AICPA Statement No. 33, at 16
(1963), reprinted in AICPA Professional Standards, supra note 3, § 509.32, as requir-
ing complete disclosure of the reasons for the qualification. The court noted that this

requirement could have been easily satisfied and suggested that the following

disclosure would have been sufficient: "Agreements for the purchase of Monterey Nur-

sing Inns, Inc. for $13,362,500 and the sale thereof to Continental Recreation, Inc. for

$15,393,000, have been executed. When, as and if these transactions are consummated,

FGL expects to realize a profit of $2,030,500." 540 F.2d at 36.
,5l540 F.2d at 37.
152
"[I]nvestors [should] be provided 'with all the facts needed to make intelligent in-

vestment decisions [which] can only be accomplished if financial statements fully and

fairly portray the actual financial condition of the company.' " Id. at 32-33 (quoting the

district court).



1978] QUALIFICATIONS AND DISCLAIMERS 465

disclosures made in the financial statements. When evaluating
qualifications and footnote disclosures, both the SEC and the courts
will consider not only whether the minimum standards of the ac-
counting profession have been met, but also whether the financial

statements as a whole are useful to the average reader. Thus,

auditors should attempt to draft clear opinions and footnotes in

order to avoid ambiguous or inconsistent statements. If any general

formulation can be made regarding the required contents of a
qualification in an auditor's report filed with the SEC, such a check

list would require the qualification to be specific and readily

understandable, presenting every reason for the qualification as ac-

curately and completely as circumstances permit.

III. Conclusion

As the foregoing materials indicate, it is possible for an auditor
to limit his liability. It should also be clear that the auditor must
walk a tightrope of adequate disclosure. He must balance the
reader's interests in fair disclosure and understandability against

his client's interests in showing results of operation and changes in

financial position in the most favorable light possible. The guiding
factor in striking this balance is the auditor's evaluation of the

ultimate impact of each problem area on the client's financial condi-

tion. This standard necessarily involves judgment calls, and errors
do occur. Additionally, the auditor should be aware that courts will

closely scrutinize attempted limitations on liability. They will
evaluate the adequacy of disclosures with the benefit of hindsight,

looking for not only technical compliance with professional stan-

dards, but also compliance with the more practical standards of
usefulness and understandability to the average reader.

Michael P. Lucas