Reference no: EM131624695

Question: Common Law Liability Exposure. An accounting firm was engaged to examine the financial statements of Martin Manufacturing Corporation for the year ending December 31. Martin needed cash to continue its operations and agreed to sell its common stock investment in a subsidiary through a private placement. The buyers insisted that the proceeds be placed in escrow because of the possibility of a major contingent tax liability that could result from a pending government claim against Martin's subsidiary. The payment in escrow was completed in late November. Martin's president told the audit partner that the proceeds from the sale of the subsidiary's common stock, held in escrow, should be shown on the balance sheet as an unrestricted current account receivable. The president held the opinion that the government's claim was groundless and that Martin needed an "uncluttered" balance sheet and a "clean" auditors' opinion to obtain additional working capital from lenders. The audit partner agreed with the president and issued an unmodified opinion on Martin's financial statements, which did not refer to the contingent liability and did not properly describe the escrow arrangement. The government's claim proved to be valid and, pursuant to the agreement with the buyers, the purchase price of the subsidiary was reduced by $450,000. This adverse development forced Martin into bankruptcy. The accounting firm is being sued for deceit (fraud) by several of Martin's unpaid creditors who extended credit in reliance on the accounting firm's unmodified opinion on Martin's financial statements.

Required: a. What deceit (fraud) do you believe the creditors are claiming?

b. Is the lack of privity between the accounting firm and the creditors important in this case?

c. Do you believe the accounting firm is liable to the creditors? Explain.