$3.5 Million : Accounting Firm Must Pay for Slip

A small meat-processing business, assured by its accountants that all was well even as it was sinking into financial ruin, has won $3.5 million in damages in what attorneys believe is the first decision in the country holding an accounting firm liable for unaudited financial reports.

The verdict, reached this week by a Los Angeles Superior Court jury, is likely to have profound implications for the accounting industry, both because it awarded damages to the company’s cr1701079412that ordinarily are not fully audited.

“It’s a big warning to accountants that they will have to account, no pun intended, for their negligence. One slip of the pen, one failure to add up something, and you’ve got a three-, four-million-dollar problem on your hands,” said attorney Arnold Schwartz, representing creditors of the Wilcor Co., who relied on the now-bankrupt firm’s optimistic financial statements in extending merchandise.

The verdict, returned after a 10-week trial, is part of a relatively new field of law known as accounting malpractice. It is the first to be returned by a trial court after a recent California appellate court decision allowing outside parties to sue accountants when they are forced to rely on inadequate financial reports.

The decision was a “disturbing” one for the accounting industry because it appears to expose auditors to a wide range of unhappy clients--creditors, lenders, potential investors--over routine financial reports that their own clients do not necessarily expect to be foolproof, said Thomas Hozduk, attorney for the Beverly Hills accounting firm of Hollander, Harrison & Co., which lost the case.

“Particularly in today’s business climate, full-audited statements are a relatively small number of the financial statements generated. And to now extend the accountant’s liability to an unforeseen class of potential plaintiffs exposes the accountant to insolvency,” Hozduk said. “You have an unlimited class of plaintiffs.”

Wilcor, a Los Angeles firm that processes the beef sold at the Arby’s chain of fast-food restaurants, was reeling under several years of heavy losses in 1980 when things began to take a turn for the better.

A year-end auditing statement prepared by Hollander, Harrison & Co. “showed a business turning around, on its way up to expand,” Schwartz said, and a subsequent midyear report showed a continuing upward trend.

Schwartz’s clients, relying on the reports, extended large sums of unsecured credit to Wilcor. The City of Los Angeles, which was not a party to the case, approved a multimillion-dollar redevelopment loan but later backed out.

It was not until more than seven months later that serious questions began to be raised, and Hollander accountants concluded that they had woefully underestimated the extent of the company’s debts, attorneys on both sides say.

Instead of showing a $360,000 profit for the year, Wilcor was ahead by barely $40,000--not counting the $3.5 million in personal loan guarantees to which owner Michael Gibbs had committed under the rosier fiscal scenarios.

“Instead of showing a company that was rising from a loss position, the later statements showed a company that was dying,” Schwartz said.

Accountants traced the root of the problem to a $94,000 disparity between what Gibbs had initially estimated as his accounts payable and what accountants calculated during the 1980 audit--a disparity that was not investigated during the audit or a subsequent financial review and subsequently grew to larger proportions, according to both sides.

Hozduk said normal accounting procedures, which look at a company’s financial statements on a random sample basis, hold such a small disparity in a $2.4-million accounts payable ledger to be “not material.”

“The accountants were not negligent. They conducted an audit in accordance with generally accepted accounting standards, and under those, the mere existence of an error in the company’s books that is not detected by an audit does not mean that the audit was somehow substandard,” he said.

“But the public from whom a jury panel is drawn has a view of accountants as people who never fail to detect errors,” he added.

Equally disturbing, in Hozduk’s view, was the $1.3 million awarded to creditors of Wilcor.