Union Bank Wins $5 Million in Suit Against Auditor

An Orange County Superior Court jury Thursday ordered the accounting firm of Arthur Young & Co. to pay $5 million to Union Bank of San Francisco for negligence in preparing financial statements on a small Los Angeles company.

Bank officials testified at the Santa Ana trial that they depended on the accountants’ financial statements when loaning about $10 million to Small World Greetings, a gift company that later went bankrupt. The bank was seeking to recover $6.7 million it said it was still owed.

A lawyer for Arthur Young said the jury, which deliberated for five days, also faulted the bank for what he called “its own ineptness” in making the loans. The accounting firm said it would appeal.

The suit was watched closely by both the banking and accounting industries. With massive insolvencies in the thrift and banking industries, several major suits recently have been brought against accounting firms for failing to detect and report financial troubles of shaky institutions.

In its lawsuit, Union Bank accused accountants in the Orange County and Pasadena offices of Arthur Young of negligence in preparing the financial statements.

(The firm is now called Ernst & Young after a 1989 merger with another big national firm, Ernst & Whinney.)

Based on the financial statements, Union Bank said it lent $5 million to Small World Greetings in May, 1985, and another $5 million within the next year. The company filed for bankruptcy in October, 1987. Arthur Young audited the company in 1983, 1984 and 1985.

During the seven-week trial, Union Bank accused the accountants of overestimating the value of Small World’s inventory, one of the biggest items on its balance sheet. It also said the auditor’s opinion at the end of the statement should have been a “limited” opinion, which indicates doubt about some of the figures in the statement, rather than the “unqualified” opinion Arthur Young appended. And a lawyer for the bank said the auditors--some of whom still work for Arthur Young--”got too close” to and “too involved” with the company.

The financial statements, in short, “didn’t suggest a business going under in any way, shape or form,” said Bruce L. Simon, a Burlingame, Calif., lawyer who represented the bank.

But Arthur Young’s lawyer said it was the bank’s own sloppy lending practices, not the accounting firm, that was to blame.

“Our defense was twofold,” said Gene Erbstoesser, a lawyer for the accounting firm. “We did good work, and we stand behind it. This bank screwed up. The jury agreed with the second statement, but unfortunately they didn’t totally agree with the first.”

It’s not uncommon for a small company with a seasonal business to go under quickly, Erbstoesser said. Small World made pencil cases and other back-to-school products such as stationery. When it went under in 1987, it was having its best sales year at $27 million. As for the overstated inventory, the accountants can only rely on the information the client gives them, Erbstoesser said.

Arthur Young is also being sued by people who bought worthless bonds from Lincoln Savings & Loan in Irvine, who say they were misled by inaccurate information prepared by the accounting firm.

And the accounting firm is being sued in Texas by the federal government for $560 million in the wake of the $1-billion collapse of Western Savings Assn. in Dallas, the largest such suit ever filed by the government against an auditor. The Federal Deposit Insurance Corp. says the accounting firm should have recognized numerous irregularities in Western’s books.