Court confirms the primacy of GAAP and GAAS.

Legal Scene

Court Rules on Importance of GAAP and GAAS

In National Medical Transportation Network v. Deloitte & Touche , the California Court of Appeals, Fourth Appellate District, held that judges must instruct juries that professional standards promulgated by the AICPA authorize auditors to withdraw from engagementsregardless of prejudice to the clientsbased on a showing of good cause. The plaintiff in this case, Medtrans, was an ambulance service provider that retained Deloitte & Touche to audit its annual financial statements. In 1992, Medtrans was highly leveraged and in need of a capital infusion. It sought to convince an outside investor to provide $10 million in financing. Medtrans gave the investor unaudited financial statements showing profits of $1.9 million during fiscal year 1992.

The CPA firm, whose audit was proceeding during these investor negotiations, proposed adjustments to Medtrans financial statements showing Medtrans actually had lost $500,000. Even before the firm suggested these adjustments, Medtrans CFO had resigned, after indicating he could not sign a management letter attesting to the accuracy of the companys financial statements because he did not think they were fairly presented.

The firm discussed options for resolving the proposed adjustments, but Medtrans rejected them all. At one point, Medtrans CEOa 50% shareholderallegedly told the audit supervisor that you better not propose any adjustment that will queer my deal or you will be sorry. Subsequently, when the firm continued to press for adjustments, the CEO allegedly stated, You are finished. Based on this statement, the firm advised the client that it would have to resign from the engagement. At this point, the CEO allegedly said, You are going to finish this regardless, under court order or otherwise.

The firm then promptly withdrew from the engagement. Thereafter, Medtrans retained two other CPA firms, both of which either were discharged or withdrew from the engagement. Ultimately, a third successor auditor issued an unqualified report, which contained the adjustments Deloitte & Touche had proposed.

Medtrans alleged that as a result of Deloitte & Touches wrongful withdrawal from the engagement, the investor failed to complete a letter of intent to lend the company the $10 million. According to Medtrans, because it had lost the loan, it was sold several months later for approximately $10 million less than its true value.

At trial, the evidence as to whether the firm had had good cause to withdraw from the engagement was disputed. Medtrans asserted, under established California law and court-approved jury instructions concerning the duration of a professionals responsibility, that a CPA could not, under any circumstances, withdraw from an engagement if it unduly jeopardized the interest of a client. The firm contended that the approved California jury instruction on the duration of a professionals duty is contrary to professional standards, which authorize an auditor to resign regardless of the effect on the clients interest or whether the client retains a successor auditor. Medtrans arguments prevailed, however, and the jury awarded the company nearly $10 million.

Later, the Court of Appeals reversed the decision, holding that judges should instruct juries about AICPA standards, which authorize withdrawal from an audit engagement based on good cause. The court held that an auditor, by certifying public reports that depict a corporations financial status, assumes a public responsibility transcending any employment relationship with the client. The firm offered expert testimony showing that an auditor may properly resign when so permitted or required by professional standards regardless of whether such resignation jeopardizes the clients interest. Finally, the court held that an auditor is not required to continue an engagement until a successor auditor is retained because professional standards require simply that an auditor respond promptly and fully to a successor auditors reasonable inquiries.

The courts decision in Medtrans is significant because it held that an accountants duty of care to a client can, as a matter of law, be based on professional standards rather than on rules of the law that are contrary to rules promulgated by the AICPA. It also upheld the auditors right to withdraw from an engagement when the client requests conduct that is not in keeping with GAAP or GAAS. ( National Medical Transportation Network v. Deloitte & Touche , 98 D.A.R. 2850, March 23, 1998.)

Editors note: Thanks to Paul D. Fife of the San Francisco firm of Wild Carey & Fife for this case.

Edited by Wayne Baliga, CPA, JD, CPCU, CFE, president of Aon Technical Insurance Services.