Can an Accountant Hired to Perform “Compilation Services” be Shielded from Liability for the Alleged Improper Activities of a Corporate Officer?

• Posted on: Apr 8 2024

By Jeffery Haber

There are four primary levels of services provided by an accountant with respect to an entity’s financial statements: preparation, compilation, review, and audit. 

A preparation engagement is a basic one. In this level of service, the accountant assists management or the business owner in preparing financial statements for internal use. 

In a compilation engagement, the accountant assists management or the business owner in the presentation of the entity’s financial statements in accordance with General Accepted Accounting Principles (“GAAP”). In this level of service, the primary function of the accountant is to review the financial statements and propose adjustments, if any are necessary to make them materially correct. The accountant is not required to obtain an understanding of the entity’s internal controls or assess the presence of fraud risks. However, if the presence of fraud comes to the accountant’s attention, then he or she is supposed to report such fraud to management or the business owner. 

In a review engagement, the accountant takes a more in-depth examination of the financial statements than in a compilation. In this level of service, the accountant provides a limited level of assurance that there are no material modifications that should be made to the financial statements. This limited assurance is obtained primarily through inquiry and procedures, which are not required in a preparation or compilation engagement. In a review, the accountant is not required to obtain an understanding of the entity’s internal controls or assess any fraud risks that may be extant at the time of the review. 

In an audit engagement, the highest level of service provided by an accountant, the objective is to obtain reasonable assurance about whether the financial statements are free of material misstatement. In this level of service, the accountant expresses an opinion on whether the financial statements are presented fairly, in all material respects, in accordance with GAAP.

In all four levels of services, the responsibility for the financial information provided, and the financial statements that are prepared, is with management or the business owner. 

In 1650 Broadway Assoc., Inc. v. Sturm, 2024 N.Y. Slip Op. 01864 (1st Dept. April 4, 2024) (here), the Appellate Division, First Department was asked to determine whether an outside auditor performing a compilation can be held liable for aiding and abetting a fraud in connection with the services provided by the accountant. As discussed below, the First Department held that when an accountant performs “unaudited services,” the accountant is not shielded “from liability because [the] accountant must perform all services in accordance with the standard of a reasonable accountant under similar circumstances, which includes reporting fraud that is or should be apparent” to the accountant.”¹ 

1650 Broadway is action for accounting malpractice and fraud, in which the “question on appeal [was] whether an accountant hired to perform ‘compilation services’ [was] shielded from liability for the alleged improper activities of an officer of the company.”²

[Eds. Note: the factual discussion below comes from the First Department decision and order.]

Plaintiff 1650 Broadway Associates, Inc. owns the Stardust Diner, a family business originally owned by Irving Sturm and plaintiff Ellen Sturm, and then in part by their son, defendant Kenneth Sturm. At all relevant times, Ellen, along with the two trust plaintiffs, owned 89% of the Diner, and Kenneth owned 11%. After Irving’s death in 2010, Kenneth assumed day-to-day managerial responsibility for the Diner. Ellen was vice-president of the Diner, while Kenneth served as secretary and treasurer.

Plaintiffs alleged that when Ellen stepped back from active operations of the Diner, Kenneth began looting the Diner. In particular, he allegedly gave himself large salary increases and began to take unauthorized loans from the Diner. Over the course of several years, these loans amounted to approximately $12 million. Plaintiffs also alleged that in 2016 and 2017, Kenneth obtained a $2.5 million line of credit from Citibank. Kenneth allegedly forged Ellen’s signature on loan documents that made Ellen the personal guarantor on the loans. The books and records of the Diner reflected the loans. They also reflected certain “reductions” in the amounts of the loans. Plaintiffs alleged that the records purporting to show the reductions were manufactured after the fact by Kenneth.

Defendant Getzel, Schiff & Pesce, LLP is a public accounting firm. For a period including 2012 through 2019, defendant performed certain accounting services for plaintiffs, the Diner, and Kenneth. It provided these services through a series of year-after-year engagement letters. Under the terms of these letters, for each of the relevant years, defendant agreed to provide “compilation services” and to prepare the local, state, and federal tax returns for the clients. Between 2002 and 2008, defendant’s managing partner had annual meetings with Ellen at her home, during which the partner provided her only a broad summary of the Diner’s finances but never disclosed any details about the Diner’s accounting, books and records.

In 2019, Ellen hired new personal accountants who uncovered the alleged loans to Kenneth. In addition to taking the money for himself, Kenneth also allegedly used the “loan” proceeds to finance various other business ventures. Plaintiffs alleged that defendant was the accountant to these other businesses.

In 2021, plaintiffs commenced the action asserting claims for fraud and breach of fiduciary duty against Kenneth. Regarding defendant, plaintiffs asserted claims for accounting malpractice and aiding and abetting fraud. Kenneth and defendant each moved to dismiss. The motion court granted Kenneth’s motion, but gave plaintiffs leave to amend. The court also granted defendant’s motion. The court held that because it was undisputed that the loans were disclosed on the financial statements, plaintiffs could not show how defendant breached professional accounting standards or aided Kenneth’s fraud. Plaintiffs appealed the grant of defendant’s motion. The First Department reversed.

The Court held that “Plaintiffs sufficiently pleaded causes of action for accounting malpractice and aiding and abetting fraud, which [were] not utterly refuted by the documentary evidence” presented with the motion.³

On appeal, defendant primarily argued “that the malpractice and fraud claims [were] refuted by the fact that the accounting firm was hired to prepare tax returns and other financial statements that documented the loans at issue”; it was not engaged to “investigat[e] and report[ ] Kenneth’s alleged fraud,” as such services “were beyond its duties.”⁴ Defendant did not contend that plaintiffs failed to plead accounting malpractice and aiding and abetting fraud by Kenneth. 

Plaintiffs countered, arguing that defendant was not “hired to discover Kenneth’s wrongdoing, but rather that information obtained by defendant during its business interactions with Kenneth and information used by defendant in order to prepare tax returns and financial statements put defendant on notice about the impropriety of Kenneth’s loans to himself such that defendant had a duty to inform plaintiffs of the questionable payments.”⁵ The Court agreed, noting that the “law is very clear that an agreement to perform unaudited services does not shield an accountant from liability because an accountant must perform all services in accordance with the standard of a reasonable accountant under similar circumstances, which includes reporting fraud that is or should be apparent.”⁶ 

In addition, plaintiffs argued that not only did defendant have knowledge of Kenneth’s alleged improper transactions but that it participated in the alleged breaches.⁷ Under New York law, noted the Court, “[o]ne who aids and abets a breach of a fiduciary duty is liable for that breach as well, even if he or she had no independent fiduciary obligation to the allegedly injured party, if the alleged aider and abettor rendered ‘substantial assistance’ to the fiduciary in the course of effecting the alleged breaches of duty.”⁸ 

Alternatively, defendant argued that the accounting malpractice and aiding and abetting claims were refuted by the fact that the allegedly improper loans were included in the tax returns and financial statements, which plaintiff Ellen had a duty to review.⁹ “However,” said the Court, “while plaintiffs’ own negligence in monitoring Kenneth’s activities in managing the Diner may have been a factor in enabling Kenneth to continue his alleged fraudulent scheme for several years, the pleadings and documentary evidence submitted do not show that such negligence was the sole proximate cause of the Diner’s loss.”¹⁰ The Court noted that it had “not been established that such negligence impeded defendant’s duties to reveal to plaintiffs what it knew about Kenneth’s alleged improper conduct regarding the loans.”¹¹ 

Accordingly, the Court reversed the motion court’s order which granted defendant’s motion.

Jeffrey M. Haber is a partner and co-founder of Freiberger Haber LLP. 

This article is for informational purposes and is not intended to be and should not be taken as legal advice.

References

1. Slip Op. at *3.
2. Id. at *1.
3. Id.
4. Id.
5. Id. at *2-*3.
6. Id. at *3 (citing 1136 Tenants’ Corp. v. Rothenberg & Co., 36 A.D.2d 804 (1st Dept. 1971), aff’d, 30 N.Y.2d 585 (1972); William Iselin & Co., Inc. v. Mann Judd Landau, 71 N.Y.2d 420, 424-425 (1988); United States v. Natelli, 527 F2d 311, 320-321 (2d Cir. 1975), cert. denied, 425 U.S. 934 (1976); Blakely v. Lisac, 357 F. Supp. 255, 265-266 (D. Or. 1972); Robert Wooler Co. v. Fidelity Bank, 330 Pa. Super. 523, 531-535, 479 A.2d 1027, 1031-1033 (1984)).
7. Id.
8. Id. (citing Caprer v. Nussbaum, 36 A.D.3d 176, 193 (2d Dept. 2006); Operative Cake Corp. v. Nassour, 21 A.D.3d 1020 (2d Dept. 2005)).
9. Id.
10. Id.
11. Id. (citing Collins v. Esserman & Pelter, 256 A.D.2d 754, 757 (3d Dept. 1998); National Sur. Corp. v. Lybrand, 256 App. Div. 226, 235-236 (1st Dept. 1939)).