Many transactions require parties to provide financial statements for review. This can include businesses seeking loans or investors, cooperative or condominium sponsors, companies who owe performance royalties and other parties. However, all financial statements are not created equal. One primary difference is the level of review and verification of the underlying financial data undertaken by the Certified Public Accountant (CPA) who prepares the statements. Regardless of which side of the transaction you’re on, it’s critical to understand what type of review was conducted so you know how much you can rely on the accuracy of the financial statement.

There are three categories of review: audit, review, and compilation. An audited financial statement provides the highest level of CPA review. The CPA extensively reviews the reported transactions, including verifying transactions and obtaining third-party confirmations. The purpose of an audited financial statement is to offer a reasonable assurance that the financial statement is free of material misstatement and presents a true and fair view of the company’s finances in accordance with the applicable financial reporting framework.

In a reviewed financial statement, the CPA conducts a moderate level of investigation that involves less transaction verification or review of internal company procedures as compared to audited statements. This type of statement is intended to report whether anything has come to the CPA’s attention that would suggest the financial statement is not in conformity with the applicable reporting framework.

The lowest level of review applies to a compiled financial statement. As its name suggests, a CPA merely accepts, organizes and reports the information provided by a company. It does nothing to review the accuracy of the information and contains express disclaimers to that effect.  

While these categories seem clear, a recent decision of the New York Appellate Division First Department highlights exactly how important it is to know what information a provided financial statement includes. The case, 1650 Broadway Assocs, Inc. v. Sturm, involved an accounting malpractice and fraud claim resulting from the succession plan of the Stardust Diner. When the son of the original owners took over the day-to-day operations after his father’s death, the son engaged in significant financial misconduct, including increasing his salary, taking unauthorized loans and forging his mother’s signature on personal guarantees of the unauthorized loans.

The defendant tax firm was retained by the plaintiff to provide “compilation services” and prepare tax returns. Subsequently, other accountants identified the misconduct, and the plaintiff sued the defendant for malpractice and aiding and abetting fraud.

The trial court held that because the loans were disclosed on the financial statements, the plaintiff could not show that the defendant breached professional accounting standards and aided a fraud. The Appellate Division reversed the trial court’s dismissal, finding that the fraud should have been readily apparent to the defendant based upon information available to it. While the defendant was only hired to provide “unaudited services,” it still “must perform all services in accordance with the standard of a reasonable accountant under similar circumstances.”

In addition to finding the accountant may have liability to the plaintiff, there is another important takeaway from the case for any party relying on financial statements. The record shows how differently the CPA understood its obligations in preparing an unaudited financial statement than what the court held in its decision. 

Accordingly, if you need a compiled financial statement or received one, you should clarify whether the CPA had evidence of fraud in its possession that was not included in the statement. This can provide you with an extra level of protection. If you are a CPA, you should take care that you meet your legal obligations as indicated by the appellate court to avoid potential liability.

If you need assistance with a transaction, contact one of our attorneys to learn how we can help you with your matter.