Question-1-Common-law-constructive-fraud-negligence

4-20. (Common law—constructive fraud, negligence) Astor Inc. purchased the assets of Bell Corp. A condition of the purchase agreement required Bell to retain a CPA to audit Bell’s financial statements. The purpose of the audit was to determine whether the unaudited financial statements furnished to Astor fairly presented Bell’s financial position. Bell retained Winston & Co., CPAs, to perform the audit.

While performing the audit, Winston discovered that Bell’s bookkeeper had embezzled $500. Winston had some evidence of other embezzlements by the bookkeeper. However, Winston decided that the $500 was immaterial and that the other suspected embezzlements did not require further investigation. Winston did not discuss the matter with Bell’s management. Unknown to Winston, the bookkeeper had, in fact, embezzled large sums of cash from Bell. In addition, the accounts receivable were significantly overstated. Winston did not detect the overstatement because of Winston’s inadvertent failure to follow its audit program.

Despite the foregoing, Winston issued an unqualified opinion on Bell’s financial statements and furnished a copy of the audited financial statements to Astor. Unknown to Winston, Astor required financing to purchase Bell’s assets and furnished a copy of Bell’s audited financial statements to City Bank to obtain approval of the loan. Based on Bell’s audited financial statements, City loaned Astor $600,000.

Astor paid Bell $750,000 to purchase Bell’s assets. Within six months, Astor began experiencing financial difficulties resulting from the undiscovered embezzlements and overstated accounts receivable. Astor later defaulted on the City loan.

City has commenced a lawsuit against Winston based on the following causes of action:

  • Constructive fraud
  • Negligence

Required

In separate paragraphs, discuss whether City is likely to prevail on the causes of action it has raised, setting forth reasons for each conclusion.

AICPA