To: File

Prepared by: Viet Hoang

Date: 9/3/2016
Reviewed by: Dr. Deis
Date:
Client: Phar-Mor, Inc.
Subject: Accounting Fraud, Litigation, and Auditor Liability
Facts
Phar-Mor, Inc. is a deep-discount retail chain run by Michael Mickey Monus. Unfortunately,
they started losing money since 1988 due to their price was too low. To keep the facts from exposing to
the publics, Phar-Mor upper management team did accounting fraud until it was revealed in 1992.
During that time, Coopers & Lybrand LLP did the audit for Phar-Mor and was unable to uncover the
fraud. Coopers was aware that Phar-Mors internal accountants never provided the auditors with
requested documents or data without first carefully reviewing them.
Issues:
1) Some of the members of Phar-Mors financial management team were former auditors for
Coopers & Lybrand. (a) Why would a company want to hire a member of its external audit
team? (b) If the client has hired former auditors, would this affect the independence of the
existing external auditors? (c) How did the Sarbanes-Oxley Act of 2002 and related rulings by
the PCAOB, SEC or AICPA affect a public companys ability to hire members of its external audit
team? (d) Is it appropriate for auditors to trust executives of a client?
2) (a) What factors in the auditor-client relationship can put the client in a more powerful
position than the auditor? (b) What measures has and/or can the profession take to reduce the
potential consequences of this power imbalance?
3) (a) Assuming you were an equity investor, would you pursue legal action against the auditor?
Assuming the answer is yes, under what law(s) would you bring suit and what would be the
basis of your claim? (b) Define negligence as it is used in legal cases involving independent
auditors. (c) What is the primary difference between negligence and fraud; between fraud and
recklessness?
4) Coopers & Lybrand was sued under both federal statutory and state common law. The judge
ruled that under Pennsylvania law the plaintiffs were not primary beneficiaries. Pennsylvania
follows the legal precedent inherent in the Ultramares Case. (a) In jurisdictions following the
Ultramares doctrine, under what conditions can auditors be held liable under common law to
third parties who are not primary beneficiaries? (b) How do jurisdictions that follow the legal
precedent inherent in the Rusch Factors case differ from jurisdictions following Ultramares?
5) Coopers was also sued under the Securities Exchange Act of 1934. The burden of proof is not
the same under the Securities Acts of 1933 and 1934. Identify the important differences and
discuss the primary objective behind the differences in the laws (1933 and 1934) as they relate
to auditor liability?
6) (a) The auditors considered Phar-Mor to be an inherently high risk client. List several factors
at Phar-Mor that would have contributed to a high inherent risk assessment. (b) Should
auditors have an equal responsibility to detect material misstatements due to errors and fraud?
(c) Which conditions, attitudes, and motivations at Phar-Mor created an environment conducive
for fraud could have been identified as red flags by the external auditors?
Discussion and Analysis:
1) (a) A company would want to hire a member of its external audit team because the former
members will know an audit process and they could provide insight for the company to hide the
fraud.
(b) By hiring former auditors, the client will impair the independence of the existing external
auditors because:
The former auditor knew the process of the external auditor
The former auditor maybe friends with the external auditor and might cause bias in the
auditing process

(c) Section 206 of the Sarbanes-Oxley Act 2002 establishes a one-year cooling off period before
a member of the audit team may accept employment in certain, designated positions with an
issuer. The act limits the ability of a public companys ability to hire members of its external
audit team
(d) ET section 1.300.001.01 states that the auditor needs to exercise due professional care
while performing professional services. Thus, they must keep professional skepticism and not
fully trust executives of a client.
2) (a) The factors in the auditor-client relationship that can put the client in a more powerful
position than the auditor:
a. The auditor wants to sell additional services to the client.
b. The client can hire, and fires the auditor at the clients discretion.
(b) To reduce the potential consequences of this power imbalance, the auditor could:
a. Dont consider the client as a constant source of new business.
b. Independent from the client. The auditor must keep professional skepticism, resist
certain demands and withstand certain pressures from the client.
3) (a) If I were an equity investor, I would pursue legal action against the auditor under Section
10(b) of the Federal Securities and Exchange Act of 1934. The basis of my claim are:
a. The auditor failed to exercise due professional care (tort)
b. The financial statements were materially misstated
c. Loss was caused by reliance on materially misstated financial statements.
(b) There are two kinds of negligence:
Ordinary negligence: Lack of reasonable care
Gross negligence: Lack of minimal care
(c) Negligence: unintentional breach of duty owed to another party due to lack of reasonable
care.
Recklessness: extreme negligence due to lack of minimal care. There is no intention to deceive
here.
Fraud: misrepresentation of face that has the intention to deceive.
4) (a) Under the Ultramares doctrine, ordinary negligence is not sufficient for liability to third
parties because of a lack of privity of contract between the third party and the auditor unless
the third party happens to be a primary beneficiary. However, liability can be established for
general third parties who are not primary beneficiaries if the third party plaintiff can establish
that the auditor demonstrated gross negligence, recklessness, or fraud during their audit.
(b) Jurisdictions that follow the Rusch Factors case or the Restatement of Torts increased the
liability that auditors face by allowing recovery of third parties who are considered foreseen
users. Generally, a foreseen user is a member of a limited class of users who the auditor is
aware will rely on the financial statements. For example, a bank with loans outstanding to a
client at the balance sheet date is a foreseen user.
5) Under the Securities Exchange Acts of 1933, the plaintiff has to prove that the audited financial
statements were consisted material misstatement which caused the plaintiff suffered a loss. If
the auditor faces an unusual burden of proof, the auditor must demonstrate as a defense. The
defenses are about the auditor had been conducted an adequate audit and the loss of plaintiff
was caused by another reason which other than the misleading financial statements.
Under Securities Exchange Acts of 1934, the plaintiff must prove the reliance on
financial statements where the financial statement consists material misstatement which
caused a loss.
The Securities Exchange Acts 1934 had exposes the auditor to more litigation risk than
the Securities Exchange Acts 1933. This change is to protect the buyers of new securities.
In this case, even though neither Phar-Mor's management, the plaintiffs' attorneys, nor
anyone else who associated with the case ever alleged the auditors knowingly participated in
the fraud, a jury had found that Cooper liable under fraud claim. The important key of this

fraud charge is the plaintiffs had been alleged that Cooper made representations which
recklessly without regard to whether they were true or false. This had enabled plaintiffs to sue
the auditors in term of fraud.
6) (a) Some of the factors that would have contributed to a high inherent risk assessment include
the following:
The accounting system was not keeping pace with the rapid expanding of Phar-Mor
stores. Phar-Mor is expanding in size continuously (15 stores in 1985 to 310 stores in
1992); however, the internal control system is not keeping up with the expansion.
The management system was in the lack of regulation but it is highly motivated to
maintain the rapid growth on the account.
The complexity of the related parties involved with Phar-Mor made detection of
improprieties and fraudulent activity difficult. During its investigation, the federal
fraud examiner identified 91 related parties. It adds the complexity to the transaction
records
(b) According to AU-C Section 200.06, the auditor has the responsibility to obtain reason
assurance about whether the financial statements as a whole are free from material
misstatement, whether due to fraud or error.
(c) The red flags at Phar-Mor identified by the external auditor is the unwillingness to allow the
shortfalls to damage Phar-Mor's appearance of success. The upper management had a great
motivation on hiding Phar-Mor's cash flow problems, attracting investors, and making the
company look profitable. In addition to the financial statement fraud, internal investigations by
the company estimated an embezzlement in excess of $10 million.

Conclusion:
1) According to ET section 1.300.001.01, the auditor needs to keep
professional skepticism and not fully trust executives of a client. Also,
section 206 of the Sarbanes-Oxley Act 2002 limits the ability of a public
companys ability to hire members of its external audit team by setting
the one-year cooling off period.
2) The auditor-client relationship will be lean toward the client if the auditor
wants to sell the additional business to the client. The auditor must keep
3)

4)

5)

6)

professional skepticism, resist certain demands and withstand certain pressures from the
client.
Under Section 10(b) of the Federal Securities and Exchange Act of 1934, an equity
investor could pursue legal action against the auditor with the basic claim that the auditor
failed o exercise due professional care and the financial loss due to materially misstated
financial statements.
Under the Ultramares doctrine, ordinary negligence is not sufficient for liability to third
parties because of a lack of privity of contract between the third party and the auditor
unless the third party happens to be a primary beneficiary. Jurisdictions that follow the
Rusch Factors case or the Restatement of Torts increased the liability that auditors face by
allowing recovery of third parties who are considered foreseen users
Under the Securities Exchange Acts of 1933, the plaintiff has to prove that the audited
financial statements were consisted material misstatement which caused the plaintiff
suffered a loss. Under Securities Exchange Acts of 1934, the plaintiff must prove the
reliance on financial statements where the financial statement consists material
misstatement which caused a loss. The Securities Exchange Acts 1934 had exposes the
auditor to more litigation risk than the Securities Exchange Acts 1933. This change is to
protect the buyers of new securities.
According to AU-C Section 200.06, the auditor has the responsibility to obtain reason
assurance about whether the financial statements as a whole are free from material
misstatement, whether due to fraud or error. The red flags at Phar-Mor identified by the

external auditor is the unwillingness to allow the shortfalls to damage Phar-Mor's

appearance of success