Lara Khoury, a lecturer at the Faculty of Law, McGill University, observed that “…the accounting profession has evolved greatly. Modern accountants, once only bookkeepers, have gradually been attributed a large range of responsibilities. They now not only prepare, investigate, and audit accounts, but also perform important advisory, reporting, investigatory, regulatory, and administrative functions. This new diversity in their functions exposes them to a greater risk of liability towards a larger range of people”.1 So, if the financial statements2 are inaccurate will the accountant who prepared them be liable to the lender who relied upon them? This was the issue raised in Canadian Commercial Bank v. Crawford, Smith & Swallow.3[CCB v. CSS]
Professionals, including accountants, will be held liable to their client for not exercising a reasonable degree of care and skill in carrying out their duties.4 Accountants are hired to audit financial statements for their clients – not their client’s lenders or third parties who may be provided with the financial statements. Arguably, the law should hesitate before invoking a duty of care on the part of accountants vis-à-vis third parties. Conversely, it would be naïve in the extreme to ignore the fact that accountants/auditors know that the financial statements audited by them will likely be relied upon by financial institutions when considering whether to extend financing.5 What Ontario’s Divisional Court considered in CCB v. CSS was under what circumstances accountants owe a duty of care to third party lenders. Without the accountant owing a duty of care to the third party lender the accountant cannot be held liable for damages incurred by the lender notwithstanding that the lender relied upon the financial statement to make the loan.
In this case CSS were the accountants for Hodgson’s Steel & Iron Works Limited (“Hodgson’s Steel”). For certain years CSS only reviewed and did not audit the financial statements. For other years the statements were audited. In their correspondence to Hodgson the accountants acknowledged that the financial statements were prepared for both the company and their bankers the Royal Bank of Canada. At one point, CCB assumed the Royal Bank’s position as Hodgson’s lender. CSS was unaware that CCB was considering taking over as the lender or that CCB was relying on the financial statements that had been reviewed or audited by the accountants.
The audited financial statements for the years ended May 31, 1979 through May 31, 1981 showed Hodgson’s Steel to be a profitable company. However, there were mistakes in the financial statements and CCB lost money on its loan to Hodgson. CCB blamed the accountants. They argued that they would not have taken over the loans if the financial statements accurately showed Hodgson’s financial situation. CCB argued that the accountants knew or ought to have known that those financial statements would be relied upon by third party lenders and should be held liable for negligence in auditing the financial statements. The court had to decide whether CSS had a duty of care to an unknown bank who would eventually become its client’s lender.
The court considered there to be two classes of lenders in this case. The Royal Bank was the lending bank and CCB the takeover bank. The accountants admitted that the lending bank who they knew received and relied on the financial statements had status to sue. But what about the takeover bank? The court held:
…. It is not just and equitable to expose the auditors to damages calculated on a different basis than that to which they had knowledge might be their responsibility. This is especially true because the damage suffered by the takeover bank will almost invariably be far greater than that portion of the damages suffered by the lending bank for which the auditors might be responsible. To define it in the terms of Mr. Justice Dickson in Haig v. Bamford the nature of the transaction was not known to the accountants. Not only was it of a different nature but that different nature would result in a different and more severe method of calculating the damages for which the accountants could be found liable.
The court then went on to point out that in order to establish the existence of a duty of care owed to the plaintiff by a defendant who is alleged to have made a negligent misstatement, three requirements must be satisfied: (i) it must be reasonably foreseeable by the defendant that the statement will be relied on by the plaintiff, (ii) there must exist the relevant degree of proximity between the parties, and (iii) it must be just and reasonable in all the circumstances to impose a duty of care on the part of the defendant to the plaintiff. In conclusion the court dismissed the law suit because it would be unfair to extend the duty of care when the amount or scale of the proposed loan was not known to the accountant. Moreover, it was unfair to extend the duty of care when in this instance CCB could not have known the method by which potential damages was to be calculated.
A note of caution for those readers unfamiliar with how the accounting profession works. Ordinarily, only smaller companies would rely on their accounting firms to both prepare and review or audit their financial statements. Rather, the preparation of the financial statements is generally the responsibility of management. Furthermore, most private companies don’t generally even have their statements audited.6
For both the accountant and the lender the key point to take away from this decision, which was upheld at the court of appeal,7 is that accountants can be held liable to third party lenders when the accountants know that the third party lenders are relying on those statements. However, when accountants are unaware that the financial statements they prepare will be considered by a lender there is no duty of care. In the case referred to, the initial lender who the accountant knew was reviewing the statements was owed a duty of care, but the takeover lender who had nothing to do with the accountant was not owed a comparable duty by the accountant.
- THE LIABILITY OF AUDITORS BEYOND THEIR CLIENTS: A COMPARATIVE STUDY. McGill Law Journal200146 McGill L.J. 413 Lara Khoury ↩
- As defined by Investopedia, “Financial statements for businesses usually include income statements, balance sheets, statements of retained earnings and cash flows. It is standard practice for businesses to present financial statements that adhere to generally accepted accounting principles (GAAP) to maintain continuity of information and presentation across international borders. Financial statements are often audited by government agencies, accountants, firms, etc. to ensure accuracy and for tax, financing or investing purposes.” This site can be found on line at Financial Statements http://www.investopedia.com/terms/f/financial-statements.asp#ixzz4da1p7DH4 ↩
- Canadian Commercial Bank v. Crawford, Smith & Swallow (1993), 15 C.C.L.T. (2d) 273, 9 B.L.R. (2d) 311, 1993 CarswellOnt 177 (Ont. Gen. Div. (Commercial List)); ↩
- Hodgkinson v. Simms 1994 CarswellBC 1245, 1994 CarswellBC 438, (1994) 3 S.C.R. 377, (1994) 9 W.W.R. 609, (1994) B.C.W.L.D. 2658, (1994) S.C.J. No. 84, 117 D.L.R. (4th) 161, 16 B.L.R. (2d) 1, 171 N.R. 245, 22 C.C.L.T. (2d) 1, 49 B.C.A.C. 1, 50 A.C.W.S. (3d) 469, 57 C.P.R. (3d) 1, 5 E.T.R. (2d) 1, 6 C.C.L.S. 1, 80 W.A.C. 1, 95 D.T.C. 5135, 97 B.C.L.R. (2d) 1, J.E. 94-1560, EYB 1994-67089 Supreme Court of Canada ↩
- We refer the reader to the decision of Haig v. Bamford, (1977) 1 S.C.R. 466 and in particular Dickson J. comments at pp. 475-77 and pp. 482-83; ↩
- A special thanks to Laurence W. Zeifman of Zeifmans who reviewed a draft of the blog and pointed out that this reminder may be helpful. ↩
- Canadian Commercial Bank v. Crawford, Smith & Swallow 1994 CarswellOnt 930, (1994) O.J. No. 632, 21 C.C.L.T. (2d) 89, 46 A.C.W.S. (3d) 978. Leave to appeal to the Supreme Court of Canada was refused. ↩