Question

In order to expand its operations, Gibson Corp. raised $5 million in a public offering of common stock, and also negotiated a $2 million loan from Citizens National Bank. In connection with this financing, Gibson engaged Horton & Co., CPAs, to audit Gibson’s financial statements. Horton knew that the sole purpose of the audit was so that Gibson would have audited financial statements to provide to Citizens National Bank and the purchasers of the common stock. Although Horton conducted the audit in conformity with its audit program, Horton failed to detect material acts of embezzlement committed by Gibson Corp.’s president. Horton did not detect the embezzlement because of its inadvertent failure to exercise due care in designing the audit program for this engagement.

After completing the engagement, Horton issued an unqualified opinion on Barton’s financial statements. The financial statements were relied upon by the purchasers of the common stock in deciding to purchase the shares. In addition, Citizens National Bank approved the loan to Gibson based on the audited financial statements. Within 60 days after the sale of the common stock and the issuance of the loan, Gibson was involuntarily petitioned into bankruptcy. Because of the president’s embezzlement, Gibson became insolvent and defaulted on the loan from the bank. Its common stock became virtually worthless. Actions have been brought against Horton by

• the purchasers of the common stock, who have asserted that Horton is liable for damages under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934.

• Citizens National Bank, based upon Horton’s negligence.

• trade creditors who extended credit to Gibson based upon Horton’s negligence.

Required

1. Discuss whether you believe Horton will be found liable to the purchasers of common stock.

2. Indicate whether you believe Citizens National Bank will be successful in its claim against Horton.

3. Indicate whether you believe the trade creditors will be successful in their claim against Horton

Answer 1

Part A

In case the suit is brought under Rule 10b-5 of the Securities Exchange Act of 1934, then Horton will not be found liable to the purchasers of common stock as he unaware about it or carry no intent to deceive by the auditor. In case the purchasers are original purchasers, then it becomes their obligation to bring suit under the Securities Act of 1933. The success is likely to be in favor of plaintiffs as the existence of material error or omission can be easily prove by them.

Part B

Horton knew that the use of financial statements was to done to get finance from Citizens National Bank. So, he is supposed to be responsible for negligence to the bank. Banks is considered as third party and it relies heavily on the financial statements.

Part C

Horton did not know that the use of financial statements was to done by the creditors and thus he will not be liable to the trade creditors. They cannot claim gross negligence on the part of Horton.