In the mid-1990s, KPMG Peat Marwick audited a small, Dallas-based drugstore chain, Texas Drug Warehouse (TDW). Before beginning the company’s 1995 audit, KPMG “made a business decision to reduce the number of hours it would expend on the TDW audit and to use less experienced personnel to perform the audit.” KPMG did not inform the client’s executives of that decision. Following the 1996 audit, KPMG told TDW management that it would be increasing the engagement audit fee the next year. This decision caused TDW to dismiss KPMG and retain a smaller accounting firm, King Griffin & Adamson, to serve as its independent auditor.

The King Griffin audit team discovered material errors in TDW’s accounting records shortly after beginning the 1997 audit. The auditors could not reconcile the general ledger balances for accounts payable and cash to the company’s subsidiary ledgers and other supporting documentation for those accounts. Further investigation revealed that the errors had existed in the company’s accounting records since 1995. After being informed of these errors, KPMG issued a letter to parties known to be relying on TDW’s 1995 and 1996 financial statements - which had been accompanied by unqualified audit opinions. The letter indicated that those financial statements were “materially misstated and should no longer be relied upon.”

In 1999, TDW sued KPMG, alleging that the accounting firm had been negligent in its 1995 and 1996 audits. During the discovery phase of that lawsuit, TDW’s attorneys learned that prior to the 1995 audit, KPMG had reduced the budgeted hours for the engagement and assigned less experienced auditors to the engagement team. That discovery prompted TDW’s attorneys to amend the lawsuit and charge that KPMG had also engaged in “deceptive business practices” by failing to notify TDW manage-ment of its decision to reduce the “quality of its services.”

Before civil cases proceed to trial, defendants often file a motion asking the presiding judge to dismiss the complaint or complaints filed against them. If such a motion is approved, the judge issues a “summary judgment” in favor of the defendant. To the surprise of TDW’s management, the state judge presiding over the TDW-KPMG case approved KPMG’s request for summary judgment. TDW immediately appealed that decision to the Texas Court of Appeals. The appellate court issued its opinion on that appeal in late 2001.

Much of the appellate court’s review of the lower court’s decision focused on two key issues. The first issue involved a controversial ruling made by the lower court judge regarding the engagement letters signed by TDW’s president and chief financial officer (CFO) prior to the 1995 and 1996 audits. The second issue addressed the question of whether audit firms must disclose to client management major changes they plan to make in the nature and scope of their audits.

Before beginning each TDW audit, KPMG obtained a standard engagement letter from the company’s president and CFO. Those executives stated in the letter that, “to the best of our knowledge and belief, there are no material transactions that have not been properly recorded in the accounting records underlying the financial statements.” In the lower court, KPMG’s attorneys had argued that the errors in TDW’s 1995 and 1996 accounting records demonstrated that the assertion was false. KPMG’s attorneys then maintained that this false statement in the engagement letter released KPMG from any liability for failing to discover the material errors in the 1995 and 1996 financial statements. The lower court judge agreed with this argument despite the fact that KPMG’s attorneys never suggested that TDW’s president and CFO had been aware of the material errors in the company’s accounting records when they signed each engagement letter.

The appellate court overturned the lower court judge’s decision, reinstated TDW’s negligence complaint against KPMG, and remanded the case to the lower court for further legal proceedings. The appellate judges pointed out that the caveat “to the best of our knowledge and belief” in the engagement letter meant that TDW’s president and CFO were not responsible for informing KPMG of unknown errors in their company’s accounting records. Later in the legal opinion, the appellate court scolded KPMG’s attorneys for the weak reasoning they had used in their effort to mitigate the accounting firm’s legal liability.

It appears KPMG’s argument is that TDW should have known its financial records did not fairly represent the true condition of the company before it hired KPMG to give the expert opinion on that very issue. In reality, however, corporations and auditors alike are aware that a corporation’s financial statements may be at risk of misstatement for several reasons and the very reason a corporation may hire an independent auditor is to get an expert opinion on its own financial statements.

A novel feature of TDW’s lawsuit against KPMG was the allegation that the accounting firm had engaged in deceptive business practices. TDW’s executives argued that KPMG should have alerted them to the planned changes in the scope and nature of the 1995 audit. The company’s CEO also suggested that a more appropriate audit plan “presumably would have discovered the errors in the financial statements.”

The lower court judge dismissed TDW’s deceptive trade practices complaint against KPMG because the relevant state statute exempted “claims based upon rendering of a professional service, the essence of which is providing of advice, judgment, opinion or similar professional skill.” In its appeal, TDW noted that there was a key exception to this latter clause in the Texas law. This exception allows plaintiffs to sue professional service providers if they intentionally fail to disclose information regarding the nature of their service to induce a potential client to purchase those services.

After studying the deceptive trade practices allegation, the appellate court upheld the lower court’s decision to dismiss that complaint. The appellate court pointed out that KPMG personnel never discussed the nature and scope of their audits with TDW because those were matters of “professional judgment” that the accounting firm was entitled to resolve on its own without consulting or informing the client. As a result, TDW could not reasonably argue that KPMG had improperly withheld information regarding the nature of its audit services. The appellate court indicated, however, that if KPMG had failed to budget sufficient hours or assign sufficiently experienced auditors to the TDW engagements, the company could have sued the firm for professional malpractice.

1. What factors or circumstances may have caused KPMG to reduce the number of budgeted hours for the 1995 TDW audit and to assign less experienced personnel to that engagement? For each factor or circumstance, you identified, indicate whether you believe it is a valid reason for the given decision.

Answer rating: 100% (QA)

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