Ernst & Young pays pounds 1.35m to Tunstall

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ERNST & YOUNG, the accountancy firm, has paid pounds 1.35m in an out-of-court settlement after it was sued over its auditing of Sound Diffusion, the television rental group which collapsed in December 1988.

Tunstall Group, the electronics company which built up a 4.9 per cent stake in Sound Diffusion, has agreed to drop its claim against Arthur Young, which has since merged with Ernst & Whinney, in exchange for a payment of pounds 750,000 and costs of pounds 600,000.

The claim was based on Arthur Young's audit of Sound Diffusion's 1987 accounts and its backing of a rights issue by Sound Diffusion in May 1988. Tunstall had been claiming pounds 1.9m, made up of losses of pounds 500,000 paid when it took up its rights in shares and pounds 1.4m lost when it bought shares in the open market after the rights issue had been announced.

The fact that Arthur Young has settled for more than pounds 500,000 implies that it accepts liability for investors who were not shareholders when it conducted its audit. This may go against the 1990 House of Lords ruling on Caparo Industries v Dickman which says that auditors have a duty of care only when it is known in advance or forseeable that the claimant would rely on the audit.

A Department of Trade and Industry inquiry into the collapse of Sound Diffusion, published last year, severely criticised the auditing by Arthur Young and its predecessor as auditors, Ernst & Whinney. The main problem area was accounting for leases written by Sound Diffusion on televisions. The company credited itself with an inflated profit for the leases.

The inquiry concluded that 'Arthur Young either failed to identify or otherwise accepted serious defects in the company's lease accounting practices' and that 'Ernst & Whinney either failed to identify or otherwhise accepted serious defects in the company's accounting practices.'

In addition the DTI inspectors said that 'it is apparent that the rights issue was necessary for the company's survival, but this was not made clear to shareholders.'

Tunstall decided not to take legal action against Ernst & Whinney because of the Caparo ruling, because Tunstall did not hold shares in Sound Diffusion when Ernst & Whinney was auditor.