Auditor negligence liability to third parties revisited

Journal of Legal, Ethical and Regulatory Issues, Jan, 2007 by J. Keaton Grubbs, Jack R. Ethridge, Jr.

ABSTRACT

The Enron disaster prompted the Sarbanes-Oxley Act of 2002 with new auditor independence rules, creation of the Public Company Accounting Oversight Board, corporate governance and certification requirements, whistleblower protections, extended statutes of limitations, and more severe penalties. Although some provisions affect privately traded companies, the Act was primarily aimed at publicly traded companies. In any event, Sarbanes-Oxley did not create a private cause of action against auditors for malpractice. Securities laws that govern fraud carry a heavy scienter burden, and the negligence and strict liability provisions in these laws are limited to specific parties and functions within the purview of the respective Acts. Common law fraud also includes the intentional or reckless disregard burden. The bread and butter of aggrieved investors, lenders, and creditors for claims against accountants performing auditing activities remain the common law negligence and negligent misrepresentation torts. The law on these torts is not monolithic among the states, and because the variance in approaches is dramatic, accountants, lawyers, and academics must constantly revisit auditor liability to nonclients to stay abreast of developments. This article reintroduces the subject in the post-Enron era, reviews key attributes of auditing functions-reports-standards, discusses the historical paradigm of liability, explores recent cases, and offers policy implications for this fact-driven, unsettled area.

INTRODUCTION

The accounting profession has been bombarded with litigation primarily due to corporate failures. The recent collapse of Enron is no exception. Due to this major debacle the accounting profession has once again come under severe attack. The common thread between Enron and other corporate failures is the questionable performance of the companies' accountants (Gomez 2003). According to Impastato, because of audit failures accountants are to blame for investors losing billions of dollars in earnings in addition to market capitalization (2003). These losses usually come as a result of reliance upon misleading or erroneous financial statements (Impastato 2003). Once these companies become insolvent they no longer have the source of revenue to repay upset investors and creditors. These investors and creditors often view accountants as having "deep pockets." Consequently, accountants are sought after in an attempt to recoup their (investors and creditors) losses (Allegaert and Tinkelman 2000).

Although financial statements are assertions made by management and are primarily the responsibility of management, it is the accountant's duty to provide assurance of these assertions for the users of the information (Shore 2000). As the liability of auditors to third parties increases, auditors will be forced to more carefully perform their work and look for additional means of reducing their liability. However, if accountants are not held to a high standard, their incentives to carry out their job will be reduced (Allegaert and Tinkelman 2000). If someone is not held accountable for these erroneous financial statements, investors will be hesitant to invest in the American economy (Gomez 2003).

ACCOUNTING FUNCTIONS AND PRINCIPLES

The Auditing Function

For a better grasp of the accountants' duties, the auditing function must first be understood (Gomez 2003). The audit committee is in charge of hiring an independent auditor. With the oversight of the audit committee, management's responsibility is the preparation of the financial statements. Traditionally the audit function was not in place as a guard against accounting fraud within a company. The assumption that management is dishonest is both impractical and costly (Gomez 2003). The overall goal of the auditing function is to provide assurance to the users of financial statements of the accuracy of the assertions made by management and to ensure the statements comply with Generally Accepted Accounting Principles (GAAP) (Shore 2000).

An audit is a systematic, objective examination of a company's financial statements and results in an opinion expressed by the auditor. Although the company retains the auditor to evaluate the assertions made by management, the auditor is aware his opinion is relied upon by persons outside the company. While the audit function informs management of internal accounting irregularities, the main beneficiaries of the audit are third parties. Individuals rely upon the assurances provided by the auditors to make economic decisions (Gomez 2003). "This validation [by the auditor] is meant to make the financial information reliable; therein lies the value of auditing" (Impastato 2003).

An important first step in the audit process is for the auditor to gain basic knowledge and understanding of the client's business. This understanding aids the auditor in conducting the audit efficiently and in assessing the "audit risk" of the client (Buffington 1997). Audit risk is defined as "the risk that the auditor may unknowingly fail to appropriately modify his opinion on financial statements that are materially misstated" (Shore 2000) or the risk that management's financial statements have been materially misstated (Buffington 1997).