While this idea may sound appropriate at first glance, there are many
problems with such a strict standard of auditor liability. First, it
ignores that companies can go bankrupt for a variety of reasons, most
of which are not under the purview of the auditor. Business
conditions can change very rapidly, and especially if poor management
decisions are made, a previously unforeseen crisis can rapidly arise.
In these cases, which account for a sizable percentage of
bankruptcies, it would be inappropriate to hold the auditor liable for
investors' losses because the auditor was not responsible and could
not have detected the cause of the bankruptcy through its audit.
Such a strict standard of liability also creates a moral hazard as
well. If accounting firms are liable for bankruptcies under any
circumstances, investors have less interest in performing their own
research because the accounting firms are effectively ensuring their
investments. This could lead to more reckless investment, resulting
in less efficient allocation of capital in the economy as a whole.
Riskier appearing investments, which most investors should properly
shun, suddenly become less risky despite the business's prospects
being unchanged if auditors are forced to reimburse investors for
their losses in a bankruptcy under any circumstances.
Another point against this approach is that it fails to recognize that
even in the case where fraud has caused a bankruptcy, an auditor need
not be negligent for such a fraud to have gone undiscovered during a
previous audit. Auditors conduct tests using sampling techniques to
evaluate whether or not a company has adequate internal controls to
generate reasonably accurate financial reports as a whole. Various
organizations, including the AICPA, the SEC, and the PCAOB produce
standards that an auditor must follow to conduct a competent audit.
However, company insiders still possess the ability to perpetrate
frauds that a competent audit will not uncover. For this reason,
Sarbanes-Oxley requires company managers to sign off on the financial
statements so that they will be easier to prosecute in the event they
are engaged in fraud. The law recognizes that deterrence is needed
because audits can be insufficient to detect fraud even when the audit
is performed properly.
Another concern about strict liability of this type is its effect on
accounting firms. Such liability requires the firm to either purchase
insurance, which would be much more expensive and perhaps not even
available, or risk being put out of business much more easily than is
possible currently. Audits do not add value to a company if its
controls are good, so it is desirable for the economy as a whole to
keep audit expenses low. Furthermore, it would be difficult to
encourage qualified people to join accounting firms if the firms'
stability were always in considerable doubt. Finally, if a firm is
exposed to too much risk, it creates a hazard of the firm not worrying
about the quality of its audits with the goal of making as much money
as possible because it is inevitable it will be put out of business
even if it does a good job of auditing because of factors beyond its
control. A generally stable and respected industry could be
transformed overnight into a bunch of fly-by-night outfits. That
would not be in the best interest of the economy or investors.
Auditors do need to be exposed to some liability, however, to ensure
their independence from the companies they audit. Since auditors are
hired by the companies they audit, there is a need to ensure that they
remain independent of their customers to encourage a diligent audit.
Under current law, auditors bear financial responsibility for
negligent or fraudulent audits. In accordance with their obligation
to produce an opinion of the Company's financial statements as a
whole, they are also obliged to comment on whether or not they believe
the company is viable as an ongoing concern. Failure to properly
identify that a company faces significant risks of not being able to
continue its operations because of negligence or fraud on the part of
the auditor does rightfully create liability on their part. This more
limited standard, which creates auditor liability when its actions
contribute to investor losses, is far more appropriate than the broad
standard proposed above.
"Interagency Advisory on the Unsafe and Unsound Use of Limitation of
Liability Provisions and Certain Alternative Dispute Resolution
Provisions in External Audit Engagement Letters" Federal Financial
Institutions Examination Council, Federal Register (May 10, 2005)
"Auditor Liability" 123helpme.com (2005)
"Prevent Financial Fraud: Repeal the Accountant Immunity Act: the 1995
Private Securities Litigation Reform Act (PSLRA)" Enron Watchdog
"FOOTNOTES: Recent Going-Concern Statements" NASDAQ,Dow Jones &
Company, Inc. (2005)
"Accountants' liability after Enron" by James W. Semple, FDCC
Quarterly (Fall 2002)
Search terms: Auditor liability United States; auditor bankruptcy;
auditor "ongoing concern"; auditor liability