Title: Reconsidering the "Lack of Duty" Defense to State Auditor Negligence Claims
Abstract: I. INTRODUCTION 489 II. OVERVIEW OF THE LAW REGARDING AUDITORS' TO THIRD PARTIES 491 III. LACK OF PREDICTABILITY OF THE DUTY OF CARE STANDARD 494 A. Stand-Pat Management Scenario 494 B. Active Management Scenario 497 C. Major Expansion 499 IV. CONFLICTS BETWEEN GOOD AUDITING AND GOOD LEGAL DEFENSES 500 V. THE APPLICATION OF PRECEDENTS BASED ON AN OUTMODED VIEW OF ACCOUNTING 502 VI. POLICY IMPLICATIONS 506 VII. CONCLUSION 509 I. INTRODUCTION This Article critically reexamines the common law limits of third parties' standing to sue auditors for negligence and misrepresentation. This Article suggests both a possible improvement in the legal standard and also identifies areas where empirical research could prove useful to the courts. We argue that the case law has evolved inconsistently in different jurisdictions since the leading case, Ultramares Corp. v. Touche,1 was decided in 1931. More importantly, the law has developed as if the work and products of auditors have remained unchanged since the 1920s, ignoring the emergence of a body of authoritative accounting and auditing standards. The law has lost touch with actual professional and business practice. As a result, it treats plaintiffs inequitably and has perverse effects on auditors' incentives to perform high-quality audits. The accounting profession has long been concerned with its exposure to litigation.2 A stereotypical situation involves an auditor who has issued an unqualified (clean) report on the financial statements of a client. The financial statements portray a solvent company, but the client proves to be insolvent. The client's creditors and investors lose money and claim that their losses are due to reliance on misleading financial statements. Although the primary fault for deceitful or erroneous financial statements lies with the client's management, which prepared them, management lacks the money to make the creditors and investors whole. Where joint and several liability rules are in effect, the creditors and investors can try to recoup their losses from other pockets. The auditors, as a surviving deep pocket, are often sued for negligence, negligent misrepresentation, gross negligence, or fraud. The ability of injured parties to sue auditors adds to the auditors' incentives to perform their work carefully. To the extent the law imposes arbitrary barriers on the right to sue, this incentive is reduced.3 We illustrate below how inconsistent and vague state standards of care make the extent of the auditors' liability for negligent acts uncertain. The lack of certainty that substandard audit work will be penalized reduces auditors' incentives to expend effort on the audit. The law also creates a second disincentive. In many jurisdictions, as discussed in Part II, a third party may sue for negligence only if it can prove the auditors (i) were specifically aware of the third party's identity and (ii) had consented to the third party's reliance on the auditors' work for a particular purpose. As a defensive legal strategy, therefore, auditors should avoid awareness of their clients' current and intended sources of financing. This strategy is in direct tension with Generally Accepted Auditing Standards (GAAS), which in many cases require precisely such awareness. …
Publication Year: 2000
Publication Date: 2000-04-01
Language: en
Type: article
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Cited By Count: 1
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