Auditors beware: key factors can lead to lawsuits.

The number of lawsuits and the dollar amount of damages awarded in proceedings against accountants have increased significantly in the past two decades. One researcher reported that between 1962 and 1987, more lawsuits were filed against accountants than in the entire history of the profession and that the largest accounting firms collectively have paid more than $250 million in settlements of mostly audit-related lawsuits since 1980.(1) Because of our research, we are able to identify the key factors that contribute to this trend of growing litigation against auditors. Increased use of financial statements has led to an attitude that investors and creditors are consumers of financial information and, therefore, are entitled to expect more from their purchases than they did in the past.(2) The public perceives that an audit precludes publication of misleading financial statements and that the financial reporting system warns financial statement users of impending business failure.(3) Although Statement on Auditing Standards No. 30 maintains that the auditor is not an insurer or guarantor of the financial statements, the public perceives the auditor in that role. The public's perception that an auditor acts as a "guarantor" of financial statements is part of a body of misperceptions known as the "expectations gap." These misperceptions have resulted in an increasing number of lawsuits against auditors. Nine Statements on Auditing Standards were issued in 1988 specifically to address these misperceptions. The trend of court decisions and changes in legal statutes may also contribute to an increase in the number of audit-related lawsuits. The court's application of the "fraud on the market" theory, the product liability rule, and legal statutes have increased auditors' exposure to litigation. Under the "fraud on the market" theory, some courts have ruled that investors need not have been aware of the misrepresentation if reliance on the financial statements by other investors affected the price of the security.(4) The product liability rule holds that auditors are responsible for the quality of their work product and for passing these costs to their clients. Because these trends of litigation have developed, auditors have an acute need to recognize factors that may lead to increased exposure to litigation. Recognizing these factors may help auditors minimize their exposure. Auditors have a legal liability under both common and statutory law. Common law is unwritten, has evolved through court decisions rather than government statutes, and is state-dependent. If no precedent exists, a court may look to cases in other states, but is not bound to follow such cases. Statutory law is created through legislation. A court is bound by statutory law unless the statute violates the federal, or a state, constitution. A court makes its own interpretations if the statutes are unclear. Legal liability in auditing extends to two groups: clients and third parties. Liability Under Common Law Auditors' common law liability to clients generally falls into two categories: breach of contract and tort. The typical case would allege both breach of contract and tort. For breach of contract, the client alleges that the auditor did not fulfill the requirements of the contract. A suit in tort (a civil wrong other than breach of contract) may be filed by a client to claim ordinary negligence, gross negligence, or fraud on the part of the auditor. These performance criteria are part of a continuum along which the auditor's performance can be judged.(5) As Figure One illustrates, auditor performance may range from innocent to fraudulent behavior. Innocence is the belief, with adequate basis, that the opinion is correct. Errors in judgment occur when the auditor believes, but with debatable basis, that the opinion is correct. Ordinary negligence is the failure to exercise due professional care, whereas gross negligence is a reckless departure from due care. Gross negligence may be also considered to be constructive fraud. Fraud requires the element of intent to deceive. On this continuum, there are three important "gray areas." The distinction between errors of judgment and ordinary negligence is important because auditors are not liable for errors of judgment but may be held liable for ordinary negligence. Where does the distinction between errors of judgment and ordinary negligence lie? The "prudent man" concept, as expressed in Cooley on Torts, describes a professional's obligation for reasonable care as follows: Every man who offers his services to another, and is employed, assumes the duty to exercise in the employment such skill as he possesses with reasonable care and diligence. In all these employments where peculiar skill is prerequisite, if one offers his service, he is understood as possessing the degree of skill commonly possessed by others in the same employment, and if his pretensions are unfounded, he commits a species of fraud upon every man who employs him in reliance on his public profession. But no man, whether skilled or unskilled, undertakes that the task he assumes shall be performed successfully, and without fault or error: he undertakes for good faith and integrity, but not for infallibility, and he is liable to his employer for negligence, bad faith, or dishonesty, but not for losses consequent upon pure errors of judgment.(6) The distinction between ordinary negligence and gross negligence appears to be the most troublesome to determine.(7) Although there is an inherent problem in providing unambiguous definitions of any of these pairs of verbal terms, judges in different districts, faced with different circumstances, are most likely to render somewhat inconsistent decisions in distinguishing between ordinary negligence and gross negligence. The distinction between gross negligence and fraud depends on whether there is intent to deceive. In Ernst & Ernst v. Hochfelder, (425 U.S. 185, 1976), the Supreme Court defined scienter as "a mental state embracing intent to deceive, manipulate, or defraud."(8) The client-plaintiff has the burden of proof in a suit against the auditor under common law. The plaintiff must prove that the auditor accepted a duty of care and breached that duty, the client suffered damages, and there exists a close causal connection between the auditor's breach and the client's damages.(9) Third Party Liability Auditors also have liability to third parties under common law. Third parties cannot sue for breach of contract because of lack of privity but can sue in a tort action for ordinary negligence, gross negligence, or fraud. The burden of proof in such cases is upon the third party-plaintiff to prove the elements of duty of care, breach of that duty, damages suffered, and a causal connection between the auditor's actions and the plaintiff's losses. A plaintiff who can prove gross negligence or fraud can recover damages or losses suffered in any state; however, ordinary negligence recoveries vary by state. Until the late 1960s, CPAs were liable under common law only to their clients for ordinary negligence.(10) In 1931, the Supreme Court of New York decided the case of Ultramares Corp. v. Touche, Niven & Co. The Ultramares Doctrine was a product of that decision. The court ruled in favor of the auditor and stated: If a liability for negligence exists, a thoughtless slip or blunder, the failure to detect a theft or forgery beneath the cover of deceptive entries, may expose accountants to a liability in an indeterminate amount for a indeterminate time to an indeterminate class. The hazards of a business conducted on these terms are sufficiently extreme to enkindle doubt whether a flaw may exist in the implication of a duty that exposes to these consequences.(11) The court reaffirmed this doctrine in Credit Alliance Corporation v. Arthur Andersen & Co.(12) The court stated that certain prerequisites must be met for an auditor to be held liable to third parties for ordinary negligence: an awareness by the auditor that the financial statements were to be used for a particular purpose by a known third party and the existence of some conduct by the auditor that links the auditor to the third party.(13) Satisfying these prerequisites establishes a third party beneficiary status. The Ultramares Doctrine is not a federal ruling, but it has been followed in several states. The impact of the Ultramares Doctrine has been diminished somewhat by the Restatement of Torts rule and the Rosenblum rule. The Restatement of Torts rule is not a binding legal expression, but merely the opinion of legal scholars about what the common law should be in each state. The rule extends the auditor's liability for ordinary negligence to third parties who are members of a limited class of known or intended beneficiaries of audited financial statements. The Rosenblum rule extends the liability beyond the Restatement of Torts rule to cover all those whom the auditor should reasonably foresee as recipients of audited financial statements.(14) The evolution of the auditor's liability to third parties for ordinary negligence shows that decisions vary among the states depending on the precedent being followed. On one extreme, the Ultramares Doctrine (as modified by Credit Alliance) holds the auditor liable for ordinary negligence only to known third parties who can link their claim to the auditor's conduct. On the other, the Rosenblum rule holds the auditor liable for ordinary negligence to any foreseeable third party. Figure One Range of Misinterpretation