Why Auditors Can Blatantly Approve Corporate Financial Statements That Inflate Their Profitability

(Source: Houston Chronicle/Steve Ueckert)

In part one, Exposing The Enablers Of Corporate Corruption, I explained how auditor complicity in corporate deception was exposed using the infamous Enron case.

That collaboration continued after the supposed reforms of Sarbanes Oxley.

As related in the first article of this series, Arthur Anderson’s cover-up of Enron’s and WorldCom’s wild overstating of income using deceptive accounting practices brought that auditing firm down. If this esteemed firm was looking the other way at blatant fraud, it’s highly likely many other auditors were also. A large-scale reform was needed to bring honesty back into auditing.

Next is one of the astonishing realities in our legal system that you will find hard to believe. Every other profession has liability in negligence, but Auditors have immunity from lawsuits in negligence.

There was, and remains, a simple solution to keep auditors honest. Take away that immunity and make them responsible in civil law for negligence just as every other profession is. This means giving investors, who rely on corporate financial statements to buy shares, the right to sue auditors for incompetence. Then the market could police the auditors. However, politicians opted to preserve auditor immunity and instead let government regulators do the oversight. In 2002, Congress passed Sarbanes-Oxley (SOX), which by its complexity alone was touted as a thorough response. We shall shortly see that it wasn’t.

BTW: One of the techniques politicians use to make it appear that they are doing something major but are actually doing as little as possible is the use of complexity. See how complex this legislation is, they say, it’s so convoluted it must be doing something: complexity guarantees effectiveness.

Attempted to get honesty in corporate reporting

First, the necessary background on this auditor immunity. After the Great Depression of the 1930s, FDR determined that one of the causes for that stock market crash was the unreliability of corporate financial statements. He championed a law requiring all public corporations to retain auditors who would give an independent opinion on the veracity of the financial statements.

Yet, about the very same time, a commercial judge was fashioning a new law in a case before him, that would virtually give auditors immunity from lawsuits. In that lawsuit, investors were suing the auditors Touche Ross for losses they suffered from buying shares in Fred Stern and Company relying on the financial statements audited by that firm. There was no question the auditors were negligent, but that did not carry the day.

Justice Cardozo reasoned that if the courts made auditors responsible for negligence to investors who bought shares in corporations, there would be no limit on the size of their liability. Shares might be flogged around the world. Such responsibility could open a floodgate of lawsuits against auditors. They soon would not be able to get insurance and we soon would not have any auditors for the large public corporations. So he formulated a doctrine in professional negligence law that became accepted around the common-law world: that the law should not admit “to a liability in an indeterminate amount for an indeterminate time to an indeterminate class.”

It’s worth noting that here is an unelected official, with no evidence but only unsupported allegations by lawyers for the auditors, making a law that has proved to be an unrecognized principle undermining capitalism — as we shall soon see.

Why is this special protection for auditors a big deal? A long legal geek explanation is needed to answer that question. You may need a cup of strong coffee to make it through the thickness of this next few paragraphs. Unfortunately, it’s necessary to be able to understand both the harm that auditor immunity has done and how unnecessary it is.

Most other professions are subject to the law of professional negligence. This awkward phrasing (typical of the law) translates into incompetence in ordinary speech.

Proving incompetence depends on establishing the widespread, accepted practice of the profession relating to the issue in question. For example: it is the standard (widespread) practice for family doctors to always ask if a patient has had an allergic reaction to penicillin in the past before prescribing it. Any other family doctor could give evidence saying in effect, ‘Yes, we all do it. We all know of the dangers of penicillin allergy and are very careful to ask’.

So if a doctor prescribed penicillin, especially by a brand name, to a patient who had had an allergic reaction to penicillin, but failed to ask about allergic reactions beforehand, that doctor would have breached the standard practice of family physicians and would be negligent.

However, this is not insurance. If the doctor had asked and the patient said no, but the patient died from the penicillin, the doctor would not be negligent. The standard practice only requires that he ask the patient.

Now we go deeper into legal geek territory (if any readers have made it through the drudgery so far). The Touche Ross decision mentioned above was a ruling at common law — which is made by judges. Investors then tried statutory law — which is made by Congress: §10(b) of the Securities Exchange Act of 1934. But the judges blocked that as well saying that section only gives the right to a lawsuit for fraud, not negligence. See Ernst & Ernst v. Hochfelder.

What’s the big deal? The supporters of auditor immunity from negligence may argue that the auditors are still liable for fraud. However, because management has access to competent accountants who know the tests that auditors use to detect fraud, management can often successfully conceal the fraud from auditors. On their part, auditors can know when not to dig too deep. The plaintiffs would have to prove that the auditors actually knew of the well-concealed fraud. That’s a big hurdle; proving incompetence is much, much easier.

Negligence law has proved an effective remedy to control incompetent or careless behavior. When some drivers get into their car, is it uppermost in their mind that they shouldn’t hit someone because of the harm to that person, or is it worry about the increase in their insurance premium if they do? Imagine if the law of negligence did not apply to car drivers? Well, that is effectively what we have with regard to auditors.

Auditors grew bold under this unique protection from the market forces governing other professionals. But there is another factor that blossomed under this immunity.

A Geek Interlude: Accountants prepare the financial statements for the Corporation and are usually in-house. Their jobs doing what their bosses tell them. Hardly independent.

Auditors review these financial statements to give an opinion that they are prepared in accordance with widely accepted accounting principles. Auditors are not employees of the corporation but come from outside accounting firms and so are supposedly independent watchdogs

Once that independence may have been true, but the business model of accounting firms has changed radically and the law had not caught up. This change became apparent after Enron and WorldCom. Accounting firms no longer merely provide auditing, but a host of other services that provide much more lucrative fees. Taking away the punch bowl at the height of the party, which may be an auditor’s duty, would mean the loss of multi-millions of dollars in advisory fees.

The SEC enforces SOX

So the politicians proclaimed that they were going to end this conflict of interest and passed section 201 of SOX. The operative/ relevant/critical language in subsection g) specified that auditors are not to “provide… contemporaneously with their audit, any non-audit services, including…” There follows a list of obvious no-nos such as providing bookkeeping services for the corporation’s financial statements they were to audit.

The freight train sized loophole you were expecting came in subparagraph h). It says auditors can provide any non-audit service except those specified in g) above if approved by the corporation’s audit committee. Anything of consequence which the right hand hath taken, the left can giveth back.

So how has SOX fared as a deterrent to auditor support of misleading corporate financial statements that are a continuing basis for outsized executive pay? I have lots to say about that next article.

Disclaimer: While I acted for Lloyd’s of London who insured Canadian auditors in the 1980s, I have not referred to any cases in which I represented or advised auditors. All references are to publicly available information.

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