Accountants are responsible for detecting material misstatements in financial statements due to error or fraud. Auditors provide “reasonable” assurance to those using the financial statements. As such, auditors may not always be to blame when financial reporting failures like frauds or restatements occur. However, auditors can be sued for negligence or recklessness if they fail to detect or prevent material misstatements.
Key Facts
- Public restatements of audited financial statements are often the key triggers prompting lawsuits against auditors.
- Auditors can effectively reduce the risk of being sued by preventing material misstatements of the audited financial statements.
- Different states have different policies on who can sue an auditor, and auditors based in states with higher litigation risk may be at a disadvantage.
- Higher auditor litigation risk can lead to auditors producing higher quality audit and financial reporting information for their clients.
- Audit firms are co-defendants in only 20% of lawsuits alleging financial misreporting.
- The frequency within which auditors are named as co-defendants has increased from 14% in 2000 to 30% in 2015.
- In 74% of the cases examined, the court did not dismiss the case and a settlement was reached resulting in a payout to the plaintiff.
- The average payout value in the full sample of cases was $41.8 million, with auditors contributing only 12% of the total damages paid to the plaintiff.
- Big Four audit firms are significantly less likely to be sued than non-Big Four auditors, but payouts to plaintiffs are larger when a Big Four firm is a co-defendant.
- Audit committee members are infrequently named as defendants in cases involving financial misreporting.
- Auditors are more likely to be included as co-defendants when the accounting allegations involve fictitious assets, reductions of expenses, overvalued assets, or undervalued liabilities and expenses.
- Auditors are less likely to be sued when the lawsuit relates to omitted or improper disclosures or when management is accused of profiting from the misreporting.
Common Reasons for Auditor Lawsuits
There are several reasons why auditors may be sued, including:
- NegligenceAuditors may be sued for negligence if they fail to exercise the proper care and skill in conducting an audit. This can include failing to follow generally accepted auditing standards (GAAS), failing to detect material misstatements, or failing to communicate material weaknesses in internal control to management.
- Breach of contractAuditors may be sued for breach of contract if they fail to fulfill their obligations under an audit engagement letter. This can include failing to complete the audit on time, failing to provide the client with a written audit report, or failing to maintain the confidentiality of client information.
- FraudAuditors may be sued for fraud if they knowingly or recklessly misrepresent the financial statements of a client. This can include falsifying audit records, concealing material misstatements, or issuing an unqualified audit opinion when they know that the financial statements are materially misstated.
Factors that Increase the Risk of an Auditor Lawsuit
There are several factors that can increase the risk of an auditor lawsuit, including:
- Complex financial statementsCompanies with complex financial statements are more likely to be involved in financial reporting failures. This is because complex financial statements are more difficult to audit and more likely to contain material misstatements.
- Aggressive accounting policiesCompanies that use aggressive accounting policies are more likely to be involved in financial reporting failures. This is because aggressive accounting policies can be used to manipulate financial results and hide material misstatements.
- Weak internal controlsCompanies with weak internal controls are more likely to be involved in financial reporting failures. This is because weak internal controls make it easier for management to perpetrate fraud or make errors.
- History of financial reporting problemsCompanies with a history of financial reporting problems are more likely to be involved in future financial reporting failures. This is because companies with a history of financial reporting problems are more likely to have weak internal controls and aggressive accounting policies.
Conclusion
Auditors can be sued for negligence, breach of contract, or fraud. The risk of an auditor lawsuit is increased by factors such as complex financial statements, aggressive accounting policies, weak internal controls, and a history of financial reporting problems. Auditors can reduce their risk of being sued by exercising due care and skill in conducting audits, fulfilling their obligations under audit engagement letters, and maintaining the confidentiality of client information.
FAQs
What are the most common reasons why auditors get sued?
The most common reasons why auditors get sued are negligence, breach of contract, and fraud.
What is negligence in the context of an audit?
Negligence is the failure to exercise the proper care and skill in conducting an audit. This can include failing to follow generally accepted auditing standards (GAAS), failing to detect material misstatements, or failing to communicate material weaknesses in internal control to management.
What is breach of contract in the context of an audit?
Breach of contract occurs when an auditor fails to fulfill their obligations under an audit engagement letter. This can include failing to complete the audit on time, failing to provide the client with a written audit report, or failing to maintain the confidentiality of client information.
What is fraud in the context of an audit?
Fraud occurs when an auditor knowingly or recklessly misrepresents the financial statements of a client. This can include falsifying audit records, concealing material misstatements, or issuing an unqualified audit opinion when they know that the financial statements are materially misstated.
What factors increase the risk of an auditor lawsuit?
Factors that increase the risk of an auditor lawsuit include complex financial statements, aggressive accounting policies, weak internal controls, and a history of financial reporting problems.
How can auditors reduce their risk of being sued?
Auditors can reduce their risk of being sued by exercising due care and skill in conducting audits, fulfilling their obligations under audit engagement letters, and maintaining the confidentiality of client information.
What are the consequences of an auditor lawsuit?
The consequences of an auditor lawsuit can include financial damages, reputational damage, and loss of clients.
What are some recent trends in auditor lawsuits?
Recent trends in auditor lawsuits include an increase in the number of lawsuits filed against Big Four audit firms and an increase in the size of settlements and judgments.