Why Do Accounts Need To Be Audited Accounting Essay


This essay is set around to pertinent questions; the need for a financial audit and whether auditors can be sued for audit mistakes. To improve presentation, both questions will be answered in two different sections. The first section will review why the audit of accounts is necessary and the second question will investigate whether auditors can be sued for audit errors.

Section 1: Why do accounts need to be audited?

The audit of accounts- balance sheets, income statements and cash flow statements, constitutes financial audits (Whittington and Pany, 2008). Whittington and Panny (2008) contend that the goal of financial audits is to ascertain whether statements have been prepared in conformity with accounting principles and whether the information presented in the statements show a true and fair view of the business at that point in time.

Several well researched theories of accounting and finance have been used to explain the need for audits. The two major explanatory theories which will be discussed here are problem of Information Asymmetry and the Agency theory of a firm (Akerlof, 1970; Jensen and Meckling, 1976). Aside from a theoretical reason why audits are necessary, a review of some contemporary practical problems will be used to build the argument.

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The agency theory of a firm (Fama, 1980; Jensen and Meckling, 1976) models a situation where there is a separation between the ownership of an asset (principal) and the control of that asset (agent). In the principal-agent relationship, the principal delegates responsibility for the control of the asset to the agent. The agent is responsible for managing the asset and reporting back to the principal in return for a fee. The theory notes that this sort of arrangement is problematic in that the principal's and the agent's interest conflict (Watts and Zimmerman, 1983). The principal's aim is to maximize his wealth while the agent's aim (under rational neoclassical assumptions) is to maximize his utility (Jensen and Meckling, 1976; Manne, 1964). For the agent to maximize his utility he must expropriate wealth from the principal. An example of wealth expropriation behaviour relevant to this context is the practice of fraud. There is information asymmetry [1] between the principal and the agent which can be taken advantage-of by the agent.

The principal has several ways of mitigating this problem. Some of these ways include; the use of financial incentives (performance related pay), the institution of internal control structures and through corporate governance. Performance related pay for example only alleviates the agent's incentive of presenting 'optimistic' and 'impressive' reports. A major tool available to principals to guard against such a move is the external financial audit.

The problem of information asymmetry has long been recognized and documented in the finance literature. Akerlof (1970) was one of the earliest researchers to document the problem and its effects on the transaction of business. Information asymmetry occurs when two parties to a transaction do not have the same level of knowledge or information about the transaction. The importance of reliable and objective information to the proper conduct of business cannot be overemphasized. Companies have different stakeholders who rely on management to furnish them with information about their companies' performance. Management clearly know much about the company but has the discretion of providing stakeholders with the full information, incomplete information or even misleading (or faulty) information about the firm.

Consider a particular group of stakeholders; Investors. Management has a motive to paint an optimistic picture in the performance information it passes to this group of stakeholders as managerial rewards depends on their performance (ICAEW, 2005). Investors are aware of this tendency and therefore need an independent party to verify whether the information provided by management reflects the current state of affairs in the business. Because management knows much more about their firms than the owners (investors), and because management has an incentive to present a distorted view of the state of affairs, it is necessary for an independent third party (the auditor) to review the information provided to ensure that it paints a true picture of activities.

As noted in the stakeholder theory of the firm (Freeman, 1984), there are other important groups of stakeholders reliant on the information provided by management. The government for example collects taxes from companies and the amount of tax due is a function of the corporate earnings. Managers have an incentive to pay as little tax as possible and thus susceptible to falsifying accounts to meet this need. The recent case of Barclays Group illustrates the determination of companies to keep their tax liability at a minimum. Although their annual profit was over £4.9Billions, the company only paid £113 million (2.4%) in corporate taxes [2] (BBC, 2011).

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From a practical stance point, there have been several cases of corporate fraud recorded in the last few years. Investors are therefore weary of the risk of fraud and deception on the part of managers. Some of such cases include; The Madoff Ponzi fraud scheme where the fund manager (Bernard Madoff) defrauded investors to a tune of $18 billions; Worldcom (audited by Arthur Anderson) and Tyco International (audited by PWC) cases of improper accounting and accounts falsification; Parmalat (audited by Grant Thornton) case of improper accounting and accounts falsification; Nortel (audited by Deloitte) case of unearned managerial bonuses amongst others. Noteworthy, is that fact that much of these corporate frauds were perpetrated irrespective of the fact that reputed audit firms were auditing these firms. Although there are no guarantees that the presence of an auditor will eliminate corporate fraud, it has the potential of deterring fraud at different levels.

Section 2: Can auditors be sued if audit errors are made?

Under contract law, auditors (like every other business) can be litigated for breach of contract if they do not fulfil the contract with their clients (Albrecht et al., 2008). In fact, suing of auditors for breach of contract has become a norm rather than an exception. There are several cases every year of auditors being sued for breach of contract. When there is no contract, auditors can still be sued for negligence under common law (Albrecht et al., 2008). The amount sued for can cover monetary losses as well as pain and suffering caused to the litigants (Albrecht et al., 2008). This is common with class actions taken against auditors by investors and other stakeholder groups.

The case of Arthur Anderson and Enron presents a strong case for auditors to be liable for damages caused by their audit errors or poor oversight. Arthur Anderson has been severally blamed for the collapse of Enron in that it failed to highlight the risks inherent in Enron's operations and the problems associated with the off balance sheet financing programs that Enron was undertaking. Enron's share price fell from a Mid-2000 high of over $90 per share to a low of $1 per share by November 2011. Investors lost over $11.2 Billion in the process. Considering the fact that auditors are hired by investors to act as an information intermediary and to make an informed decision on whether the firm in question has prepared its statements in conformance with generally accepted accounting principles, it is therefore reasonable that auditors be held liable for such losses. In the case of Arthur Anderson and Enron, several law suits were filed against Arthur Anderson. Although the firm is still incorporated, it has ceased to function as an audit firm.

A review of practical cases of law suits brought against auditors for negligence in oversight highlight the potential legal risks and liabilities faced by audit firms due to negligence or audit errors. These cases are noted in an article written by Alex Spence and published by The Sunday Times in September 2009, titled 'Auditors left unprotected against claims of negligence'. This article highlights several unsuccessful lobbies made by auditing firms to revert the law and place a cap on how much they could be sued for. The current law allows auditors to be liable for damages caused to investors and companies alike (The Sunday Times, 2009). Some of the cases of recent suits raised against the 'Big Four' audit firms included;

'KPMG- A defendant in a class-action lawsuit in the Southern District of New York against Tremont, a Bernard Madoff feeder fund; Ernst & Young- Sued by investors in a Luxembourg court with UBS for oversight of a European Madoff feeder fund; PwC- Included in several lawsuits in Canada claiming damages of up to $2 billion against Fairfield Sentry, a big Madoff feeder fund; KPMG- Sued in the US for at least $1 billion by creditors of New Century Financial, a failed sub-prime mortgage lender, which claimed that KPMG's auditing was recklessly and grossly negligent; Deloitte- Sued by the liquidators of two Bear Stearns-related hedge funds that collapsed at the start of the credit crunch' (The Sunday Times, 2009) [3] .

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This highlights the fact that auditors are not shielded from the law. While the liabilities of the individual partners of the firm are limited to their holdings, the liability of the firm is unlimited and the firm can be dissolved to settle its claimants. Nonetheless, a review of several cases brings to light the fact that most of these cases are settled out of court by auditors (Cloyd et al., 1996). The argument is that such cases can be costly in the long run and may lead to reputational damage for auditors and therefore they are better settled out of court.

This essay has reviewed two theoretical reasons why accounts are audited (the stakeholder and the agency theory). It has also highlighted recent accounting scandals and cases of fraud that makes and independent audit all the more necessary. On the question of whether auditors can be sued, there is evidence that auditors are held liable both for negligence and for breach of contract on several occasions. The law (common law) allows for auditor litigation. Several contemporary cases of auditor litigation are reviewed.