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Audit malpractice cases often hinge on compliance with technical audit standards and the effective presentation of such to judges and juries. To triers of fact adjudicating such matters, understanding the rules governing how auditors practice, Generally Accepted Auditing Standards or GAAS,1 can seem like trying to decipher a foreign language. For example, recent litigation involving MF Global Holdings and PWC was described as follows:

The trial testimony was document- and regulation-heavy, leading U.S. District Judge Victor Marrero to observe that the jury of five women and five men might be ‘enormously confused’ and to suggest a mid-trial summary of the case to help jurors understand the issues.2

Armed with an understanding of GAAS and how they are applied in practice, attorneys can focus their strategy on elements of audit malpractice claims that will ring true with judges and juries.

Role of an Auditor

On paper, auditors provide what might seem like a straightforward service: Express an opinion as to whether a client’s financial statements are fairly presented in conformity with Generally Accepted Accounting Principles (GAAP). However, for complex, multinational entities, the work that goes into providing that opinion can consume thousands of hours from locations all over the world. Considerations regarding resource allocation, planning, complexity of the client’s business, risk assessments and internal controls all influence the nature, timing and extent of audit testing. Those decisions are often second guessed by stakeholders, investors, and litigators after the fact.

GAAS

GAAS is the body of guidance followed by auditors to plan, conduct and report on the results of their work. An auditor’s compliance with GAAS figures prominently in cases of alleged malpractice and thus, being able to articulate what an auditor should have done and what actually was done are important to presenting one’s arguments. While GAAS comprises thousands of pages of guidance, it is not a set of “bright line” rules; rather, it is a “principles”-based set of standards which allows for judgment and directing effort to audit areas with greater risk of error. To illustrate, consider the following:

(1) The auditor must prepare audit documentation that provides a clear understanding of the work performed (AU 339, Audit Documentation). The workpapers should allow an experienced auditor with no prior connection to the client to understand the procedures performed, audit evidence obtained and conclusions reached. The actual amount of documentation necessary, however, is a matter judgment.

(2) Audit evidence is the information used by the auditor in arriving at conclusions (AU 326, Audit Evidence). An auditor should assess the sufficiency (i.e., the quantity) and appropriateness (i.e., quality) of its audit evidence and their interrelationship in determining the appropriate balance needed to support his conclusions. For example, higher quality audit evidence may reduce the quantity of audit evidence needed to support a conclusion. Thus, audit evidence obtained is a matter of judgment.

(3) When evaluating whether an accounting error is “material,” an auditor considers the guidance in AU 320, Materiality, which provides that an error is material if it would reasonably be expected to influence a financial statement user’s decision. Apart from the dollar amount of the error, “qualitative” elements should also be considered (i.e., the error has the effect of increasing management bonuses). Thus, an auditor considers multiple factors in making his assessment which are all considered in forming his judgment.

Common Alleged Failures

Although the facts and circumstances of each allegation are unique, the standards below are germane to most audits. The following hypothetical, albeit simplistic, example will be used to demonstrate how to consider each of the standards addressed below. Consider that revenues at a diamond retailer have doubled over the prior year, despite a current global recession. The CEO explains to the auditor that sales are increasing because her diamonds “are the best” and their limited availability makes them recession proof, which the auditor dutifully documents in his workpapers.

Due Professional Care and Professional Skepticism. Broadly, “due professional care concerns what the independent auditor does and how well he or she does it” (AU 230.04). The auditor must possess the abilities and experience to perform such work, and exercise professional skepticism, or a questioning mind, related to the evidence he gathers.

In evaluating the auditor’s due professional care and professional skepticism, one might consider if he questioned whether the CEO’s explanation made sense, particularly in light of economic conditions. Was he aware of and did he consider circumstances that may lead the CEO to overstate revenues? For example, were there loan covenants that had to be satisfied by higher sales figures? In this case, one might consider whether the auditor further corroborated the CEO’s explanation by obtaining additional audit evidence.

Audit Evidence. When audit evidence is at question, a jury should be informed of the types of audit evidence relevant to the facts and circumstances, as well as the relevance, reliability and quality of such evidence. For example, audit evidence provided by original documents is more reliable than that provided by photocopy (AU 326.08). When addressing whether audit evidence is reliable, information provided by independent third parties (i.e., customers, vendors) can be perceived as stronger than information generated by the company under audit.

In assessing whether the auditor obtained sufficient and appropriate audit evidence, one might consider whether the CEO’s explanation, was adequate or whether additional evidence should have been obtained by the auditor. In this example, the auditor could have obtained sales invoices and inspected them for validity and verified cash receipts associated with sales. The extent of such testing would be based on a variety of factors, including the quality and quantity of evidence.

Audit Documentation. AU 339.04 defines documentation as “the record of audit procedures performed, relevant audit evidence obtained, and conclusions the auditor reached.” One may point to a large stack of banker’s boxes as sufficient audit documentation. However, the standard notes that “documentation alone does not guarantee audit quality.” Thus, a seemingly enormous amount of workpapers may seem to pass “the weight test”; however, one must still consider the quality of the documentation.

For example, the auditor should not only document the CEO’s explanation but the additional testing he performed to corroborate his reasoning, i.e., inspecting sales invoices and verifying with cash receipts. Doing so allows another trained auditor to understand the work the CEO’s auditor did and the results of his testing.

Translating Technical Issues

In cases involving technical audit standards, it may be useful to explain the authoritative guidance in layman’s terms. Even with its possible negative connotation, the phrase “dumbing down” is often referred to when presenting facts and expert testimony in audit malpractice cases. As defined in Merriam-Webster’s Dictionary, to dumb down is “to lower the level of difficulty and the intellectual content of something.”3 Attorneys and testifying experts should be mindful when using technical jargon to further articulate the work that should have been done and what was done, when necessary.

It may be helpful to portray one’s case based on comparisons among GAAS, audit testing performed and evidence obtained, audit workpaper documentation, and witness testimony. For example, exhibits can be presented showing the relevant provisions of an audit standard compared with relevant workpapers with indicators to emphasize relevant testing and documentation … or the lack thereof.

Conclusion

In audit malpractice cases, replete with strange and unfamiliar terms, it is important to distill GAAS and the work performed into information understanable by judges and juries who may lack the requisite familiarity with it. As is often the case, a simpler explanation might be the most illuminating to triers of fact. Comparing what an auditor should have done to what an auditor actually did may help clarify the conclusions ultimately made by jurors.

Endnotes:

1. Auditors of publicly traded entities must also follow the Auditing Standards of the Public Company Accounting Oversight Board (PCAOB).

2. Law360, “MF Global, PwC Settle $2B Malpractice Claim,” March 23, 2017.

3. Merriam-Webster’s Dictionary, https://www.merriam-webster.com/dictionary/dumb down.

Audit malpractice cases often hinge on compliance with technical audit standards and the effective presentation of such to judges and juries. To triers of fact adjudicating such matters, understanding the rules governing how auditors practice, Generally Accepted Auditing Standards or GAAS,1 can seem like trying to decipher a foreign language. For example, recent litigation involving MF Global Holdings and PWC was described as follows:

The trial testimony was document- and regulation-heavy, leading U.S. District Judge Victor Marrero to observe that the jury of five women and five men might be ‘enormously confused’ and to suggest a mid-trial summary of the case to help jurors understand the issues.2

Armed with an understanding of GAAS and how they are applied in practice, attorneys can focus their strategy on elements of audit malpractice claims that will ring true with judges and juries.

Role of an Auditor

On paper, auditors provide what might seem like a straightforward service: Express an opinion as to whether a client’s financial statements are fairly presented in conformity with Generally Accepted Accounting Principles (GAAP). However, for complex, multinational entities, the work that goes into providing that opinion can consume thousands of hours from locations all over the world. Considerations regarding resource allocation, planning, complexity of the client’s business, risk assessments and internal controls all influence the nature, timing and extent of audit testing. Those decisions are often second guessed by stakeholders, investors, and litigators after the fact.

GAAS

GAAS is the body of guidance followed by auditors to plan, conduct and report on the results of their work. An auditor’s compliance with GAAS figures prominently in cases of alleged malpractice and thus, being able to articulate what an auditor should have done and what actually was done are important to presenting one’s arguments. While GAAS comprises thousands of pages of guidance, it is not a set of “bright line” rules; rather, it is a “principles”-based set of standards which allows for judgment and directing effort to audit areas with greater risk of error. To illustrate, consider the following:

(1) The auditor must prepare audit documentation that provides a clear understanding of the work performed (AU 339, Audit Documentation). The workpapers should allow an experienced auditor with no prior connection to the client to understand the procedures performed, audit evidence obtained and conclusions reached. The actual amount of documentation necessary, however, is a matter judgment.

(2) Audit evidence is the information used by the auditor in arriving at conclusions (AU 326, Audit Evidence). An auditor should assess the sufficiency (i.e., the quantity) and appropriateness (i.e., quality) of its audit evidence and their interrelationship in determining the appropriate balance needed to support his conclusions. For example, higher quality audit evidence may reduce the quantity of audit evidence needed to support a conclusion. Thus, audit evidence obtained is a matter of judgment.

(3) When evaluating whether an accounting error is “material,” an auditor considers the guidance in AU 320, Materiality, which provides that an error is material if it would reasonably be expected to influence a financial statement user’s decision. Apart from the dollar amount of the error, “qualitative” elements should also be considered (i.e., the error has the effect of increasing management bonuses). Thus, an auditor considers multiple factors in making his assessment which are all considered in forming his judgment.

Common Alleged Failures

Although the facts and circumstances of each allegation are unique, the standards below are germane to most audits. The following hypothetical, albeit simplistic, example will be used to demonstrate how to consider each of the standards addressed below. Consider that revenues at a diamond retailer have doubled over the prior year, despite a current global recession. The CEO explains to the auditor that sales are increasing because her diamonds “are the best” and their limited availability makes them recession proof, which the auditor dutifully documents in his workpapers.

Due Professional Care and Professional Skepticism. Broadly, “due professional care concerns what the independent auditor does and how well he or she does it” (AU 230.04). The auditor must possess the abilities and experience to perform such work, and exercise professional skepticism, or a questioning mind, related to the evidence he gathers.

In evaluating the auditor’s due professional care and professional skepticism, one might consider if he questioned whether the CEO’s explanation made sense, particularly in light of economic conditions. Was he aware of and did he consider circumstances that may lead the CEO to overstate revenues? For example, were there loan covenants that had to be satisfied by higher sales figures? In this case, one might consider whether the auditor further corroborated the CEO’s explanation by obtaining additional audit evidence.

Audit Evidence. When audit evidence is at question, a jury should be informed of the types of audit evidence relevant to the facts and circumstances, as well as the relevance, reliability and quality of such evidence. For example, audit evidence provided by original documents is more reliable than that provided by photocopy (AU 326.08). When addressing whether audit evidence is reliable, information provided by independent third parties (i.e., customers, vendors) can be perceived as stronger than information generated by the company under audit.

In assessing whether the auditor obtained sufficient and appropriate audit evidence, one might consider whether the CEO’s explanation, was adequate or whether additional evidence should have been obtained by the auditor. In this example, the auditor could have obtained sales invoices and inspected them for validity and verified cash receipts associated with sales. The extent of such testing would be based on a variety of factors, including the quality and quantity of evidence.

Audit Documentation. AU 339.04 defines documentation as “the record of audit procedures performed, relevant audit evidence obtained, and conclusions the auditor reached.” One may point to a large stack of banker’s boxes as sufficient audit documentation. However, the standard notes that “documentation alone does not guarantee audit quality.” Thus, a seemingly enormous amount of workpapers may seem to pass “the weight test”; however, one must still consider the quality of the documentation.

For example, the auditor should not only document the CEO’s explanation but the additional testing he performed to corroborate his reasoning, i.e., inspecting sales invoices and verifying with cash receipts. Doing so allows another trained auditor to understand the work the CEO’s auditor did and the results of his testing.

Translating Technical Issues

In cases involving technical audit standards, it may be useful to explain the authoritative guidance in layman’s terms. Even with its possible negative connotation, the phrase “dumbing down” is often referred to when presenting facts and expert testimony in audit malpractice cases. As defined in Merriam-Webster’s Dictionary, to dumb down is “to lower the level of difficulty and the intellectual content of something.”3 Attorneys and testifying experts should be mindful when using technical jargon to further articulate the work that should have been done and what was done, when necessary.

It may be helpful to portray one’s case based on comparisons among GAAS, audit testing performed and evidence obtained, audit workpaper documentation, and witness testimony. For example, exhibits can be presented showing the relevant provisions of an audit standard compared with relevant workpapers with indicators to emphasize relevant testing and documentation … or the lack thereof.

Conclusion

In audit malpractice cases, replete with strange and unfamiliar terms, it is important to distill GAAS and the work performed into information understanable by judges and juries who may lack the requisite familiarity with it. As is often the case, a simpler explanation might be the most illuminating to triers of fact. Comparing what an auditor should have done to what an auditor actually did may help clarify the conclusions ultimately made by jurors.

Endnotes:

1. Auditors of publicly traded entities must also follow the Auditing Standards of the Public Company Accounting Oversight Board (PCAOB).

2. Law360, “MF Global, PwC Settle $2B Malpractice Claim,” March 23, 2017.

3. Merriam-Webster’s Dictionary, https://www.merriam-webster.com/dictionary/dumb down.