This essay is set around to pertinent inquiries ; the demand for a fiscal audit and whether hearers can be sued for audit errors. To better presentation, both inquiries will be answered in two different subdivisions. The first subdivision will reexamine why the audit of histories is necessary and the 2nd inquiry will look into whether hearers can be sued for audit mistakes.
Section 1: Why do histories necessitate to be audited?
The audit of accounts- balance sheets, income statements and hard currency flow statements, constitutes fiscal audits ( Whittington and Pany, 2008 ) . Whittington and Panny ( 2008 ) contend that the end of fiscal audits is to determine whether statements have been prepared in conformance with accounting rules and whether the information presented in the statements show a true and just position of the concern at that point in clip.
Several good researched theories of accounting and finance have been used to explicate the demand for audits. The two major explanatory theories which will be discussed here are job of Information Asymmetry and the Agency theory of a house ( Akerlof, 1970 ; Jensen and Meckling, 1976 ) . Aside from a theoretical ground why audits are necessary, a reappraisal of some modern-day practical jobs will be used to construct the statement.
The bureau theory of a house ( Fama, 1980 ; Jensen and Meckling, 1976 ) theoretical accounts a state of affairs where there is a separation between the ownership of an plus ( chief ) and the control of that plus ( agent ) . In the principal-agent relationship, the principal delegates duty for the control of the plus to the agent. The agent is responsible for pull offing the plus and describing back to the principal in return for a fee. The theory notes that this kind of agreement is debatable in that the principal ‘s and the agent ‘s involvement struggle ( Watts and Zimmerman, 1983 ) . The principal ‘s purpose is to maximise his wealth while the agent ‘s purpose ( under rational neoclassical premises ) is to maximise his public-service corporation ( Jensen and Meckling, 1976 ; Manne, 1964 ) . For the agent to maximise his public-service corporation he must expropriate wealth from the principal. An illustration of wealth expropriation behavior relevant to this context is the pattern of fraud. There is information dissymmetry[ 1 ]between the principal and the agent which can be taken advantage-of by the agent.
The principal has several ways of extenuating this job. Some of these ways include ; the usage of fiscal inducements ( public presentation related wage ) , the establishment of internal control constructions and through corporate administration. Performance related wage for illustration merely alleviates the agent ‘s inducement of showing ‘optimistic ‘ and ‘impressive ‘ studies. A major tool available to principals to guard against such a move is the external fiscal audit.
The job of information dissymmetry has long been recognized and documented in the finance literature. Akerlof ( 1970 ) was one of the earliest research workers to document the job and its effects on the dealing of concern. Information dissymmetry occurs when two parties to a dealing do non hold the same degree of cognition or information about the dealing. The importance of dependable and nonsubjective information to the proper behavior of concern can non be overemphasized. Companies have different stakeholders who rely on direction to supply them with information about their companies ‘ public presentation. Management clearly know much about the company but has the discretion of supplying stakeholders with the full information, uncomplete information or even deceptive ( or faulty ) information about the house.
See a peculiar group of stakeholders ; Investors. Management has a motivation to paint an optimistic image in the public presentation information it passes to this group of stakeholders as managerial wagess depends on their public presentation ( ICAEW, 2005 ) . Investors are cognizant of this inclination and hence necessitate an independent party to verify whether the information provided by direction reflects the current province of personal businesss in the concern. Because direction knows much more about their houses than the proprietors ( investors ) , and because direction has an inducement to show a deformed position of the province of personal businesss, it is necessary for an independent 3rd party ( the hearer ) to reexamine the information provided to guarantee that it paints a true image of activities.
As noted in the stakeholder theory of the house ( Freeman, 1984 ) , there are other of import groups of stakeholders reliant on the information provided by direction. The authorities for illustration collects revenue enhancements from companies and the sum of revenue enhancement due is a map of the corporate net incomes. Directors have an inducement to pay every bit small revenue enhancement as possible and therefore susceptible to distorting histories to run into this demand. The recent instance of Barclays Group illustrates the finding of companies to maintain their revenue enhancement liability at a lower limit. Although their one-year net income was over ?4.9Billions, the company merely paid ?113 million ( 2.4 % ) in corporate revenue enhancements[ 2 ]( BBC, 2011 ) .
From a practical stance point, there have been several instances of corporate fraud recorded in the last few old ages. Investors are hence weary of the hazard of fraud and misrepresentation on the portion of directors. Some of such instances include ; The Madoff Ponzi fraud strategy where the fund director ( Bernard Madoff ) defrauded investors to a melody of $ 18 one million millions ; Worldcom ( audited by Arthur Anderson ) and Tyco International ( audited by PWC ) instances of improper accounting and histories disproof ; Parmalat ( audited by Grant Thornton ) instance of improper accounting and histories disproof ; Nortel ( audited by Deloitte ) instance of unearned managerial fillips amongst others. Noteworthy, is that fact that much of these corporate frauds were perpetrated irrespective of the fact that reputed audit houses were scrutinizing these houses. Although there are no warrants that the presence of an hearer will extinguish corporate fraud, it has the potency of discouraging fraud at different degrees.
Section 2: Can hearers be sued if audit mistakes are made?
Under contract jurisprudence, hearers ( like every other concern ) can be litigated for breach of contract if they do non carry through the contract with their clients ( Albrecht et al. , 2008 ) . In fact, actioning of hearers for breach of contract has become a norm instead than an exclusion. There are several instances every twelvemonth of hearers being sued for breach of contract. When there is no contract, hearers can still be sued for carelessness under common jurisprudence ( Albrecht et al. , 2008 ) . The sum sued for can cover pecuniary losingss every bit good as hurting and agony caused to the litigators ( Albrecht et al. , 2008 ) . This is common with category actions taken against hearers by investors and other stakeholder groups.
The instance of Arthur Anderson and Enron presents a strong instance for hearers to be apt for amendss caused by their audit mistakes or hapless inadvertence. Arthur Anderson has been independently blamed for the prostration of Enron in that it failed to foreground the hazards built-in in Enron ‘s operations and the jobs associated with the off balance sheet funding plans that Enron was set abouting. Enron ‘s portion monetary value fell from a Mid-2000 high of over $ 90 per portion to a depression of $ 1 per portion by November 2011. Investors lost over $ 11.2 Billion in the procedure. Sing the fact that hearers are hired by investors to move as an information mediator and to do an informed determination on whether the house in inquiry has prepared its statements in conformity with by and large accepted accounting rules, it is hence sensible that hearers be held apt for such losingss. In the instance of Arthur Anderson and Enron, several jurisprudence suits were filed against Arthur Anderson. Although the house is still incorporated, it has ceased to map as an audit house.
A reappraisal of practical instances of jurisprudence suits brought against hearers for carelessness in inadvertence highlight the possible legal hazards and liabilities faced by audit houses due to negligence or scrutinize mistakes. These instances 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 carelessness ‘ . This article highlights several unsuccessful anterooms made by scrutinizing houses to return the jurisprudence and topographic point a cap on how much they could be sued for. The current jurisprudence allows hearers to be apt for amendss caused to investors and companies likewise ( The Sunday Times, 2009 ) . Some of the instances of recent suits raised against the ‘Big Four ‘ audit houses included ;
‘KPMG- A suspect in a class-action case in the Southern District of New York against Tremont, a Bernard Madoff feeder fund ; Ernst & A ; Young- Sued by investors in a Luxembourg tribunal with UBS for inadvertence of a European Madoff feeder fund ; PwC- Included in several cases in Canada claiming amendss of up to $ 2 billion against Fairfield Sentry, a large Madoff feeder fund ; KPMG- Sued in the US for at least $ 1 billion by creditors of New Century Financial, a failed sub-prime mortgage loaner, which claimed that KPMG ‘s auditing was recklessly and grossly negligent ; Deloitte- Sued by the murderers of two Bear Stearns-related hedge financess that collapsed at the start of the recognition crunch ‘ ( The Sunday Times, 2009 )[ 3 ].
This highlights the fact that hearers are non shielded from the jurisprudence. While the liabilities of the single spouses of the house are limited to their retentions, the liability of the house is limitless and the house can be dissolved to settle its claimants. However, a reappraisal of several instances brings to illume the fact that most of these instances are settled out of tribunal by hearers ( Cloyd et al. , 1996 ) . The statement is that such instances can be dearly-won in the long tally and may take to reputational harm for hearers and therefore they are better settled out of tribunal.
This essay has reviewed two theoretical grounds why histories are audited ( the stakeholder and the bureau theory ) . It has besides highlighted recent accounting dirts and instances of fraud that makes and independent audit all the more necessary. On the inquiry of whether hearers can be sued, there is grounds that hearers are held apt both for carelessness and for breach of contract on several occasions. The jurisprudence ( common jurisprudence ) allows for hearer judicial proceeding. Several modern-day instances of hearer judicial proceeding are reviewed.