Chapter 4

Auditor Responsibilities and the Law

Geoffrey Aronow and Hartwell Harris*

The pressure to establish increased auditor responsibility has been stronger in some decades and weaker in others. Recently, it has tended toward the former. The Sarbanes-Oxley Act of 2002 and its implementation are the latest steps in seeking to enhance the role of auditors in detecting and helping prevent financial fraud. There are lessons to be learned from a review of the past eight decades—lessons that can help identify potential future risks to auditors and strategies for minimizing those risks.

Over 75 years ago, Judge (later Justice) Benjamin Cardozo recognized, in the important Ultramares decision, the danger of exposing auditors to “a liability in an indeterminate amount for an indeterminate time to an indeterminate class” for “failure to detect a theft or forgery beneath the cover of deceptive entries”—in other words, management fraud.1 Cardozo held that, under the rule of privity of contract (the relationship between contracting parties), only the audit client could sue accountants for negligent auditing and failing to detect a fraud. To allow other parties to sue on such grounds, Cardozo warned, would make the “hazards of a business conducted on these terms … so extreme as to enkindle doubt whether a flaw may not exist in the implication of a duty that exposes to these consequences.”

Since then, with each wave of corporate scandals, reformers have pushed, often with some success, to ...

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