Legal liability: Exploring instrumental reasoning and the evolution of the auditor's duty

Abstract

Under common law, the auditor was originally liable to his or her client or to the primary beneficiary of the audit contract. This was the so-called “privity of contract” theory. This view was employed until the 1970s when a number of courts began to adopt the slightly broader scope of accounting liability as articulated in the Restatement (Second) of Torts. Under the Restatement's “foreseen user” standard, the auditor's liability is limited to losses suffered by users whose reliance is (or should be) specifically foreseen by the auditor. Dissatisfaction with the “foreseen user” test gradually occurred because the plaintiff bore the burden of showing that he or she fell within the specifically foreseen group. Such a limitation led some courts to search for a standard that was “fairer” to the plaintiff—the “foreseeable user” test—in which the auditor has a duty to all third parties whom the auditor would reasonably foresee as users of the audited financial statements. There is wide variation across the states as to whom the independent auditor owes a duty. At one extreme is New York, where the famous Ultramares and the more recent Credit Alliance cases require privity for recovery. The auditor must know the identity and purpose of a third party's reliance on the financial statements at the time of the audit. At the other extreme, California courts, in International Mortgage and recently in Bily vs. Arthur Young & Co. , held the independent auditor liable to all reasonably foreseeable users of audited financial statements. Why do these differences exist? Are the auditor, investors, and creditors in California involved in transactions that are that different from their New York counterparts? This paper examines the judiciaries' diverse public policy considerations that result in the wide variations in the scope of the auditor's duty. The reasoning used in various common law jurisdictions and the evolution of the scope of the auditor's duty are explored. A closing commentary questions the consistency of the profession's efforts to limit the scope of its duty with the profession's public interest responsibility. Finally, suggestions for the accounting profession's response to this highly uncertain legal environment are made.