Burned Investors Ask ‘Where Were the Auditors?’ A Court Says ‘Who
Cares?’
Judges request that SEC weigh in on case that could affect $17
billion industry
By
Jonathan Weil
Dec. 21, 2023 5:30 am ET
|
 The
Securities and Exchange Commission has said that properly
executed audits are crucial for investors. PHOTO: ARIEL
ZAMBELICH/THE WALL STREET JOURNAL
|
One of the country’s most influential courts has asked the nation’s
top securities regulator for its views on an uncomfortable
subject: whether audit reports by outside accounting firms actually
matter.
The court already ruled that, at least in one case, they didn’t. That
case, where an insurer overstated profits and an auditor signed off on
its books, led to an investor lawsuit against the auditor that was
dismissed. In its ruling, the court said the audit report was so
general an investor wouldn’t have relied on it.
The decision could have broad ramifications for the Securities and
Exchange Commission, which oversees corporate financial disclosures,
and for the
auditing industry, which charged about $17 billion last
year for blessing the books of publicly listed companies in the U.S.
The ruling, by a three-judge panel of the Second U.S. Circuit Court of
Appeals, prompted three former SEC officials to tell the court it got
the answer wrong. They asked the court to reconsider its decision,
noting that the SEC in a previous enforcement
case had said that “few matters could be more important to
investors” than whether a company’s financial statements had been
subjected to a properly conducted annual audit.
The court responded by inviting the SEC to file a brief expressing its
views on the former officials’ arguments. The SEC in a court filing
said that “the commission has an interest in ensuring its views on
this issue are considered by the court.” Its brief is due Feb. 16. An
SEC spokeswoman declined to comment.
The court ruling involved a lawsuit by investors over an audit gone
wrong. AmTrust Financial Services, an insurance company, had
overstated its profit, and BDO USA, its outside accounting
firm, had blessed the numbers.
|
 Three
BDO accountants were accused in 2018 of signing off on
their audit work prematurely. PHOTO: KRIS
TRIPPLAAR/SIPA USA/REUTERS
|
Investors sued BDO, and a court dismissed their claims. They appealed,
and the Second Circuit this summer said the language of BDO’s audit
report was so general that an investor wouldn’t have relied on it.
Consequently, the court said the audit report wasn’t material— meaning
it didn’t matter—and upheld the dismissal of the claims against BDO.
Audit reports operate on a pass-fail model, and their language is
standardized. Either a company gets a clean opinion on its financial
statements from the outside auditor, or it doesn’t.
The notion that the standardized language is essentially meaningless
raises larger questions about whether audit reports serve a useful
purpose. Total audit fees at U.S.-listed companies were almost $17
billion last year, according to the research firm Ideagen Audit
Analytics. Independent audits have been a legal requirement for public
companies since Congress passed the Securities Act of 1933, four years
after the stock market crash that spurred the Great Depression.
Andrew Bailey, a former SEC deputy chief accountant and one of the
three former agency officials who wrote a brief for the court, said
that “investor reliance on the audit opinion has a long history in
practice, regulation and law.” Audit opinions that warn
of problems often send stocks tumbling. “This observable
fact in the marketplace seems to directly contradict the court’s
position that the current audit report is not material to investors.”
he said.
BDO and AmTrust declined to comment. AmTrust in 2017 restated five
years of earnings downward, and its shares are no longer publicly
traded. In 2020, the company and its former chief financial officer
settled SEC
fraud claims covering several years and were fined, without
admitting or denying the allegations.
The SEC in a 2018 order accused three
BDO accountants of signing off on their audit work for
AmTrust’s 2013 annual report without completing all the required audit
procedures beforehand. The trio agreed to be suspended from auditing
public companies, without admitting or denying the agency’s misconduct
claims. The SEC didn’t allege any violations by BDO.
The firm’s audit report, using the industry’s customary language, said
that BDO “conducted our audits in accordance with the standards of the
Public Company Accounting Oversight Board,” often referred to as the
PCAOB and which regulates auditors. It also said that “we believe that
our audits provide a reasonable basis for our opinion” that AmTrust’s
financial statements conformed to U.S. generally accepted
accounting principles.
The investors suing BDO claimed those statements were fraudulent. The
appeals court disagreed, saying they were “so general” that “a
reasonable investor would not depend” on them. Further, the court
said, the investors’ “claim that these statements were knowingly and
verifiably false when made does not cure their generality, which is
what prevents them from rising to the level of materiality required to
form the basis for assessing a potential investment.” The court said
its ruling was specific to the facts in the case, and that it didn’t
mean to suggest that audit opinions would always be deemed too general
to be material.
The former SEC officials in their friend-of-the-court brief wrote: “In
this case, BDO’s false claims were material because had it told the
truth, it couldn’t have issued an ‘unqualified opinion’ that AmTrust’s
financial statements fairly presented its financial condition. Indeed,
BDO would have been compelled to disclaim any opinion at all.” They
said that the court’s “contrary conclusion conflicts with the views of
the SEC and the PCAOB, and could have broad implications for those
agencies’ enforcement authority.”
Write to Jonathan Weil at jonathan.weil@wsj.com
Appeared in the December 22, 2023, print edition as 'Court Asks
SEC: Do Outside Audits Matter?'
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