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Hastings Law Journal

Abstract

This Article considers the interplay between new auditing standards governing audits of internal control over financial reporting and pre-existing legal standards governing auditor liability for audit failure. The interplay produces skewed liability incentives that, if unadjusted, threaten to impair the objective of this new control-audit regime. The regime's objective is, in part, to provide an early warning to financial statement users when current financial statements are reliable but control weaknesses indicate material risk of a company's future inability to produce reliable financial statements. To be meaningful, auditor disclosure of material weaknesses in control and their potential effects on financial statements is necessary.

While liability rules under Section 11 of the Securities Act of 1933 will reinforce auditor incentives to provide this disclosure, liability rules under Section 10(b) of the Securities Exchange Act of 1934 will discourage auditors from providing disclosure because doing so likely makes them primary actors subject to liability rather than secondary actors not subject to liability. To address this skewed interplay between new auditing standards and pre-existing legal liability rules, this Article suggests developing a safe harbor system to protect from Section 10(b) liability auditor disclosure of forward-looking information necessary to make the early warning system meaningful.

This Article gives a comprehensive account of new auditing standards, noting interpretive questions and showing a system entirely dependent on extensive auditor disclosure. It then explains how the new system expressly nullifies existing case law under Section 11 by substantially expanding required auditor disclosure of internal control conclusions and how it probably nullifies existing case law under Section 10(b), including the Supreme Court's landmark 1994 case, Central Bank of Denver v. First Interstate Bank of Denver, that generally insulated auditors from Section 10(b) liability. These effects pose limits on the early warning system's promise and this Article suggests using safe harbors to overcome them. This Article also offers some criticism of the current preoccupation with control effectiveness as the key to reliable financial reporting evident in auditing's otherwise appealing new early warning system.

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