Judge Rules 'Seriously Botched' Audit Is Not Fraud

Despite a public clamor for tighter regulation of auditors, a U.S. Court of Appeals ruled on April 19, 2002 that a "seriously botched" audit that led to a plunge in stock prices is not grounds for a securities fraud lawsuit.

Violations of GAAP

The case sets important precedent as an interpretation of the Private Securities Litigation Reform Act (PSLRA), a law passed by Congress in 1995 over President Clinton's veto. Under the court's interpretation of PSLRA, an accounting firm is not liable for fraud unless the auditor was deliberately reckless.

In this case, the allegations were that the accounting firm failed to see the obvious – that according to generally accepted accounting principles (GAAP), millions of dollars in revenue from software sales reflected in a financial statement should not have been recognized. The facts were that several factors caused the company to subsequently restate its financial results. One factor involved the accounting for transactions made on the last day of the year with value added resellers. Another involved compliance with Statement of Position 91-1, under which revenue recognition from software sales is restricted when there is significant uncertainty as to whether the company will ever get paid.

No Deliberate Recklessness

In explaining his decision, the judge said that the complaint sets out a compelling case of negligence, perhaps even gross negligence. But negligence alone does not subject an accounting firm to liability for securities fraud. In this case, the departures from GAAP did not constitute such an extreme departure from reasonable accounting practice that the accounting firm knew or had reason to have known that its conclusions would mislead investors. There was no proof of a strong inference that the auditor acted with an intent to defraud, conscious misconduct, or deliberate recklessness.

The company involved in the lawsuit was Altris Software, Inc., a publicly traded company that develops document management software. The accounting firm was PricewaterhouseCoopers (PwC). A spokesperson for PwC was not available for comment. The AICPA and Big Five firms (excluding Andersen) have joined together in a lobbying effort to oppose any rollback of the gains won for the accounting profession in the Private Securities Litigation Reform Act.

Download the full text of the court's opinion.

-Rosemary Schlank

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