Tuesday, August 29, 2006

Auditor Cert. of Financials Was Not Opinion on Management's Integrity

By James Hamilton, J.D., LL.M.

One of the most lucid judicial statements about what an outside independent auditor’s certification of a company’s financial statements actually means, and what it does not mean, is to be found in a recent opinion by a federal judge in the Southern District of New York. In this case. an outside auditor certified its audit of the company’s annual financial statements for the years 2003 and 2004. In each instance, the financial statements reported millions of dollars of losses and negligible revenue. Both of the auditor’s certifications included a going concern paragraph. The court noted that there were no false statements regarding the company’s financial condition in either of the annual financial statements audited by the outside auditor.

Instead, in their securities fraud action, investors asserted that the auditor’s certification of the financial statements contained a misstatement when the certifications said that the audit firm had conducted its audits in compliance with GAAS. The investors contended that the auditor could not have reasonably relied upon the integrity of management because red flags should have alerted it to management's lack of integrity.

In dismissing the securities fraud claims against the auditor, the court held that, in certifying the audits, the audit firm did not vouch for the integrity of management. Rather, its certification was addressed to the degree to which those financial statements comported with GAAP when audited with the degree of care mandated by GAAS.

In the court’s view, GAAS is relevant only insofar as it provides investors with a level of assurance that the financial statements accurately reflect the company's financial position when measured against GAAP. The court emphasized that an auditor's certification that a company's financial statements comport with GAAP is not also a representation about the integrity of management; and nothing in GAAS requires such a representation. In re Ramp Corporation Securities Litigation, (SD NY 2006), is reported in the CCH Federal Securities Law Reporter at ¶93,914.