They Must be held responsible because one of the component of legal enforcement is that how much the parties held responsible and what penalties or punishment law has for them. so External auditors can not be waived. 

The truth is that external auditors carried out their responsibilities based on the quantum of information supplied by their clients.  Although, it is their responsibility to ascertain its correctness and use it as a basis to form the audit opinion.  As a result, if  a third party rely on such report and incur some losses, then the external auditor should be held liable if they intentionally connive to falsify the report to favour their clients; otherwise, they should not be held held responsible...which is a good reason they expressly include a disclaimer in the report.

If the third party could rely upon the audit reports and sue the external auditors, does this mean that the agency theory, which cements the relationships between the principal and agents, have lost its grip? Also, how to define who constitute third parties?

You might be interested in the attached paper.

You should think about what is a 'third party'. They are paid by the 'first party'. As a comparison, what would you think to be paid according to the opinion of your students?

Caparo's Case clearly demonstrates that auditors are only liable to  sue stockholders under common law although other parties can sue under Law of Tort for negligence where it can be proven that auditors were aware that somebody would rely on their work and they (auditors) did not do a good job i.e. when there is possible takeover and one condition is that there must be a clean audit report and auditor was aware of such condition. Central Banks under Basel II are gaining powers of taking banks' auditors to task if they do not act in good faith. For more details please see this article ssrn.com/abstract=2137207.

The Caparo case (1990) has set the right tone on the extent of external auditors' responsibilities and liabilities to the third party. In the case, the judge has applied the agency theory that a third party could only sue the auditors if they are deemed to be in a close proximity, that is the third party has established an understanding that they are going to make a decision based on the outcome of the audit report, provided the auditors are still working in the field, and provided the third party has faced damages subsequently due to negligence on the audit. Having said that, many recent cases and situations seem to suggest that auditors are liable to the principals (stockholders) but also to the third parties, with or without any proximity in relationships. The courts and audit profession need to put a stop on `anyone could sue the auditors' and firm up the agency theory. Any thoughts?  

Audit Oversight Board (AOB) by the Malaysian securities commission with the cooperation of MIA. The AOB became effective in 2010. Basically, the AOB’s task is to ensure high audit quality  by preserving the independence of auditors, make sure only a qualified person is allowed to audit financial statements, modernize the appeal process and maintain extensive sanctions 

Thanks Abdullah. Is there any audit failure after the establishment of AOB? It would be interesting to analyze the numbers and types of audit failure and improvements pre and post formation of AOB.

The external auditors' tasks are directly related to the audit committee of the entity's board of directors whom it sees are the best to perform the external audit. The AICPA (1981) requires that external auditors communicate with the audit committee formally as a main part of the audit performance. It also requires that the external auditors communicate with the audit committee regarding errors and irregularities (SAS 53), illegal acts by clients (SAS 54), and internal control structure (SAS 60). European Union Directive 2006/43/EC state: “The statutory auditor or audit firm shall report to the audit committee on key matters arising from the statutory audit, and in particular on material weaknesses in internal control in relation to the financial reporting process”.

As part of the corporate governance mechanisms, the audit committee as well as the external auditors should provide the public with correct, accurate, complete, and reliable information, and it should not leave a gap for predictions or uninformed expectations. With this responsibility to the public, the external auditors may be held liable to beneficiary or creditor third parties.

Thanks Dr. Al-Baidhani. Presumably an audit committee is part of the organization, so it should not constitute as a third party.

Dear Chon,

It is true that agency theory in its primitive form considers the relationship between one individual ( the agent , in your question external auditors) and another individual ( principal, in your question ,stockholders). But  ,in more advanced relations ,agency theory is not limited just to one individual  relationship. The relationship between the external auditors (agents) and the third parties (creditors, bondholders and other stakeholders) could also be considered as an agency relationship .The new relationship between external auditors and the third parties stakeholders  is established by laws and auditing standards which hold auditors responsible to the third parties .Hence practically  the auditors are the agents of the stockholders as well as the agents of other stakeholders (managements ,creditors ,bondholders ,government , etc. ). In case of the external auditors , instead of a single agency relation ,there are multiple agency relations .This does not mean that agency relation is confusing ,it simply means that the role of the agency relation ,in this case, is multiple  and it is enhancing.

@Juha: I don't think that your paper has much--if, indeed, anything--to do with this Q&A.

@Ahmed: Let's start with the obvious: With some notable exceptions--Cash, for instance--most accounting numbers are estimates. That especially true now that U.S. GAAP has embraced the misguided notions of 'fair value' accounting under the dreadful provisions of ASC 820 (Accounting for Fair Value Measurements). Such measurements are exit values, not entry values. One sees that in the definition of fair value: the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The key word there is participants (i.e., > one). In other words, the value of an asset is not what a company paid for it; it's what it can (in a perfect world) sell it for. Let me illustrate with an example I have used in webinars with national audiences.

Let's assume that you own an upscale art gallery in Midtown Manhattan. Sotheby's announces on short notice that it is going to auction off a painting by Picasso. One of your gallery's best clients is a wealthy man who collects Picassos. He's in Nepal about to begin a mountain-climbing expedition to get him ready (he hopes) to climb Mt. Everest. You call him and let him know about this opportunity. He authorizes you to borrow enough money--in his words, "whatever it takes"--to buy the Picasso @ auction. He says you and he will settle up as soon as he gets back to the U.S. in a couple of weeks. He sends you an e-mail to that effect. You, in turn, share that e-mail with your banker in order to give her a heads-up that you're probably going to be spending tens of millions of dollars to buy this painting.

(For the purposes of this discussion, ignore the additional several million dollars that you will have to pay as "seller's commission" to Sotheby's.)

On auction night, you go to Sotheby's--with a security detail. The bidding starts @ $5 million. It rapidly escalates to $15 million and then to $20 million, as bidders begin to thin out. It gets to $25 million with only a few bidders remaining. It then hits $29 million; you and one other bidder are the only ones still bidding. The $29 million came from the other bidder. You bid $30 million, and the other bidder salutes you and quits bidding. The auctioneer announces, "Sold for $30 million." You and your security detail transport the Picasso back to your gallery where it is placed in your vault. You text-message your client to let him know you were successful--and how much that success cost.

All of this occurs on the night of June 28th. Your gallery's fiscal year ends on June 30th. On July 7th, your gallery's outside auditors show up. Your client is still incommunicado in Nepal. The auditors are especially interested in the value of your inventory, of course. 

For the purposes of inventory accounting, what will be the carrying value of the Picasso you bought for your client with your own (borrowed) funds on June 28th?

If you think it's $30 million, think again. It's $29 million.

Why?

Because that was the last price point where 'market participants' were involved. So, despite what you paid for the painting nine days before, you must take a $1 million write-down.

This is the perversion of 'fair value accounting'. The incentives are all wrong: They encourage buying and selling assets--"The bazaar [bizarre?] is open," as one colleague of mine noted--not designing products and processes that generate annuity streams of high profits for shareholders.

What? "That's absolutely crazy," you say? Of course, it is. But this is what happened when the U.S. Securities and Exchange Commission told the Financial Accounting Standards Board "no more Enrons." This is why fair-value accounting is an exit price, not an entry one.

Those who are interested can go to the Accounting Standards Codification (free after registering) and read ASC 820 for themselves. A link is here: https://asc.fasb.org/login. Explanations written in everyday English are here (http://asc-820.com/) and here (http://www.pwc.com/us/en/cfodirect/issues/fair-value/index.jhtml). Pay particular attention to the 'Fair Value Hierarchy' and, especially, to Level 3 of that hierarchy.

Not to be outdone when it comes to bad ideas, the International Accounting Standards Board issued a pronouncement similar to ASC 820 in 2011 when it first released IFRS 13 ("Fair Value Measurement"). More is here: http://www.ifrs.org/news/press-releases/Pages/ifrs-13-fvm-may-2011.aspx.

Nobody could make this stuff up. Nobody. It is, in my view, completely and totally insane, not to mention a huge disservice to companies and to users of financial statements. But it has generated, and will continue to produce, billions and billions of dollars in needless fees for CPA firms and valuation professionals like me. I guess I should be grateful, but I'm not. Fair value is the greatest hoax since 'one size fits all.'

So, Ahmed, you might want to rethink your use of "correct, accurate, complete, and reliable information" and about the outside auditors needing not "[to] leave a gap for predictions or uninformed expectations." If only life were that simple.

Warren. I appear to have a totally different view as far as fair value is concerned. IFRS 13 Fair Value is there to avoid arbitrary valuation. The Level Inputs which is Hierarchy for USA GAAP Counterparts are there to guide companies when preparing financial statements. If you are investors, you would rather deal with companies whose assets are mostly in Level 1 (Active Market or Quoted) - i.e. stock exchange markets, futures market, commodity markets where information about prices are readily available at the touch of the button. Secondly as investor, you could be comfortable with Level 2 (Observable Market) - comparable instruments similar to those in active market. The Picasso Painting would be placed under Level 3 Input Unobservable Market. Here we have specialized items where there is inactive market because the painting is not sold regularly and changes  hands very few times in a year/years. If you are investor you would require greater caution with any company dealing with specialized items. Therefore, Fair Value is the greatest achievement in accounting history as companies must categorize all their items according to those three levels to ensure that investor is well informed. After all, there is this notion of caveat emptor - (buyer beware). It is the investor who needs to take greater caution on where to place precious resources.

Dear Chong

This depend on the position of third party in the contract between auditor and his client. if the name of third party is explicitly mention in the contract and the audit is toward to the benefit of this party, external auditors should be liable to the third party.

But, if the name of third party is not mention in the contract, the external auditors will be liable to the third party if this party is able to prove that he take an investment or credit decision (or any other decisions)  depend on the external audit report. in other words, If the third party was able to prove that he relied on the auditor's report to take a particular decision and the elements of responsibility (error- Damage  or harm- cause-effect relationship) was proved. in this case, the external auditors should be liable to the third party.

Regards

@Brian: If you think that valuation does not have a certain level of judgment--you'd call that 'arbitrary', wouldn't you?--then you need to look at the fair value hierarchy.

And you're also dead-wrong about the classification of the Picasso painting. If you think that a single transaction can't drive fair-value pricing, you haven't read about the meltdown @ Merrill Lynch in 2008. In July of that year, ML sold $30 billion of collateral debt obligations for 22 cents on the dollar. That 22 cents drove CDO valuations for several months thereafter and sent commercial and i-banks into the tank for TARP money.

This is an interesting example. So would the external auditors remain liable to the third parties?

@Gin: I don't understand the question. Are you referring to the specific Merrill Lynch case or to the general case?? Also, why would anything change where auditors' liability is concerned? Please elaborate, if you don't mind. Thanks in advance.

@ Warren, allow me to digress from external auditor's liability and comment on Merrill Lynch and advise that Fair Value is the Price for which an asset can be exchanged or liability settled between market participants in orderly transaction at a measurement date. This means that Merrill Lynch the seller agreed to receive 22 cents for $30 billion valuation since the complex derivative in form of collateralized debt was worth only 22 cents. You can have a house valued by professional property valuer at $22 million (this would be determined by location, materials used, accessories thereof and estimated lifespan) but you can sell it at $1 million depending on how desperate the seller is, liquidity in the market and other forces. 

Reverting to external auditor's liabilities, auditor's objective to obtain reasonable assurance that financial statements are not materially misstated due to errors or fraud and confirm that the financial statements have been prepared in accordance with applicable financial reporting framework. Regarding collateralized debts, the blame should go the Financial Industry Regulators who allowed firms to venture into risky and hazy assets. External auditors could not be blamed for products duly endorsed by regulators.

Thank you, Brian. You're preaching to the converted.

Having done purchase-price allocations under ASC 805 (Business Combinations), I'm well familiar w/the provisions of ASC 820 (Fair Value Measurements and Disclosures) and its predecessor, SFAS 157. In fact, I opposed SFAS 157 from the time its first exposure draft came out. I've also spoken out against it, loudly and publicly, including a face-to-face disagreement with the then-head of the Financial Accounting Standards Board (FASB), Bob Herz. I even wrote a lengthy piece that was published in the Institute of Management Accountants' magazine - see "The Fatal Flaw in SFAS 157," Strategic Finance, August 2008, pp. 41-47. I'm attaching a PDF to this post. 

In a similar vein, I wrote a much shorter piece for CFA Magazine; it was published in its July-August 2008 edition, pp. 53, 55. It appeared in the magazine's 'Point-Counterpoint' feature and was entitled "Fair Value's True Believers are Wearing Blinders." A PDF of the entire feature is attached.

I think that third party is constituated of Banks, institutional investors, suppliers, etc ...

In short all external members who have interests in the company

Discuss the concepts of auditors’ liabilities in relation to external auditing regarding an external client organization.

it is question.

The fact is agency theory, as it has been described in the literature (Jensen and Meckling, 1976, Namazi, 1985&2016; Baiman 1990), does not directly apply to the relationship between the auditor and the third parties (bankers, investors, creditors, government, etc.) outside of the organization, because there is no direct contract between the third parties and the auditor, and the third parties are not in the position to delegate the organization's decision making process with respect to allocation of resources to the auditor. However, the relationship between the auditor and the manager of the organization can be characterized as "agency relationship. Since the manager is the agent of the stockholders, thus the auditor should be responsible to the stockholders of the organization. In addition, due to the fact that the auditor has the social responsibility, and it is his/her duties should consider the benefits of all outside stakeholders of the organization, the domain of his/her responsibility is extended to the third parties of the organization as well -The bankers, for receiving loans, the investors for investing in the stocks of the organization, the creditors for their related transactions, government for taxes, and other stakeholders who use the audited financial statements. In this respects, the auditors has responsibility to the third parties.

I respectfully disagree, Mohammad.

There need NOT be "direct contact between the third parties and the auditor" because the auditors are the agents of the shareholders. The latter own the company, but obviously cannot be there every day, and maybe never. Therefore, they, acting through the Board of Directors that they elected, authorize the Board to retain the auditors to run certain tests to ensure that those running the company have a low likelihood of being able to steal money and other corporate assets and also that the financial statements of the company are accurate in all material respects. That is why, for all publicly-held companies in the United States, there is a requirement for an annual audit. The results of that audit appear (a) in the audited financial statements and (b) in the audit firm's assertion that those statements represent the financial position of the company.

Dear Warren,

Thank you very much for your response. The following assertions are made with respect to your point:

1. I should respectfully inform you that I stated, the relationship of the auditor and the third parties is not based on the THEORY of agency, because there is no direct CONTRACT (not-CONTACT as you have mentioned) between them…….. So my statement has not read carefully.

2. In spite of the preceding statement, since the manager is the agent of the stockholders and the auditor has a social responsibility to the third parties and public, the auditor has the responsibility to the third parties. Thus, our final conclusion is the same, and I do not see any basis of your disagreement.

We'll just have to agree to disagree.

@namazi, dont forget to mention community as other stakeholders or third party.

Dear Ludwina,

Yes, of course. Thanks.