will be discussed in the following subsections after which the authors will consider the structural changes that might occur in the accounting profession if common law privily barriers are eliminated but the joint and several rule is retained. This part concludes by considering whether the elimination of privily accompanied by a proportionate several only rule would be economically more efficient.
Estimating Auditors' Risk
Audit Risk and Negligence Principles
Auditors are confronted with two interrelated risks. Audit risk is the probability of auditors issuing incorrect audit opinions because of their failure to detect material errors and irregularities in their client's financial statements.(n288) We define liability risk as the probability of an auditor issuing an incorrect audit opinion and being found liable for negligence.(n289)
Negligence rules require that there be potential liability whenever the auditor has failed to take precautions commensurate with the quantum of harm that could occur to parties to whom the auditor owes a duty of care.(n290) This quantum of harm is estimated ex ante by calculating the probability of an incorrect audit opinion being issued multiplied by the probable magnitude of pecuniary loss that will be suffered by the plaintiff class. Auditors are then expected to expend resources on precautions equal to the estimated quantum of harm. Thus, liability risk is a function of probability, magnitude, and precautions. The liability risk increases with increases in probability and magnitude and decreases with precautions.
For the tasks of calculating and minimizing audit risk, auditors use Generally Accepted Auditing Standards (GAAS)(n291) The operative parameter of GAAS is that of materiality.(n292) Auditors consider themselves responsible for detecting only material misstatements.(n293) Materiality is a relative term referring to the magnitude of the misstatement compared with the total financial activity of the enterprise under audit.(n294) Thus, an undetected million dollar embezzlement could conceivably be deemed immaterial in an audit of a multi-billion dollar enterprise.
Auditors sued for malpractice or negligent misrepresentation will often argue that liability risk should depend solely on whether GAAS has been followed, but it is clear that negligence liability can be imposed despite an auditor's adherence to GAAS.(n295) For example, if the auditor following GAAS were to underestimate the quantum of harm threatened by a misstatement and, as a result, she failed to take commensurate precautions, she may have breached her duty of care, even though the misstatement was arguably immaterial. Conversely, losses can occur in the absence of negligence in instances when, for example, the cost of preventing (detecting) the misstatement would be greater than the total probable harm that the misstatement might proximately cause.(n296) Audit risk is related to liability risk in the sense that efforts to reduce the one will tend to reduce the other, but there is no assurance that meeting professional auditing standards will satisfy the law, or that merely avoiding negligence liability is sufficient to conduct a satisfactory audit.