embezzlement scheme by the management of Cedars of Lebanon Hospital Corp., the court ruling that "management cannot sue an auditor for failing to detect a fraud that management itself perpetrated"). If material, one would expect that this fraud would be discovered during the audit engagement.
"Validity of the accounts" is a problem related to receivables and inventories. Auditors have been sued because the financial statements reflected accounts receivables that were fictitious. See, e.g., Ultramares v. Touche, 174 N.E. 441 (N.Y. 1931) (audited company's accounts receivables included fraudulent amounts that more than doubled the true size of the balance) or because inventories on the books did not exist. See KONRATH, supra, at 78 (describing McKesson & Robbins case, ultimately settled in 1938, in which a significant portion of accounts receivable were fictitious and a large amount of inventory was nonexistent). This case precipitated the auditing standard which now requires auditors to confirm accounts receivable and observe inventory on a sample basis. See 1 AICPA PROFESSIONAL STANDARDS, U.S. Auditing Standards AU Section 331.01 (Am. Inst. of Certified Pub. Accountants (CCH) 1990). Obviously, if nonexistent assets are reflected in the books and records, total assets will be inflated by the dollar amount assigned to the fictitious assets.
(n290) What follows in text is a garden variety application of the Learned Hand Rule. See United States v. Caroll Towing Company, 159 F.2d 169, 173 (2d Cir. 1947).
(n291) See 1 AICPA PROFESSIONAL STANDARDS, U.S. Auditing Standards AU Section 150.02, at 81-82 (Am. Inst. of Certified Pub. Accountants (CCH) 1990).
(n292) See id., Statement on Auditing Standards No. 58 Section AU 508.08 ("In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position ... and the results of its operations and its cash flows ... in conformity with generally accepted accounting principles."). Materiality is defined by accounting standards as "[t]he magnitude of an omission or misstatement of accounting information that, in light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement." 2 ORIGINAL PRONOUNCEMENTS, Accounting Standards, FASB Concepts Statements 706 (Fin. Accounting Standards Bd. 1990). Hence, auditors do not assert to financial statement users that the audited financial statements are completely accurate. Instead, they attest that the financial statements are materially correct. Therefore audited financial statements are likely to contain some misstatement deemed immaterial by the auditors.
The management of the client company is responsible for the accuracy of the financial statements. ARENS & LEOBBECKE, supra note 289, at 36. The fact that an audit is performed by an independent party does not relieve management of its responsibility for both fair and accurate presentation of the financial information. Any material misstatements in the audited financial statements remain the responsibility of management.
(n293) See Jennings et al., supra note 102, at 100-01.