The U.S. Court of Appeals for the Seventh Circuit has concluded that, under Indiana law, an auditor is under no obligation to include a going concern qualification in its audit report when it does not have information that would cause it to question the financial health of the business being audited. Fehribach v. Ernst & Young, LLP, 493 F.3d 905 (7th Cir. 2007). In Fehribach, the court also addressed the issue of whether it is proper to impose litigation costs on a bankrupt corporation.
The plaintiff, the chapter 7 trustee of Taurus Foods, Inc., brought negligence and breach of contract claims against the defendant, Ernst & Young, Taurus’ auditor. The claims arose from Ernst and Young’s failure to include a going concern qualification in its October 1995 audit report as governed by Indiana’s Accountancy Act of 2001. The plaintiff appealed from a grant of summary judgment and award of costs in favor of the defendant.
The Seventh Circuit affirmed the district court’s decision and award of litigation costs. A going concern qualification indicates “substantial doubt about the [audited] entity’s ability to continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited,” the court noted.
The court determined that under Indiana law, an auditor is under no obligation to include a going concern qualification in its audit report when it does not have information in the documents reviewed that would cause it to question the financial health of the business being audited. Further, beyond review of the financial documents provided by the company, the auditor was under no obligation to conduct an investigation to discover extraneous facts that may have indicated the negative financial health of the company being audited. The court drew a sharp distinction between an auditor, which must determine the accuracy of the audited company’s financial statements and its compliance with Generally Accepted Accounting Principles, and a management consultant, which provides business advice. In performing its audit, Ernst & Young only was required to analyze Taurus’ financial statements, and any relevant facts of which it was actually aware that might pertain to the company’s financial health.
The Seventh Circuit also analyzed the propriety of the district court’s imposition of costs on Taurus. The plaintiff argued that because Taurus was “indigent,” litigation costs should not have been imposed.Despite its chapter 7 filing, the Seventh Circuit rejected the notion that Taurus was indigent. The court expressed concern with the idea that corporations could be “indigent” because, unlike individuals, they “are not allowed to proceed in forma pauperis . . . and to allow them to escape paying costs, on grounds of indigency, would blur the distinction between individuals and corporations.”
The Seventh Circuit also expressed deference to the bankruptcy action as the appropriate forum for determining whether a victorious adversary seeking litigation costs should receive preference over a bankrupt company’s creditors. This case limits the responsibility of auditors to explore the financial health of a corporation. As a result, reliance on a company’s audit report must be gauged by the limited nature of the report’s contents. An audit report is a means of ensuring an absence of fraud and inaccuracies in the audited company’s financial statements. It should not be viewed as a substitute for a comprehensive analysis of the external market factors that may bear on a company’s future financial success or failure.