Do audit reports by outside accounting firms really matter? That’s the discomfiting question posed by The Wall Street Journal and implied by a recent federal appeals court decision. After three former Securities and Exchange Commission (SEC) officials asked the appeals court to reconsider that decision, the appeals court invited the SEC  to file a brief addressing the former officials' arguments.

A recent ruling by the Second U.S. Circuit Court of Appeals dismissed an investor lawsuit against auditing firm BDO, which signed off on the books of insurance company AmTrust Financial Services, which overstated profits. The court ruled that the audit report, while including "potentially actionable misstatements,"  was so general that an investor wouldn’t have relied on it. That decision prompted three former SEC officials to ask the court to reconsider its decision. They noted that the SEC, in a previous enforcement case, had said that “few matters could be more important to investors” than whether a company’s financial statements had been subjected to a properly conducted annual audit.

As a result, the appeals court invited the SEC to file a brief expressing its views on the former officials’ arguments. The SEC in a court filing said that “the commission has an interest in ensuring its views on this issue are considered by the court," the Journal reported. The SEC's brief is due Feb. 16. The Journal reported that an SEC spokeswoman declined to comment.

The case involving BDO stems from the period between March 3, 2014, and April 10, 2017, during which BDO served as AmTrust’s outside auditor.

In a 2018 order, the SEC accused three BDO accountants of signing off on their audit work for AmTrust’s 2013 annual report without completing all the required audit procedures beforehand. The SEC suspended the three "from appearing and practicing before the SEC as accountants, which includes not participating in the financial reporting or audits of public companies." The SEC’s order allowed one accountant to apply for reinstatement after five years, a second to apply for reinstatement after three years, and the third to apply for reinstatement after one year.

The investors sued BDO in 2017, and the U.S. District Court for the Southern District of New York dismissed their claims, holding that none of the misstatements were actionable under the securities laws. On appeal, the Second Circuit, on Aug. 23, upheld the dismissal of the claims against BDO.

The investors suing BDO claimed that the audit report’s statements that BDO “conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (PCAOB)” and that “we believe that our audits provide a reasonable basis for our opinion” that AmTrust’s financial statements conformed to U.S. generally accepted accounting principles (GAAP) were fraudulent.

The appeals court did find that BDO's audit opinion was potentially actionable, stating, "We agree with the District Court that the Appellants have adequately alleged that BDO’s audit opinion contained potentially actionable misstatements of opinion because the Complaint 'render[s] it plausible that Bertuglia,'” who signed the audit opinion, “disbelieved the statement that the audit was conducted in accordance with the relevant PCAOB standards.”

The appeals court, however, also found that the misstatement was not material, stating, "But we also agree with the District Court that the Appellants’ Section 10(b) and Rule 10b-5 claim against BDO must be dismissed because the 50 Complaint does not adequately allege that the misstatement in BDO’s 2013 Audit Opinion was material. ... The audit statements to which the Appellants point were 'so general' in this case “that a reasonable investor would not depend on [them] as a guarantee.'" The court added, "Appellants’ 'claim that these statements were knowingly and verifiably false when made does not cure their generality, which is what prevents them from rising to the level of materiality required to form the basis for assessing a potential investment.'”

The appeals court concluded that the appellants "have failed 'to allege any facts relevant to the way or ways in which BDO's failure to supervise, review, document, and perform in good faith the 2013 audit would have been significant to a reasonable investor in making investment decisions.'”

Andrew Bailey, a former SEC deputy chief accountant and one of the three former agency officials who wrote a brief for the court, told the Journal that “investor reliance on the audit opinion has a long history in practice, regulation and law. This observable fact in the marketplace [of audit opinions affecting stock performance] seems to directly contradict the court’s position that the current audit report is not material to investors.”

“In this case, BDO’s false claims were material because had it told the truth, it couldn’t have issued an ‘unqualified opinion’ that AmTrust’s financial statements fairly presented its financial condition," the former SEC officials wrote in their friend-of-the-court brief, the Journal reported. "Indeed, BDO would have been compelled to disclaim any opinion at all." The former SEC officials said that the court’s “contrary conclusion conflicts with the views of the SEC and the PCAOB, and could have broad implications for those agencies’ enforcement authority.”

For CPAs in public practice who are engaged to perform financial statement audits; reviews, and attestation engagements:  Attend the Foundation for Accounting Education's Learn About The New Quality Management Standards With Renee Rampulla Webcast REPLAY on Dec. 29.