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Ethical Obligations and Decision Making in Accounting Text and Cases 4Th Edition Mintz Solutions Manual Full Chapter PDF
Ethical Obligations and Decision Making in Accounting Text and Cases 4Th Edition Mintz Solutions Manual Full Chapter PDF
On March 25, 2015, the Second Circuit and Eleventh Circuit Courts of Appeal affirmed
dismissals of securities fraud claims filed against the auditors that audited Chinese reverse-
merger companies because the plaintiffs did not adequately plead scienter under the heightened
pleading standard imposed by the Private Securities Litigation Reform Act of 1995.1 Under the
PSLRA, plaintiffs must “state with particularity facts giving rise to a strong inference that the
defendant acted with the required state of mind” with respect to each act or omission of the
defendant that is alleged to violate the securities laws.
The Second Circuit’s opinion in ABAT stated that to allege scienter on a recklessness theory
against an independent audit firm under Section 10(b) of the Securities Exchange Act of 1934
and Rule 10b-5, a plaintiff must allege facts showing that the audit firm’s auditing practices were
so deficient as to amount to “no audit at all” or that the audit firm disregarded signs of fraud that
were “so obvious” that the audit firm must have been aware of them.
The ABAT ruling is significant because it is the first federal appellate case to expressly reject
scienter arguments based on the alleged discrepancy between a company’s filings with the U.S.
SEC and with China’s State Administration of Industry and Commerce (SAIC), a regulatory
agency to which Chinese companies must submit financial statements as part of an annual
examination. The decision reflects a growing trend of courts rejecting securities fraud claims
filed against independent audit firms in the context of Chinese reverse-merger companies.
In ABAT, the plaintiffs alleged that the auditors falsely represented that they performed their
audits in accordance with professional standards and that ABAT’s financial statements were
fairly presented. An amended complaint upon appeal of the lower court decision against ABAT
alleged that the audit firms were reckless and committed an “extreme departure from the
reasonable standards of care” by failing to identify several purported “red flags,” including: (1)
conflicts between ABAT’s financial statements filed with China’s SAIC and with the SEC; and
(2) the unreasonably high profits that ABAT reported in its SEC filings, in contrast to the
significant losses that it reported in its SAIC filings. The district court denied leave to amend,
and the Second Circuit affirmed.2
The Second Circuit agreed with the district court that the proposed amended complaint, like the
previous complaint, failed to adequately plead the audit firms’ scienter under the theory of
recklessness and that amendment would be futile. The appellate court explained that the plaintiff
was required to allege conduct “that is highly unreasonable, representing an extreme departure
from the standards of ordinary care,” such that the conduct “must, in fact, approximate an actual
intent to aid in the fraud being perpetrated by the audited company as, for example, when a
Much of the Second Circuit’s analysis focused on the plaintiff’s argument that the audit firms
acted recklessly by failing to inquire about or review ABAT’s financial filings with China’s
SAIC. In rejecting these arguments, the court noted that none of the “standards on which [the
lead plaintiff] relies—the Generally Accepted Auditing Standards, Statements on Auditing
Standards, or GAAP [generally accepted accounting principles]—specifically requires an auditor
to inquire about or review a company’s foreign regulatory filings.”
The court declined to adopt the general rule, urged by the plaintiff, that allegations of an audit
firm’s failure to inquire about or review such foreign filings are adequate to plead recklessness
under the PSLRA. Although the court noted that “such a legal duty could arise under certain
circumstances” (which it did not explain), it concluded that those circumstances were not pled
here. In addition, the Second Circuit held that ABAT’s report of high profit margins in its SEC
filings triggered, at most, a duty to perform a more rigorous audit of those filings, not of the
company’s SAIC-China filings. The court declined to infer recklessness from the allegations that
one of the audit firms had access to, and “presumably relied” on, the financial data underlying
ABAT’s SAIC filings but failed to see that the data contradicted the company’s SEC filings.
Instead, the court found another inference more compelling—that ABAT maintained different
sets of data for its Chinese and U.S. regulators and provided the audit firm with false data.
The ABAT opinion is significant because it illustrates the high burden plaintiffs face in pleading
recklessness in Section 10(b) cases against independent audit firms. Notably, since under the
PSLRA the plaintiffs filing suit must plead with particularity facts alleging that the audit firm’s
work was so deficient as to amount to no audit at all, the historical legal standards for auditor
liability seem to have turned in favor of the auditors. Also, the Second Circuit’s determination
that allegations that an audit firm failed to review AIC filings is not sufficient to meet this high
burden for pleading scienter is significant, as such allegations are frequently pled in matters
involving audits of the financial statements of Chinese companies listed on U.S. securities
exchanges.
Questions
1. Do you believe the legal standards of allegations with “particularity sufficient facts”
and of “no audit at all” cited in ABAT under Section 10(b) of the Securities
Exchange Act of 1934 are too strict, too lenient, or just about right with respect to
auditors’ legal liability in cases similar to ABAT? Explain.
Since the standard requires that the auditor act with the “required state of mind” it would
seem the standards are fair in that the scienter requirement requires intent; to prove fraud
in the financial statements exist, intent must be shown. Thus, the legal standard is
consistent with the ethical one of justice/fairness.
As for an audit being so deficient as to constitute no audit at all, this may be too strict a
pleading requirement because a deficient audit need not be so faulty as to describe “no
The facts of the case indicate the auditors was reckless and they committed an “extreme
departure from acceptable standards by failing to adhere to a reasonable standard of care”
and failed to identify several purported red flags. Here it does seem that the audit was so
deficient as to be no audit at all because due care standards were not met and
identification of red flags are essential to assess the risk that material misstatements in the
financial statements exist and that the internal financial controls may not be operating as
intended. Absent a proper assessment of risk, it would seem the audit was so deficient as
to be no audit at all. In the end it all comes down to what constitutes no audit at all.
Absent specific standards to that effect, it seems legally questionable to draw that
conclusion.
2. In ABAT, the plaintiffs alleged that the auditors falsely represented that they
performed their audits in accordance with professional standards and that ABAT’s
financial statements were fairly presented. The amended complaint alleged that the
audit firms were reckless and committed an “extreme departure from the
reasonable standards of care” by failing to identify several purported “red flags.”
Do you believe the failure to identify red flags should be sufficient in a court of law
to successfully allege gross negligence? Include in your discussion the purpose of
auditors looking to detect red flags as part of their audits in accordance with GAAS.
Gross negligence is a conscious and voluntary disregard of the need to use reasonable
care, which is likely to cause foreseeable grave injury or harm to persons, property, or
both. It is conduct that is extreme when compared with ordinary negligence which is a
mere failure to exercise reasonable care. Ordinary negligence and gross negligence differ
in degree of inattention, while both differ from willful and wanton conduct, which is
conduct that is reasonably considered to cause injury. This distinction is important, since
contributory negligence—a lack of care by the plaintiff that combines with the
defendant's conduct to cause the plaintiff's injury and completely bar his or her action—is
not a defense to willful and wanton conduct but is a defense to gross negligence.
As stated above, the failure to identify red flags is a serious oversight as it is one of the
most important standards in assessing the risk that material fraud exists in the financial
statements and material departures exist in the operations of internal controls. The failure
to identify these red flags by auditors should be sufficient in a court of law to successfully
allege gross negligence.
The key consideration is whether the difference in filings is due to some conscious effort
to manipulate earnings under one regime or the other, or whether it is a by-product of
different accounting standards in reporting results.
Much of the regulation of public stocks in China is done directly by the Hong Kong
Stock Exchange and the Shanghai Exchange. Both have listing procedures similar to U.S.
exchanges. Companies must report financial results on a timely basis, and audits of
company financial results are performed, although the accounting rules are different from
the U.S.
Chinese companies are required to follow “Accounting Standards for Business
Enterprise” in filings with the Chinese government for regulatory oversight purposes and
they use International Financial Reporting Standards (IFRS) in their annual report
information that is targeted to the global investor. In the U.S. we use GAAP for both.
These are different standards and it is logical to conclude that the different filings to
different regulatory agencies in the U.S. (SEC) and China (China Securities Regulatory
Commission) are to be expected.
Using ethical reasoning, the rights of the users of financial reports is paramount in
determining the information provided to regulatory agencies in each country. The
Chinese government is the main investor in most so-called “state-owned enterprises”;
public ownership is more pronounced in non-government owned companies. In the U.S.,
shareholders, investors and creditors are the primary users of the financial reports. Each
group has different needs and attending rights to receive accurate, full and fair financial
information to meet their decision making needs.
MISSION TO TANGIER.
In 1844 Mr. Hay went to England on leave, and visited also
Stockholm and Copenhagen. At this latter capital he met the ‘fair girl’
who was to be his future wife, as Leila had predicted. Whilst in
Stockholm, he was presented to King Oscar by our Minister, Mr.
Cartwright, and in the course of conversation with His Majesty about
Morocco, pointed out the advisability of abolishing the old
Convention between Morocco and Sweden, and Morocco and
Denmark, which stipulated that $25,000 (£5,000) should be paid
annually to the Sultan, in order that vessels under the flags of these
two nations should pass the Straits unmolested by Moorish cruisers;
these cruisers having virtually ceased to exist, though the
Convention remained in force.
A rupture of relations between France and Morocco was at this
time imminent, and Mr. Hay’s father, then Political Agent at Tangier,
had been sent, with the knowledge of the French Government, to the
city of Marákesh on a mission to endeavour to induce the Sultan to
accept the French demands. On hearing of this expedition Mr. Hay
wrote to Lord Aberdeen, who was then Secretary for Foreign Affairs,
to offer his services temporarily in Morocco. This offer was accepted.
That Mr. Hay, while at Constantinople, had gained the kindly
opinion of Sir Stratford and Lady Canning may be gathered from the
following letter written to him after his departure from Constantinople,
when Lady Canning learnt that he had been sent to Tangier. The
note was accompanied by the gift of a beautiful cushion in Turkish
embroidery.
You must not leave Constantinople, my dear Mr. Hay, without some little
memento from me to remind you in future days of our life spent together on the
Bosphorus in which, though it may have had some cloudy moments, I hope the
bright ones have preponderated and will alone be remembered by you. We shall
miss you sadly; for your labours have not been thrown away on Sir Stratford, and
you have helped to keep us all in good humour with our neighbours, and for all this
I thank you much. Let us hear of you often, and believe that we shall feel interest
in all that concerns you.
Yours very sincerely,
E. C. Canning.
’Tis a sad thing that all folks in Europe, my masters in Downing Street may not
be excepted, have hardly any just conception of the difficulties of my position. It
would take a volume—not small—to relate the bother and the tricks and bad faith
with which I have had to contend—and as to going fast, as Mr. Bulwer has
everlastingly urged, who among mortal men can make Moors go fast, nay, nor
hardly move at all—in the straight path of honour and sound policy? . . .
Alas! I know not what to think. I had hoped the French would have waited until
my report reached Tangier or myself arrived there and told them all. So they are
now preparing to cast fire and the sword on this unhappy country of ignorant
barbarians.
The Moors are mere children, vain children; obstinate, through a shocking
bigotry and ignorance scarcely credible. They have, I believe, had at least two
collisions with the French on their frontier; but all their acts of folly were, I am
certain, without authority. Alas, again, for the poor Sultan; he cannot manage his
own people! If the war do burst forth here, when shall it end? There will be an
internal revolution forthwith, I am almost sure! And drivellers in pomposity and self-
sufficiency would ever publish that all was well.
The elder Mr. Hay did not long survive the effects of the journey,
with all its worry and vexation; but succumbed shortly after his
return, to low fever and other complaints. During his illness, which
lasted several months, Mr. John Hay was directed by Lord Aberdeen
to take charge of political affairs in Morocco, whilst Mr. H. Murray, the
Consul, conducted the consular duties.
The crisis was one of considerable importance. In addition to the
internal difficulties of Morocco, questions with foreign Powers
embarrassed the Sultan’s Government. Denmark and Sweden had
sent squadrons in this year to Moorish waters, demanding the
abrogation of the treaty referred to in Mr. Hay’s audience of King
Oscar.
The Spanish Government had also a question pending with
Morocco regarding the neutral ground and frontier of Ceuta; and, for
the settlement of this question, Sir Henry Bulwer, then H.B.M.’s
Minister at Madrid, had been appointed special Plenipotentiary.
In the following letter to his late chief at Constantinople Mr. Hay
gives an account of the state of affairs which he found on his arrival
at Tangier.