Critical to most well-grounded credit decisions are audited financial statements, which supply a meaningful measure of past performance.

They establish a benchmark against which to evaluate the reliability of interim financial statements and other data that come from the potential borrower.

Application of generally accepted auditing standards by public accounting firms assures a high degree of reliability in financial statements. If financial results are based on generally accepted accounting principles, comparisons can be made within and outside the borrower's business.

What happens if the audited financial statements-the building blocks of a credit analysis-are fundamentally wrong? What if inventory, net income, and net worth are materially overstated? What if, as a result, assets are insufficient to repay a loan, or cash flow is insufficient to service a debt?

When such a disaster strikes, the public accounting firm, in cases of negligence, recklessness, or fraud, should be held responsible to lenders and other creditors who have reasonably relied on the audited financial statements. But whether under the current legal regime the accountants will be held responsible is no sure thing.

Courts and legislatures have imposed significant roadblocks to a creditor's ability to hold public accounting firms accountable for negligent auditing work. Through litigation and effective public relations, the accounting industry has convinced jurists and legislators that special rules are required to insulate accountants from a supposed threat to unlimited liability.

For example, in New York, a world financial center, creditors cannot sue auditors for negligence without satisfying a rigorous three-part test. The key element of that test is a requirement that creditors prove the existence of conduct by the accountants that links them to the party bringing the suit and that shows the accountants' understanding of the creditors' intent to rely on the audited financial statements.

As a practical matter, to satisfy New York's pleading requirements may require that creditors have had direct contact with the auditors before credit was extended.

Such strict pleading requirements may not be applicable if a lender proves that there has been a gross departure from accounting standards or that the audit is infected with fraud. But the law has erected another hurdle to alleging fraud or recklessness amounting to fraud. A party asserting a fraud claim must plead it with particularity. Without access to the auditor's work papers, this can be an insurmountable task. Obtaining such access may be near impossible.

Unless the borrower declares bankruptcy, in which case wide-ranging discovery is permitted, there is no means to require an accounting firm to offer access to its audit work papers.

What can creditors do to make sure that public accounting firms are held responsible for bad audit work that causes creditor injury? Creditors may not be able to force accounting firms to minimize the roadblocks, but they can require their borrowers to do so.

Before extending credit, creditors have leverage with the prospective borrower. Creditors should use it to require the potential borrower to take steps that will eliminate key roadblocks if it becomes necessary to hold the accounting firm responsible for bad audit work. Here are four requirements that creditors should demand:

First, potential borrowers should be required-in the commitment letter and as a condition of the loan-to inform, in writing, their outside auditors of the proposed extension of credit. The letter also should authorize and direct the auditor to communicate with the creditor, and it should require a written acknowledgement from the auditor. Imposing this requirement would strip public accounting firms of immunity from litigation in states that impose a high threshold requirement on suits against accountants by creditors.

Second, creditors should require that borrowers have their outside auditors deliver to the creditor copies of management reports on internal controls. This would not only create another direct link between the auditor and the creditor but also potentially give the creditor significant information about deficiencies in the borrower's internal controls.

Third, creditors should insist that prospective borrowers authorize in writing, with an acknowledgement by the auditors, access by the creditor and its designated agents to all audit work papers. If disaster strikes, this would ensure that creditors have an opportunity to review and evaluate the adequacy of the auditor's work. In that way, if litigation is required to hold the auditors responsible for a bad audit, the creditor will more likely be able to plead its claim with the specificity required in court.

Fourth, before extending credit, lenders should meet or talk with representatives of the borrower's audit team about the audit, significant accounting policies and issues, financial results, and the borrower's internal controls. The creditor should explain the reason for the meeting- that it is considering an extension of credit. It should make a written record after the meeting and confirm its occurrence in writing with the auditor. Like some of the other steps suggested above, having such discussions with the auditors should eliminate their ability to prevent the assertion of valid claims resulting from bad audit work.

As a matter of standard credit policy, creditors should incorporate these steps into their credit decision-making. Commitment letters should be revised to impose these conditions. Credit agreements should add them as covenants and conditions.

Creditors should also obtain written acknowledgements from the outside auditors and meet or talk directly to them before any credit is extended. If borrowers are unwilling to agree to these terms, or if auditors are unwilling to supply the requested acknowledgement and hold the requested meeting, creditors should weigh carefully the wisdom of proceeding with the loan.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.