The Impossibility of Auditor Independence

  • Max H. Bazerman, Kimberly P. Morgan and George F. Loewenstein
  • July 15, 1997

In 1992, Phar-Mor, Inc., the largest discount drugstore chain in the United States, filed for bankruptcy court protection following discovery of one of the largest business fraud and embezzlement schemes in U.S. history. Coopers & Lybrand, Phar-Mor’s former auditors, failed to detect inventory inflation and other financial manipulations that resulted in $985 million of earnings overstatement during a three-year period. A federal jury unanimously found Coopers & Lybrand liable to a group of investors on fraud charges. The attorney for one investor argued that “this sends a strong signal to the accounting community that investors take very seriously the role of audited financial statements and rely on them for their integrity.”1

The investors who successfully sued Coopers & Lybrand contended that Gregory Finerty, the Coopers & Lybrand partner in charge of the Phar-Mor audit, was “hungry for business because he had been passed over for additional profit-sharing in 1988 for failing to sell enough of the firm’s services.”2 In 1989, Finerty began selling services to relatives and to associates of Phar-Mor’s president and CEO (who has been sentenced to prison and fined for his part in the fraud). Critics claim that Finerty may have become too close to client management to maintain the professional skepticism necessary to conduct an independent audit.

The Phar-Mor case is one of many in which auditors have been held accountable for certifying faulty financial statements. Investors in the Miniscribe Corporation maintained that auditors were at least partially responsible for the now-defunct company’s falsified financial statements; at least one jury agreed, holding the auditors liable to investors for $200 million. In the wake of the U.S. savings and loan crisis, audit firms faced a barrage of lawsuits, paying hundreds of millions of dollars in judgments and out-of-court settlements for their involvement in the financial reporting process of savings and loan clients that eventually failed.

The accounting profession maintains that it is being unfairly assaulted by plaintiffs looking for a convenient “deep pocket” from which to recover losses that may result from their own poor investment decisions. The investing and lending public, on the other hand, has become cynical about the accounting profession and its role in the financial reporting process.