This paper examines the case of auditor Cousteau, who chose to waive a fraudulent misstatement rather than resign the engagement or report the matter to the SEC. Drawing on SEC regulations, the PCAOB, the landmark TSC Industries v. Northway (1976) precedent, and the efficient market hypothesis, the paper argues that Cousteau's decision was defensible under contemporary auditing practice. Because current law leaves auditors with substantial latitude to determine materiality in context, and because prospective buyers of the firm were not ultimately misled by the fraud, the paper concludes that evidence of fraud does not automatically render financial statements materially misleading.
The paper exemplifies the use of a legal-regulatory framework to evaluate professional conduct. Rather than arguing from moral intuition alone, the author systematically traces the chain of authority — from court precedent to SEC interpretation to PCAOB guidance to practitioner behavior — before applying that framework to the case facts. This layered approach is characteristic of strong accounting and business-law argumentation.
The paper opens with an introduction that states the central tension and thesis. Two background sections ("Materiality" and "Current Auditing Practice") establish the legal and professional context. A third contextual section addresses auditor responsibility within capital markets. The penultimate section applies all prior context to defend Cousteau's specific judgment. A brief conclusion synthesizes the argument and restates the core finding.
Cousteau's decision to waive the material error may seem, in the context of the subsequent SEC litigation release, to have been an error on the part of the auditor. Indeed, the responsibility of the auditor is to detect and report material errors.
There is, however, some leeway in practice for the auditor to do as Cousteau did and determine that the error was not material. Despite that leeway, the financial markets depend on the accuracy of the information provided by financial statements and approved by the auditor. Evidence of fraud, to the investor and to regulatory authorities, is always material. This points to a gap between the fundamental assumptions upon which our capital markets are designed and the real-world practice of auditors. This paper argues that, given this gap, Cousteau was not in the wrong. If current auditing practice allows for auditor judgment on issues of materiality, then Cousteau retains the right to exercise that judgment.
The concept of materiality is central to the auditing role. The notion of materiality "recognizes that some matters, either individually or in aggregate, are relatively important for true and fair presentation of financial information in conformity with recognized accounting policies and practices."
There is no set definition for materiality, but there are standards. In the United States, the SEC governs materiality. It has been argued by Sauer that the SEC has diverged from the primary precedent set regarding materiality in TSC Industries v. Northway (1976). In that case, the court ruled that information is material if a "reasonable investor" would have regarded it as "having significantly altered the 'total mix' of information available to the public." As such, it is not the size of the monetary value but rather the type of information and its importance to the fair presentation of financial information.
The vagueness of the term "reasonable investor" leaves the precise interpretation of TSC v. Northway to individual courts in cases where fraud is suspected. The SEC, on the other hand, interprets materiality in its own way, which Sauer argues has become increasingly divergent from the relevant court decisions on the subject. Also weighing in on the issue is the PCAOB, which has loosely attempted to guide auditors, although its guidance is also considered by Sauer to be weak.
Sauer points out that auditors are instructed by the SEC, when they uncover illegal acts, to take steps to ensure that the company corrects the figures. Failing that, they must either resign the engagement or inform the SEC of the illegality. Studies have shown, however, that auditors waive approximately 50% of the material errors they uncover. While waiving material errors increases auditor risk, it is not specifically illegal. While it runs against SEC rules, those rules have yet to specifically define the limits of materiality for auditors. This leaves auditors in the position of defining materiality themselves. Materiality is always considered in the context of the entire set of financial statements and all publicly available information about the company.
Thus, while there is today a trend toward auditors resigning engagements, Sauer argues that this merely reflects increased auditor risk resulting from the growing variance between legal precedents and SEC rulings. Current auditor practice with respect to materiality, therefore, does not reflect changes in the laws regarding financial statement fraud. It still holds in law that there is considerable leeway for auditors to determine materiality, pending the court's view of the "reasonable investor." It should be noted that courts prefer to use proxies for the "reasonable investor," and there is little consistency with respect to the proxies chosen.
Although the outsider, and indeed the SEC, may have viewed Cousteau's decision as erroneous, it certainly was not so in the context of contemporary auditor practice. The auditing profession appears to support the view that auditors have leeway over the determination of materiality in financial statements, even when it concerns overt errors or fraud. It is important to note that the capital markets themselves backed this up: in the context of the totality of publicly available information about Acme, none of the prospective purchasers was enticed to make a bid. Given that, it is reasonable to view Cousteau's interpretation as being supported by both the auditing profession and the stakeholders in the capital markets.
You’re 48% through this paper. Sign up to read the remaining 2 sections.
Sign Up Now — Instant Access Already a member? Log inAlways verify citation format against your institution’s current style guide requirements.