A competent auditor has done a conscientious job of auditing Hercules Corporation, but because of a clever fraud by management, a material error is included in the financial statements. The irregularity, which is an overstatement of inventory, took place over several years, and it covered up the fact that the companys financial position was rapidly declining. The fraud was accidentally discovered in the latest audit by an unusually capable audit senior, and the SEC was immediately informed. Subsequent investigation indicated Hercules Corporation was actually near bankruptcy, and the value of the stock dropped from $35 per share to $1 in less than one month. Among the losing stockholders were pension funds, university endowment funds, retired couples, and widows. The individuals responsible for perpetrating the fraud were also bankrupt.

After making an extensive investigation of the audit performance in previous years, the SEC was satisfied that the auditor had done a high-quality audit and had followed generally accepted auditing standards in every respect. The commission concluded that it would be unreasonable to expect auditors to uncover this type of fraud.

Required: State your opinion as to who should bear the loss of the fraudulent financial reporting. Include in your discussion a list of potential bearers of the loss, and state why you believe they should bear the loss.