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Auditor Liability

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Auditor Liability

Post  Joe_Morningstar on Wed Feb 10, 2010 6:06 am

Throughout the Eighties and into the Nineties the question of
liability has become more prevalent in the practice of public accounting.
Recently, the AICPA has been lobbying for liability reform in cases
involving negligence or malpractice by public accountants. Opposition to
this lobbying has come from consumer advocacy organizations, trial
lawyers' associations, and state public interest groups to name a few.
(Bolinger p. 53) The key to success for the AICPA, according to Gary M.
Bolinger is creating an image as a, "profession performing high-quality
services but faced with excessive liability burdens that harm the public
interest." (Bolinger p.56)
One should not be concerned, however, in the pending political
outcome, but in weighing the evidence argued by both sides and developing
a sound reasonable basis. Therefore, the remainder of this document shall
concern itself with comparing the prevalent arguments of both sides
against one another and drawing a conclusion based on the evidence.
Opponents of liability reform rely heavily on an idealistic
constitutional argument as well as an economic argument to foster their
point. The main components of their argument are as follows: Limiting
recovery of loss has a detrimental effect on those which are harmed by
alleged negligence. The cost of liability is reasonable when compared to
total revenues, and in light of a CPA's public responsibility. Indemnity
insurance spreads risk in the aggregate therefore removing the element of
risk at the firm level. The threat of litigation provides public
accountants with a deterrent against negligent work. Finally, the results
of lawsuits cause the profession itself to implement new standards.
(Bolinger p.54)
The AICPA and its supporters have developed their argument based
on continued liability's likely effect on the profession as well as an
economic argument. The arguments in favor of liability reform include the
effect of continued liability on the availability of CPA services. The
likelihood of fee increases resulting from liability risk. The threat of
the inability of public accounting to obtain and retain qualified
individuals. (Bolinger p.56) Finally, the complexities involved in the
audit engagement and the subjective decision making process versus the
ability of a given jury to understand and levy a fair decision in such
cases. After examining the arguments of both sides one will see that
litigation in its current form is a hindrance to the accounting profession
as well as society, and the benefits provided by litigation are attainable
through enforcement of professional standards.
The first of the opponents arguments finds it's basis from
idealistic Constitutional principal. The notion that those which have
been wronged, either directly or indirectly, deserve compensation for
their estimated loss is one which first found favor in the case of Thomas
v. Winchester in 1942. (Minnis p.4) In this case, for the first time a
third party received compensation. (Minnis p.4) The precedent set by this
case is the notion of duty owed to a third party-- if it ascertains that a
duty is owed then a third party has a right to seek compensation. The
case which most directly affected auditors is a case filed in the UK,
Hedley Byrne and Co Ltd v Heller and Partners Ltd (1964). (Minnis p.9)
This case ultimately developed a situation where a bank passed to its
client a certificate of credit-worthiness on a potential client. The
business which was deemed credit-worthy ultimately failed, and claim
resulted by the third party against the bank issuing the certificate.
(Minnis p.9) The finding in the The notion that all parties remotely
affected by a given action (or lack thereof) deserve compensation for
their loss is one which is embraced by the legal community-- and
rightfully so, after all a drastic reduction in the number of claims filed
would result otherwise. The argument made in its favor is that all those
harmed by negligent activity deserve compensation. Idealistically this is
true, and theoretically anyone who makes a decision based entirely on the
results of an auditor's report, and suffers a loss due to negligence in
preparation by the auditor, deserves compensation. Realistically, however,
this is not usually the case. With the exception of banks, whom are
approached by businesses for the possibility of tendering a loan, and
therefore do not initiate contact; all other investors would only take the
time to review the financial statements of a given company if another
mitigating force attracted them. Therefore, it is reasonably asserted,
that significant third parties, such as banks.
A second argument against liability reform is that the cost of
malpracticesuits are reasonable in comparis on with the revenues and level
of public responsibility delegated to CPA firms. An argument against this
is made twofold. First, the total number of claims is not reasonable, but
rather, astronomical. "According to a recent industry estimate, the
accounting profession as a whole is facing 4,000 lawsuits and $30 billion
in potential claims pending against it." (Clolery p.42) Recent trends
indicate the total value of claims are continually increasing, one has to
ask at what point will the value of claims become unreasonable? As claims
continue to increase the demand for indemnity insurance, which is cyclical
in nature, will increase also causing insurance expense to continually
This brings about the second argument which is indemnity insurance
itself. Indemnity insurance is a very specialized area of insurance and
most insurers are unwilling to underwrite it. (Minnis p.58) When
discussing the cost of assuming liability for accounting firms, one must
take into consideration that as claims increase and insurance companies
begin assuming losses as a result of indemnity claims, the willingness of
firms to underwrite indemnity insurance decreases substantially; and those
who do underwrite it will demand a much higher premium resulting from the
decreasing supply and to compensate for losses generated previously.
(Layton-Cook p.109) In the long term, the argument that revenues
substantiate the cost of claims is no longer justifiable on a ratio basis.
To illustrate, firm XYZ has insurance costs x and fees y. Over time
insurance costs increase by z and consequently fees increase by z. The
resulting ratio is x+z/y+z rather than x/y.
The opposition's third argument is insurance spreads the risk over
the aggregate. Theoretically, this is true-- firms pass insurance costs
to clients who in turn pass additional overhead costs to consumers.
Additionally, all firms carry insurance therefore causing each firm to
bear the brunt of liability risk. Realistically speaking, however, a
point is reached where the inflationary implications of insurance is
greater than the market is willing to accept creating a situation where
clients are no longer willing to accept the additional costs imposed by
firms to compensate insurance expense leaving the firms as bearers of the
cost of liability risk. Also, when taking into consideration the fact
that a firm's cost of indemnity insurance is at least partially dependent
on prior claims against the firm, a situation will arise when firms are
unwilling to accept engagements which present risk, leaving the market
with a certain number of businesses which firms are not willing to
The final two arguments of the opposition are sufficiently related
to combine into one discussion. These are: the threat of litigation acts
as a deterrent against negligence, and malpractice suits lead to
professional reform. The first of these arguments is clearly true,
litigation threat does indeed act as a deterrent against negligence.
Currently, the primary means of punishing negligent acts is through
litigation; therefore, one can reasonably assume the threat of lawsuit
causes firms to exhibit a greater level of care when completing an
engagement. If, however, standard violations are investigated and handled
properly by the profession this means is also accomplishable.
Finally, the opposition asserts litigation promotes reform. Again,
the same argument as before is appliable-- if the profession accepts the
responsibility of investigating possible claims of malpractice and
negligence, and acts in areas where new standards are necessary the same
result is achievable. The arguments the AICPA have developed in favor of
liability reform begin with the effect of litigation on the availability
of accounting services. As claims increase firms are forced to
selectively choose their client base in an effort to limit their
liability risk. This phenomena is briefly covered in the section on
indemnity insurance. In an article entitled "How To Get Sued" Patrick
Romano, CMA lists ten surefire ways to ensure a lawsuit. His rule five
states, "Choose clients whose principals are not honest, and take no extra
precautions" (Romano p.58) This illustrates a continuing trend which is
prevalent in the profession, which is avoid liability risk by better
screening prospective clients. This seems reasonable, except for the fact
that all SEC corporations require audits, and audits are required in other
situations as well. In the end, someone must accept the audit engagement;
and with the ever looming threat of lawsuit a point is reached when there
are no willing takers. Additionally, he asserts staff qualifications as a
major point of emphasis in litigation. (Clolery p.44) The result is firms
must incur extra expenses in order to, not only adhere to the principals
of GAAS; but also to provide the appearance of adhering to GAAS.
This brings up another key point in the liability reform issue,
which is the likelihood of fee increases. Fee increases as a result of
malpractice are incurred in three areas: the increase resulting from
insurance expense, the increase resulting from the costs of performing the
engagement, and increases resulting from litigation expense. The first
two issues are covered previously. The area of insurance expense is
discussed in the section covering indemnity insurance, while the cost of
the engagement is illustrated in the most recent section. Additionally,
the cost of litigation services are also absorbed in engagement fees.
A third area used in the AICPA's argument is that of obtaining and
retaining quality professionals. The basis for this argument is that well
educated intelligent persons, ones which public accounting seeks to
attract into the profession, are less likely to pursue a career in public
accounting if high levels of liability risk exist. Furthermore, those who
do enter public accounting are more likely to leave the profession due to
liability risk. This argument has merit inasmuch as pointing out the
professions dedication to employ only qualified individuals; however the
effect it will have on those choosing to enter the profession is difficult
to prove. One may ascertain the rationale behind leaving a profession
where the pressures of liability exist, but public accounting will never
have difficulty recruiting young professionals.
Finally, an area not addressed by the AICPA but which deserves
consideration nevertheless, is that of the complexities and subjectiveness
of auditing versus the ability of jurors to issue an educated decision.
The justice system relies on the services of jurors to levy decisions;
however, in highly technical areas the ability of jurors is suspect. In
malpractice cases the verdict often hinges on compliance with GAAS.
(Buckless p.164)
A study was conducted concerning juror decisions based on a firm's
compliance with GAAS by Frank A. Buckless and Robert L. Peace of the North
Carolina State University. They conducted a factorial experiment using
2x2 format. The four possibilities are as follows: instructions
indicating compliance with GAAS and such compliance is the only
considerable factor, compliance with GAAS and all factors are considered,
compliance with government standards and only compliance is considerable,
and compliance with government standards with all factors being considered.
(Buckless p.169) The study concluded, "that jurors attached greater
credibility to auditing standards established by the federal government
than to those established by the auditing profession." (Buckless p.173)
In a subsequent article the point is raised that when discussing the issue
of government versus professional standards, one area included a
government witness while the other a witness from the profession, but not
a cross sample of both. In regression analysis of the same sample,
education is found significant with those more educated being more likely
to find in favor of the auditor. (Buckless p.172) This creates
significant implications regarding a jury's ability to reach a fair
verdict in cases as technical and subjective as accounting malpractice
The above argument shows major points used by both sides in the
ongoing fight involving liability reform in public accounting.
Additionally it suggests that the profession itself need bear the burden
of deterrence, enforcement, and investigation whereby eliminating the
existing systems only strength. If the AICPA in cooperation with state
boards becomes more willing to accept the role as investigator and
punisher, then the economics of the argument suggest that liability reform
is in order.

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