Auditor Liability Essay, Research Paper

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 acco untants.

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 prevalen t 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 f irm 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 availab ility 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 engagemen t 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 accou nting

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 t hen 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

ban k 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 r esult 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 suf fers 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 therefo re 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 significa!

nt third parties, such as banks a

A second argument against liability reform is that the cost of

malpractice suits are reasonable in comparison 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 indicat e 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 rise.

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 ac counting 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 un derwrite 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 justifiabl e 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 there fore 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 lon ger 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 pa rtially 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 represent.

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 argumen ts 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 standa rds 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 l iability 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 al l 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. When this situat

completeness. 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 appearan ce 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 t he 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 likel y 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

profe ssions 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, b ut 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 o f 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

2×2 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 wit h 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, b!

ut not a cross sample of both; th

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 verdi ct in cases as technical

and subjective as accounting malpractice cases.

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 whereb y 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.