|
|
 |
Essay on Auditor Liability
| Date: |
10-14-04 8:08pm |
| Subject: |
Law |
| Word Count: |
2167 |
| Page Count: |
8.67 |
Auditor Liability
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 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
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 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 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 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 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.
??
Complete List:
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
|