Essay/Term paper: Auditor liability

Essay, term paper, research paper:  College Papers

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
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 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.