Auditor Liability

.. r 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.

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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 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 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. ??.