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    Auditor Liability (2004 words) Essay

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    Auditor LiabilityannonThroughout the Eighties and into the Nineties thequestion of liability has become more prevalent in the practice of publicaccounting. Recently, the AICPA has been lobbying for liability reform incases 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 afew. (Bolinger p. 53) The key to success for the AICPA, according to GaryM. Bolinger is creatingan image as a, “profession performing high-quality services but facedwith excessive liability burdens that harm the public interest. ” (Bolingerp. 56)One should not be concerned, however, in the pending politicaloutcome, but in weighing the evidence argued by both sides and developinga sound reasonable basis.

    Therefore, the remainder of this document shallconcern itself with comparing the prevalen t arguments of both sidesagainst one another and drawing a conclusion based on the evidence. Opponents of liability reform rely heavily on an idealisticconstitutional argument as well as an economic argument to foster theirpoint. The main components of their argument are as follows: Limitingrecovery of loss has a detrimental effect on thosewhich are harmed by alleged negligence. The cost of liability isreasonable when compared to total revenues, and in light of a CPA’s publicresponsibility.

    Indemnity insurance spreads risk in the aggregatetherefore removing the element of risk at the f irm level. The threat oflitigation provides public accountants with a deterrent against negligentwork. Finally, the results of lawsuits cause the profession itself toimplement new standards. (Bolinger p. 54)The AICPA and its supporters have developed their argument basedon continued liability’s likely effect on the profession as well as aneconomic argument. The arguments in favor of liability reform include theeffect of continued liability on the availab ility of CPA services.

    Thelikelihood of fee increases resulting from liability risk. The threat ofthe inability of public accounting to obtain and retain qualifiedindividuals. (Bolinger p. 56) Finally, the complexities involved in theaudit engagemen t and the subjective decision making process versus theability of a given jury to understand and levy a fair decision in suchcases.

    After examining the arguments of both sides one will see thatlitigation in its current form is a hindrance to the accou ntingprofession as well as society, and the benefits provided by litigation areattainable through enforcement of professional standards. The first of the opponents arguments finds it’s basis fromidealistic Constitutional principal. The notion that those which havebeen wronged, either directly or indirectly, deserve compensation fortheir estimated loss is one which first found favor inthe case of Thomas v. Winchester in 1942. (Minnis p.

    4) In this case, forthe first time a third party received compensation. (Minnis p. 4) Theprecedent 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 toseek compensation. The case which most directly affected auditors is acase 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 aban k passed to its client a certificate of credit-worthiness on apotential client.

    The business which was deemed credit-worthy ultimatelyfailed, and claim resulted by the third party against the bank issuing thecertificate. !(Minnis p. 9) The finding in theThe notion that all parties remotely affected by a given action(or lack thereof) deserve compensation for their loss is one which isembraced by the legal community– and rightfully so, after all a drasticreduction in the number of claims filed would r esult otherwise. Theargument made in its favor is that all those harmed by negligent activitydeserve compensation. Idealistically this is true, and theoreticallyanyone who makes a decision based entirely on the results of an auditor’sreport, and suf fers a loss due to negligence in preparation by theauditor, deserves compensation. Realistically, however, this is notusually the case.

    With the exception of banks, whom are approached bybusinesses for the possibility of tendering a loan, and therefo re do notinitiate contact; all other investors would only take the time to reviewthe financial statements of a given company if another mitigating forceattracted them. Therefore, it is reasonably asserted, that significa!nt third parties, such as banks aA second argument against liability reform is that the cost ofmalpractice suits are reasonable in comparison with the revenues and levelof public responsibility delegated to CPA firms. An argument against thisis made twofold. First, the total numberof claims is not reasonable, but rather, astronomical. “According to arecent industry estimate, the accounting profession as a whole is facing4,000 lawsuits and $30 billion in potential claims pending against it.

    “(Clolery p. 42) Recent trends indicat e the total value of claims arecontinually increasing, one has to ask at what point will the value ofclaims become unreasonable? As claims continue to increase the demand forindemnity insurance, which is cyclical in nature, will increase alsocausing insurance expense to continually rise. This brings about the second argument which is indemnity insuranceitself. Indemnity insurance is a very specialized area of insurance andmost insurers are unwilling to underwrite it. (Minnis p.

    58) Whendiscussing the cost of assuming liability for ac counting firms, one musttake into consideration that as claims increase and insurance companiesbegin assuming losses as a result of indemnity claims, the willingness offirms to underwrite indemnity insurance decreases substantially; and thosewho do un derwrite it will demand a much higher premium resulting from thedecreasing supply and to compensate for losses generated previously. (Layton-Cook p. 109) In the long term, the argument that revenuessubstantiate the cost of claims is no longer justifiabl e on a ratiobasis. To illustrate, firm XYZ has insurance costs x and fees y. Overtime 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 overthe aggregate. Theoretically, this is true– firms pass insurance coststo clients who in turn pass additional overhead costs to consumers. Additionally, all firms carry insurance there fore causing each firm tobear the brunt of liability risk. Realistically speaking, however, apoint is reached where the inflationary implications of insurance isgreater than the market is willing to accept creating a situation whereclients are no lon ger willing to accept the additional costs imposed byfirms to compensate insurance expense leaving the firms as bearers of thecost of liability risk. Also, when taking into consideration the factthat a firm’s cost of indemnity insurance is at least pa rtially dependenton prior claims against the firm, a situation will arise when firms areunwilling to accept engagements which present risk, leaving the marketwith a certain number of businesses which firms are not willing!to represent.

    The final two arguments of the opposition are sufficiently relatedto combine into one discussion. These are: the threat of litigation actsas a deterrent against negligence, and malpractice suits lead toprofessional 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 throughlitigation; therefore, one can reasonably assume the threat of lawsuitcauses firms to exhibit a greater level of care when completing anengagement. If, however, standard violations are investigated and handledproperly 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 professionaccepts the responsibility of investigating possible claims of malpracticeand negligence, and acts in areas where new standa rds are necessary thesame result is achievable. The arguments the AICPA have developed in favor of liabilityreform begin with the effect of litigation on the availability ofaccounting services. As claims increase firms are forced to selectivelychoose 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 tensurefire ways to ensure a lawsuit. His rule five states, “Choose clientswhose principals arenot honest, and take no extra precautions” (Romano p. 58) This illustratesa continuing trend which is prevalent in the profession, which is avoidliability risk by better screening prospective clients. This seemsreasonable, except for the fact that al l SEC corporations require audits,and audits are required in other situations as well.

    In the end, someonemust accept the audit engagement; and with the ever looming threat oflawsuit a point is reached when there are no!willing takers. When this situatcompleteness. Additionally, he asserts staff qualifications as a majorpoint of emphasis in litigation. (Clolery p. 44) The result is firms mustincur extra expenses in order to, not only adhere to the principals ofGAAS; 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 ofmalpractice are incurred in three areas: the increase resulting frominsurance expense, the increase resulting from t he costs of performingthe engagement, and increases resulting from litigation expense. Thefirst two issues are covered previously. The area of insurance expense isdiscussed in the section covering indemnity insurance, while the cost ofthe engagementis illustrated in the most recent section. Additionally, the cost oflitigation services are also absorbed in engagement fees. A third area used in the AICPA’s argument is that of obtaining andretaining quality professionals. The basis for this argument is that welleducated intelligent persons, ones which public accounting seeks toattract into the profession, are less likel y to pursue a career in publicaccounting if high levels of liability risk exist.

    Furthermore, those whodo enter public accounting are more likely to leave the profession due toliability risk. This argument has merit inasmuch as pointing out theprofe ssions dedication to employ only qualified individuals; however theeffect it will have on those choosing to enter the profession is difficultto prove. One may ascertain the rationale behind leaving a professionwhere the pressures of liability exist, b ut public accounting will neverhave difficulty recruiting young professionals. Finally, an area not addressed by the AICPA but which deservesconsideration nevertheless, is that of the complexities and subjectivenessof 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. Inmalpractice cases the verdict often hinges on compliance with GAAS. (Buckless p. 164)A study was conducted concerning juror decisions based on a firm’scompliance with GAAS by Frank A.

    Buckless and Robert L. Peace of the NorthCarolina State University. They conducted a factorial experiment using2x2 format. The four possibilities are as follows: instructionsindicating compliance with GAAS and such compliance is the onlyconsiderable 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 beingconsidered. (Buckless p.

    169) The study concluded, “that jurors attachedgreater credibility to auditing standards established by the federalgovernment than to those established by the auditing profession. ” (Buckless p. 173) In a subsequent article the point is raised that whendiscussing the issue of government versus professional standards, one areaincluded a government witness while the other a witness from theprofession, b!ut not a cross sample of both; thIn regression analysis of the same sample, education is foundsignificant with those more educated being more likely to find in favor ofthe auditor. (Buckless p.

    172) This creates significant implicationsregarding a jury’s ability to reach a fair verdi ct in cases as technicaland subjective as accounting malpractice cases. The above argument shows major points used by both sides in theongoing fight involving liability reform in public accounting. Additionally it suggests that the profession itself need bear the burdenof deterrence, enforcement, and investigation whereb y eliminating theexisting systems only strength. If the AICPA in cooperation with stateboards becomes more willing to accept the role as investigator andpunisher, then the economics of the argument suggest that liability reformis in order.

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