Auditor Liability

Auditor Liability

Recently, the question of liability has become more prevalent in the practice of public accounting. 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 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 significant 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