It’s Time to Limit Auditor Liability

 

The public expects auditors to find fraud — any and all fraud. That’s what auditors do, right? Well, it’s really not that straightforward. A case in point: The FDIC is suing PricewaterhouseCoopers in federal court to recover $2.5 billion in losses relating to fraud at now-defunct Colonial Bank, previously audited by PwC. The purpose here is not to debate the merits of this or any other case; rather, it is to offer a solution that might be even more advantageous than taking auditors to court.

It’s time to consider litigation reform to limit auditor liability in the United States. Now, that might sound counterintuitive, but it’s not for the benefit of accounting firms. Limiting liability will improve audit quality, and here’s why:

Under our current legal system, most auditor liability cases are settled before or during a trial for a relatively small portion of the huge reputed amount of damages claimed. The settlements are generally confidential, so no actual determination of negligence or fraud on the auditor’s part is ever made. Therefore, no one beyond the parties to the case can learn lessons and apply them going forward. In other words, the rest of the auditing world won’t find out how the fraud was missed in the first place.

But let’s back up a bit: It’s important to understand the landscape for auditor liability in the U.S. Auditors face difficult challenges when they are sued for negligence (or more rarely, actual fraud) and face trial by a jury uneducated in the complexities of securities laws and auditing standards. After all, the public expects auditors will uncover fraud in all circumstances, but that isn’t what auditors are actually tasked to do. This creates an “expectation gap,” and it’s problematic.

PCAOB auditing standards require auditors “to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.”

The standards also say the auditor should be “able to obtain reasonable, but not absolute, assurance that material misstatements are detected.” So even if auditors did their jobs properly, financial statements might still be materially misstated. Why? Often management executes fraud involving internal collusion and perhaps aided by external parties. They might even have documentation to make questionable transactions appear legitimate. That means the fraud was likely to go unnoticed by auditors by design. And that’s a difficult concept to explain to a jury.

Because of this expectation gap, auditors simply can’t take the chance of a “bet the firm” jury verdict. Instead, they’ll generally settle out of court for a manageable amount. (Plaintiff settlements are often as low as 5% of overall damages claimed.)

If liability caps were in place, auditors would be more likely to take the fight all the way to a jury conclusion and — ironically — would probably wind up paying more than if they had elected to settle, knowing the cap would prevent catastrophic financial ruin. Investors would benefit from a liability cap, too. But here’s the important part: There would be full transparency. If all evidence from both sides was presented and a verdict rendered, the information would be public, and all auditors could analyze and learn from it.

It is also important to understand that the plaintiff’s bar doesn’t actually want the defendant accounting firm to go out of business. They want a large dollar award, but one that the auditor can pay and still survive to be sued again. Lawyers should also be in favor of liability caps, not opposed.

We don’t know what the outcome will be of FDIC v. PwC. But if it settles under confidential terms, the profession as a whole loses no matter the outcome. That’s why limiting auditor legal liability is critical. The goal here isn’t to protect auditors from failing to properly perform their professional responsibilities. The goal is to implement processes that improve audit quality and help auditors uncover more fraud. Isn’t that what the public expects?

 

About The Author

Jeff Johanns

Jeff Johanns is an accounting lecturer at the McCombs School of Business. He is a former U.S. Assurance Risk Management Leader...

Leave a comment

We want to hear from you! To keep discussions on-topic and constructive, comments are moderated for relevance and for abusive or profane language.
Login or register to post comments