Causes Of Increased Legal Liability Trials Accounting Essay

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In the US, lawsuits against Public Accounting firms are common. At one time is there is one or several of the 'Big Four' filing defense papers or pursuing an appeal with the courts. The 'Big Four' is an informal term referring to the four largest auditing firms comprising PricewaterhouseCoopers, Deloitte & Touché, Ernst & Young and KPMG. Investors badly hurt with erosion of their equity in the recent economic crisis are seeking to have courts uphold malpractice charges on auditors of their companies (Aubin 1). Audit firms have had a mix of results in defending lawsuits. While they have succeeded in convincing courts to dismiss most these cases, the few that have gone through have been awarded huge damages. It is not clear though the value of suits that audit firms have settled in private (1). Notably, Arthur Anderson is a casualty that collapsed from its involvement in fraud.

Causes of increased legal liability trials

Audit liability lawsuits are on the rise. The common cause is born of the expectations gap in investor perception of audit. Shareholders interpret an audit report as insurance or guarantee of a firm's financial health and it should therefore warn them of impending company failure (Dickey and Minnery 2). Coming from a period of economic recession that contracted shareholding equity, the investors are looking for ways to recover part of their losses from suing auditors of their companies. Another explanation to increased lawsuits lies with increased awareness of lawsuits seeking damages for audit liability. Some major ongoing lawsuits involving high stakes are having news headlines following through (Aubin 1).

Legal liability to auditors

The legal basis for liability to auditors is provided for in both statutory law (Thompson and Qinn 2). The unwritten common law evolves with precedent case decisions and it depends on the state. On its part, statutory law is founded on legislation and it applies federally to all courts. An auditor can expect civil suits brought against them by two main groups: the client and third parties. The client is the entity that engaged their audit services whereas a third party is an entity that was expected to make decisions relying on audit report.

Legal action against the conduct of an auditor occurs in four instances (Chambers 1-5). Firstly, a breach of contract happens when the client claim a violation of their agreement by the auditor. In the second scenario, negligence happens when an auditor fails to exercise care that is reasonable thereby resulting in damage to an interested party. When it comes to gloss negligence, an auditor will have acted in reckless disregard of minimal care although without willful desire to harm anyone. Fraud is evident when an auditor has deliberately altered or hidden material facts in the audit report thereby causing the users of it suffer damage (4).

An auditor also has a legal responsibility under statutory law. The statutes are the Securities Act of 1933, the Securities Exchange Act of 1934 and the modification by Sarbanes/Oxley Act of 2002. In these acts, companies must file the annual report [audited] to the Securities and Exchange Commission, SEC (Chambers 5-20). The SEC is empowered to discipline, auditors violating ethics or are practicing auditing while unqualified. The sanctions include company deregistration, penalties of a value not exceeding $750,000 and compulsory auditing education. In these two Acts, an auditor can be charge with criminal offence attracting a fine or a sentence of up to five years. The modification by Sarbanes/Oxley Act of 2002 requires that Public Company Accounting Oversight Board (PCAOB) conducts quality reviews in accounting firms that are registered and mandated to audit any company.

Auditor liability is too great

Auditor liability in the US is unlimited. The threat of bankruptcy is real; it sank Arthur Anderson implicated in Enron fraud. Koch and Schunk suggest that a common view ties the quality of audit to exposure of auditor liability (1). This has given birth to 'over-auditing' where the costs in the effort for quality audit exceed the audit value. Even the Committee on Capital Markets Regulation acknowledged in 2006 that high effort in audit is proving inefficient. It is a double loss as the auditor pays for liability costs and their reputation suffers (2).

Effects of unlimited liability

There is a belief especially among the investors that unlimited auditor liability is healthy for auditing quality. In the US at the moment, 'over auditing' induced by the threat of unlimited liability is counterproductive (Koch and Schunk 1). High risk firms are being avoided by the auditors; in some cases, the auditors give an industry a wide berth. Consequently, affected companies cannot raise capital through securities market shriveling their growth; they may collapse eventually. In another scenario, unlimited liability deals the death blow to the auditing firm as demonstrated by the collapse of Arthur Anderson after successful claim of involvement in fraud. Failure of any of the 'Big Four' would disrupt the economy. It would not only sink with its shareholders' equity but it would acutely contract choices for audit services (1). Therefore, a collapse of either large company or an audit firm shocks the economy unfavorably.

Proposals to change audit liability

The regulators that exercise oversight role in the interest of the public as well as the auditing profession converge on a desire to initiate reforms. For the auditors they are keen to have caps introduced to auditor liability at the earliest chance. Like, in parts of Europe, a cap delimits the liability exposed to the auditor in the circumstances of auditing (Dickey and Minnery 3). A fixed money cap sets the cost of potential liability in monetary figures. Another model of the cap considers the audited company's market capitalization. There is also a cap base of the fee of the audit while the final type relates liability with the extent of auditor's responsibility. The auditors are fronting a second proposal to enjoy 'safety' for auditing done in certain respect such as in high risk companies. Due to common expectation gap, the auditors want a clarification of their duties impressed on Section 10A (Dickey and Minnery 2). Finally, instead of targeting on partner individually, criminal prosecution should be leveled against the audit firm.

Regulators too, want their watchful eye in the audit process. They are proposing to be given powers to have their appointed 'monitors' in audit firms suspected of systemic malpractices. A second proposal from government is seeking a fundamental shift of financial reporting from Generally Accepted Accounting Principles (GAAP) to 'principles-based' accounting (Dickey and Minnery 3). In SEC's view, GAAP is detailed with technical standards while 'principles-based' advocates an accounting judgment. A significant segment of the auditing profession opposed to the change has expressed concern over potentially greater exposure to auditor liability. Even in cases of legitimate judgment, a plaintiff can argue for the merit in an alternative judgment with a claim for enormous damage.

Ways to limit audit liability exposure

Although there are signs of interest on regulators to hear auditors' concerns about excessive audit liability, in the meantime, auditors have to exercise utmost care in their audit practice. Avoidance of a high risk client is the first step (Laux and Newman 1). The risk is hinted by questionable company management, financial losses inconsistent with the industry trend and persistent lawsuits challenging previous financial statements. Auditors have also sought protection from litigation risk under indemnity agreements with the clients. The ethics of American Institute of Certified Public Accountants allow it where "misrepresentation by management" was known beforehand (Dickey and Minnery 2). When it comes to SEC, though, indemnification casts a shadow on auditor independence.

Another caution auditors exercise is to demand that all correspondence with the client be in written documentation. Success in dismissal of frivolous cases is attributable for to risen pleading standards by the auditors. (Dickey and Minnery 1)


The climate for audit is harsh to the profession. The common blame by investors over their role in companies that suffered huge shock in the recent financial credit crisis arise from misconception over their roles. The government is aware of the implication should a major audit collapse from lawsuits. In the meantime, auditors have to exercise utmost case in their conduct.