The plaintiffs' bar discusses auditor performance.by Goldwasser, Dan L.
The news of settlements and awards against accountants and auditors arising out of litigation has tarnished the public's image of the CPA. While the size of some recent awards has blown the significance of litigation out of proportion to the number of suits, the consequences can not be ignored. This discussion with attorneys representing those making claims against accountants was conducted to help identify steps the profession can take to reduce its exposure to claims and improve its standing in the public eye.
Attorneys, as do accountants, break their practices into specialized areas. Such a specialty exists in the area of accountants' malpractice. Attorneys with this specialty frequently represent plaintiffs who allege they have been wronged or damaged because of an accountant's or firm of accountants' failure to discharge their duties in accordance with professional standards.
The New York State Society of CPAs, in a second of a series of round- table discussions, met with members of the securities industry plaintiffs' bar in an effort to provide insights into the performance of the accounting profession from those that have direct contact with it. The attorneys that participated are principally involved in actions involving losses claimed under the Federal securities' laws. Participating were David Bershad, Milberg Weiss Bershad Hynes & Lerack; Daniel L. Berger, Bernstein, Litowitz, Berger & Grossman; Marian Rosner, Wolf Popper Ross Wolf & Jones; and Edward Labaton, Goodkind Labaton Rudoff & Sucharow.
Dan L. Goldwasser, editor of The CPA Journal's Accountants Liability Department and frequent defender of accountants against malpractice claims, led the discussions. For many of the subjects, unanimity of opinion among the panel of attorneys did not emerge. The highlights that follow attempt to capture the prevailing feelings of the group with differences of opinion noted when significant to the topic.
In examining the performance of accountants as independent auditors, it became clear from the discussion that independence is an issue in many legal proceedings against auditor performance.
Biting the Hand That Feeds. A common sequence in the courtroom in the view of the panel finds juries initially quite impressed with the accountants on trial. They present themselves well, in dress and conduct. The jurors have no preconceived notions about them.
As the typical trial proceeds, however, jurists become concerned about the relationship between the independent accountant and his or her client because of the way the accountant is compensated. Since the client pays the fee, the jurors become skeptical about whether the independent accountant was able to take tough stands and seriously question management about what the audit revealed. When substantial audit fees are involved, which continue at the goodwill of the client, it is only human nature for independence and skepticism to come under question.
The independence question in this context is not a function of the performance of the particular accountant on trial; it touches upon the fundamental nature of the auditor/client relationship. In effect, the lawyers are saying the defending accountant may be coming to bat with a built-in one-strike count.
Consulting Services. The attorneys noted instances where independent accounting firms that provide consulting services to audit clients find themselves in problematic situations. In one scenario, a client engaged consultants from the auditing firm to "fix" a problem. The consultants in the process learned of conditions that, if known by the auditing side of the practice, would have affected the nature and extent of the audit. But the consultants did not communicate the conditions to the audit team. Was this a failure to communicate? Or did the firm not wish to jeopardize future "fix" engagements that might not come if management felt that the audit opinion might be adversely affected?
Consulting engagements were also noted to be a device to keep the audit firm "in tune" with the objectives and goals of the client. One attorney noted a situation where whenever the auditor began to pursue a "red- flag" condition, management would find an additional MAS engagement for the firm to provide.
The advice to the profession from the attorneys was not to undertake management information engagements for audit clients where the MIS fees become disproportionately large in relation to the audit fees.
Dominant Client. The performance and independence of a firm also comes into question in litigation if the audit fee for the engagement being challenged comprises a substantial part of the firm's total fees.
Sooner or later in the litigation, said the panel, the quality of the work done and the overall performance of the audit will be the focus of attention.
Ought to Know. Very often the defendant accountant will be asked to explain why certain events and transactions were not detected or otherwise brought to the surface. The accountant will defend his or her performance by claiming the audit was performed in accordance with professional standards, and an expert will agree with that position. An expert for the plaintiff will assert that the firm did not go far enough considering the "red flags" that were readily apparent.
The issue will be decided when the jury determines if the defendant should have known and communicated the error, or wrongdoing.
In this connection one attorney expressed the view that the standards of the accounting profession appear to be established to shun responsibility. When confronted with a fraud situation, the accountants offer as a defense that their audit cannot be expected to detect all fraud. It should be recognized that the SAS 53, Auditor's Responsibility to Detect Fraud and Other Irregularities has not been in effect sufficiently long to have a noticeable impact on most court actions with which this group of attorneys would have been involved. This SAS was designed to close the expectation gap in the area of fraud detection. Recent statements by the AICPA have indicated its plans to explore additional ways to make the audit process more effective in detecting fraud.
Along this same line, another attorney observed that independent accountants never admit to any deficiencies or shortcomings in their work. Whenever confronted with a finding of irregularity or other problem, the auditor says, "We weren't supposed to find that." The attorney acknowledged that the accountant would not be expected to admit to any wrong doing, but felt that auditor disclaimers are often just not reasonable.
The attorney went on to question why auditors are needed if they can't reveal irregularities. Too often the audit seems to have merely skimmed the surface.
One attorney noted that often the red flag signaling the irregularity was properly noted and described in a memo written by a bright young staff accountant. However, somehow the facts and circumstances were never properly dealt with at the supervisory level.
Review Notes. Another attorney expressed dismay over the treatment afforded review notes created in the performance of an audit. Most of the major firms have a policy of destroying these notes to prevent them from becoming a road map to problems in the event the audit ever becomes the subject of litigation. This gives the perception that the auditor is seeking to shirk responsibility by preventing injured third parties from knowing what the audit review process revealed.
Opinion Shopping and GAAP Problems. The attorneys also noted the selection of a "favorable" accounting treatment is more of a problem than bad auditing or overlooked management fraud. Auditors find themselves in difficult situations when the method of accounting is not appropriate for the circumstances or not adequately disclosed. The panel strongly stressed the importance that the accounting treatment should portray the economic reality of the transaction.
One of the very real danger signs on the road to litigation is a switch in method of accounting that presents a more favorable financial result.
A common GAAP problem noted by one attorney is in the area of percentage-of-completion income recognition on long-term contracts. It also becomes a GAAS problem when the auditor attempts to deal with management's estimates of costs to complete.
Other Performance Deficiencies. The panelists discussed the following other deficiencies that cast a dark shadow over the audit conclusion and the proper performance of engagements:
* Young and inexperienced staff doing the audit work in important and complex areas, or in some cases the staff assigned are not sufficiently dedicated or bright to uncover the problems lying beneath the surface.
* A lack of adequate supervision of the work done by less experienced staff.
* A lack of training and experience of the audit team in the industry in which the client operated. In this regard, the first engagement in a highly specialized area can be particularly hazardous.
In an attempt to put the matter of auditor performance in perspective, one attorney expressed the view that in many cases the auditors are well schooled on the issues and are trying to do a good job. What traps them are inadvertent false steps, the kind that are very difficult to avoid.
In supporting this point, an attorney observed the plaintiffs' bar exists because of human nature. Companies come under pressure to perform and begin to do things they normally wouldn't consider. They begin to bend the rules in their favor or take a very optimistic position on matters of uncertainty. Actual fraud is very rare. Unfortunately, "The Crazy Eddies of this world will never be eliminated," said one attorney.
Internal Control Reporting and Other Matters
Mr. Goldwasser asked the panelists to comment on a number of matters facing the profession.
Auditors' Reports on Internal Control. The panelists did not think reports to shareholders on the effectiveness of a company's internal control structure would contribute to better financial reporting or improved public confidence. They felt the public does not know what internal controls are all about. Such reports would be of more use to analysts.
Whistleblowing. The lawyers recognized the awkwardness of the accountant informing third parties about audit findings. They acknowledged that with regard to public companies there is a way (through a SEC Form 8-K filing reporting a change in auditors), to inform third parties about disagreements between auditors and companies. No solution emerged from the discussions.
What is just as difficult and just as important, noted one attorney, is to blow the whistle within the firm when a partner is not doing his or her job.
The attorneys noted comparability on this issue between CPA firms and law firms. Both professions are grappling with their responsibilities to inform third parties. The public envisions the CPA as a watchdog; the panelists admitted that this expectation may be unreasonable.
Overselling of the Assurances of Audits. The attorneys generally did not believe auditors and the profession oversold the worth or effectiveness of an audit. An auditor's seal of approval or unqualified report does not promise more than it reasonably can deliver. A problem was noted in the area of tax shelters. An opinion about the "more likely than not" deductibility of an expense or existence of a tax credit thrust many CPAs into tenuous and litigious situations. Investors put a lot of weight in those kinds of opinions, and when those tax benefits did not materialize, law suits proliferated.
Forecasts and Projections. The public has a tendency to place too much worth on those reports. Because of the nature of forward looking financial information, the attorneys said that if the CPA is going to get involved, the work must be carefully and thoroughly done. One noted having seen engagements related to future-oriented financials where the testing of assumptions was skimpy at best.
Audit Quality and Firm Size. The attorneys felt that generally firm size was not a determinant of audit quality, until the very small firms come into the picture. Firms of 50 to 100 can do just as competent a job as the very largest firms.
The attorneys, as might be expected, did not see any compelling reason for tort reform with respect to accountant's liability. They feel the possibility or threat of serious consequences for poor performance contributes to the overall quality of services being performed. It motivates the firms to be tough, realizing the potential financial loss could be catastrophic. To limit the potential financial risk to the amount of the audit fee or some multiple thereof would not serve the public interest in their opinion.
There are enough factors in the process, say the attorneys, to protect the auditor without reform. There is the doctrine of privity in New York and now California. In Federal securities cases there is the need to establish scienter, which is not always that easy. And courts are on their own are moving towards proportionate fault and liability in settlements. There has been a shift in many court rooms making it more difficult to prove against the accountants.
The lawyers went on to comment that since mere negligence is not sufficient to be successful against an accounting firm, joint and several liability is a legitimate operating factor. If you perform in a grossly incompetent fashion, the consequences should be severe.
The lawyers had no particular feeling about the chances of achieving tort reform but indicated the U.S. Supreme Court may rule on it.
The attorneys expressed their view that the accounting profession, with its huge numbers when compared to the plaintiffs' bar, has significant clout in seeking legislative change. But, they repeated, that would not be in the public's interest.
Limiting Liability in the Form of Practice
The attorneys were generally indifferent to the profession's interest in limiting vicarious liability--the exposure to personal liability for misfeasance of another partner--through practicing in limited liability companies or general corporations. It was their experience that any financial loss was limited to the assets of the firm, and no claims were made on the personal assets of the partners.
Moderator Goldwasser asked the group to consider the following consequences in reaction to the heavy liability exposures:
* CPA firms begin operating without the lightning rod of malpractice insurance;
* CPA firms choose to serve only prosperous, honest clients;
* CPA firms contract and limit their practices because of a lack of qualified staff; and
* The profession becomes unattractive and loses stature in the eyes of the public.
The attorneys felt the picture painted was far too bleak. They also did not see any particular dramatic increase in the number of cases in which CPAs are involved. Also if a case against a CPA is not strong, they do not pursue it.
During the discussions, the panelists considered areas for improvement in the basic nature and structure of the independent accountant/client relationship.
* Establish more stringent rules to protect the independence of the accountant. One way is to require the auditor to communicate findings to an independent authority at the client, typically an audit committee or the board of directors. In the smaller, privately held company this is often a problem. The board and active management are the same, and they do not want to hear problems.
* Strengthen the consultation and inspection elements of the quality control system. Along these lines an attorney suggested the benefit of an immediate in-depth, inspection-like review of engagements that appear problematic based upon pre-established criteria. Criteria might include events such as the audit partner leaving the firm to become employed by the client, the client experiencing cash flow and operating problems, or fees exceeding a certain amount. When the event occurs, the engagement would be subject to a complete detailed review by accountants within the firm not directly associated with the engagement, but knowledgeable in the industry. The attorney noted that often second partner reviews, or independent partner concurring reviews, were perfunctory.
* Introduce a process to certify firms competence to perform audits of SEC reporting companies. It was the view of one attorney that membership in the SEC practice section of the AICPA Division for Firms was not per se providing the assurances that the member firm was sufficiently knowledgeable or qualified to perform these types of engagements.
* Encourage greater selectivity on the part of firms in choosing clients to serve. One attorney noted a new breed of exposure that comes from associating with "scum" companies. Having a firm's name associated with what turns out to be the wrong kind of client can be very detrimental. Given the time lag between when an audit or service is performed and when litigation might take place, by this time accountants know better than to associate with clients of questionable character.
The Plaintiffs' Bar Point of View
The attorneys were frank and helpful in discussing the issues that face the profession. Their point of view is obviously affected by their objectives and the cases they see. Nevertheless there is much to be learned from them. In addition, many of their recommendations and comments have appeared in the recent recommendations of the Public Oversight Board and the AICPA to improve financial reporting and public confidence.
ABOUT THE PANELISTS
David Bershad, Esq. is a partner of the firm of Milberg Weiss Bershad Hynes & Lerack, a firm specializing in re-presenting plaintiffs in securities litigation.
Marian Rosner, Esq. is a partner of the law firm Wolf Popper Ross Wolf & Jones which specializes in securities and class action litigation. Ms. Rosner is co-chair of the firm's securities litigation department.
Edward Labaton, Esq., is a partner of the law firm Goodkind Labaton Rudoff & Sucharow. In addition to his efforts there, Mr. Labaton is a member of Association of the Bar of the City of New York's Committee on Securities Regulation.
Daniel L. Berger, Esq., is a partner of the law firm Bernstein Litowitz Berger & Grossman, which specializes in prosecuting securities fraud class actions and other commercial litigation. Mr. Berger also served as an assistant attorney general for the State of New York from 1979 through 1983.
Dan L. Goldwasser, Esq. is a partner of the law firm Vedder Price Kaufman Kammholz & Day and the editor of The CPA Journal's Accountants' Liability Column.
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