Problems of Defining and
Reforming Auditor Liability
Tim Bush, Stella Fearnley and
Shyam Sunder
24th World Continuous Auditing and Reporting
Symposium
Inonu University, Malatya, Turkey
May 3-4, 2012
Overview
• A century of regulatory efforts to improve
auditing by redefining auditor liability:
punish failure to improve quality
• Little evidence of improvement
• Moves towards global accounting and
auditing standards to eliminate
comparative analysis of policy proposals
(liability limitations, LLPs, proportional)
• Fortunately, still major differences
between US and UK regimes
• Balancing regulation, market forces, and
social
norms
to
improve
financial
reporting
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Bush, Fearnley, Sunder: Auditor
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Liability
US before 1990
• Federal securities laws since 1933, dominance
of the decision usefulness reporting model
• U.S. federal securities acts focus on protection
of markets i.e. buying and selling shares;
contract law at state level
• Tort law at federal level attracts class actions for
loss from share price falls (potential investors)
• Joint and several liability, with burden of proof
on defence who bears own costs regardless of
outcome
• But had to prove recklessness or intent
(Hochfelder, 1976) i.e. more than negligence
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US After 1990
• 1991 onwards: states allowed LLPs, firms able
to protect partners assets
• Audit firms writing private restrictive clauses in
engagement letters stop contract law cases at
state level (jury trial and punitive damages)
• Now PCAOB’s independence concern
• Genuine concerns about merit-less class actions
which may be cheaper to settle than defend
against
• Auditors appointed by management (until SOX)
and report to directors. Shareholders could not
sack the directors
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US after 1990
• 1995 PSLRA and 1998 SLUSA brought
proportionate liability, except for criminality &
fines for meritless cases
• Presidential veto: quid pro quo improvements to
audit quality suggested by Treadway in 1987
(illegal acts, related party transactions, going
concern, report breaches)
• No evidence of improvements to audit quality;
even the meaning of quality is unclear
• Suggestions (Zeff, 2003, Francis and Krishnam,
2002, Coffee and others) that moral hazard
undermines audit quality, but no established
causal link
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UK before 2000
• Company law controlled corporate and
auditor responsibilities; auditor liability
limitations banned since 1929
• Duty of care to shareholders but Caparo
1990 limits rights to sue
• Almost no liability to 3rd parties
• No class actions when share price drops
• Sue for loss in company; most claims from
liquidators
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UK before 2000
• 1989 Companies act allowed incorporation
–only KPMG had limited take-up. Was the
price too high?
• Reform of Joint and several rejected by
Law Commission in 1996 but possibility of
allowing proportionate liability by contract
was mooted
• Key argument was only 6 audit firms
• LLPs allowed from 2,000 after some hanky
panky in Jersey, all are LLPs now.
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UK after 2,000
• Government scared by KPMG tax scandal and
Equitable Life case
• Like banks, audit firms also became too big to
fail, and too big to jail?
• Whose fault that only four of them now?
• Company Law Reform Bill in the House of Lords
• Allows limitation by contract subject to
shareholders agreement. Some shareholders
said they will vote against
• Criminalises reckless or knowing misreporting,
including omissions; also to name partners,
publish engagement letters, nothing onerous
except criminalisation.
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UK after 2,000
• Profession lobbied to get rid of reckless or
knowing and making it fraudulent; US has class
actions
• Attempt to change requirement to report where
company hasn’t kept proper accounting records
(in law since 1948) to records ‘adequate for
accounts preparation’ only
• Really upset investors who need to approve
liability contracts
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Criticisms of Reform Campaigns
• Case overstated (28/year, 50%, recklessness, not just
negligence)
• No improvement, even reduction, in quality post-PSLRA
• 2005-6 saw large (9-22%) increases in average profit per
partner in U.K.
• Sharp drop in cases against auditors, and increase in
restatements post-PSLRA
• Ronen and Cherny insurance proposal
• Jamal and Sunder: finer gradations in audit report
• Gietzman et al. weaker incentives of proportional liability
• Mitchell: resolve crisis by better audits, not liability reform
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Economics of Liability Caps
• Liability caps favor auditors if all other
things were equal, but they are not
• Consequences for quality of service and
exposure to dispute
• Consequences for audit fees
• What are the net consequences of liability
caps for auditor profitability and investor
risk and returns?
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Economics of Regulatory Audit
Requirement
• What would happen if public companies
were allowed to choose if they will be
audited in their charter, and let the
shareholders decide?
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Liability Caps and Industry
Consolidation
• Is the issue of liability caps a consequence
of letting the audit industry consolidate into
a few firms?
• Will the issue still arise if the audit industry
consisted of some 10 or 20 major firms?
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Global Liability
• Creation of global firms/networks to create
economies of scale, training, global brands
and sale to global customers through
referral
• Problem of putting limits on global liability
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Global Regulation
• Big firm advantages of training, marketing, uniformity of
service
• Comparability across economies, legal, tax, economic
and business systems, and languages is a problem
• Major differences even between US and UK
• Making better policy through comparisons across
domains of diverse practices (and empirical research on
such questions) impossible
• Use of international standards as a competitive
advantage by the big firms
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Implications
• Big firms want liability limitation and global
standards; reduces costs and brings
economies of scale
• Consider differences and motivation for
liability reform in US and UK and
motivation for financial reporting (and
SME)
• Challenged assumptions: compliance with
accounting standards and auditing
standards means good financial reporting
• And, global standardization eliminating
comparisons helps make better policy
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Implications
• Are ISAs based on decision usefulness model of
auditing, when UK motivation for audit is
stewardship?
• Already had UK problem over true and fair
override- judgement rather than rules driven
• Risk passing from firms to others via increased
regulation and audit committee monitoring
• Should high income carry higher risk?
• Should we allow firms to become globally bomb
proof with regulation; only possible at country
level?
• Problems with accountability of standard
setters?
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Liability
Possible Outcomes
• If audit wasn’t compulsory, price and quality would find
its own level
• In compulsory environment liability limitation reduces
value of audit to investors – pay less and value service
less
• Increased regulation, brought on by previous poor
auditor performance, devalues profession
• Global standards may produce box tickers as in varying
environments may be no other solution
• What price true audit professionalism, moral hazard and
continuing trust, or are the B4 over reaching
themselves?
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Auditor Liability without Regulatory Prescription