Auditor Liability without Regulatory Prescription

							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
                      to Fearnley, Sunder: financial reporting2
     social norms Bush, improveAuditor
8/31/2012
                             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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                             Liability
              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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                            Liability
              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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                            Liability
            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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                          Liability
            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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                          Liability
              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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                           Liability
             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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                           Liability
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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                                 Liability
      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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                          Liability
  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
        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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                            Liability
            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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                           Liability
              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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                               Liability
               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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                           Liability
                 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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                               Liability