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Public accountancy: a profession at risk?

Public Accountancy A Profession At Risk?

The negative publicity generated by the Savings and Loan Industry and the Chapter 11 Bankruptcy petitions of Laventhol & Horwath and Spicer & Oppenhiem have provided painful reminders of the risk associated with public accountancy. The profession has long been aware of this risk, of course, and has attempted to promulgate standards which allow the public accountant to clearly understand his responsibilities in the high-risk practice areas and to defend himself against charges of negligence or gross negligence. It seems, however, that on occasion auditors find themselves in court regardless of the quality of the audit work performed. The apparent reason is the fact that the investing public has long had a great deal of difficulty distinguishing between business failure and audit failure. Is this perception accurate and, if so, is there anything that auditors can do to eliminate or significantly reduce the risk of audit-generated litigation?

Say It Ain't So!

Are accountants often caught up in litigation as innocent bystanders or is the auditor's involvement in litigation, more often than not, the direct result of substandard work performed by the auditor? There is a definite possibility that the answer to both parts of this question could very well be "yes."

Like it or not, the "deep pocket" theory is more than just a myth. When a business fails, those who have incurred economic loss look for someone to blame. Those assessing the blame hope to obtain financial recovery from the supposed culprit. More often than not, the auditor is the one party associated with the failure who is likely to be the most able to pay and is thus a prime target of the plaintiff's attorney. Additional factors contributing to the explosion of litigation targeting accountants are recent legal developments which have stripped away some of the traditional protections enjoyed by accountants and the increasing litigiousness of society in general.

Evidence of this mind-set is furnished by an article that appeared in the Fall 1990 issue of The Brief(1), a professional publication directed primarily toward the legal profession. In a section of that publication, subtitled "Practice Tips," a practicing attorney named Davis J. Howard wrote an article instructing attorneys serving as receivers of failed insurance companies on how to maximize the failed insurer's value on behalf of the policy holders and general creditors. Davis identifies three possible targets of litigation in such a situation: former directors, former officers and the independent auditor. The following is a direct quote from that article:

Auditors are the preferred

defendants for several reasons.

First, it is likely that they will

have appropriate errors and omissions

insurance in place, with

high limits of liability. By contrast,

those who mismanage or

defraud their own concern may

well have been remiss in purchasing

adequate - or any - directors

and officers coverage.

Second, insurance aside, individual

directors and officers are

less likely to have deep pockets

than independent accounting

firms. The larger ones, especially,

are typically organized as

general partnerships and have

deep pockets. Third, even assuming

that adequate insurance

is in place, the managers of the

insurance company are more

likely than the auditors to be

adjudged liable for fraud, and

fraud is a conduct exclusion in

virtually all D&O insurance policies.(2)

Thus, when an insurer's liquidator sues a defunct insurance company's managers and auditor, he or she is likely to view the suit against the accountants as more viable and as a more realistic means of maximizing the infusion of substantial assets into the insolvent's estate. Moreover, in order to induce an earlier and more favorable settlement, the liquidator will wish to charge the auditor not merely with negligence or breach of contract, but also with common law and statutory fraud (such as RICO), because the latter counts create the prospect of recovering punitive or treble damages as well as costs and counsel fees.(3)

The obvious focus of the above iscourse is on who is best able to pay and not who is most responsible for the financial failure, i.e., the deepest pocket available. The article goes on to discuss the likely defenses that the auditor will use in requesting dismissal of the charges and how to attack those defenses. In that discussion the author begins a discourse on the relative vulnerability of the auditor to charges of fraud with the statement, "Although it may be a long, long while from May to December, it is but a short, short distance from negligence to fraud when it comes to suing independent auditors."(4) The article concludes with a discussion of the fact that the lack of direct reliance on the financial statements by the suing parties should not present major problems for the plaintiff.

The basic tone of the article reflects the assumption that, if the insuring business failed, then the independent auditor also failed. Furthermore, because the independent auditor is still financially solvent and has good malpractice insurance, he or she is the "fairest" of all fair game. Remember that the article cited was written by a lawyer (not an accountant) and is addressed to other plaintiff lawyers. The "targeting" of accountants has been effectively endorsed by no less an authority than the United States Supreme Court. Consider the following quote from United States v. Arthur Young & Co.(5), a dispute over production of audit workpapers:

By certifying the public reports

that collectively depict a

corporation's financial status, the

independent auditor assumes a

public responsibility transcending

any employment relationship

with the client. The independent

public accountant performing

this special function

owes ultimate allegiance to the

corporation's creditors and stockholders,

as well as the investing

public. This "public watchdog"

function demands that the accountant

maintain total independence

from the client at all

times and requires complete fidelity

to the public trust.(6)

The "citadel of privity" created by Judge Cardozo in the famous Ultramares(7) case, which has protected accountants from unlimited liability for decades, began to develop cracks in 1968. That year, the Federal District Court for Rhode Island decided that an accountant could be held liable for professional negligence to a party not in privity with the accountant.(8) Although the Ultramares doctrine remains strong in New York, several states have shown no reluctance in expanding the class of persons to whom an accountant may be liable for negligence. In a dispute involving plaintiffs who acquired stock in a publicly traded corporation, in reliance on financial statements, the New Jersey Supreme Court stated:

When the independent auditor

furnishes an opinion with

no limitation in the certificate

or to whom the company may

disseminate the financial statements,

he has a duty to all those

whom that auditor should reasonably

foresee as recipients from

the company of the statements

for its proper business purposes,

provided that the recipients rely

on the statements pursuant to

those business purposes.(9)

This decision was followed by one issued by the Wisconsin Supreme Court, in a case where a bank made loans in reliance on audit reports which contained a number of material errors.(10) In that case, the Wisconsin Supreme Court said that an accounting firm can be held "fully liable for all foreseeable consequences of [its] acts except as those consequences are limited by policy factors."(11) The effect of this new "foreseeability standard" is to open the independent accountant to potentially unlimited liability.

Perhaps even more disturbing is the "make the accountants pay" stance taken by a California court in a case brought by a real estate developer who relied upon negligently prepared statements when purchasing government loans.(12) There, the Court stated:

The risk of such loss is more

appropriately placed on the accounting

profession which is

better able to pass such risk to its

customers and the ultimate consuming

public. By doing so,

society is better served, for such

a rule provides financial disincentive

for negligent conduct

and will heighten the profession's

cautionary techniques.(13)

Viewed in the cold light of the above-cited quotes, the article from The Brief is not shocking. The commentator is merely reporting the strategic thinking of many lawyers across the nation. As the above-cited quotes attest, that thinking is bolstered by legal reality.

Although the article appearing in The Brief focused on the legal problems of independent auditors associated with failed insurance companies, independent auditors of troubled savings and loans and banks face even more imposing difficulties. The United States government, through the FDIC, has made the accountants and lawyers of troubled financial institutions primary targets in the government's strategy to offset or reduce losses on failed banks and S&Ls. The FDIC has alleged that if a professional accountant leaves a firm which is subject to a malpractice claim arising from a financial-institution failure and joins another accounting firm, then the malpractice policy of the new firm is also responsible for losses related to that accountant's services for the failed financial institution.(14) Whether or not this position will be sustained in court remains to be seen, but the prospects of success cannot be lightly dismissed.

Anyone who thinks that the so-called S&L crisis does not pose a serious threat to the accounting profession as it exists today should consider the recent address of Scott Univer to the ABA Litigation Section. Mr. Univer, assistant general counsel at Ernst & Young, speaking about accountants' liability regarding their work for failed thrift institutions, told his audience that because of the magnitude of the claims, 14 of the 16 major accounting firms would be bankrupt. Indeed, because of rumors associated with the S&L litigation, Ernst & Young has been compelled to purchase newspaper advertisements and send "comfort letters" to accounting educators declaring its solvency and financial stability.

Generally, public accountants tend to view the audit service as that portion of public practice which creates the greatest potential for litigation. However, recent events have clearly shown that other areas of public practice also carry significant litigation risk. When Laventhol & Horwath filed for Chapter 11 bankruptcy protection in November of 1990, it was the opinion of many observers that the firm's difficulties were the direct result of the firm's association as auditors with troubled S&Ls. However, based upon the documents prepared by Laventhol & Horwath in its bankruptcy filing, that assumption appears unwarranted. The majority of the litigation which led to the Chapter 11 filing, arose from the firm's work on financial projections in three separate groups of engagements. Almost a quarter of the pending litigation relates to Laventhol & Horwath's association with profit projections for Chicago's VMS Realty Partners, a syndicator of hotel limited partnerships, which is now all but out of business. Those suits allege that the firm prepared projections based on assumptions that the firm knew were unreasonable and that the firm deliberately failed to investigate representations made by VMS principals.

The second group of claims resulted from Laventhol & Horwath's work for Barry Turpin, a developer who syndicated numerous tax-sheltered real-estate investments that are now virtually worthless. In these cases, much like the VMS Realty Litigation, the firm is accused of not properly investigating the assumptions used in developing prospectus information for potential investors. In the Turpin case, the firm's Dallas office had been professionally involved with some of the properties in the tax-shelter packages for quite some time and was aware of large vacancy rates and other problems associated with the properties which do not appear to be consistent with the assumptions reflected in the prospectus information.

The third group of claims was spawned by the empire of fallen evangelist Jim Bakker. There, plaintiffs are seeking $550 million in damages. The charges against Laventhol & Horwath in that litigation stem, in part, from market projections developed for marketing "lifetime partnerships" involving Heritage Village Church and Missionary Fellowships which were developed by the Bakker organization. Although some of the claims are associated with audit services, the vast majority if the firm's litigation problems appear to be related to the firm's work with financial projections rather than its audit practice.

What's an Accountant to Do?

Is there anything that an individual accounting firm or practitioner can do to completely eliminate the risk of litigation from its (his or her) practice? Probably not. Because it is likely that at least some of the litigation directed at auditors is based solely on the deep-pocket theory, the practicing accountant will never be able to entirely remove the risk of litigation from public practice. However, this is not to imply that the practicing accountant is defenseless against the claims of those who might be inclined to sue for negligent work.

First of all, public accountants must remember that the risk of future litigation is heavily affected by the quality of a firm's clientele. This fact has long been recognized by practitioners, and the concept is incorporated into numerous auditing standards, quality control standards and other types of authoritative literature. However, profit pressures in public accounting have increased in recent years as a result of changes in numerous standards, such as those relating to advertising. It is quite possible that a given firm could have "unofficially" relaxed its own quality-control standards related to client acceptance and continuance because of increased profit pressure.

Second, public accounting firms must periodically make a careful review of the pressure placed on managerial personnel to maintain clients. Obviously, this is a subject much more easily written about than implemented in practice, but there is little question that the risk of poor choices by managerial personnel of public accounting firms is significantly increased if the firm personnel detect a consistent pattern of "career damage" when clients are lost regardless of the circumstance. During a period of recession, such as the one the U.S. economy appears to be entering now, the pressure from clients to compromise reporting principles is likely to increase. If an accounting firm's personnel assume, from their own experience, that clients must be pacified at any cost in order to maintain their career progression, the firm's internal culture may put it on a collision course with litigation.

Third, practicing accountants must educate themselves about prevention of malpractice claims. The time-worn platitude "an ounce of prevention is worth a pound of cure" is extremely appropriate with regard to the issue of accountant's liability. Lawsuit prevention begins months or even years before the audit engagement and is a continuing process. Foremost among prevention measures is creation of a "paper trail" which documents the fact that the accounting firm conducts its affairs in a reasonable and prudent manner and constantly strives to improve its procedures. Lawyers are creatures of habit who continuously exploit successful litigation strategies. Therefore, expect that the initial assault will include a demand for the accounting firm's internal manuals, guidelines, checklists and procedures. In addition, expect a demand for personnel records. The underlying motive for obtaining these documents is to demonstrate negligence in one or more of the firm's operational areas to include negligent hiring and retention of personnel. Assuming that the firm already maintains high standards with regard to quality control and acquisition of personnel, the next step is creation of a malpractice-prevention program. The following points constitute a minimal program: 1. Send key firm personnel to CPE

sessions on legal liability; 2. Create a "required reading list"

for all professional personnel to

raise the overall awareness of the

legal liability issue. The

Accountant's Audit Liability

Manual(15) and Duties and Liabilities

of Public Accountants(16) are

good titles for such a list; 3. Train professional personnel to

recognize potential litigation issues

related to implementation

of auditing standards such as

SAS47, SAS53, SAS54 and SAS

57; 4. Identify "high-risk" areas of the

firm's practice and develop additional

guidelines, procedures,

checklists, etc., designed to minimize

exposure; and 5. Emphasize thorough documentation

of procedures and evaluation

steps in the workpapers.

As alumni of national accounting firms, it has been our experience that little if any CPE training within these firms is directed toward a specific program of understanding the types of action on the part of practicing public accountants that tend to either lead to or minimize an accountant's legal liability. It is true that many technical standards, such as those related to managing audit risk and evaluating the control environment of an audit client, are related to legal liability; however, there are no specific professional standards promulgated by the AICPA that solely address the problem of the public accountant's potential liability. Therefore, although a public accounting firm's staff may be highly educated regarding the content of the statements on auditing standards, that same staff might not fully understand the legal-liability issues created by those standards. Accountants must also recognize that lawyers read their material and are fully prepared to use it against them. Standards like SAS 59 are made to order for plaintiffs' lawyers. If the auditor's conclusions and evaluation process are not thoroughly documented in the workpapers, an otherwise defensible position will be impossible to support, despite SAS 59's denial of "going concern" assurance.


Litigation is a part of public accounting practice that cannot be avoided. Public practitioners, however, can reduce the risk of litigation by taking steps to constantly monitor and control those aspects of firm culture that generate an increased risk of conduct that will result in malpractice claims and, by providing specific CPE training, in minimizing legal liability while implementing the firm's auditing philosophy. Accountants must recognize that the risk of malpractice claims is no longer limited to an accounting firm's audit practice alone, as evidenced by the Laventhol & Horwath litigation described above. Tax and MAS staffs must be made aware of the legal liability associated with those areas of the firm's practice.

Given the deep pocket concept prevalent in our society, practitioners must recognize that difficult economic times, such as the ones we are now facing, increase the risk of litigation against accountants regardless of the quality of work. This fact alone makes it even more important to take current action to reduce the risk of litigation and to minimize the risk of loss should litigation occur.


(1 )The Brief is published guarterly by the Tort and Insurance Practice Section (TIPS) of the American Bar Association, 750 N. Lake Shore Drive, Chicago, IL 60611.

(2 )Howard, "Accounting Should Be Held Liable," 20 The Brief 51 (1990), citing William E. Knepper and Don A. Bailey, Liability of Corporate Officers and Directors section 21.12 at 716-22 (Michie 4th Ed. 1988); Davis J. Howard, "D&O Insurance Through the Looking Glass: An Attitudinal Primer," 38 Fed'n Ins. & Corp. Couns. Q. 163, 175-80 (1988).

(3 )Ibid.

(4 )Ibid. at 52.

(5 )465 U.S. 805 (1984).

(6 )Ibid. at 817-18.

(7 )Ultramares Corp. v. Touche, 255 N.Y. 170; 174 N.E. 441 (1931).

(8 )Rush Factors, Inc. v. Levin, 284 F. Supp. 85 (D.R.I. 1968).

(9 )H. Rosenblum, Inc. v. Adler, 93 N.J. 324, 352; 461 A.2d 138, 153 (1983).

(10)Citizens State Bank v. Timm, Schmidt & Co., P.C., 113 Wis.2d 376, 335 N.W.2d 361 (1983).

(11)Ibid. at 366.

(12)International Mortgage Co. v. John P. Butler Accountancy Corp., 177 Cal. App. 3d 806, 223 Cal. Rptr. 218 (1986).

(13)Ibid. at 227.

(14)"Kolb and Carroll, Don't Blame the Lawyers," Nat. L. J., Nov. 26, 1990, at 13, col. 1.

(15)Ralph S. Janvy (Callaghan, 1990).

(16)Denzil Causey and Sandra A. Causey (Accountant's Press, 1990).

Lowell S. Broom is an associate professor of accounting at the University of Alabama at Birmingham. He received his DBA from Louisiana Tech University. Dr Broom is also a CPA and served frequently as an expert witness in cases involving malpractice claims against public accountants. He has previously published articles in the Journal of Business Ethics, CPA Journal, Controller's Quarterly and the National Public Accountant.

Steven C.R. Brown is an assistant profesor of accounting at the University of Alabama at Birmingham. He earned his JD at the Cumberland School of Law and his LLM (taxation) from the New York University School of Law. He is a member of the American Bar Association and its Taxation and Tort and Insurance Practice sections. He has previously published articles in Management Accounting, The Banking Law Journal and the Cumberland Law Review.
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No portion of this article can be reproduced without the express written permission from the copyright holder.
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Author:Broom, Lowell S.; Brown, Steven C.R.
Publication:The National Public Accountant
Article Type:Cover Story
Date:Oct 1, 1991
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