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Risk management: identifying a company's vulnerability.

Due to the nature of today's business environment, effective risk management has become increasingly valuable. Faced with litigious conditions, every company must wrestle with issues that do not have clearcut solutions. With the lack of definitive answers, the potential effects on financial statements cannot be predicted with any certainty. These uncertainties in turn present a special challenge to the auditors of those financial statements.

For example, a recent Supreme Court decision considered a company's policy regarding female employees and its discrimination against them. At issue were two potential sources of litigation against the company. First, policies that exclude female employees from certain work or work areas may expose a company to litigation because of discrimination. Second, policies that permit female employees to work under hazardous conditions that could cause harm to unborn children may subject a company to litigation from these children. The company faces a dilemma. Which risk is greater? The issue is risk management: every company must contend with it and every auditor must report on it.

Legal Background

The 1964 Civil Rights Act prevents discrimination against female employees because of their reproductive potential unless it interferes with their ability to perform a job. The only exemption for sex discrimination is for a "bona fide occupational qualification (BFOQ) reasonably necessary to the normal operation of that particular business." An example of a cost-based BFOQ, according to Supreme Court Justice Antonin Scalia, is a shipping company that may refuse to hire pregnant women on a long voyage because providing on-board facilities for foreseeable emergencies, though quite feasible, would be inordinately expensive.

The Pregnancy Discrimination Act (PDA) amends the Civil Rights Act and specifies that unless pregnant employees differ from others "in their ability or inability to work," they must be treated the same as other employees. Furthermore, the PDA mandates that decisions about the welfare of future children be left to the parents who conceive, bear, support and raise them rather than TABULAR DATA OMITTED to the employers who hire those parents or to the courts.

One Company's Dilemma

Prior to the Civil Rights Act of 1964, Johnson Controls, Inc. did not employ women in a battery manufacturing work area because they would be exposed to lead. In June, 1977, however, the company announced its first official policy concerning women employees in lead exposure work:

"... protection of the health of the unborn child is the immediate direct responsibility of the prospective parent... Since not all women who can become mothers wish to become mothers (or will become mothers), it would appear to be illegal discrimination to treat all who are capable of pregnancy as though they will become pregnant."

Consequently, the company did not exclude women capable of bearing children from lead exposure, but it emphasized that a woman who expected to have a child should not choose a job in which she would have some exposure. The company also required women who wished to work in the lead exposure area to sign a statement that they were aware and had been advised of the risks. Between 1979-1983, eight female employees who worked in this area became pregnant. Table 1 summarizes the company's handling of the dilemma.

In 1982, the company changed its policy of warning to a policy of exclusion: "It is policy that women who are pregnant or who are capable of bearing children will not be placed into jobs involving lead exposure or which could expose them to lead."

The company apparently believed that this policy qualified as a BFOQ exemption. Since the company did not believe it was guilty of an illegal act, no disclosure by either the company or its auditor would be necessary.

In 1984, several employees filed a class action suit challenging the company's fetal protection policy on the basis of sexual discrimination. The plaintiffs included two females, one who had chosen to be sterilized in order to avoid losing her job and one who had suffered a loss in compensation when she was transferred out of a job in which she was exposed to lead. The plaintiffs also included a male who had been denied a request for a leave of absence for the purpose of lowering his lead level because he intended to become a father.

In 1985, a district court ruled in favor of the company and the Court of Appeals affirmed this decision in 1989. The Court of Appeals stated that the policy was facially neutral because the company's purpose, protecting women's unconceived offspring, was not a violation. Johnson Controls was deemed to have met the test of business necessity and its policy of exclusion qualified as a BFOQ. As far as the company was concerned (and the courts had agreed), no illegal act had occurred. The case was, however, appealed to the Supreme Court.

In 1990, the Supreme Court heard arguments on the case, and the following year the Court of Appeals' decision was reversed. The Supreme Court ruled that section 703(e)(1) of Title VII, which allows discrimination on the basis of sex in certain instances where there is a business necessity, expressly states unless pregnant women differ in their ability or inability to work they must be treated the same as other employees. Further, the court stated that they had no difficulty concluding Johnson Control could not establish a BFOQ. Thus, the company could no longer discriminate on the basis of sex in the lead exposure work areas, and female employees must be allowed to work in the lead exposure areas even though there may be some risk to an unborn child of a pregnant employee.

Compliance with the Supreme Court's ruling would not, however, eliminate the company's risk of litigation. More than 40 states currently allow children born alive to recover in tort for prenatal injuries caused by third parties. Employer warnings may preclude claims by injured employees, but these warnings will not preclude claims by injured children. The general rule is that parents cannot waive causes of action on behalf of their children and the parents' negligence will not be imputed to the children. Thus, by allowing women to work in this area to avoid committing an illegal act, the company may be subject to future liability claims filed on behalf of any injured children born to these women (or men).

These situation presents the company with a dilemma. If it denies job opportunities on the basis of sex, the company may have committed an illegal act by discriminating against female employees. On the other hand, if the company follows equal opportunity policies and allows female employees to work in these high risk areas, some time in the future the company may be sued by a child for prenatal injuries. Thus, future liability is possible even though two judges concurred that "common sense tells us that it is part of the normal operations of business concerns to avoid injury to third parties, if for no other reasons than to avoid tort liability and its substantial costs."

The Auditor's Dilemma

The company's dilemma also becomes the auditor's dilemma because he must decide whether and when an illegal act has occurred and whether and how to report a possible or actual illegal act. Furthermore, the auditor must assess the potential monetary effects and evaluate whether they affect the company's ability to continue as a going concern.

According to SAS No. 54, Illegal Acts By Clients, an illegal act refers to violations of laws or governmental regulations. Illegal acts by companies are acts attributable to the entity or its employees acting on behalf of the entity. The auditor's responsibility to detect and report misstatements resulting from illegal acts having a direct and material effect on the financial statements is the same as that for errors and irregularities.

Normally, an audit that is conducted in accordance with generally accepted auditing standards (GAAS) does not include audit procedures designed specifically to detect illegal acts. However, the auditor should make inquiries of management concerning the client's compliance with laws and regulations. Ordinarily, the auditor also obtains written representations from management concerning the absence of violations or possible violations of laws or regulations.

When the auditor becomes aware of a possible illegal act or determines that an illegal act has occurred, he should consider the possible effects on the financial statements and apply additional auditing procedures to obtain further evidence. In evaluating the materiality of a possible or actual illegal act that has surfaced, the auditor should consider both the quantitative and qualitative materiality of the act. One consideration in determining materiality is that an illegal act deemed not to result in an immaterial amount in an earlier period could lead to future amounts that might be material in the aggregate.

How does this affect the auditor's report and opinion? If the auditor concludes that an illegal act has a material effect on the financial statements and the act has not been properly accounted for or disclosed, the auditor should express a qualified opinion or an adverse opinion, depending on the materiality, on the financial statements taken as a whole. However, the auditor may be unable to determine whether an act is illegal or whether its effects would be material because of uncertainty associated with the interpretation of applicable laws.

Classification of the employment practices by a company as an illegal act is difficult for the auditor because TABULAR DATA OMITTED TABULAR DATA OMITTED the end result will be decided by a court of law. At what point is the auditor responsible for reporting and disclosing possible illegal acts? Before a claim is filed, the auditor should make inquiries of management concerning the client's compliance with laws and regulations. After a claim is filed, the auditor should obtain an understanding of the nature of the act and consider the potential effect on the financial statements. Even after an initial court decision is rendered, whether favorable or unfavorable, is the auditor in any better position to classify a practice as legal or illegal since the decision may be appealed?

The auditor is not a judge and decisions about the legality of company policies are outside the auditor's scope of responsibility. Therefore, the auditor is not responsible for deciding whether an employment policy is a violation of the civil rights laws. Predicting future claims and future court decisions is also beyond the scope of an auditor's responsibility. Even after a claim is filed, the auditor is not responsible or in a position to judge the legality and predict the final court's decision. Proper disclosure of the facts after a claim has been filed should represent sufficient notification of a possible illegal act to the financial statement readers.

Table 2 presents a summary of the auditor's dilemma and illustrates his dilemma relating to whether and when to report a possible illegal act and its potential monetary effects. Of particular note are the changing potential consequences based on the most recent court decision.

Recently, Federal legislation was proposed to expand the auditor's responsibilities relating to the detection and disclosure of fraud and other illegal acts by clients. One proposed bill would have required audits to be conducted in accordance with methods prescribed by the SEC to detect illegal acts and would have, in effect, transferred the setting of auditing standards from the private sector to the government.

Applying GAAS to a Specific Situation

Before a claim is filed, an auditor is required to make inquiries of management concerning compliance with laws and regulations. After a claim is filed or when the auditor becomes aware of a possible illegal act or determines that an illegal act has occurred, he or she should consider and evaluate the potential quantitative and qualitative materiality of the act including any future material effects. The auditor should then require proper and adequate disclosure of the facts in the financial statements. After a decision is first rendered but before any appeal, the auditor must still consider and evaluate the possible effects and require proper and adequate disclosure of the facts. After an appeal, the auditor must again consider and evaluate any possible future material effects and require proper and adequate disclosure of the facts.

Since the auditor is neither a judge nor a jury, he or she should avoid predicting the future ("What will the Supreme Court ultimately decide?"). The author's responsibilities, as required by GAAS and GAAP, include inquiries of management and the enterprise's legal counsel, consideration of any possible illegal act and its potential consequence, and appropriate disclosures. Table 3 illustrates how current GAAS and GAAP can be applied to this situation.


With today's litigious conditions, every company must consider risk management and the potential consequences it may face from litigation. The auditor must also consider any potential consequences related to these risks. The auditor must be alert for illegal acts and their potential effects on the financial statements. An auditor is not a judge, however, nor does he or she have a responsibility to judge the legality of a company's policies. But the dilemma for an auditor is whether and how to report or disclose the potential consequences of policies that may be in violation of laws or regulations.

Any potential effects must be considered in relation to the financial statements prior to a claim being filed, after a claim has been filed and after a court decision is first rendered but prior to an appeal. Favorable lower court decisions are not sufficient to preclude disclosure. Reliable estimates of the amount of a contingent liability may not be feasible until the "final" court decision; and, even then, reliable estimates may or may not be possible. Even after an appeal, an auditor (or any one else) may not be able to assess the potential impact of that decision.

Even though an auditor may not be able to predict the outcome of an appeal, he or she does have an obligation to inquire, investigate and report the circumstances. Current GAAS and GAAP require inquiry of the company's management legal counsel concerning litigation and fines, pending lawsuits and their status in the courts, reports of illegal acts, consideration of the company's ability to continue as a going concern and consideration of the effect of these items on the financial statements and the auditor's report. Following these professional standards should provide adequate disclosure to the investing public.

James H. Thompson, CPA, PhD, is a professor of accounting in the Meinders School of Business at Oklahoma City University. He has published articles in numerous professional journals.

James S. Worthington, CPA, PhD, is an associate professor of accountancy in the School of Accountancy, Auburn University, Auburn, Alabama.

Lori Wren has a masters of accountancy in taxation from the School of Accountancy, Auburn University, Auburn, Alabama.
COPYRIGHT 1993 National Society of Public Accountants
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Author:Thompson, James H.; Worthington, James S.; Wren, Lorie
Publication:The National Public Accountant
Date:Dec 1, 1993
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