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Expanded Audit Report Proposal Raises Litigation Concerns

Published Date:
Apr 8, 2014

Though the Public Company Accounting Oversight Board (PCAOB) believes that a proposal for major revisions to the standard audit report it released last August will provide investors with better, more actionable information, critics of the plan are expressing concern that the changes will significantly expand legal costs, by creating more areas of attack for potential plaintiffs.

If implemented, the PCAOB’s proposal would retain the pass/fail grading that is in the current reporting model, but would greatly expand the other information and disclosures required. For example, the proposal would require that the auditor use the report to communicate “critical audit matters,” or CAM, which are essentially areas that the auditor found to be challenging during the course of the engagement. This, according to the PCAOB’s exposure draft, is meant to provide users with previously unknown information about the audit, enabling them to conduct a more thorough analysis of the financial statement and bridge what the board describes as information asymmetry between investors and management.

The NYSSCPA has come out strongly against the proposed changes, arguing in a comment letter released last year that efforts by regulators to expand the role of the auditor and provide more hand-holding to investors as they navigate a company’s financial information would not only fail to improve users’ understanding of entities, but could create further confusion with unnecessary details.

In a public forum about the auditor’s reporting model that the PCAOB held on April 2, many of those who might be affected by the proposal expressed their own concerns about the potential for increased litigation that could accompany the changes. During the session, Richard Murray, an attorney who represents large insurance companies and is a former head of legal affairs for Ernst & Young, noted that the nation has an “unfortunately litigious culture,” adding that the CAM proposal would create a new and more extensive risk of exposure to private rights of action for auditors.

“It puts the auditor in a devilish position in the way the litigation process moves forward,” he said. “The auditor can be questioned—if whatever went wrong happened to involve something you addressed in the CAM process—‘Why didn’t you carry through and recognize the consequences? Why did you address so many CAMs and not happen to find the right one?’”

That view was shared by Russell J. Kranzler, chair of the NYSSCPA’s Litigation Services Committee, who said he imagined that “the class action attorneys are jumping up and down because they’ll have more people to sue,” given what he felt was the subjective nature of the CAM requirement under the PCAOB’s proposal. Critical audit matters, he said, aren’t well defined in the literature, which leaves what to include and exclude up to auditor judgment. Ultimately, this opens up the possibility that an auditor will wind up sitting in a courtroom as a result, being asked, ‘houldn’t you have done this or that?’” he added.

According to Lisa L. Shrewsberry, an attorney and partner at Traub Lieberman Straus & Shrewsberry LLP, the CAM requirement would also increase liability insurance costs. Shrewsberry’s firm focuses on defending insurance claims, with professional liability as one of its practice areas, and has a history of defending CPA firms from lawsuits. For audit firms “that plan to do this type of auditing work, I think it’s fair to assume that they will have an increase in premiums, because the risk will most certainly increase,” she said.

“Anytime you have a situation where the scope of professional responsibility is increased, you have an increase of potential liability,” she explained. “So, from my perspective and those of insurers of accountants, there is certainly a concern. I can certainly foresee an uptick in claims against accountants.”

On the other side of the coin, Daniel L. Evans, a CPA and an attorney who is active in the Bar Association, was far from rattled by the changes. In fact, he welcomed them, saying that it’s better for the profession to be known for its judgment vs. what he referred to as the ability to simply memorize a deluge of rules.

“Any kind of judgment is a two-edged sword, no doubt about it, but that’s what the profession is about,” he said. “The profession should embrace judgment. That’s why [auditors receive] training, that’s why they have the experience, that’s why they have accounting education programs. They are designed to shape and mold and develop a fine-tuned instrument of judgment as to what is and is not important, and the profession should not be ducking that.”

Evans added that bright-line standards are their own kind of litigation trap, as missteps of arcane and byzantine rules can bring legal consequences as well. He said that if he had to choose being sued for having a different assessment of what’s important vs. missing a rule , he’d rather pick the former than the latter, as “I don’t want to be known for [being able to] memorize rules; I want to be known for the judgment and the value that [I] bring to the examination.”

What’s really at stake

Howard B. Levy, a member of the NYSSCPA’s Auditing Standards Committee who was one of the principal drafters of the Society’s comment letter about the PCAOB proposal, said that he isn’t concerned that there will be an increased frequency of lawsuits but, rather, an increased intensity of litigation. “The real fear here is that when litigation does arise, it will be more costly,” he elaborated.

“Lawsuits happen. … But as they do, this new reporting vehicle is going to give people more to raise questions about, more to challenge,” he said.

This, he added, will run up defense costs for firms and, by extension, settlement costs.

“[Plaintiffs] will pursue these lines of questioning with, ‘Why put this in the report and not this,’ ‘Why say this and not that,’ and all those costs looked at down the road will cause insurers and people whose pockets are at risk to be willing to settle for higher amounts,” he said.

And for Arthur J. Radin, a member of the Society’s SEC Committee, the real bone of contention is that the proposal aggravates the already heavy disclosure load that CPAs currently face, which, he said, drowns out helpful information in other data that aren’t actually that useful to investors. “Redundancy and overdisclosure is the issue,” he said.

“All this does is add another layer of disclosure, in addition to all the other ones that already exist,” Radin said. “If you own a stock, you get a book about a half inch thick, which everyone looks at and then puts in the garbage because it’s totally unreadable. Everything is in there three times, and the SEC makes noises about cutting it down, but nothing happens.

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