A Feather In Their Cap – Audit Firms Win Liability Battle With EU

“Your face is black, your hair like flame, And one eye’s damaged, one foot lame: 

If, still, you’re quite decent chap – Well ’tis a feather in your cap.” 

Marcus Aurelius (Roman emperor, best known for his Meditations on Stoic philosophy, AD 121-180)

On June 6, 2008, the European Commission published a recommendation calling for EU Member States to develop liability caps for auditors, or permit listed companies to develop such caps in consultation with their shareholders and governing boards, subject to judicial review and disclosure. These caps would pertain to statutory audits of listed companies.

Edith Orenstein at the FEI Blog gives her usual thorough and super-informative summary of the situation in Europe and the reaction and related activities in the US. I would strongly encourage you to go to the FEI Blog and to Jennifer Hughes’ article in FT for the details. Given my exhaustive coverage of this issue here in the past and my well known views on the subject, I will only comment, out of context, to a few of the quotes in Edith’s report.

First Quote: 

The EC explains in this Frequently Asked Questions (FAQ) document: “It is in the public interest to ensure sustainable audit capacities and a competitive market for audit firms at international level… liability risks arising from the increasing litigation trend combined with insufficient insurance cover may deter auditors from providing audit services for listed companies. If these structural obstacles (liability risks/lack of insurance) persist, mid-tier audit firms are unlikely to become a major alternative to the ‘Big 4’ audit networks on European capital markets… there is also a risk of losing some of the existing players. One of the reasons might be that catastrophic claims cause the collapse of one of the major audit networks.”

My Response:

Is there anything that will deter auditors from providing audit services for listed companies?  We have not seen it yet.  

Notwithstanding the failure of Arthur Andersen, the loss of their self-regulatory framework, or the so-called threat of “catastrophic claims”, the Big 4 and the next tier firms are more than ever committed to providing audit services and charging as much as the market will bear.  

Why? Because they make a ton of dough doing it!

In fact, they are thanking the SEC and Chairman Cox for handing them the next big things, windfalls for additional work and fees that requirements such as IFRS and XBRL will bring to the firms now that Sarbanes-Oxley fees are stabilizing.  Although the SEC thinks they will have an impact by “strongly encouraging” implementation of Auditing Standard 5 to bring more “cost-benefit” to SOx, only good little boys and girls who say their prayers and follow their auditors’ directions for multiple years with minimal deficiencies and weaknesses will be able to reap the benefits of this standard, assuming there is one for companies in the first place.  Uncertainty breeds more fees for the firms, since they are the final arbiters of the success of implementing any of these initiatives.

Mid -tier or “next tier” firms as I like to call them, are unlikely to ever be able to compete with the Big 4, not because of liability claims, although in the US all three of the main next tier firms are facing serious issues, but because there is a significant barrier to entry.  They can not achieve critical mass.  

To be able to compete with the Big 4, you have to have the firepower.  And to have the firepower, that is, the brains, bulk, and broad coverage, takes lots of volume.  It would require combining the next four or five or six firms in the US (someone probably has the numbers) to give any new firm the equivalent capital and client base to be able to invest in the infrastructure to compete for audits of large multinationals.  And that would be after a very large gearing up via training, development of more robust internal methodologies, bulking up their risk and quality teams, and tools buildup.  It was pathetic to hear one of the next tier firms at the most recent PCAOB Standing Advisory Committee admit that there was no one in their network that had any experience whatsoever in IFRS and they had no idea how or where they would get it.  

That’s the problem.  Getting to critical mass is just too big a leap.
Second Quote:
U.S. Treasury ACAP Debates Liability; To Publish Addendum in FR for Comment
In related news, the U.S. Treasury Advisory Committee on the Auditing Profession (ACAP) voted on June 3 to formally publish in the Federal Register – and seek public comment on – an Addendum to its May 5 Draft Report… 

The Addendum includes one recommendation and three matters for further consideration,
(with responses):

(1) a recommendation that the PCAOB reconsider the form and content of the auditor’s report,
re: The Auditors votes yes, but they’re going to have to do a lot of work to make this boilerplate meaningful. In particular, I lament the integration in the report of the opinions on internal controls under SOx and the overall financial statement opinion. Now you will never get an idea of how bad the SOx deficiencies and weaknesses are.   And it will take a catastrophe to cause a SOx negative trend to change an “unqualified” opinion to a “qualified” one. We have seen the frequent use of adverse opinions on internal controls while still maintaining an overall unqualified opinion. But at least the two opinions forced the auditors to make a judgement and gave the company a kick in the ass when they needed it. 

(2) whether engagement partners (not just the ‘firm’) should sign audit reports,

re: The Auditors strongly votes yes.

(3) whether audit firms should be required to make public a set of audited financial statements for their own firm, 
re: The Auditors strongly, emphatically, demonstrably votes yes. Now, the question becomes: Under which standard they should be prepared (currently info is not prepared under GAAP in the US and who would audit it?) and when to phase in Sarbanes-Oxley requirements for the firms? LOL 


(4) whether it would be appropriate to transfer to federal court jurisdiction certain claims against auditors and related issues regarding a uniform standard of care.
re: The Auditors votes no.  This is limitation of liability through the back door.

Third Quote:

PwC General Counsel Charles W. Gerdts III (testimony) and attorney Michael R. Young of Willkie, Farr & Gallagher (testimony), explained that the threat of catastrophic loss limited audit firms’ abilities to exercise their right to take the matter to trial, instead having no real choice but to settle, rather than – as Oberly soberly put it – ‘bet the firm.’

My response:

What a load of horse manure.  If the auditors thought they had a strong case and were not afraid of discovery, they have the means and the motive to take more cases to trial.  As we have seen, even the most incredible auditor cases, as in, “I’m incredulous that the jury bought this line of BS,” can be won if you’ve got a brilliant lawyer.  A real superhero story.

We can clearly see this strategy,  avoiding trials at all costs, in the backdating scandal.  Even when they are directly accused, as they were in the ESSI case, they will try to avoid having to testify whether they actually advised clients to backdate and/or to not report in compliance with GAAP and SEC requirements.  

Would any or all be “betting the farm” if they went to trial, as BDO has?  We don’t know, because unless they go to trial, we have no idea what their overall litigation exposure might be and what reserves and access to reserves they may have.

10 replies
  1. Independent Accountant
    Independent Accountant says:

    As usual, I agree with you. Ever since the 1977 1760-page “Green Book”, Uncle Sam has fiddled around with CPA industry “reform”. Fiddlesticks, I say. I await Chris Cox’s “reforms” for the rating agencies. Hahahaha.

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