|Zoe-Vonna Palmorose, CPA, PhD, is the Price Waterhouse Auditing Professor at the University of Southern California, Los Angeles. The research reported in this article is largely based on her studies, "Auditor Litigation and Modified Reporting on Bankrupt Clients," Journal of Accounting Research , 1994 Supplement (pages 1-29) (with Joseph V. Carcello) and "The Joint & Several vs. Proportionate Liability Debate: An Empirical Investigation of Audit-Related Litigation," Stanford Journal of Law, Business & Finance , Fall 1994 (pages 53-72).|
As the accounting profession adjusts to state and federal legal reform-such as the Private Securities Litigation Reform Act of 1995-it is important to consider what we know from past litigation against auditors. This article discusses research on more than 1,000 instances of litigation against 20 or so large audit firms. Publicly held clients made up about 65% of the cases; however, all types of clients, actions and jurisdictions were represented in the overall sample, which covered litigation over the last three decades. The evidence had some surprises; it coincided with some but not all beliefs widely held in the accounting profession.
THE MATTER OF MERITS
A key question in studying lawsuits against auditors is, "Do the merits of the suits matter?" This question raises one of the most contentious debates among advocates and opponents of legal reform. For example, the 1992 Big 6 statement of position argued that the accounting profession was the victim of a significant amount of nonmeritorious litigation. The evidence supported this argument. Research found that between 40% and 50% of all lawsuits against large accounting firms resulted in one of two outcomes: Either the court dismissed the case against the auditors or the case was settled with the auditors paying nothing to the plaintiffs. Since both outcomes are consistent with weak claims, the evidence indicated that the merits of nearly half of the cases filed were too weak to stand up in court.
Opponents of reform counter that this evidence showed the legal system can get rid of weak claims so the system does not need changing. Additional evidence, however, supported a related argument made by the accounting profession. Defending against weak claims under the Securities Exchange Act of 1934 has been difficult, time-consuming and financially burdensome. Based on the data, it took an average of 3.7 years to conclude a suit that resulted either in charges being dismissed or auditors making no payments to plaintiffs. Using a common defense attorney gauge of costs of $1 million per year per lawsuit, this translates into average costs of $3.7 million to defend against a weak claim.
In contrast to the widespread publicity often given to large payments by auditors, the evidence revealed that auditors were not, on average, major contributors to settlements. The client and its affiliates-officers, directors and professional advisers, such as underwriters-generally contributed more than auditors. The payment data showed that auditors most often contributed 10% or less of the total. And they tended to pay nothing or paid much less than others even when total payments to plaintiffs were relatively large. For example, in only 8% of lawsuits did the auditors contribute more than 50% of the settlement and pay more than $5 million to plaintiffs.
THE IMPORTANCE OF BANKRUPTCY
Does auditor litigation tend to involve bankrupt or financially distressed clients? The answer is yes. Research based on the large sample of lawsuits against auditors found that between 30% and 40% of suits were filed on clients about to be or already in bankruptcy.
However, the evidence is slightly different when the question is changed to: Are auditors always sued when clients fail? To answer this required a sample of bankrupt companies. We looked at 655 public companies that had declared bankruptcy between 1972 and 1992. In the sample, we found slightly under 20% had litigation against the auditors. Lawsuits against auditors were more likely to come from larger bankrupt clients (median assets for companies with auditor litigation were $244 million compared with $39 million for companies without any financial reporting litigation) and from those reporting net income in the last financial statements before they filed for bankruptcy or before lawsuits were filed. Surprisingly, bankruptcy did not, on average, precipitate litigation against auditors. Lawsuits preceded client bankruptcy filings on 55% of the cases involving auditor litigation in our sample.
THE FRAUD FACTOR
Fraud was found in a number of lawsuits against auditors: Some 46% of the bankrupt public companies with litigation against auditors had evidence of client fraud such as Securities and Exchange Commission enforcement actions when companies and/or management consented to permanent injunctions for financial reporting violations. Only 1% of the bankrupt public companies without suits had SEC enforcement actions.
A link appeared to exist between the timing of litigation on bankrupt public companies and fraud. When litigation preceded rather than followed a client's bankruptcy filing, fraudulent financial reporting was twice as likely to be found.
Unfortunately, our evidence was unable to answer the question: Are auditors more likely to be held responsible when fraud is found? Although some evidence suggested auditors may pay more when fraudulent financial reporting occurs, such evidence was very preliminary and research on this important question continues.
THE POWER OF THE MODIFIED REPORT
Modified reports seemed to provide the auditor with some defense against litigation. Consider the audit report on the last financial statement issued before the bankruptcy or litigation (whichever came first): Of bankrupt public companies with no auditor litigation, 58% had modified reports, while only 36% of bankrupt public companies with auditor litigation had modified reports.
However, the story gets more complicated, in part, because lawsuits encompassed as much as six years of financial reports and did not necessarily focus on the last financial statement. As it happened, over 80% of auditor litigation either was not limited to or did not involve the last annual financial statement issued before bankruptcy. Therefore, modifying just the last audit report might not give auditors a sufficient defense against litigation.
We also considered all the audit reports issued during the multiple annual reporting periods involved in litigation. We found that 70% of the lawsuits against auditors of bankrupt public companies involved only unmodified reports. About 20% had a mixture of modified and unmodified and, for these, the last report before bankruptcy usually was the only one modified. A small portion (10%) of lawsuits involved only modified reports. For this last group with only modified reports, the claims against auditors often alleged that incorrect reports were issued despite the modifications. For example, reports with going concern modifications were alleged to be incorrect because they did not reflect that the financial statements departed from generally accepted accounting principles.
The outcomes of lawsuits on bankrupt public companies reinforced the defensive role of modified reports. In suits with only modified reports, auditors either paid the lowest settlements or won the highest dismissal rates. The highest auditor payments occurred when no modified reports were issued by auditors.
The research did not show an increase in the rate of auditor litigation after Statement on Auditing Standards no. 59, The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern , was issued in 1988. Predictions that SAS no. 59 would increase suits against auditors by expanding auditors' responsibilities for going concern reporting went unfounded. On the contrary, 14% of bankrupt public companies had suits against auditors both before and after SAS no. 59 (considering just the periods of 1984 to 1986 and 1990 to 1992, respectively). However, auditors were sued by third parties on 21% of their public clients declaring bankruptcy from 1987 to 1989, the period during which auditors moved from applying SAS no. 34, The Auditor's Considerations When a Question Arises About an Entity's Continued Existence , to SAS no. 59. In the post-SAS no. 59 period, reflecting to some extent industry-specific economic difficulties, the majority of lawsuits against auditors were filed by third parties on their clients in the financial services industries, including insurance.
LESSONS FROM LITIGATION
This evidence has an important message for auditors as they render services under recent legal reforms. It demonstrates that fraud and bankruptcy often are found in lawsuits against auditors. The auditor's detection and disclosure responsibilities in these areas are a focus of the Private Securities Litigation Reform Act of 1995. For example, the act reaffirms the auditor's responsibilities regarding going concern evaluations (SAS no. 59) and illegal acts (SAS no. 53, The Auditor's Responsibility to Detect and Report Errors and Irregularities , SAS no. 54, Illegal Acts By Clients , and SAS no. 82, Consideration of Fraud in a Financial Statement Audit ) and contains new requirements for disclosing illegal acts. To avoid litigation in the future, auditors need to be alert to these responsibilities.
Finally, the profession may want to consider that to the extent legal reforms are successful in eliminating auditors from being defendants in lawsuits with weak claims, any future litigation against auditors may involve more difficult cases. If so, now more than ever lawsuits are something to protect against.