Liability Crisis Threatens Auditors

The sedate accounting profession is becoming a risky business.

A series of court decisions this year has put the financial viability of the Big Six accounting firms in jeopardy. When businesses fail, investors and regulators often find that the company's auditor is the only solvent party remaining. In several recent cases, injured parties have sued the auditor for damages.

Recent judgments and settlements include:

Ernst & Young's historic $400-million settlement with federal regulators for its inadequate audits of four bankrupt thrifts.

Coopers & Lybrand's $95-million settlement of claims for its allegedly poor audits ofthe books of MiniScribe Corporation. It reportedly also was ordered to pay $45 million in a separate judgment relating to MiniScribe.

Standard Chartered Bank won a $338-million judgment against Price Waterhouse because an audit by the accounting firm resulted in a failed investment by Standard Chartered in the United Bank of Arizona.

"Ambulance chasers used to be confined to automobile accidents," says Jon Madonna, chairman of KPMG Peat Marwick, the world's largest accounting firm. "Now ... business accidents are alot more valuable."

Even though an accounting firm might earn only a small fee for an audit, if the business subsequently runs into trouble, the legal rule of "joint-and-several" liability means that a multimillion- or billion-dollar loss can be assessed against each party involved.

If everyone else is bankrupt, the auditor maybe the only "deep pocket" left standing. According to the chairmen of the Big Six (Arthur Andersen & Co., Ernst & Young, Deloitte & Touche, Coopers & Lybrand, KPMG Peat Marwick, and Price Waterhouse), litigation and settlement costs increased 18 percent in 1991 over 1990 to 9 percent of revenues.

This year will bring a "respectable jump again for us," Mr. Madonna says. On top of the savings-and-loan failures and problematic investments in start-up companies, well-publicized inventory-fraud schemes have shaken investors' confidence in audits. Recent examples include Phar-Mor Inc. and Comptronix Corporation, where managers claimed to have larger inventories and revenues than they actually had.

Melvyn I. Weiss, a lawyer who has handled lawsuits alleging "accounting andother misstatements issued by publicly traded companies," saysthese firms have been failing society by not providing "a quality product."

Mr. Weiss, of Milberg Weiss Bershad Specthrie & Lerach in New York, says auditors "have to affirmatively take on the responsibility to look for management misconduct." They have to "stand up to their clients when clients resist a proper audit," he adds. "Then we'll have ... what used to be called `certified statements and society will avoid billions and billions of dollars of ruinous losses."

"I hope the accounting firms are waking up," says Walter Schuetze, chief accountant of the Securities and Exchange Commission. "When we see settlements of $400 million, I do not know how much louder the bell has to ring."

Rep. Ron Wyden(D) of Oregon will introduce legislation in the next Congress (it has been introduced numerous times over the last seven years) to require auditors to disclose fraud discovered in the course of doing audits. He thinks the public simply is not aware of the problem.

"If you take a public opinion poll today, people think that fraud reporting is already required," Mr. Wyden says. "People say `You mean auditors aren't required to report fraud to government regulators?' ... They [accounting firms] are dragging their feet and hoping the fraud-reporting issue will go away."

The firms argue that raising accounting standards without controlling the resulting additional liability would, at best, be unfair to auditors and, at worst, could be calamitous. As it stands, accounting firms have to "watch who they are taking on and get rid of those clients that bring too much risk," says Arthur Bowman, of the Atlanta-based Bowman's Accounting Report. "It's much better to get rid of a $500,000 audit fee than it is to risk a $50-million lawsuit."

Accounting firms are starting to do exactly that, says John Hunnicutt of the American Institute of Certified Public Accountants. Firms are examining the nature and scope of their practices and looking carefully at riskier clients. "We are being a lot more rigid in terms of accepting clients," confirms Madonna.

But Mr. Bowman says that firms still are not being picky enough. "If the accounting firms really want to get attention to this [liability] issue, we need a few risky public companies that can't find an auditor. That would get attention. Everyone would have to come to the table."

"It's easy to audit blue-chip companies," Hunnicutt says. The real value of an audit to investors is to provide credible financial information on less well-known companies or financial institutions. To contain risk, says New York attorney Weiss, accounting firms should take several steps:

* Audits should be rotated between two firms to maintain impartiality (Canada uses a similar system).

* Auditors who do on-site research should be better trained.

* Accounting firms should not permit audit clients to hire employees from their ranks.

"The regulators and the academic community here in the US have been highly critical of the profession," SEC's Schuetze says. But "even in ... some of the celebrated business failures, I don't think anyone has asserted that [the losses] were solely and exclusively the fault of an accounting firm," Hunnicutt says. "Yet under this system, every accounting firm knows it's vulnerable for the whole shooting match."

In the last two years, "1 in 12 New York Stock Exchange [-listed] companies has been sued" over alleged securities fraud, says Lawrence Weinbach, chairman of Arthur Andersen & Co. The defendants (often including the auditors because of joint-and-several liability rules), are forced to settle the cases. "The legal system is not working," he says.

Critics of the current joint-and-several liability doctrine say that the threat of a lawsuit, however unjustified, is enough to push the large firms to settle quickly without going to trial. "There is frivolous litigation, and we ought to find a way to put a stop to that," says Schuetze, who spent more than 30 years in public accounting. "A proposal that the loser pays [legal fees for both parties] makes sense. "On the other hand, I don't want to excuse the auditing profession," Schuetze says. "No excuses for bad audits."

CORRECTION (on 12/31/1992)

On Monday, we reported that Standard Chartered Bank had won a $338 million judgment against Price Waterhouse in May. Standard Chartered blamed a failed investment on audits by the accounting firm. An Arizona judge threw out the verdict on Dec. 16 and ordered a new trial.