1. Problems of Defining and Reforming Auditor Liability Tim Bush, Stella Fearnley and Shyam Sunder 24 th World Continuous Auditing and Reporting Symposium Inonu University, Malatya, Turkey May 3-4, 2012

2. 2 Overview A century of regulatory efforts to improve auditing by redefining auditor liability: punish failure to improve quality Little evidence of improvement Moves towards global accounting and auditing standards to eliminate comparative analysis of policy proposals (liability limitations, LLPs, proportional) Fortunately, still major differences between US and UK regimes Balancing regulation, market forces, and social norms to improve financial reporting 8/16/2015Bush, Fearnley, Sunder: Auditor Liability

3. 3 US before 1990 Federal securities laws since 1933, dominance of the decision usefulness reporting model U.S. federal securities acts focus on protection of markets i.e. buying and selling shares; contract law at state level Tort law at federal level attracts class actions for loss from share price falls (potential investors) Joint and several liability, with burden of proof on defence who bears own costs regardless of outcome But had to prove recklessness or intent (Hochfelder, 1976) i.e. more than negligence 8/16/2015Bush, Fearnley, Sunder: Auditor Liability

4. 4 US After 1990 1991 onwards: states allowed LLPs, firms able to protect partners assets Audit firms writing private restrictive clauses in engagement letters stop contract law cases at state level (jury trial and punitive damages) Now PCAOB’s independence concern Genuine concerns about merit-less class actions which may be cheaper to settle than defend against Auditors appointed by management (until SOX) and report to directors. Shareholders could not sack the directors 8/16/2015Bush, Fearnley, Sunder: Auditor Liability

5. 5 US after 1990 1995 PSLRA and 1998 SLUSA brought proportionate liability, except for criminality & fines for meritless cases Presidential veto: quid pro quo improvements to audit quality suggested by Treadway in 1987 (illegal acts, related party transactions, going concern, report breaches) No evidence of improvements to audit quality; even the meaning of quality is unclear Suggestions (Zeff, 2003, Francis and Krishnam, 2002, Coffee and others) that moral hazard undermines audit quality, but no established causal link 8/16/2015Bush, Fearnley, Sunder: Auditor Liability

6. 6 UK before 2000 Company law controlled corporate and auditor responsibilities; auditor liability limitations banned since 1929 Duty of care to shareholders but Caparo 1990 limits rights to sue Almost no liability to 3 rd parties No class actions when share price drops Sue for loss in company; most claims from liquidators 8/16/2015Bush, Fearnley, Sunder: Auditor Liability

7. 7 UK before 2000 1989 Companies act allowed incorporation –only KPMG had limited take-up. Was the price too high? Reform of Joint and several rejected by Law Commission in 1996 but possibility of allowing proportionate liability by contract was mooted Key argument was only 6 audit firms LLPs allowed from 2,000 after some hanky panky in Jersey, all are LLPs now. 8/16/2015Bush, Fearnley, Sunder: Auditor Liability

8. 8 UK after 2,000 Government scared by KPMG tax scandal and Equitable Life case Like banks, audit firms also became too big to fail, and too big to jail? Whose fault that only four of them now? Company Law Reform Bill in the House of Lords Allows limitation by contract subject to shareholders agreement. Some shareholders said they will vote against Criminalises reckless or knowing misreporting, including omissions; also to name partners, publish engagement letters, nothing onerous except criminalisation. 8/16/2015Bush, Fearnley, Sunder: Auditor Liability

9. 9 UK after 2,000 Profession lobbied to get rid of reckless or knowing and making it fraudulent; US has class actions Attempt to change requirement to report where company hasn’t kept proper accounting records (in law since 1948) to records ‘adequate for accounts preparation’ only Really upset investors who need to approve liability contracts 8/16/2015Bush, Fearnley, Sunder: Auditor Liability

10. Criticisms of Reform Campaigns Case overstated (28/year, 50%, recklessness, not just negligence) No improvement, even reduction, in quality post-PSLRA 2005-6 saw large (9-22%) increases in average profit per partner in U.K. Sharp drop in cases against auditors, and increase in restatements post-PSLRA Ronen and Cherny insurance proposal Jamal and Sunder: finer gradations in audit report Gietzman et al. weaker incentives of proportional liability Mitchell: resolve crisis by better audits, not liability reform 108/16/2015Bush, Fearnley, Sunder: Auditor Liability

11. Economics of Liability Caps Liability caps favor auditors if all other things were equal, but they are not Consequences for quality of service and exposure to dispute Consequences for audit fees What are the net consequences of liability caps for auditor profitability and investor risk and returns? 118/16/2015Bush, Fearnley, Sunder: Auditor Liability

12. Economics of Regulatory Audit Requirement What would happen if public companies were allowed to choose if they will be audited in their charter, and let the shareholders decide? 128/16/2015Bush, Fearnley, Sunder: Auditor Liability

13. Liability Caps and Industry Consolidation Is the issue of liability caps a consequence of letting the audit industry consolidate into a few firms? Will the issue still arise if the audit industry consisted of some 10 or 20 major firms? 138/16/2015Bush, Fearnley, Sunder: Auditor Liability

14. Global Liability Creation of global firms/networks to create economies of scale, training, global brands and sale to global customers through referral Problem of putting limits on global liability 148/16/2015Bush, Fearnley, Sunder: Auditor Liability

15. Global Regulation Big firm advantages of training, marketing, uniformity of service Comparability across economies, legal, tax, economic and business systems, and languages is a problem Major differences even between US and UK Making better policy through comparisons across domains of diverse practices (and empirical research on such questions) impossible Use of international standards as a competitive advantage by the big firms 158/16/2015Bush, Fearnley, Sunder: Auditor Liability

16. 16 Implications Big firms want liability limitation and global standards; reduces costs and brings economies of scale Consider differences and motivation for liability reform in US and UK and motivation for financial reporting (and SME) Challenged assumptions: compliance with accounting standards and auditing standards means good financial reporting And, global standardization eliminating comparisons helps make better policy 8/16/2015Bush, Fearnley, Sunder: Auditor Liability

17. 17 Implications Are ISAs based on decision usefulness model of auditing, when UK motivation for audit is stewardship? Already had UK problem over true and fair override- judgement rather than rules driven Risk passing from firms to others via increased regulation and audit committee monitoring Should high income carry higher risk? Should we allow firms to become globally bomb proof with regulation; only possible at country level? Problems with accountability of standard setters? 8/16/2015Bush, Fearnley, Sunder: Auditor Liability

18. 18 Possible Outcomes If audit wasn’t compulsory, price and quality would find its own level In compulsory environment liability limitation reduces value of audit to investors – pay less and value service less Increased regulation, brought on by previous poor auditor performance, devalues profession Global standards may produce box tickers as in varying environments may be no other solution What price true audit professionalism, moral hazard and continuing trust, or are the B4 over reaching themselves? 8/16/2015Bush, Fearnley, Sunder: Auditor Liability