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Limiting Auditor Legal Liability

Jul 14

Written by: Jack Ciesielski
7/14/2008 7:50 AM

The auditing profession has been lusting for caps on their legal responsibility for failed audits for some time now. The failure of Arthur Andersen has played nicely into their hands in this regard, allowing them to invoke the doomsday scenario of "what would life be like if there were only three major auditing firms?" Therefore, they need protection from lawsuits that could make this a reality.

The funny thing is - the audit is under the control of the auditor. They could "audit better," if they chose to do so. And they could walk away from audits that they cannot audit better. Better that they have limits to their legal responsbility? Hmm... seems like they'd have even less incentive to do an audit better. I smell a moral hazard in the offing.

There's an idea floated by Professor Lawrence Cunningham of the George Washington Law School that's worth considering, and he blogs about it in his post at the Concurring Opinions blog. Skip the caps: instead, have the auditing firms issue catastrophe bonds as a backstop for liability above the limits of their insurance policies.

"The firms would issue bonds in debt markets to provide a backstop against the big judgment. Paying a high interest rate to reflect risk, the bonds would be repaid at maturity if no big claims arose but principal would be released to cover massive judgments if they did. This would protect share owners against losses from incorrect accounting without bankrupting an audit firm."

It's a fascinating notion, one that might be worth some effort on the part of the auditing firms to consider. One puzzle: if a market could be found/created for these bonds, why wouldn't insurance firms just underwrite the risks in that particular market?

Will auditing firms give it serious consideration? They should, but they're probably far too wedded to their lobbying efforts to minimize liability to pay much attention to it.

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Pension & Other Benefit Plans: A Look Ahead

Investors in firms with defined benefit pension plans always face the risk of suddenly being pushed farther back in line when it comes to being served their returns. Variability in plan assets and variability in benefit plan obligations are the reason: poor asset returns coupled with sinking interest rates always spell tough times for defined benefit plan funding. In that regard, this year’s asset returns combined with the Fed’s “Operation Twist” add up to “Operation Agony” for defined benefit pension plans. If trends continue along their current path, firms that may have anticipated moving to more realistic pension accounting - like Honeywell, AT&T and Verizon already have done - might forego that decision. It could be just too painful.

Pensions aren’t the only kind of benefit plan affected by Operation Twist. Other postemployment benefit (OPEB) plans share much the same accounting model as pensions, including the calculation of a projected benefit obligation that similarly incorporates a discount rate - one that will also be affected by Operation Twist. The net OPEB obligations were slightly less than pension obligations at the end of 2010, but also promise to grow in 2011. Investors perceive them as less threatening than pension obligations because they don’t require funding. Strangely, there are a number of firms that are recognizing income from these benefit plans - without ever creating a dime of cash for investors.

A recent edition of The Analyst’s Accounting Observer dissects these issues, and is available only to paid subscribers. A condensed version is available for free upon request. To receive it, send an e-mail to Brenda Rappold at brappold@accountingobserver.com, with “PENSIONS” in the subject line.

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