Risk Management: Reducing the Occurrence of Liability Litigation in Small CPA

Firms
By Joseph G. Pugh, CPP and Kenneth M. Hiltebeitel, CPA, Ph.D.

Due to the recent wave of highly publicized accounting scandals commencing with Enron, a great deal of
attention has been focused on needed changes in accounting and auditing standards, as well as the
enforcement thereof through tougher regulations and penalties. Unfortunately, little has been suggested
as practical advice for small auditing firms struggling to deal with the reputation hit and risks of litigation in
the wake of these troubles. While the powers-that-be argue over proposed systemic changes, there are
many steps that small firms can take to reduce the likelihood of future lawsuits, as well as be better
prepared to defend successfully against those that do occur. This article explores a sample of strategies
found in the literature to assist small firms in reducing liability risk. These strategies include: screening
current and prospective clients, gaining familiarity with a prospective client's industry, staffing the audit,
pricing the audit, tag-team auditing and maintaining adequate working papers.

Screening Current and Prospective Clients

It may be said that the fear of unscrupulous or incompetent clients is the beginning of wisdom when it
comes to risk management. The U.S. Securities and Exchange Commission’’s (SEC) Practice Alert No.
94-3 offers a wide range of practical tips as to how to screen prospective clients and to re-evaluate
existing clients for warning signs of high inherent risk. Although it would be redundant to list the SEC
recommendations here, a thorough review of the publication is recommended. Of primary importance is to
emphasize the significance of establishing a screening and reviewing policy and adhering to it.

One principle that bears mentioning is that when establishing procedures that will inform an auditing firm's
decision to decline or terminate a client, the firm should put the policies in writing. The procedures should
also include a mechanism for audit staff to communicate their concerns surrounding an audit to the
appropriate manager or partner. This simple practice of putting policies in writing is often overlooked
because there are always more urgent tasks at hand and the consequences of neglect are neither
imminent nor known for certain. However, the amount of effort required to set written policies can pay big
dividends in the future. For example, a partner may be more likely to make the decision to decline a risky
engagement and will find the decision easier to defend, if the policies have been clearly spelled out in
procedures. The decision to retain a risky client is a matter of judgment. Clear written guidelines can often
prevent unwise decisions. This may pose a challenge to auditors whose recent focus has been to foster
an image of a management-friendly consultant to transition to that of a representative of third parties
again for whom the asking of uncomfortable questions is part of the job.

Gaining Familiarity with the Prospective Client's Industry

An important lesson that should be learned by a review of some of the most high-profile audit failures
should be a cardinal rule for external auditors: do not audit outside your sphere of expertise. Departures
from GAAP or fraudulent representations that may require time-consuming diligence on the part of the
average auditor may be readily apparent to one experienced in the client's industry. This common-sense
maxim has been ignored all too often, much to the detriment of both the auditing firm and its clients. The
AICPA’’s publication, Risk Management: AICPA's Toolkit for a Changing Environment, offers the following
pointers if economic realities require auditing outside one's range of experience:

““Specific industry guides, published by the AICPA, are useful tools and should be included in
your library... Ensure that all staff personnel assigned to the engagement are knowledgeable
about industry-specific methods, applications and transactions...Let them know that it is
imperative that questions be addressed and resolved in an appropriate and timely manner...Seek
the assistance of a CPA or appropriate professional or expert with the required technical
experience. Additionally, if a firm accepts an engagement to perform services that the firm does
not have prior experience in performing, this should be discussed and disclosed to the client, both
orally and in writing, before engagement work commences."1

Naturally, an auditor should be suspicious of any potential client who appears eager to hire a firm without
significant experience in the client's industry.

Staffing the Audit

Auditing standards require that personnel assigned to an audit must have technical training and
proficiency in auditing and that assistants, if any, should be properly supervised. It is critical that top
management emphasize that quality work is paramount. Management can demonstrate its desire for
quality work by providing staff with appropriate training activities both during an audit engagement and
through staff training. It is important that firm personnel are properly matched to an engagement. This
matching should consider technical skill, knowledge of an industry and personality characteristics of the
staff member. Staff should be made aware of available reference materials and encouraged to ask
questions when help is needed.

Pricing the Audit

In a study of auditor decision-making, Zhang, Church and Ackert state, "The total expected cost of an
engagement consists of two components, the direct cost of planning and performing the audit and the
potential cost of litigation."2

Although the second component may have been often overlooked in the past, the recent loss of
confidence in the accounting profession by the public has ensured that this will not be the case in the
future. While suggestions for industry-wide reform are coming from such varied directions as the SEC,
Congress, academic circles, investor advocates, the media and even the White House, there is anything
but a consensus on how to reform the system effectively. This free-for-all of reform opinions and finger-
pointing leaves the small auditing firm with little confidence that the apparently ballooning risks of
performing audits will subside at any time in the foreseeable future. Davis, Gordon and Spencer have
indicated that, "smaller firms (under $5 million in revenues) have experienced increased claims activity
compared both to solo practitioners on the one hand and larger firms on the other."3 The small auditing
firm must be careful in assessing the total cost of a prospective audit before accepting an engagement.
The audit fee charged should be a composite of the audit service rendered and the risk taken.

Tag-Team Auditing
One reform that is being widely called for is that of imposing "term limits" for auditing firms, which would
require clients to periodically change auditors. There are at least two major reasons for the popularity of
this notion. The first is the perception that auditors tend, quite naturally, to develop increasingly friendly
relations with their long-term clients. This dynamic can make it easier for the auditors to lose professional
skepticism and independence, as well as become more inclined, over time, to "excuse" accounting
irregularities for which management is pushing. The second reason is that if management begins with
aggressive accounting early in the relationship in immaterial ways, they might be able to incrementally
increase the degree to which they bend the rules, with the auditor taking less notice of it over time than he
would if a significant irregularity were introduced suddenly. This calls to mind an oft-used frog analogy. It
is said that if a frog were placed in a pot of simmering water, it would immediately leap out, but if the same
frog were placed in a pot of lukewarm water, which was gradually heated, it would remain in the pot until it
was cooked.

Taking the contrary view, opponents of this measure argue that the incidence of audit failures would
actually increase if the "term limit" rule were imposed. According to James Copeland, CPA, who testified
before the U.S. Senate on the issue, a mandatory rotation would:

· result in the destruction of vast stores of institutional knowledge and guarantee that auditors
would be climbing a steep learning curve on a regular basis,

· expose the public to a greater and more frequent risk of audit failure,

· increase the likelihood of undetected fraud by management,

· make it easier for reckless management to mislead the auditor, and

 · allow companies to disguise opinion shopping by enabling them to portray a voluntary change in
auditors as obligatory.4

A further disadvantage to this proposed rule is that it would impose a heavy marketing burden on all small
auditing firms. The price of an audit would surely increase significantly if every auditing firm lost its clients
every few years. A possible way out of these enormous drawbacks would be for two auditing firms to
engage in a partnership of sorts, where each firm would trade off clients every few years, resulting in audit
rotation without a loss of revenue. A further advantage of this "tag-team approach" is that the client is
spared the disadvantage of having a new and unfamiliar audit team every few years; the two auditors may
still enjoy the benefits of a long-term relationship with the clients. Firms opting for this approach might
enjoy reduced audit failure risk as well as a favorable reputation as a responsible, proactive firm. While
this approach may not appeal to many auditing firms at this time, it is important for partners to consider
how their firm can best address this issue in the future.

Maintain Adequate Working Papers

Perhaps the single most important factor in risk management is the exercise of due professional care in
all aspects of the audit. Due care will minimize the likelihood of audit failures, which form the basis of
lawsuits. Sadly, even the most diligent firm will be hard pressed to defend a suit if their exercise of care
were not properly documented in the working papers. The auditor's working papers may become the most
persuasive evidence that will exonerate (or incriminate) the firm. As Zabihollan Rezaee pointed out,

““Maintain adequate working papers and review their completeness and accuracy. Your working
papers should indicate the extent of the procedures applied, evidence gathered during the
engagement and compliance with GAAS and applicable laws and regulations. If you were
charged with negligence, your working papers would be a major factor in refuting or
substantiating the charge. Working papers should be reviewed at every supervisory level of your
firm.””5

Conclusions
Few, if any, of the above suggestions amount to "auditing rocket-science." In most cases, the difference
between whether or not these suggestions are followed results from the perception, estimation and
tolerance of risk on the part of firm partners. In their research, Zhang, Church and Ackert demonstrate
empirically the high level of uncertainty auditors face when attempting to anticipate the cost of litigation.6
Given the recent string of high-profile audit failures, small auditing firms would do well to re-assess the
likelihood and cost of defending litigation and make the tough decisions to improve their risk management
procedures.

Endnotes
1
Davis, Gordon and Spencer, Risk Management, AICPA's Toolkit for a Changing Environment, AICPA,
Inc., New York, N.Y., 2001, pp. 18 - 19.
2
Zhang, Church and Ackert, "Uncertain Litigation Costs and Seller Behavior," Federal Reserve Bank of
Atlanta, Working Papers 98-7, September 1998.
3
Davis, Gordon and Spencer, Introduction, p. xiv.
4
James Copeland, CPA, Remarks Before the Committee on Banking, Housing and Urban Affairs,
Deloitte & Touche, March 14, 2002, www.deloitte.com.
5
Rezaee, Zabihollan, CPA Journal Online, www.nysscpa.org, May 1989, p. 3.
http://www.nysscpa.org/cpajournal/old/07505598.htm.
6
Zhang, Church and Ackert, p. 3.
About the authors
Joseph G. Pugh is an accounting consultant with Philadelphia-based Training Institute of America. He
may be contacted at jpugh@genesis-2inc.org.

Kenneth M. Hiltebeitel, CPA, Ph.D., is an associate professor of accountancy at Villanova University in

Villanova, Pa. He may be reached at kenneth.hiltebeitl@villanova.edu.

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