Principals of CPA firms are aware that publicly traded companies and their auditors are subject to regulation by the Public Company Accounting Oversight Board (PCAOB) and the Securities and Exchange Commission (SEC). They also know that when the value of stock in these companies falls precipitously or fraud is uncovered, shareholder lawsuits are often filed, and auditors can become ensnared in the litigation.

 

Based on an examination of claims filed against firms in the AICPA Professional Liability Insurance Program, public company clients who exhibit certain behaviors can present a heightened liability risk for external auditors. Careful client acceptance and engagement continuance practices can help firms manage the liability risks inherent in such audit relationships and control malpractice insurance costs.  Additional discussion of client acceptance and retention is included in the Statements on Quality Control Standards, which is applicable to both accounting and auditing practice.

 

Corporate Responsibility and Governance

Under the supervision and direction of the SEC and other agencies, the national securities exchanges and associations stipulate principles and practices of corporate responsibility and governance that public companies must adhere to. Title III (Corporate Responsibility) of the Sarbanes-Oxley Act of 2002 (SOX) further expands the responsibilities of audit committees when engaging a CPA firm to audit a company’s financial statements, and increases management responsibility for corporate financial reporting and internal controls, among other matters. In considering an engagement for a public company, you should examine the company’s corporate ethics and governance practices and procedures.

 

Financial Performance Problems

The risk of a lawsuit brought by lenders or shareholders increases when a client reports operating results that do not meet investor expectations or the company fails as a result of poor financial health. Deteriorating financial condition may lead to adverse change in management integrity.  As a CPA, you should consider the following financial risk factors as part of your client and engagement acceptance and continuance procedures for public companies:

 

·   Operating results: Entities that have been marginally profitable or in a loss position for a period of time (generally, two years or more) present increased exposures. The scrutiny of shareholders, other stakeholders, and analysts increases as operating results deteriorate. Unfulfilled forecasts and expectations typically lead to claims alleging misleading communications and deficient financial reporting and disclosures.

·   Financial condition and cash flows: Entities with significant negative cash flows, liquidity constraints, accumulated deficit, and onerous debt or other contract covenants warrant particular attention and evaluation, as these are often red flags signaling increased risks.

·   Rapid expansion financed by multiple securities offerings: Entities that are growing rapidly to gain market share may have high price-earnings ratios in the short term in anticipation of better earnings later. Notwithstanding the additional duties imposed on corporate officers by SOX, the pressure to meet earnings estimates can be intense and lead to auditor disputes with management regarding accounting matters. Additionally, failure to meet earnings estimates can result in sudden drops in stock price and shareholder litigation.

·   Uncertainties and contingencies: Entities facing significant uncertainties and contingencies (e.g., reduced markets for existing products, pending litigation, etc.) warrant close evaluation. Shareholder and lender lawsuits alleging financial reporting or disclosure deficiencies typically name external auditors as defendants.

 

Changes in Auditors

While public companies may seek new auditors due to price or service issues, a company seeking to change auditors may do so as a result of disagreements with existing auditors regarding accounting principles or practices, financial statement disclosures, or auditing scopes or procedures. Prior disagreements may be disclosed in the Form 8-K filing submitted to the SEC. In addition to contacting the predecessor auditor prior to accepting a public company audit engagement (as required by the AICPA and the PCAOB in AU Section 315), review the prospect's prior filings with the SEC, and closely scrutinize potential clients who have changed auditors more than once in the past five years.

 

Corrected or Withdrawn Financial Statements

Financial statements may have been previously restated or withdrawn due to various conditions. For example, if a company issued corrected statements, this could be an indication of a lack of adequate internal controls or corporate governance, a lack of adequate accounting procedures, unqualified accounting personnel, or undetected fraud. Similarly, if a prior auditor corrected and reissued a report, this may have been done in response to the receipt of new information previously withheld by the company, or in response to a disagreement with the company regarding an accounting issue that could have a material effect on the company's financial results.

 

Mergers and Acquisitions

A prospective client should receive special scrutiny if the company has completed or plans to complete a merger or acquisition. A number of high profile shareholder lawsuits have been filed seeking recovery of losses allegedly incurred as a result of the manipulation of financial data by insiders at companies being merged or acquired. While such lawsuits are initially aimed at directors and officers, CPA firms that have performed audits for such companies are often included as defendants.

 

Considering Risk

These are just a few examples of liability risk factors to consider in the acceptance and continuance of public company audit clients. In addition, CPA firms should consider significant changes within the client firm, such as rapid modification in the client’s operations and altered management behavior.  Other new client/engagement factors to consider in making an acceptance decision are discussed in AICPA Practice Alert 2003-03, Acceptance and Continuance of Clients and Engagements, at http://www.aicpa.org/download/secps/pralert_03_03.pdf and Conceptual Framework for AICPA Independence Standards, at http://www.aicpa.org/about/code/et_100.html. Such factors are important to both professional liability insurers and the CPA firms that audit public companies.

 

Most accountants professional liability insurers require CPA firms to identify the public companies they audit in their insurance applications. Risk factors including the issues listed above are evaluated by professional liability insurance underwriters in establishing insurance pricing and terms. Accordingly, CPA firms should consider consulting with their professional liability insurance representative regarding the potential impact of performing audits for publicly traded companies before proposing on such engagements.

 

May 2009

 

CNA, Accountants Professional Liability Risk Control, Chicago, IL 60604

 

The purpose of this article is to provide information, rather than advice or opinion. It is accurate to the best of the authors’ knowledge as of the date of the article. Accordingly, this article should not be viewed as a substitute for the guidance and recommendations of a retained professional. In addition, CNA does not endorse any coverages, systems, processes or protocols addressed herein unless they are produced or created by CNA.  CNA recommends consultation with competent legal counsel and/or other professional advisors before applying this material in any particular factual situations.

 

Any references to non-CNA Web sites are provided solely for convenience, and CNA disclaims any responsibility with respect to such Web sites.

 

To the extent this article contains any examples, please note that they are for illustrative purposes only and any similarity to actual individuals, entities, places or situations is unintentional and purely coincidental.  In addition, any examples are not intended to establish any standards of care, to serve as legal advice appropriate for any particular factual situations, or to provide an acknowledgement that any given factual situation is covered under any CNA insurance policy.  Please remember that only the relevant insurance policy can provide the actual terms, coverages, amounts, conditions and exclusions for an insured.  All CNA products and services may not be available in all states and may be subject to change without notice.

 

Continental Casualty Company, one of the CNA insurance companies, is the underwriter of the AICPA Professional Liability Insurance Program.

 

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