February 2001

Audit Engagements Produce Largest Claims

While tax engagements still outnumber audit engagements among small to mid-sized CPA firms, Camico’s experience has been that audit engagements generate claims with significantly higher dollar amounts than any other type of engagement. In fact, audit engagements are by far the costliest in terms of average claim size. The costs of audit claims average about $341,000 per claim (which includes indemnity and legal defense), outstripping the next closest category, executor/trustee claims, by about $132,000 per claim (See the Exhibit).

The liability exposure in audit engagements has been severe enough to cause many CPA firms to discontinue audit practices. When trying to understand why audit claims tend to be so severe, it helps to consider at least one important fact: The accounting profession imposes high standards on CPAs for such engagements, but members of the public, including those sitting on juries, often impose even higher standards. Camico’s jury studies and claims experience have repeatedly reinforced that fact.

Another important fact that works against CPAs is that fraud, defalcation, and material misstatements are major causes of loss in audit claims. In Camico’s experience, fraud and defalcation are the leading causes of loss in audit claims.

Exhibit

In describing professional standards for audit engagements, SAS No. 82 (AU 316.10) states in part:

Because of a) the concealment aspects of fraudulent activity, including the fact that fraud often involves collusion or falsified documentation, and b) the need to apply professional judgment in the identification and evaluation of fraud risk factors and other conditions, even a properly planned and performed audit may not detect a material misstatement resulting from fraud.

Public perceptions, however, don’t always agree with those standards. One of Camico’s jury studies asked jurors to respond to the following statement: The purpose of an audit is to uncover any type of fraud or wrongdoing.

Jurors’ responses indicate a preponderance of higher expectations for auditors: 64 percent agreed with the statement,

18 percent disagreed, and 18 percent were neutral. Furthermore, jurors have the benefit of 20/20 hindsight when assessing material misstatements that the CPA had to assess during the course of conducting an audit. Circumstances can look considerably clearer when being evaluated by a jury after all the facts have been revealed. As a consequence, the standards imposed by the public on CPAs conducting audits can become even higher.

A related statement posed to jurors in the jury study yielded similar responses: Accountants have the responsibility to police the financial reporting a company makes to investors.

The word “police” was used intentionally in the statement because it denotes catching and stopping crime. Responses to the statement confirm the public’s view of the CPA’s role as that of watchdog: 63 percent agreed, 11 percent disagreed, and 26 percent were neutral.

Another major liability area for audit engagements is that of creditor decisions by lending institutions and other lenders. While not occurring as frequently as claims involving fraud, claims involving creditor decisions tend to be large, averaging about $668,000—a substantial sum for small or mid-sized CPA firms.

Claims involving creditor decisions can also involve some kind of fraud that was not detected by the auditor. Although the conclusions reached by the auditor can appear to be reasonable at the time of the audit, they do not appear so to the jury once all the facts are available and clearly spelled out.

The public perception is that audited financial statements may be freely relied upon in making creditor decisions, so it is not unusual for a bank or other financial institution suffering a loan loss to seek recourse against the borrower’s CPA firm. Again, hindsight, combined with high public expectations for CPAs, can work against the CPA. The jury might know exactly how the fraud took place, how it could have been detected, and any red flags that existed. The situation will appear to be much more obvious than it did at the time the CPA was doing the work. Unfortunately, the CPA does not get the benefit of hindsight.

Loss Prevention Tip: Communicate with Clients in Writing

A lack of written communication about the scope of the firm’s services, advice given, or other client interactions can lead to liability claims. SAS No. 83, Establishing an Understanding with the Client, requires the auditor to establish an understanding with the client about the services to be performed. Many problems can be avoided by putting that understanding, along with the terms of the engagement, in an engagement letter.

Language in the letter should be limiting in its descriptions of services, objectives, and responsibilities. The engagement letter is not the place to embellish or market the firm’s capabilities. The CPA firm wants to limit, not expand, its risk exposure in the letter. The audit engagement letter can also clarify: