20 Years of Litigation Reform for Accounting Firms

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IMGCAP(1)]Dec. 22, 2015, marked the 20th anniversary of the enactment of the Private Securities Litigation Reform Act. Enacted at the behest of accounting firms, the PSLRA was crafted to immunize accountants from securities fraud liability. The result over the last two decades has been a substantial erosion in the ability of investors to hold accounting firms accountable.

Does it surprise anyone that, with auditors no longer concerned about liability for conducting defective public company audits, the quality of those audits has deteriorated?

According to a recently released study by the Public Company Accounting Oversight Board, one out of every four audits of a publicly traded company has “significant deficiencies.” “Significant deficiencies” is a polite way of saying that the auditors didn’t do a thorough job and the evidence does not support the auditor’s opinion. The PCAOB is a nonprofit entity created by the Sarbanes-Oxley Act of 2002, legislation passed by Congress in the wake of the accounting scandal at Enron. PCAOB’s mission: to oversee the audits of public companies in order to protect and further the public interest in the preparation of informative, accurate and independent audit reports.

So how does the PCAOB—a board that’s supposed to protect investors’ interests—characterize its findings? Well, the PCAOB was neither outraged, nor appalled, but rather just a bit “concerned.”

As Auditor Immunity Rises, So Too Does the Rate of Defective Audits
In theory, investors should be able to trust that when they review a financial statement it’s accurate. External auditors are charged by law with providing an independent assessment of a company’s financial statements. Of course, the relationship between a publicly traded company and its auditor gives rise to an inherent conflict of interest as auditors need clients for revenue, and auditors know that unhappy clients won’t be clients for long. Far too often, unfortunately, that means investors be damned.

Two decades ago, the U.S. Supreme Court ruled in the Central Bank of Denver case that investors cannot sue fraudsters who knowingly engage in securities fraud if the fraudster only aided and abetted the fraud. In other words, accounting firms that knowingly participate in a securities fraud, but only “aid and abet” that fraud, are free from liability. One year after Central Bank, the PSLRA was enacted into law over a presidential veto. The PSLRA made it even harder for investors to hold accounting firms liable for securities fraud. In fact, the scope of liability for accountants and other gatekeepers has been so narrowed it is easier for a proverbial camel to fit through the eye of the needle than it is to hold an accountant liable for securities fraud.

To be sure, an individual, company or accounting firm that has no role in the commission of a fraud should not be sued simply because a victim of securities fraud decides to cast a wide net. But one has to look no further than the Enron meltdown or Bernie Madoff’s infamous Ponzi scheme to know we have gone too far when it comes to shielding gatekeepers from liability. The health of our securities markets demands that accountants do not perceive themselves as immune from liability for securities fraud.

Which brings us back to the PCAOB report. The board examined hundreds of audits from 2012-14, with a particular focus on whether auditors complied with Auditing Standards No. 8 through No. 15, collectively known as the risk assessment standards. According to the PCAOB:

“The procedures required by these standards underlie the entire audit process, including the procedures that the auditor performs to support the opinion expressed in the auditor's report. For that reason, non-compliance with these standards can have serious implications for the audit of internal control over financial reporting or the audit of the financial statements and may affect whether the auditor performs enough work to support the auditor's opinion.”

The board found that in 26 percent of the 2012 audits and 27 percent of the 2013 audits, auditors failed to adhere to the standards. Shortcomings included “failing to perform substantive procedures specifically responsive to fraud risks and other significant risks identified, not evaluating the accuracy and completeness of financial statement disclosures, and not testing the accuracy and completeness of information produced by the company.” Preliminary indications are that 2014’s audits are also problematic.

In plain English, one in four audits can’t be trusted. While a 73 or 74 percent success rate may sound good, think of it this way: You have better odds playing a game of Russian roulette.

If you think a 26 percent failure rate is bad, consider this: Each year, the PCAOB spot checks a sample of accounting firm audits. In 2012, one accounting firm received a failing grade on 65 percent of the audits the PCAOB reviewed—the highest failure rate ever recorded. The following year the same firm earned a failing grade on 55.6 percent of the audits the board inspected. An improvement indeed—but hardly reassuring. (The PCAOB’s inspection report of 2014 audits has not yet been released.)

Auditors Must Be Held Accountable
Ideally, our laws and the regulators empowered to enforce them should ensure that publicly traded companies and the accountants who audit those companies’ financial statements are truthful in their public representations.

But one need only glance at today’s headlines to know that we don’t live in an ideal world, which is why the U.S. legal system has traditionally provided the victims of wrongdoing with the legal right to hold wrongdoers accountable. Civil suits have a powerful influence over human behavior. Often it is the potential of a lawsuit that is sufficient to dissuade people from engaging in dishonest or unethical behavior.

The role of independent audit firms in protecting investors is fundamental to the wellbeing of our financial markets. The PCAOB report underscores the fact that the specter of a federal securities lawsuit no longer represents a meaningful threat to accounting firms. That reality continues to adversely impact audit quality and the integrity of our financial markets.

Darren Robbins is a securities litigator and founding partner of the law firm Robbins Geller Rudman & Dowd LLP and a member of the firm’s Executive Committee. Over the last two decades, he has served as lead counsel in more than 100 securities actions and has recovered billions of dollars for injured shareholders.

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