Revamped Audit Report Seen Launching ‘Wave of Litigation’

The PCAOB's plan to add color to the audit report draws fire from a corporate lawyer.
David KatzApril 2, 2014

To avoid “a wave of litigation against issuers and auditors” that could result from the Public Company Accounting Oversight Board’s proposal to revamp audit reports, the PCAOB should provide legal protection for auditors, a lawyer who represents the insurance industry contended this morning.

“I anticipate that the community of attorneys specializing in the representation of shareholders seeking class-action targets would be thrilled to see this proposal adopted,” said Richard Murray, a former head of legal affairs at Deloitte & Touche and now a lawyer whose clients include an association of the world’s biggest insurance company chief executives. His prepared remarks were presented at the first of two days of hearings on the PCAOB’s August proposal to expand the auditor’s report on corporate financial statements.

“The once great feast of class actions against company and auditor has been curtailed by judicial and legislative restraints in recent years,” he noted before a panel discussion about how well the proposal would carry out the intent of the report by the U.S. Treasury’s Advisory Committee on the Auditing Profession (ACAP), of which Murray was a member.

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The Oct. 6, 2008 report, issued in the midst of the financial crisis, called on the PCAOB to take “the auditor’s report beyond the current pass/fail model to include a more relevant discussion about the audit of the financial statements.”

While the proposed standard would retain the pass-fail model, it would contain changes that could provide a view of an auditor’s state of mind as he or she assesses whether a client’s financials have been represented fairly.

In one of the more prominent changes, the PCAOB proposed that the auditor’s report detail “critical audit matters [CAM] as determined by the auditor.” Such matters would be the ones “the auditor addressed during the audit of the financial statements that involved the most difficult, subjective, or complex auditor judgments or posed the most difficulty to the auditor in obtaining sufficient appropriate audit evidence or forming an opinion on the financial statements.” If the auditor found no critical matter, he or she would have to state that in the report.

Another panelist and former ACAP member, Gaylen Hansen, said that the PCAOB standard should limit the CAM report to “those few things that keep the auditors awake at night” during the time they’re assessing the financials of their corporate clients. Hansen, an immediate past chair of the National Association of State Boards of Accountancy (NASBA) and an audit partner at EKS&H, said that he believed the proposal met the basic objectives of the treasury committee and that he supported it.

Murray, however, contended that another main goal of the committee was to make sure “no harm is done to the pass/fail model of the capital markets.” By adding auditors’ worries and insights to that model, the PCAOB’s proposal would open them up to civil lawsuits. Such suits, he said, could involve the plaintiff’s lawyer asking the auditor that if he or she had such concerns about the company, “Why didn’t you carry through?”

If, on the other hand, the company’s problem doesn’t concern any previously reported CAMs, shareholders can claim “that many concerns were expressed by the auditor but not the right one, leaving the auditor and the company to defend a multitude of judgments that have none of the established decision criteria that exists for the single pass/fail judgment,” Murray argued in his prepared remarks.

Questioned by PCAOB chairman James Doty on what could be done about the litigation risks, Murray offered an idea he said that ACAP previously explored: providing auditors with a similar protection that corporate directors enjoy under the business judgment rule.

Rather than provide “full protection or accommodation” for auditors as they report the critical matters that concern them during the audit, they could be protected on statements of concern that involve audit issues that may be in “a gray zone” between propriety and impropriety, he said.

For his part, Hansen declared in his remarks that the “auditing profession has a long and storied history of excessive secrecy.” To illustrate, he recalled that he spent his first years as an auditor with a Big 8 firm in Los Angeles, in “a large standalone, two-story, red-brick building — without a single window.”

Hansen remembers being told that “the lack of a view emphasized confidentiality — outsiders would never know what was going on within those brick walls.”

At the time, however, he couldn’t see the outside world.

That building bears comparison to today’s reporting model, according to the auditor. “Today’s auditor’s reporting standard is akin to a windowless building lacking visual functionality,” he said. “We can do better, and doing it is long overdue.”