A Very Tentative Rough Draft on the Concept of Damages

Bob Jensen at Trinity University

My answer proposed at http://www.trinity.edu/rjensen/fraudConclusion.htm#MyAnswer 
My answer, albeit naive, is that auditing firms must begin to "warrant" or "insure" their services much like insurance companies insure against liability with limits as to what they will pay such as limits to liability in automobile accidents.  Clients should decide how much auditing liability insurance they are willing to purchase as a component of the total audit fee.  The insured liability limit  should be publicized on Page 1 of a corporate annual report and in stock price listings in newspapers and on the Internet.  Accordingly, the amount of insured audit liability would then become an important input into investor and creditor decisions.  Firms paying for lower audit liability would then pay the price by having a higher cost of capital.   This does not mean that all audits should not be held accountable to identical high auditing standards or that audit insurance claims can be filed for stock price declines.  Claims should only be filed when there is evidence of audit negligence and/or fraud.

This is not a proposal that I have worked out in any kind of detail. Two components that I would like to include are as follows:

1. A whistle blowing incentive scheme that will help disclose breakdowns in the services.
   
   
   
2. For claims to be adjudicated in an "accounting court" very similar to the "court" proposed by the most famous managing partner (Leonard Spacek) in the history of Arthur Andersen --- Spacek, L., "The Need for an Accounting Court", The Accounting Review, l958, pp. 368-379.

Leonard Spacek was the most famous and most controversial of all the managing partners of the accounting firm of Arthur Andersen. It is really amazing to juxtapose what Spacek advocated in 1958 with the troubles that his firm having in the past decade or more.

In the link below, I quote a long passage from a 1958 speech by Leonard Spacek. I think this speech portrays the decline in professionalism in public accountancy. What would Spacek say today if he had to testify before Congress in the Enron case.

What I am proposing today is the need for both an accounting court to resolve disputes between auditors and clients along with something something like an investigative body that is to discover serious mistakes in the audit, including being a sounding board for whistle blowing. Spacek envisioned the "court" to be more like the FASB. My view extends this concept to be more like the accounting court in Holland combined with an investigative branch outside the SEC.

-----Original Message----- 
From: Roger Collins [mailto:rcollins@CARIBOO.BC.CA]  
Sent: Sunday, January 20, 2002 2:41 PM 
To: AECM@LISTSERV.LOYOLA.EDU  Subject: 
Re: Anderson is 10% to Blame (warning, this is quite long).

Bob, thanks for this posting. Some comments on specific statements made by Phil Livingston (Phil's comments in quotes, mine following); note that I've quoted only fragments from Phil's slides.  
(A Very Frank and Very Concise Summary of the Enron Mess from the President of the FEI
http://www.fei.org/download/Enron_1-18-02.ppt )

"Failure rests 75% with the mgt team, 15% with the Board and 10% with the auditor"

What is the basis for statements like this ? They make catchy headlines but have very little to recommend them otherwise. Its very hard to make a case for less than 10% auditor culpability - but I can easily make a case for 100% culpability. For instance, given that Anderson is now generally believed to have been involved in the creation of the SPEs, putting its foot down at that stage, while it might well have caused an enormous internal row, might also have given Enron a chance to survive, because the problems - identified earlier - would have been easier to solve. At the least, it might have made a "rescue merger" a possibility.As it is, the whole company is in the can.

JENSEN REPLY 
I SUSPECT THAT THIS 10% IS USED PRIMARILY AS AN ATTENTION-GETTING DEVICE BY PHIL LIVINGSTON.  THE 10% IDEA IS IMPORTANT IN THE LAW SINCE CONGRESS IN 1995 MADE IT POSSIBLE TO LIMIT THE LIABILITY OF THE "DEEP POCKETS" IN TORT LITIGATION TO A COURT-DESIGNATED PERCENTAGE. PERHAPS PHIL WAS MAKING A WILD GUESS AS TO WHAT ANDERSEN'S SHARE OF THE DAMAGES WOULD BECOME IN THE FLOOD OF TORT ACTIONS NOW BEING FILED. 

IN THE PAST, THE BIG FIVE FIRMS HAVE SURVIVED DUE TO FACT THAT THEY ARE OFTEN (EXCEPT WHEN THEY ARE  GUILTY OF FRAUD) NO LONGER JOINTLY AND SEPARATELY LIABLE FOR ENTIRE DAMAGES. OTHER LARGE FIRMS HAVE NOT BEEN SO FORTUNATE (e.g., "Just a few years ago the seventh largest CPA firm in the nation, Laventhol and Horwath, collapsed because it no longer had the financial resources to fight off abusive lawsuits." --- http://www.alliancecourtwatch.com/efforts/sb120/LaplaceTestimony.asp )

LIMITING LIABILITY IS A VERY CONTROVERSIAL SUBJECT.  INDIVIDUALS AND ORGANIZATIONS MAY ONLY BE LIABLE FOR SOMETHING LIKE 10% OF THE DAMAGES EVEN THOUGH THEY ARE 100% NEGLIGENT IN THEIR DUTIES AND COULD HAVE PREVENTED ALL DAMAGES.  SEE BELOW.

Crime Scenario

Controversy 1
What the victim's two-year old daughter receives is nowhere near actual damages, including funds needed for living and education until she becomes an adult.  The damage awards in her case are truly unjust!  The two deep pockets in this scenario, the security firm and the city, only pay a small portion of the judgment even though either the body guard or the policeman would have prevented all damages had they done their assigned jobs of protecting the girl's mother.

Controversy 2
If the deep pockets in this scenario had to come up with the full judgments instead of apportioned judgments, there may not have been a security firm, at least not a nation-wide firm of 84,000 employees.  There would most certainly not be a nationwide firms if judgments soared into billion-dollar awards where, even with insurance, a single deep-pocket judgment in billions of dollars could bankrupt the firm and leave 84,000 employees out of work. 

If exposures are far greater than the security firm can afford after insurance payoffs, what will happen is that the security industry will disintegrate into thousands of small firms who are willing to face bankruptcy.  For example, a firm of two persons can go bankrupt without forcing 83,998 other persons out of work

Controversy 3
A city must have police protection within its limits of jurisdiction.  If lawsuits bankrupt the city, life goes on and judgments go unpaid beyond what the city can pay after insurance claims are settled.  Even in bankruptcy, city employees are not fired because their duties are too essential to life even in a bankrupt city.  For example, after a derivatives financial instruments scandal costing Orange County in California over $1 billion in losses, the county carried on with county services to its citizens.  If Orange County had been an accounting firm or a business firm, it would not survived.

Enron Scenario

Controversy 1
There are many instances such as Enron where the auditing firm could have prevented all or most of the damages much like a policeman might have saved a life.  But if auditing firms faced an exposure of being the deep pockets for all damages when the really guilty parties have no money or remaining insurance, there most likely would not be large auditing firms.  In the United States the risk of bringing down entire firms would just be too great if the courts assigned full damages to the only remaining deep pockets in lawsuits.  The firms would long ago have dropped auditing services in favor of consultancy and tax services, because in the United States the risks would be far to great to remain in the auditing business without limits to litigation exposures.

One might argue that the large auditing firms might disintegrate much like an 84,000-employee security firm disintegrates into small firms that are willing to face bankruptcy exposures that do not impact upon 84,000 people.  The problem is that there are huge economies of scale in auditing such that it would be virtually impossible to conduct audits of large corporations without entirely restructuring the audit industry and invention of newer types of outsourcing that does not carry such risks of laying off 84,000 people due to the actions of just a few people.

Controversy 2
Large lawsuits have purportedly ended the lives of a number of large accounting firms.  For example, see http://www.alliancecourtwatch.com/efforts/sb120/LaplaceTestimony.asp .  The remaining Big Five firms managed to survive and even prosper since under legislation apportioning litigation judgments such that auditing firms are not the deep pockets having to pay out 100% of judgments.  Some argue that such limitations are key to survival.  You can read about abuses of joint and several liability claims at http://sanjose.bcentral.com/sanjose/stories/1997/09/22/editorial4.html 

But the magnitude of the Enron scandal is such that even the apportioned damages, of say 10%, to the auditing firm of Andersen might end the life of that firm.

Conclusions

Damages caused by actions of a few people have to be ultimately borne by somebody.  Insurance  companies are not the ultimate source of the funds in repeated and massive lawsuits.  The ultimate funding choices are as follows:

• The victims themselves who go uncompensated

• The customers who pay the firms that deliver the services

• The citizens who either pay the government prices for services or pay taxes

Military services are almost entirely paid for with taxes.  Postal services are mostly paid for in the prices of postage.  American airlines travel is paid for in the price of tickets.  And auditing services such as what Andersen performed for its client Enron are paid for out of the client's revenues.  

If a government must pay out millions for every person injured or killed at war, the taxpayers will revolt.  If the price of postage becomes too enormous, customers will refuse to purchase the postal services.  And if auditing services become more than firms can possibly afford, the entire economy may go into a tailspin.

Bob Jensen's Proposed Solution!

My answer, albeit naive, is that auditing firms must begin to "warrant" or "insure" their services much like insurance companies insure against liability with limits as to what they will pay such as limits to liability in automobile accidents.  Clients should decide how much auditing liability insurance they are willing to purchase as a component of the total audit fee.  The insured liability limit  should be publicized on Page 1 of a corporate annual report and in stock price listings in newspapers and on the Internet.  Accordingly, the amount of insured audit liability would then become an important input into investor and creditor decisions.  Firms paying for lower audit liability would then pay the price by having a higher cost of capital.  This does not mean that all audits should not be held accountable to identical high auditing standards or that audit insurance claims can be filed for stock price declines. Claims should only be filed when there is evidence of audit negligence and/or fraud.

EY's Turley: How Accounting Can Get Back Its Good Name In the Wall Street Journal, EY Chairman Jim Turley outlines a series of reforms to help the accounting profession respond to challenges in the post-Enron business environment. Included in the recommendations: a ban on the sale of IT consulting services to audit clients and the attempt to make financial statements more understandable

"How Accounting Can Get Back Its Good Name," by Jim Turley, Chairman, Ernst & Young

Never before has the accounting profession faced what it faces today. The fundamental underpinning of our profession -- our integrity -- is being challenged. What started as a problem for Enron and its auditor has become a problem for all auditing firms. Part of it is perception. But much is quite real. We have to deal with both.

I have been asked repeatedly what the profession should do to get back its good name. The reasons behind business failures and accounting restatements are quite complex, and it is important to bring balance to the issue.

First, let's deal with some outstanding issues. Two years ago, Arthur Levitt, then chairman of the Securities and Exchange Commission, proposed regulations that would largely ban the delivery of information technology consulting services to audit clients of the firms. It's time to adopt these restrictions. Ernst & Young supported the proposals then, and our position hasn't changed today. Recently other firms have joined our position. So let's just get it done.

I know some cynics will say that we've sold our consulting practice and therefore wouldn't be giving up much. But that's missing the point. We sold our practice because we thought it was the right and strategic thing to do. And Ernst & Young, as the leader in internal audit services, will be the firm most impacted by the restriction on internal audit services. But again, we think it's the right thing to do.

Second, we should create a new regulatory body for the profession. It should have its own funding, offices and staff. It should have direct power over the profession's disciplinary and audit quality control programs, replacing the current "peer review" process in which firms review each other. To ensure maximum public credibility, this oversight should come from a body other than the American Institute of Certified Public Accountants, because many believe it has not maintained its historic focus on professional responsibility.

While auditor independence and professional discipline are critically important, reforms in those areas alone won't prevent another Enron. We need to address other issues as well.

Financial disclosure needs to be more forthright and understandable. SEC Chairman Harvey Pitt placed this on the top of his agenda even before the current crisis. The problems with financial statements are well-known: They focus on historical information instead of current and trend information; are hard to understand; and haven't kept pace with modern corporate complexities. Additionally, companies report a single earnings per share number, as if their results were that precise. Investors might be better served by a range that reflects the reality of business uncertainties.

We need new rules, new standards, new disclosures. The Financial Accounting Standards Board, which has responsibility for rulemaking in this area, must move more quickly and with more foresight.

There are other steps that should be considered. Let's strengthen audit committees' independence to ensure they provide oversight of management's actions. Let's make it clear that auditors are to be hired and fired by the audit committee, not management. Let's make it a criminal offense to lie to the outside auditor.

Another idea to consider is the formation of a multi-disciplinary National Transportation Safety Board-like organization, which would immediately investigate the causes of a corporate "crash" and recommend steps needed to prevent a recurrence. Like the NTSB, this group's sole focus would be on prevention, not discipline.

These are all good ideas. But some changes being discussed would do more harm than good.

For instance, there is no need to ban all non-audit work for audit clients. Many so-called non-audit services are so closely linked to the audit that as a practical matter only the auditor can provide them. Another service -- tax -- has always been provided by auditors to their clients. I have yet to see one client facing a business issue that didn't have both accounting and tax ramifications.

Mandatory auditor rotation -- that is, a requirement that clients periodically switch their audit firm -- is being urged by some. That would likely reduce audit quality in both the early and late years of an audit "term." A better approach, if change is really needed: a staggered rotation of all partners and staff on the engagement -- providing a continuous flow of new eyes and objectivity, while maintaining the institutional knowledge that helps ensure audit quality.

A client recently asked me what I thought to be the worst possible outcome of the current situation. I told him it would be the implosion of Arthur Andersen, which would create an immediate supply/demand mismatch in the audit profession, coupled with legislation by Congress that unduly restricted the profession -- making it unappealing for students to enter the profession or long-time auditors to stay in it. Add to this the imposition of too many requirements on audit committees, and we could end up with nobody wanting to do audits and nobody wanting to serve on audit committees.

That's my nightmare. The client looked at me, concerned, and said, "This could happen."

But people who know me say I'm an undying optimist. I am. And I believe that with all the people looking at my profession, people who are searching for solutions, we won't make the mistakes that would lead to my nightmare, but instead will take the right steps to ensure a stronger profession, better financial reporting and stronger capital markets. ____

Mr. Turley is chairman of Ernst & Young.

Bob Jensen's Commentary
In spite of Mr. Turley's reminder that Ernst & Young supported Arthur Levitt's failed SEC "proposed regulations that would largely ban the delivery of information technology consulting services to audit clients of the firms" and, thereby, took a position opposite of most other large accounting firms, I still have to argue that retrenchment of accounting firms into audit services apart from consultancy is not the solution to restoring the image of accountancy.  Auditing by and off itself is neither a dynamic nor a very profitable industry.  I still argue for both consultancy and auditing coupled with warranties (like insurance) on the liabilities backing those services.  Thus, buyers of services could then purchase various warranty options that would pay either the clients or shareholders/creditors for failed consultancy and/or audit services.  
See http://www.trinity.edu/rjensen/fraud.htm#Bottom 

Also see http://www.trinity.edu/rjensen/cpaaway.htm 

Hi Roger,

What is ironic is that the largest CPS firms argued civil damages to be awarded on a pro-rata basis (instead of being the deep pockets in a lawsuit where the primary defendant is bankrupt) was due to "cookie-cutter" lawsuits in which identically worded lawsuits were being filed for multiple firms whose prices had severely declined. (In some cases, the letters even had the names of the defendants wrong).

I guess we have cookie cutters on both sides.

Thanks,

Bob Jensen

Original Message----- 
From: Roger Collins [mailto:rcollins@cariboo.bc.ca]  
Sent: Friday, March 01, 2002 12:14 AM 
To: Jensen, Robert Subject: Politics and standard setting

Bob, regardless of the merits of the argument, I quite like this quote from the article.. The responses show evidence of a co-ordinated US campaign against the IASB proposals, which have been criticised by Senator Michael Oxley, the chairman of the US House of Representatives' committee on financial services.

The letters include 116 from the US business community that are identical in content and even contain the same typographical error. http://news.ft.com/ft/gx.cgi/ftc?pagename=View&c=Article&cid=FT31GJ4Q4YC&live=true&tagid=FTDCZE6JFEC&subheading=accountancy 

Roger

Roger Collins Associate Professor UCC School of Business

This document is only a rough draft.  Comments are welcomed.  My email address is rjensen@trinity.edu 

Also see my discussion of "systemic problems" in accountancy at http://www.trinity.edu/rjensen/fraud.htm#Bottom