Accounting and Law

• Author: Vern Krishna
• Pages: 333-356

333

Chapter : Accounting and Law

A. OVERVIEW

Accountants and auditors can be liable to users of nancial statements.

Liability may be in contract, tort, securities, or tax law. e scope and

extent of their liability depends upon the branch of law, the particular

users of the nancial statements, the nature of the claims, statutory

structures, and public policy considerations.

Although public accountants perform a wide variety of services

for their clients, their primary function, and the one that most fre-

quently gets them into legal trouble, is auditing nancial statements.

Accountants are the traditional target in business lawsuits. is is

because most business failures, whether of public or private compan-

ies, involve some aspect of their nancials. e plainti might com-

plain that the statements were prepared without adequate care in the

audit process or that the auditors misapplied GAAP or IFRS. e

plainti may allege that the statements are misleading, whether inno-

cently or fraudulently, and caused the plainti (or class of plaintis)

nancial harm.

However, there is another more practical reason why accountants

are often in the crosshairs of plaintis’ lawyers. Accounting rms do

not like to be dragged into court, where litigation can extend for years

and attract attention in the business press. In many cases, it is the insur-

ance coverage that attracts plaintis’ lawyers, like bees to honey. us,

334 Financial Skills for Professionals

accountants and accounting rms are amenable to settlement, if the

settlement is within their professional insurance limits, and their legal

fees are insured. In the nal analysis, it is the insurance company that

loses. However, it makes up its losses through increased premiums and

tax write-os. Ultimately, taxpayers bear the settlement costs.

For example, in the s, the “Big Five” (originally the “Big Eight”

and now reduced to the “Big Four”) faced more than USD$billion

in legal actions against them. Laventhol & Horwarth, the seventh lar-

gest accounting rm at the time, declared bankruptcy in  because

it could not meet its liability claims. In four years, the “Big Six” (as

they then became) paid out USD$. billion in securities fraud cases.

e current debacle of nancial statement manipulation is merely

a variation on old themes. Accounting and auditing standards induce

behavioural responses from the users of nancial statements. e

essential question is whether the standards are ahead of the creativity

of enterprising manipulators and nancial regulators.

Although accounting fraud is sometimes a problem in the secur-

ities markets, the more signicant risk of nancial misstatement is

auditor bias. is risk arises when the auditor of a company also

advises on consulting matters, which puts pressure on the auditor to

accommodate the client on its nancial statements or risk losing the

lucrative consulting or tax work. is creates a conict between the

self-interest of the audit rm and the public interest of investors.

Ultimately, the integrity of the nancial markets depends upon

the unbiased authentication of public nancial information and fair

audit opinions. is requires regulatory and judicial rules that dis-

courage, and penalize, inappropriate nancial reporting.

B. THE ENRON DEBACLE

e Enron scandal represented the most serious consequences ever

visited upon an accounting rm and its ultimate demise. e scandal,

which destroyed a reputable accounting rm, illustrates the magni-

tude of nancial problems in the capital markets, and the human and

nancial tragedy that results from inadequate auditing and nancial

reporting.