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Auditors Brace for Legal Backlash in Credit Crisis

By Tammy Whitehouse — October 28, 2008

s the credit crisis rocks financial markets, audit firms are bracing for the inevitable onslaught of litigation and shifting personnel to prepare for new service demands.

Auditors are classic litigation targets when finances go awry, and the swift collapse of seemingly sound financial institutions is expected to clog the courts for years to come. “It is a given that they will be named in lawsuits,” says Jeff Mahoney, general counsel for the Council of Institutional Investors.

It’s not necessarily a given, however, that auditors will be saddled with ultimate responsibility. Some close to the audit profession say major audit firms feel confident that “blown audits” won’t come to light as the legal system sorts out what went wrong at so many companies.

Patrick Daugherty, a partner with law firm Foley & Lardner, says the current meltdown doesn’t have the same whiff of fraud that litigators and regulators sniffed out in the storied collapses of Enron and WorldCom—confusion about complex financial instruments, maybe, but that’s a far cry from fraud. “No one is saying financial management is deliberately misleading investors, or that a particular auditor or audit firm was in cahoots with management to mislead the market,” Daugherty says.

Instead, the focus will likely be on valuation rules, including how those rules were applied and whether assets were written down properly. “I suspect [audit firms] are going to have to defend some of this, but I also suspect they’re going to win,” he says. “I would expect they’ll get out of these suits earlier and at less cost than was the case in the Sarbanes-Oxley-inspired litigation following Enron and Worldcom.”

Damien Blenkinsopp, associate director for Kennedy Information and a consultant to the Big 4 and other companies, says audit firms expect to be sued, but they don’t expect to lose a great deal. “They feel relatively confident about that situation,” he says. Like Daugherty, Blenkinsopp says the economy’s current predicament doesn’t carry the same evidence of outright wrongdoing on the part of audit firms.

Still, auditors will have to defend claims that they should have spotted the disaster brewing. “People are asking ‘Where was the warning?’” said Gaylen Hansen, a partner with the Colorado auditing firm Erhardt, Keefe, Steiner & Hottman, and a member of the Public Company Accounting Oversight Board’s Standing Advisory Group. “Shouldn’t they get notified earlier that some of those problems were out there? Shouldn’t there have been some sort of signal from accounting firms that some of these banks were technically insolvent?”

PricewaterhouseCoopers has already settled an early claim related to its audit work for insurer American International Group. The Ohio attorney general nudged PwC into settling litigation filed by three state pension funds for $97.5 million; the funds had argued that PwC should have picked up on AIG’s alleged involvement in a market division scheme. (AIG lurched into government oversight last month and is now in hock to taxpayers for more than $100 billion.)

“We have decided to settle the case at this stage to avoid the enormous litigation costs that would be incurred if the case continued against the firm, while at the same time eliminating any potential exposure,” PwC spokesman Steven Silber says. “The settlement does not contain an admission of wrongdoing by the firm, and we continue to believe that our work was in accordance with professional standards.”

Deloitte is another prime target. It has the distinction of auditing the largest bank to fail so far (Washington Mutual), the investment bank whose failure started the crisis (Bear Stearns), and one of the two largest failed financial institutions in the whole mess (home mortgage giant Fannie Mae).

Bad for Business?

While the lawsuits begin their long journey through the legal system, the meltdown is not likely to result in any meaningful reduction in business for audit firms, experts say. The consolidation of major financial institutions is taking major audit engagements off the table, as entities like Bear Stearns and Lehman Brothers are absorbed by others. But “that doesn’t necessarily mean there will be less audit work to do,” says Salvatore Graziano, a partner with the law firm Bernstein, Litowitz, Berger & Grossman.

“Every time there’s a consolidation, the auditors have to do a lot of work to be comfortable with the financials of the newly integrated company,” he says. “The number of audits may go down, but the amount of audit work is going up. I don’t think [audit firms] will be hurt by that.”

Accounting firms are starting to turn their attention to where they can expect to see increases and decreases in demand for services based on the changing economy, Blenkinsopp says. Major IT projects, for example, are slowing down or being delayed as companies look for some signs of recovery before continuing IT investments. On the other hand, services related to the financial crisis will grow: restructuring, reorganization, bankruptcies, mergers and acquisitions, and the like, he says.

“Advisory services seem naturally protected from economic decline,” he says. Professionals who help companies find capital and M&A opportunities during boom cycles also have the right skills to provide workout and turnaround services during a decline, he contends.

Cangemi

Michael Cangemi, president of his own consultancy and a former CEO of Financial Executives International, agrees that the nature of the work done by accounting firms will change, but the overall amount of work probably won’t. “Whoever lost one audit is going to get the M&A work or the bankruptcy work instead,” he says. “Now they need to manage the change.”

Cangemi says accounting firms constantly churn staff, laying off professionals whose skills are in lesser demand and hiring where there’s more demand. “To some degree there may be some minor layoffs, but they’ll continue to hire at the same time,” he says. “That’s the way it is in accounting firms. They’re constantly looking for the best talent.”

Blenkinsopp doesn’t expect any meaningful growth in audit services. “It’s just something pretty obligatory, which goes on,” he says. “The main thing that drives demand for audit services these days is regulation changes, new accounting standards, or new reporting standards.”

Instead of traditional audit services, Cangemi expects growth to focus on “automated auditing,” where technology is rapidly developing to help companies conduct continuous, automated audits rather than bring in professional staff once a quarter or once a year.

Blenkinsopp says the continued movement toward International Financial Reporting Standards also will keep accounting firms busy for years to come. And he suspects companies may eventually face some new requirements or new market forces to pay more attention to risk management. “That will drive a lot of demand for accounting firms,” he says.