Deepening insolvency claims present increased risk for auditors
"I will go down with this ship
And I won't put my hands up and surrender
There will be no white flag above my door” – Dido
Tough economic times force business owners to make tough choices.
Management may have to decide whether to continue the fight to keep the company afloat or close up shop. Such times also force accountants to make difficult risk management decisions.
Professional liability claims from audit engagements tend to increase following economic downturns.
Business failures can lead to suits against the auditor by creditors, shareholders and others. At a minimum, auditors should make sure that their decisions regarding the stability of the company and their advice to management is well-documented.
A more difficult decision is whether to terminate engagements with clients that are likely to fail. Terminating audit engagements with struggling clients is often the best way to avoid liability claims arising from business failures.
Adele Accountant learned that, when the client is an insolvent insurance company, the state insurance commissioner, as liquidator, will also pursue a claim.
Adele audited XYZ Insurance Company, a property and casualty insurer, for five years. XYZ suffered large losses two years in a row due to exceptionally bad weather. As a result, admitted capital and surplus dropped to a negative number, rendering XYZ insolvent. Adele made appropriate disclosures to management and the insurance commissioner.
As has become common practice for insurance commissioners, the insurance department sued Adele and her firm. The commissioner claimed that Adele overvalued XYZ's assets. But for Adele's errors, the commissioner alleged, the department would have received earlier notice of the insolvency and stepped in to prevent further losses.
Claims for deepening insolvency are a developing legal theory.
Courts disagree as to whether it is a separate tort cause of action, a damage theory – or even a basis for recovery at all. One thing is certain, claims based on deepening insolvency create an increased risk for auditors of struggling businesses.
Insurance company audits present unique risks.
They are governed by rules with which the auditor may not be familiar. If the company fails, the auditor may face a greater likelihood of a suit than in audits of other industries.
In addition, some state insurance commissioners are reported to bring claims against the auditors of virtually every insurance company that goes into liquidation. The commissioner has a team that pursues the claims against auditors, and they engage law firms that specialize in such claims.
The commissioner’s representatives may establish close ties with the law firms and the judges who regularly hear such cases. The fact that the plaintiff is a state official may influence jurors and judges in a way that is not good for the auditor.
Any struggling audit client poses a risk, regardless of the industry. Management is often compelled to hold on too long to a business that is beyond saving.
The current uncertain economy makes this an ideal time to take a hard look at client lists and take steps to make sure that you don’t go down with the captain of a sinking ship.
Wes Marston, J.D., LL.M., AIC
Assistant Vice President – Claims
CPA Mutual Insurance Company of America RRG
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