Auditor Liability Bonds; Fair Value Help; More

A George Washington University law professor has proposed a market-based method for easing jitters over auditor liability: issue bonds tied to the risk of an audit failure.

In a 51-page paper titled “Securitizing Audit Failure Risk: An Alternative to Caps on Damages,” professor Lawrence Cunningham says audit firms should issue bonds, seeking investors willing to gamble on whether a firm will face a liability claim that can’t be covered by its own self-insurance. The bonds likely would have a short term, perhaps two years, Cunningham says, and would pay significant interest to compensate investors for the risk.

Cunningham

During the term of the bonds, the invested principal would be held in trust and invested in designated classes of securities, like U.S. bonds or other high-grade securities. If the firm faces no catastrophic liability claim during the term of the bonds, the principal is returned with interest to investors. If the catastrophic claim does occur, the principal would be used to cover the claim.

Cunningham says the risk is comparable to risk of corporate insolvency that investors typically accept when buying traditional corporate bonds.

The constant fear of a catastrophic audit failure and subsequent litigation is prompting increasing calls for legislative or regulatory relief. Advocates for liability caps say auditing firms’ behavior is skewed by worry over a catastrophic liability claim, pushing costs higher for companies required to have their financial statements audited. The European Union is considering some kind of cap on liability, and advocates in the United States have stepped up their call for action to ease the tension.

Cunningham says the dilemma puts Congress in a tough spot. “People have been fighting for caps on liability for decades,” he says. “But I don’t see how these members of Congress could go home and explain to people why it’s necessary to cap liability for auditors.”

The bond approach should be appealing because it provides a market-based solution that requires no regulatory or legislative action, Cunningham says. “Audit firms … don’t need any permission or any kind of regulation or law to be passed,” he says.

The hard part, he says, would be answering investors’ certain demands for data about the risks. Auditing firms would have to disclose some information about themselves “that they would prefer to keep confidential,” such as a history of liability judgments and settlements, he says. “These are private firms that don’t publish their financial statements, and they certainly don’t publish litigation information. Disclosing information about their resources to cover their losses would be a magnet for lawsuits.”

LaCroix

Kevin LaCroix, an executive at OakBridge Insurance Services, a provider of director and officer liability insurance, says Cunningham’s proposal borrows from an established insurance methodology for covering catastrophic property damage, such as from a hurricane or earthquake. “It’s an intriguing concept in many respects, and it’s meritorious in the sense that it could address concerns relating to a shortage of insurance for audit firms,” he says.

LaCroix sees some potential obstacles to its full adoption, however. In property losses, he explains, claims and damages are fairly clear-cut. “You know by the end of the policy if there’s been a loss and pretty much how much it is,” he says. “For liability, you might know there’s a claim, but it could be years before the claim is resolved.” That could lead to turbulence in bond pricing that may render the concept unworkable.

In addition, on the property side, there’s “no moral hazard,” LaCroix says. “On the liability side, an opportunistic lawyer could be drawn to manufacture a claim that could create difficulty for bond fund investors.” He wonders whether the risks would lead to pricing that ultimately would cause the bond solution to become too expensive for anyone’s taste.

More Guidance on Pegging Securities Prices

The Center for Audit Quality has finished guidance for auditors cautioning that security valuations must take current market prices into account, even when those values have tanked because of problems in subprime and other credit markets.

In a series of papers, the CAQ says proper application of Financial Accounting Standard No. 157, Fair Value Measurements, does not allow securities selling for dramatically lower prices to be categorized as “distressed” or “forced” sales for valuation purposes. “It is not appropriate to assume that all transactions in a relatively illiquid market are forced or distressed transactions,” the guidance says. “It would not be appropriate to disregard observable prices, even if that market is relatively thinner as compared to previous market volume.”

The CAQ’s advice is contained in three papers reviewed by the Securities and Exchange Commission, the Financial Accounting Standards Boards, the Public Company Accounting and Oversight Board, and a host of other professional and banking regulatory groups. In a paper titled “Measurements of Fair Value in Illiquid (or Less Liquid) Markets,” the CAQ focuses on some of the nuances of fair value rules as they apply to the current liquidity crisis.

A second white paper, “Consolidation of Commercial Paper Conduits,” discusses how to apply Financial Interpretation No. 46, Consolidation of Variable Interest Entities, for sponsors of commercial paper conduits given the current market conditions. It summarizes the basic structures and risks of commercial paper conduits and how FIN 46 should be applied by their sponsors.

A third paper, “Accounting for Underwriting and Loan Commitments,” underscores Generally Accepted Accounting Principles associated with lending money or underwriting securities as they apply to current illiquid market conditions.

Treasury Convenes Committee to Study Audit Profession

Treasury Secretary Henry Paulson has assembled another task force, this time to focus on the audit profession and brainstorm ways it can be made more sustainable.

Levitt

Arthur Levitt, chairman of the Securities and Exchange Commission during the Clinton Administration, and Donald Nicolaisen, former chief accountant at the SEC, will co-chair the committee. It will study vexing questions about auditing such as the market concentration of four large firms, audit quality, employee recruitment, and other topics. Paulson wants findings in early summer 2008.

Committee membership is meant to represent a cross-section of market players, including investors, auditors, large and small public companies, insurance companies, lawyers, and regulators. Treasury also selected official observers representing the domestic and international regulatory and policy bodies.

This committee is not to be confused with the Committee on Capital Markets Regulation, also endorsed by Paulson and known as the Paulson committee. That group is looking more broadly at regulatory or legislative changes that might make the U.S. capital markets more competitive.

Bill Proposes Tying Tax on Stock Option to Accounting Expense

A proposed Senate bill would require companies change the way they calculate and pay income taxes on stock options to be more consistent with the financial accounting of stock options.

Sen. Carl Levin, D-Mich., introduced the “Ending Corporate Tax Favors for Stock Options Act” to end what he calls favorable tax treatment for corporate stock options. Levin says the accounting and tax rules around stock options contradict each other, leading to divergent stock option expenses for book and tax purposes in the same year.

Bishop

Accounting rules require companies to show an expense for stock options at the time the option is granted. That forces companies to use sophistical modeling techniques to project factors such as when an employee might exercise an option and what the stock price might be at that time, says Keith Bishop, of the law firm Buchalter Nemer.

Tax rules, on the other hand, require companies to pay tax based on the stock option expense on the employee’s date of exercise.

In a statement to the Senate proposing the bill, Levin leaned hard on the notion that companies can win a deduction for a particular stock option larger than the expense they actually book for accounting purposes.

Levin

“But the virtue of the current system is that it actually matches an employee’s income with the deduction that is being taken,” Levin said. “It is tied to a real, recognized value, so there’s not a lot of guessing going on as to what the deduction amount should be. The financial accounting expense is really a guess as to what the value of the option should be.”