Managing Risk in Public Accounting Firms

By Huss, H. Fenwick; Jacobs, Fred A. et al. | Risk Management, September 1993 | Go to article overview

Managing Risk in Public Accounting Firms


Huss, H. Fenwick, Jacobs, Fred A., Patterson, Denise M., Risk Management


Today accountants are being held to ever-increasing levels of performance and responsibility by users of financial information and by society in general. Recent legal actions allege negligence by accountants for the failure to uncover problems in savings and loan institutions, bankrupt companies and overseas conglomerates. And according to the findings of a 1990 Johnson & Higgins report, the number of these actions continues to increase.

Pecuniary damages in the negligence suits filed against accountants are immense. For example, and Arizona jury recently levied a $338 million judgment against a Big Six accounting firm, and a recent suit filed by the Resolution Trust Corp. seeks $400 million from another Big Six firm for alleged negligence in its audit of a failed savings institution in Texas.

These are but two of the many recent suits brought against the large accounting firms. However, many mid-sized and smaller accounting firms, as well as sole practitoners, are also finding themselves increasingly subject to litigation. The Wall Street Journal estimated that the monetary payments made by accounting firms as a result of these lawsuits are equal to "9 percent of their total revenue and 16 percent of parners' capital." In addition to these pecuniary damages (which may threaten the survival of some firms), the accountant also faces possible revocation or suspension of his or her license.

Dan A. Simunic, chairman of the accounting department at the University of British Columbia and Michael T. Stein, associate professor at the University of Calgary, suggest that one way to assess and manage business risk in an accounting firm is to continually evaluate relationships with current clients and to carefully consider the impact of potential clients on one's practice. Other types of professional services firms have also used these evaluations; for example, client evaluations have been cited by the legal profession as being important to quality control. Similarly, the importance of evaluating client relationships was addressed in a 1991 American Institute of Certified Public Accountants (AICPA) Audit Risk Alert, which urged accounting professionals to consider the impact of recent economic developments on client business practices.

Accountants may improve their risk assessments by utilizing the variables that some Big Six accounting firms examine when determining the desirability of accepting or continuing a client relationship. These variables serve as a foundation for implementing formal policies and procedures that, when used consistently, will reduce potential business risk. This framework will be useful not only for public accounting firms, but also for other service professionals operating in an environment where risk management requires careful analysis of client relationships.

For accounting firms, the risk assessment involves analyzing current and potential clients. The Statements on Quality Control Standards, promulgated by the AICPA, require accountants to establish policies and procedures for accepting new clients or retaining current ones. These procedures include reviewing the client's financial information, holding discussions with third parties regarding the client's management, communicating with the predecessor auditor to gain information about the client, and evaluating the firm's independence and ability to serve the client. These procedures allow the accountant to contrast the economic consequences of future events against the cost of managing risk, and thus to categorize the potential risk of prospective clients as a means of establishing quality control procedures.

However, the highly competitive accounting market may have caused some accounting firms to eliminate or minimize the process of evaluating client relationships. Alternatively, the general nature of the language of the Quality Control Standards may be difficult to interpret and thus to put into operation. …

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