Valuation Issues,Auditor Fraud,and PCAOB Confirmation: Findings From an Analysis of Lawsuits Against Large Public Accounting Firms

Generally Accepted Accounting Principles (GAAP)—Valuation Issues

Valuation issues appeared frequently in the allegations against the client and accounting firms were a critical finding in this research and emphasize the difficulty of this activity for the profession. As valuation includes significant estimation issues, both current and future oriented, it is imperative that regulatory bodies understand the difficulties involved in this process for both the client and the public accounting firm and understand that these issues appear in many of the legal allegations. It is apparent from the lawsuits analyzed that many third-party plaintiffs are very aware that the client and accounting firms are vulnerable in the valuation area. Valuation of stock options, goodwill, intangibles, other long-term assets, inventory, receivables, debt, and financial securities and investments are examples of items in this category.

Errors in the interpretation or application of GAAP appeared in the allegations found in 121 of the 217 cases. These errors focused on the application of GAAP either due to incorrect interpretation of the principle or improper application of the principle to the specific situation. Sixty-five (54%) of the cases with GAAP allegations were due to valuation issues and were, by far, the most frequent occurrence in this category. The frequency of valuation errors accounts for the increase in GAAP versus Generally Accepted Auditing Standards (GAAS) errors found in the current study versus the earlier ST&A paper. It should be noted that since the ST&A paper in 1984, the accounting profession has seen a significant shift to more complex valuation issues and issues requiring greater judgment on the part of the auditor. The allegations analyzed in this article emphasize that a move from an arms-length type of transaction (valuing sales in a retail situation) to situations where, for example, future cash flows must be predicted (asset impairment/fair value considerations) or fair market values must be estimated, that the estimation requirements create a much greater risk to the auditor and the client. The increase in required “future oriented” estimations appears to have driven the increase in valuation allegations in our analysis.

In the context of regulations requiring these estimates, Basu (2012) argues that even though more and more detailed, complex rules are being written by the U.S. Securities and Exchange Commission (SEC), FASB, International Accounting Standards Board (IASB), PCAOB, American Institute of Certified Public Accountants (AICPA), and other accounting regulatory bodies, the number and severity of accounting scandals are not declining. Basu also makes the critical observation that as accounting standards often reflect standard setters’ ideology more than research into the effectiveness of different alternatives, it is hardly surprising that accounting quality has not improved. For example, the past handling of intangibles (and other long-term assets) was comparatively straightforward with amortization/depreciation over a period of years and write-down occurring only if a qualitative judgment determined that the value had diminished. When FASB made the change to an impairment test for long-term assets based upon an initial complex calculation of future cash flows and comparison of fair market value to carrying value, the valuation difficulty increased. Our findings also suggest that the frequency of valuation allegations by third parties has increased. As noted, valuation issues requiring prediction of future events provide difficulty for clients and their auditors. As third parties realize this fact, the result is that many of the allegations we found in our analysis (and concerns in the PCAOB firm reports) focus on valuation.

From a more positive perspective, at least for accounting firms from a legal viewpoint, it should be noted that the FASB is considering changes to the accounting for goodwill (Goswami & Kimmel, 2021). The volatility of the market in the past year has further complicated efforts to assess fair values and future cash flows of long-term assets. Many finance executives and their companies believe the calculations are too subjective and costly to implement. One approach being considered by the FASB would allow the company to forgo annual tests as currently required and instead write down a predetermined portion for impairment of goodwill each year. This approach would be similar to the previous handling of goodwill and remove some of the difficulties involved in the valuation process. The PCAOB requirement for listing critical issues in the audit and explaining the approach used to address these issues is also a positive attempt to mitigate the concerns noted. Unfortunately, the required disclosure of critical issues does not address whether the approach used by the firm was adequate from an audit perspective, which is the point often raised in the PCAOB reports on the large firms and by plaintiffs in a legal action.

In addition, the growth of firms in the financial and technology sectors in the business environment and the increased presence of these firms in our study present significant valuation problems that the profession is still addressing. Valuing new technology, licensing agreements, stock options, derivatives, and a myriad of innovative financial instruments are examples of areas that create challenges for the client and the external auditors. In the current study, the valuation issue was not as significant on the debt and equity side of the balance sheet in the cases analyzed. In most of the cases, the valuation issues were due to overstatements of the values of the items involved, with understatements being rare.

The valuation errors noted in the cases are highly correlated to the client industry. As noted, many of the valuation errors were due to the instruments or assets found in the financial sector. Ninety-six of the total cases were found in the investment/banking/insurance segment of our society and many of the challenges were focused on the audits of this segment and the valuation of the assets used in the “financial” oriented sector. Forty-four percent of the total cases were found in this industry, a significantly higher number than any of the other client classifications. This number increases to 49% of the total cases if we exclude the 22 tax shelter lawsuits where the clients primarily included wealthy individuals, not corporations. The software/technology/communications industry classification included 30 additional cases or 14% of the total cases, making these two sets of industries (approximately 58% of the total cases) the dominant players in our legal analysis. Unfortunately for the auditor, the valuation issues noted in the financial sector did not disappear with this second grouping of firms (for a comprehensive discussion on rules-based accounting standards and litigation risk, see Donelson et al., 2016).

Fraud Allegations

Alleged fraud against the client company or the auditor was prevalent in our study and increased compared with the ST&A study. In the ST&A paper, fraud against the client or auditor or both occurred 30 times in the 70 cases (43%) against the largest firms. In the current study, 116 cases (54% of all the cases analyzed) had an allegation of fraud against the client, audit firm, or both. Twenty-two of these cases alleged fraud against the client only, 38 cases alleged fraud against the auditor only, and 56 cases alleged fraud against both the client and the auditor. Most of the work on fraud (i.e., Hogan et al., 2008; Trompeter et al., 2013) in the accounting literature has focused on fraud by the client and on why discovery by the auditor did not occur. Article after article discusses the reasons why client fraud may have occurred and details efforts to detect the fraud by the auditor, yet few, if any, address the situation where the auditor is accused of committing fraud. Based upon our findings, it appears that more work should be focused on why there are so many cases where fraud against the auditing firm is alleged (43% of the total cases) and the implications of this finding to the auditing firms themselves and the profession in general. Based upon our review of the fraud literature, one must question the priorities in this line of research and why the auditor fraud aspect has been ignored. It should also be noted that although the auditing literature has argued that fraud cannot be easily detected when collusion occurs, sixteen of the cases against the auditor specifically noted that there was alleged client fraud and the auditor failed to discover the activity resulting in alleged auditor liability. The arguments made in the accounting literature may not meet the expectations of the investing public in these situations.

This increase in allegations of fraud in our study occurred although Goldwasser et al. (2013) noted that in 1995 the accounting profession worked with Congress to adopt the Private Securities Litigation Reform Act which made it more difficult to file under SEC Rule 10b-5 (securities fraud provision), the provision under which most large class action suits had been brought. Although the legislation has not reduced the number of fraud claims filed under 10b-5 in total, it has supposedly reduced the number of these claims filed against public accounting firms (Goldwasser et al., 2013). The Act has also made these claims more difficult to prosecute although more than 50% of such cases also include allegations of accounting irregularities. It is not apparent that a reduction in fraud claims occurred in the filings we analyzed in this study. Although it is difficult to determine the motivations of third parties, we hypothesize that the increasing complexity of accounting activities may result in third parties alleging fraud because they (a) had been financially damaged in some way, (b) cannot understand or determine the possible accounting explanations for the damages, and (c) bring fraud charges against the auditor or client in the hope that these charges will bring financial restitution.

Finally, independence of the auditor (a primary and critical attribute for the credibility of the profession) in the auditor–client relationship has been studied extensively in the auditing literature and pronouncements on this issue are numerous (Church et al., 2015). In our study, there were nine cases where independence was specifically alleged, but in 41 additional cases where fraud against both the client and auditor was part of the allegations we believe that lack of independence may be present. One could argue that when fraud is alleged against both parties—client and auditor together—there is an “implied” allegation that collusion has occurred and not simply fraudulent behavior by each party without knowledge of the fraud by the other defendant. From this perspective, the issue of auditor independence becomes more critical and of greater concern and is worthy of additional research and analysis.

Confirmation of Results in PCAOB Reports

When analyzing legal cases, there are legitimate questions as to the accuracy of the research findings given the large number of lawsuits filed against accounting firms each year versus the sample of cases actually studied. There are also legitimate concerns about the predictive value of any findings given the ever-changing nature of the legal environment, the economy, the accounting rule-making system, and the conduct of the accounting firms themselves (see also Bar-Yosef & Sarath, 2005, for an excellent discussion of the large firms and inferences concerning audit quality and litigation rates). In previous legal studies, these same concerns and questions about accuracy were present for those conducting legal research, often with no potential remedies available. A major finding in this article argues that GAAP issues dominated other areas of concern in the time frame studied and that this finding goes counter to our priors and results from previous research (Feinman, 2003; St. Pierre & Anderson, 1984). Given that GAAP dominated GAAS issues in an environment where GAAS is present in everything the auditors do, it would be beneficial to provide additional support for our contention. Our study is able to at least address this additional support idea due to the fact that the PCAOB, unlike previous regulatory bodies, operates in a manner that provides insight into the current complexities of the audit function and makes their findings available to the general public.

The PCAOB conducts an “audit of the auditors” by inspecting and disciplining firms in addition to offering analysis and critiques of the work of the firms reviewed (see Cutler & Arnold, 2017, for an in-depth discussion of the legal governance of the profession). Depending upon the number of audits conducted, a firm is either reviewed annually or every 3 years. We examined the latest available PCAOB reports for the Big 4 firms (PCAOB, 2020), seeking information that might provide support or refute several of our findings in the actual case analysis, although we have examined a large number of cases in this study and maintain our results are representative of the general population. The PCAOB reports are not offered as legal/evidentiary support for what we found in the cases, but are written from a purely accounting perspective. The major question we ask is whether the accounting/auditing points noted in the findings of our analysis are similar to the problems or issues found by the PCAOB in their reports on the large public accounting firms. We reason that if we find this to be true, it would provide support for our conclusions about potential issues of concern for the auditor. These PCAOB concerns could provide a window into GAAS or GAAP issues that may result in future allegations in lawsuits against the accounting profession.

There has been extensive work on the activities of the PCAOB and its role in the audit environment. Acito et al. (2018) conducted a study on whether PCAOB noted audit deficiencies lead to higher fees or higher turnover of clients. They argue that the usefulness of the PCAOB reports may be limited because the selection of audit engagements is risk-based and the findings are therefore not generalizable or representative of firm audit deficiencies. Abbott et al. (2013) and Lennox and Pittman (2010) debate this assertion concluding that audit committees of inspected companies use the inspection reports as a signal of audit quality. In all of these and other articles on the value of the PCAOB reports, the focus is on the client company, the audit firm, or the relationship between the two. However, in our article, we have taken a different approach and focused on the effects of the PCAOB and the evaluation of the audit firms’ work on the third parties affected by the outcome of the audit.

The large firm reports we selected for examination included numerous audits with major deficiencies from the PCAOB perspective. Although the PCAOB attempts to examine more difficult, complex audits in its selection, even with this selection several of the reports specifically noted that the PCAOB did not believe the audit firms had accumulated sufficient credible evidence to support their audit opinion. These conclusions were not limited to one or two situations, but on multiple engagements in each large accounting firm PCAOB report. This finding alone provides information that could be useful for third parties’ future allegations.

The deficiencies noted reinforced our results in several ways. First, many of the major problems for the selected PCAOB audits focused on valuation issues similar to those we found in our lawsuit analysis. The dominance of GAAP-related items in this study versus GAAS-related items in the ST&A study (St. Pierre & Anderson, 1984) and in Feinman (2003) is a major change in the lawsuit against accounting firms environment, and a significant result in our analysis. The fact that the majority of the GAAP issues are valuation-oriented affects the entire perspective of what places the auditor in trouble when discussing legal liability. Valuation of acquired intangibles, valuation of goodwill, valuation of inventory and obsolete inventory, impairment test valuation for oil and gas properties and equipment, valuation of long-term assets, valuation of derivative instruments and other long-term investments, and valuation of accounts receivable and the allowance for doubtful accounts are examples of issues considered problematic with a deficiency noted by the PCAOB. In addition, the PCAOB also noted problems with revenue recognition issues, revenue in a joint interest arrangement, the accounting for business combinations, and numerous cases of inadequate internal control testing resulting in improper substantive testing based on the actual control weaknesses present—again all issues found in our analysis, but not to the same extent as valuation concerns. As the complexity of businesses increase (finance, telecommunications, health care) we argue that the profession should expect an increase in the problems associated, in general, with auditing these companies and, in particular, in the valuation of the items found on the financial statements.

The PCAOB reports serve as both a validation mechanism for our results and a potential source of information for future plaintiffs. If a plaintiff has reason to search for irregularities in the accounting/auditing areas of a company’s financials, the PCAOB reports provide an outline for potential causes, although company names are deleted. For example, if a plaintiff or lawyer for a plaintiff is looking for alleged errors in the accounting/auditing efforts of the client of interest or accounting firm, the list of deficiencies provided by the PCAOB on each specific accounting firm by client industry may provide a starting point and a window into potential problems in that particular industry. If one examines a company’s 10-K reports focusing on the audit/accounting deficiencies noted by the PCAOB, it may be possible to predict potential risk issues for the auditor or areas where potential problems could be discovered by third parties.

Although specific company names were deleted, information on industries of the clients is available in the PCAOB reports and the information again matches the industries found in our analysis. Firms in the financial services and technology industries were found frequently in the PCAOB reports and in our study and would be considered complex from an accounting perspective, given the measurement issues involved in the industries and the complexity of their “deliverables” when compared with manufacturing or retail enterprises.

Internal control allegations were found in 21 of the 217 cases analyzed. Given the passage of Sarbanes-Oxley and the emphasis on internal controls in this Act, the required reporting on these controls with the audit opinions, and the discussions on internal controls by the PCAOB in their reports on the public accounting firms, one would expect a greater number of internal control issues in the cases analyzed. Sarbanes-Oxley may have had a positive effect on the importance of strong internal controls, but as noted, it is difficult to conclude on that assumption based on the results of our analysis. The relatively small number of cases alleging weak internal control problems for the client or the auditor may be the simple result of not being able to determine internal control weaknesses by outside parties. There is no external “deliverable” for internal control analysis and this is one of those areas where problems or weaknesses are not easily discernible by outside third parties. It should be noted, however, that the PCAOB reports discussed in this article may eventually change the internal control focus by third parties. Disclosure of continuing deficiencies in internal controls found in the PCAOB reports that were not adequately addressed by the auditors during the audit may signal third parties and result in more internal control allegations against the auditor and client.