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Accounting firms should be liable

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With the recent prevelence of corporate scandals in the United States recently, there have been many efforts made towards reform.

You have been asked to evaluate the following proposal and debate it

"Accounting firms should be liable to pay stockholders if they give a company a clean audit and it goes bankrupt within a year".

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Solution Summary

"Accounting firms should be liable to pay stockholders if they give a company a clean audit and it goes bankrupt within a year".

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While this idea may sound appropriate at first glance, there are many problems with such a strict standard of auditor liability. First, it ignores that companies can go bankrupt for a variety of reasons, most of which are not under the purview of the auditor. Business conditions can change very rapidly, and especially if poor management decisions are made, a previously unforeseen crisis can rapidly arise. In these cases, which account for a sizable percentage of bankruptcies, it would be inappropriate to hold the auditor liable for investors' losses because the auditor was not responsible and could not have detected the cause of the bankruptcy through its audit.

Such a strict standard of liability also creates a moral hazard as
well. If accounting firms are liable for bankruptcies under any
circumstances, investors have less interest in performing their own
research because the accounting firms are effectively ensuring their
investments. This could lead to more reckless investment, resulting
in less efficient allocation of capital in the economy as a whole.
Riskier appearing investments, which most investors should properly
shun, suddenly become less risky despite the business's prospects
being unchanged if auditors are forced to reimburse investors for
their losses in a bankruptcy under any circumstances.

Another point against this approach is that it fails to recognize that
even in the case ...

Solution provided by:
Sandeep Bardia, MBA
Education
  • BCom, SGTB Khalsa College, University of Delhi
  • MBA, Rochester Institute of Technology
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