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In an effort to reduce their exposure to costly litigation, accounting firms are increasing their investigations of prospective and current auditing clients and are selecting new clients more carefully.

As a result of this heightened scrutiny, many firms have refused to take on companies as clients or have dropped others if they perceive the companies to be susceptible to class-action shareholder suits or other legal threats.

The heightened scrutiny is designed "to manage the firm's business risk," said Alan Anderson, senior vp of technical services for the American Institute of Certified Public Accountants in New York. "The whole industry is focusing on that."

It's "a major risk control function," added Peter Christie, vice chairman of Aon Group Inc. and former chairman of Minet Group, the leading broker of professional liability insurance for the Big Six accounting firms.

According to accounting firm executives, insurers and attorneys, no single event triggered the efforts, but they arose from an awareness by the accounting industry that it had to reduce its liability and improve its ability to buy professional liability insurance.

Accounting firms have paid out millions of dollars in the past few years-one verdict against a firm was $81.3 million-in legal actions.

"It went hand in glove. As the accounting industry saw the litigious nature of the economy, they said they have to heat up their efforts to manage this risk," Mr. Anderson said.

"It's driven by liability," said John Doyle, president of the professional liability division of National Union Fire Insurance Co. of Pittsburgh, Pa., a unit of American International Group Inc. in New York. "There's nothing else driving it."

Coopers & Lybrand L.L.P., one of the Big Six accounting firms, initiated its effort about three years ago "to mitigate risk and to upgrade our client portfolio," a spokesman said.

This effort includes a more thorough examination of potential clients' financial records and putting existing clients under the microscope to cull those the firm thinks represents too great a risk.

A large part of Coopers & Lybrand's program is "a general unwillingness to accept as clients companies whose predecessor auditors were dismissed or resigned over accounting disputes," a company spokesman said.

Price Waterhouse also has become more selective in picking clients, according to Peter Frank, vice chairman and head of the accounting firm's risk management. Because of its heightened scrutiny, the number of companies Price Waterhouse has rejected as clients has increased in each of the past five years, he said.

He said that large, blue-chip companies are the safest to audit, but the firm has long believed in pursuing new, smaller companies.

These smaller, less established companies, however, represent greater risks to their auditors. To minimize the risks, Mr. Frank said Price Waterhouse examines the company's financial statements, talks to its officers and top employees, looks at its products and investigates the company's willingness to invest in its infrastructure.

The firm also looks at the potential client's business. Price Waterhouse specializes in certain industries, and for companies outside its area of expertise, the firm applies an extra degree of scrutiny. If needed, the firm will add auditors who specialize in that field to make a proper risk evaluation. Unless Price Waterhouse is willing to commit the required resources and expertise to an account, that client will not be in the portfolio, Mr. Frank said.

As Coopers & Lybrand does, Price Waterhouse also considers in its risk assessment for taking on new clients whether previous accountants dropped a company. "That would be a major signal to us not to deal with them," Mr. Frank said. Price Waterhouse also examines whether a prospective client has filed for bankruptcy protection or been flagged for any SEC violations, he added.

The primary goal of the accounting firms is to reduce liability, primarily from shareholder suits. Often, when a company files for bankruptcy or suffers a financial setback, shareholders or lenders bring suit not only against the company but also the firm that audited the failed company's books.

In the past few years, the number of suits against accounting firms has dropped, Mr. Frank said. The strong economy, with fewer business failures, is one reason. Also, Mr. Frank said, courts and juries now are more understanding that auditors are not to blame for a company's financial problems, leading to more dismissals of suits and fewer verdicts.

Recent research backs up his conclusions. A study released in April by the Securities and Exchange Commission looked at the effects of the Securities Litigation Reform Act of 1995 and concluded that accountants are named less frequently in suits. The study says that of the 109 class-action suits filed under the new law, only six have named accounting firms. Figures for years prior to enactment of the law are not available, but the study states that from 1990 to 1992, the Big Six accounting firms settled a total of 111 securities suits.

Another aspect of the 1995 law that helps accounting firms is the elimination of joint and several liability. Under that doctrine, the accounting firm could be held liable for the entire judgment, even if the firm was found responsible only for part. Without joint and several liability, accounting firms now are responsible only for their proportion of any verdict or settlement.

"I think that as the post-1995 suits start to work their way through the judicial process, you will see that the changes in the law on proportional responsibility will operate to benefit the accounting firms," said Phil Brown, an attorney with Vorys, Sater, Seymour & Pease in Columbus, Ohio, who represents accounting firms in shareholder suits.

For plaintiffs, bringing the big accounting firms into the suit pays. When an accounting firm is named as a co-defendant, the settlement value of the case increased by 75%, according to a 1996 study by National Economic Research Associates. The study by the White Plains, N.Y., consulting economics firm examined settlements from 1991 to mid-1996.

An example of how an accounting firm can be hurt by an auditing client recently took place. In May, the accounting firm of BDO Seidman paid $8 million as its share of a $35 million settlement in a class-action suit against The Leslie Fay Cos. Inc.

In 1993, Leslie Fay announced "accounting irregularities" and restated its earnings from 1991 and 1992 to show a loss rather than a profit. Shareholder suits rapidly followed, and the company filed for bankruptcy in April of that year. Because of its position as Leslie Fay's accountant, BDO Seidman was named as a co-defendant, resulting in its multimillion-dollar settlement.

Other recent hits accounting firms have taken for their auditing practices include a $65 million settlement agreed to by Deloitte & Touche L.L.P. in 1996 (BI, April 29, 1996), and an $81.3 million verdict against Deloitte in 1995 (BI, March 13, 1995). Coopers & Lybrand paid $68 million last year to settle litigation arising out of its auditing of Macmillan Inc. (BI, Aug. 26, 1996).

Besides looking at reducing suits, the accounting firms want to obtain more professional liability coverage at lower prices.

The Big Six firms have high self-insured retentions mainly because of a shortage of capacity as insurers backed out of the market because of high losses, said Aon's Mr. Christie.

"We're basically self-insured," Price Waterhouse's Mr. Frank said. He would not specifically discuss the firm's professional liability coverage.

The increased scrutiny has not existed long enough to have a significant impact on coverage availability, both insurers and the firms said, but it's a move in the right direction.

Because of their efforts, accounting firms are "beginning to see the fruits of that in both reduced losses and increased insurer interest," Mr. Christie said.

"It's a major factor in avoiding litigation, and that in turn is a major factor in the availability of insurance," he added.

Mr. Doyle of National Union said the additional scrutiny is good but cautioned he does not foresee a change in the insurance situation "unless we see a turnaround in loss experience."