A Study On Certified Public Accountants Professional Liability Insurance

Adam Smith put it in The Wealth of Nations(1776)that the trade of insurance gives great security to the fortunes of private people,and by dividing among a great many that loss which would ruin an individual,makes it fall light and easy upon the whole society.The litigation explosion since the mid-19 th century has arisen public attention towards certified public accountants(hereinafter CPA)liability,which led to the development of CPA Professional Liability Insurance(also called Professional Indemnity Insurance,hereinafter PLI).Since the beginning of the 21 st century,a lot of litigation against listed companies occurred in western countries' capital markets,claiming huge amount of compensations,e.g.Enron and World Com cases.In these cases,auditors were sued as joint defendants by plaintiffs.And the court decisions usually supported that auditors should burden certain part of liabilities.In this background,the PLI developed quickly in major economies and it is adopted by regulators or accounting professional associations in many jurisdictions as a compulsory requirement for accounting firm registration or professional practicing.In China,the PLI was introduced in 2000,but developed comparatively slowly.From 2002 to 2007,China's Supreme Court released three legal interpretations,“Notice of the Supreme People's Court on the Relevant Issues concerning the Acceptance of Cases of Disputes over Civil Tort Arising from False Statement in the Securities Market”,“Some Provisions of the Supreme People's Court on Trying Cases of Civil Compensation Arising from False Statement in Securities Market”,“Several Provisions of the Supreme People's Court on the Trial of Compensation Cases for Civil Tort Involving Accounting Firms Engaging in the Audit Business”,which provide the legal basis for courts to accept,hear and judge cases concerning auditor securities compensations and to which extent auditor shall burden civil liabilities.These legal interpretations greatly influence the CPA profession and the profession starts to attach great importance to litigation risk.Then in 2010 and 2015,the Ministry of Finance of China released the “Opinion of Promoting Large and Medium-sized Accounting Firms to Transfer to Special Limited Liability Partnership” and “Notice of the Ministry of Finance and the China Insurance Regulatory Commission on Issuing the Interim Measures for Professional Liability Insurance for Accounting Firms”.Since 2010,the Chinese Institute of Certified Public Accountant and the provincial Institute of Certified Public Accountanthave been dedicating to promote group insurance of PLI.The above mentioned measures of legal departments,supervision authorities and accounting professional bodies have greatly enhanced the development of CPA PLI in China.CPA PLI insurance is now one of the main measures taken by accounting firms to protect themselves from practicing risk and is considered more and more important by practicing circle and authorities.PLI insurance is also a hot topic in academic circle,but most current research focuses on medical liability and corporate governance etc.Because of the low transparency of insurance information,the main research theme in China focuses on status quo and system construction etc.,lacking of quantitative analysis.The change in institutional background provides favorable conditions for the research of CPA PLI.During 2010-2015,the coverage of CPA PLI among security accounting firms has risen from 66% to 92%(Big Four excluded).Premium of CPA PLI has increased by 49%,from 17.35 million RMB to25.79 million RMB and the amount insured has enjoyed a growth of 222%,from 1.8billion RMB to 5.8 billion RMB.The change of security accounting firms provides an opportunity to look into the demand and economic effect of CPA PLI.Thus,the author tries to utilize the data of insurance policies of security accounting firms during 2010-2015 and corresponding listed companies information to carry out in-depth research on the status quo,factors and influences.We introduce the whole pictures of theoretical foundation and research status quo of CPA PLI,and discuss thoroughly the institutional background and its development history.We describe the overall situation of data and information of CPA PLI policies of security accounting firms during 2010-2015.Statistics show that,from 2010 to 2015,the CPA PLI is regarded more and more important by accounting firms.However,it is noted that several accounting firms still have not acquired the CPA PLI and some accounting firm stopped buying insurance during that period.So,the demand and economic effect of PLI need further examination.Focused on the main concern,there are two major parts of this paper.The first is the demand of CPA PLI,and the second is the economic effect of CPA PLI.The first part is about the demand.There are two main characteristics of Chinese institutional background,comparatively low litigation risk and non-compulsory insurance requirement.Using data from 242 firm-year observations in 2010-2015,the results showthat:(1)The firm size is significantly and positively related to the propensity of insurance acquisition decision.This finding justify De Angelo(1981)basic assumption that bigger accounting firms are more likely to seek safeguard for their accumulated wealth.I find this assumption is also applicable to China's circumstance.Meanwhile,I find those firms of limited liability organization form are more likely to buy insurance.The amount of risk funds is negatively related to insurance acquisition decision.(2)The firm size is significantly positively related to the amount of premium,which also justify the afore mentioned hypothesis that large firms are inclined to seek guarantee for their accumulated wealth.The more wealth at risk an accounting firm has,there is stronger motivation for it to buy the PLI and the coverage is higher than it the supervision authorities ask for.(3)There is a propensity for accounting firms to have retrospective clause in the contracts and the protected period becomes longer and longer.I also find the amount of risk funds is negatively related to the length of retrospectivity,which justifies the substitution nature between insurance and risk funds.The second part is the economic effects of CPA PLI.The content is divided into two parts,the impact on audit fees and on audit quality when accounting firms convert to buy CPA PLI.(1)The impact of CPA PLI acquisition on audit fees.Using 4549 firm-year observations during 2010-2015,I find CPA PLI acquisition has a positive effect on audit fees in full sample.After acquiring CPA PLI,small firms' audit fees have increased significantly while large firms' audit fees do not change significantly.The finding supports the reputation theory,i.e.large firms have more wealth and thus they are more capable to“digest” the increased cost,while small firms do not own such resources and ability.Further test shows PLI acquisition constrains the positive effects of risk premium on audit fees.This finding supports the incremental risk charge hypothesis.(2)The impact of CPA PLI acquisition on audit quality.Based on 3839 firm-year observation during 2010-2015,I find CPA PLI acquisition has no significant effect on audit adjustment in general.However,after acquiring CPA PLI,small firms' audit adjustments have increased significantly while large firms' audit adjustments do notchange significantly.The finding shows that the audit quality of small firms is enhanced and large firms appear not affected.Meanwhile,the paper finds before PLI acquisition,there is a significant difference on audit adjustments between large and small firms.But,after PLI acquisition,the difference no longer exists.The findings support the hypothesis of PLI supervision function and motivation function.Based on the transitional period in which the CPA PLI becomes prevailing in security accounting firms,this paper conducts systematic analysis on institutional framework,demand and economic effects of CPA PLI.It provides empirical evidence for the CPA profession,capital market regulators and investors and fills the research gap in this area.The academic contribution of this paper is as follow:(1)Existing literature about CPA PLI are mostly analytical and institutional researches.This paper is the first to study the CPA PLI demand and economic effects empirically and systematically in a large sample.(2)the paper verifies the insurance demand theory and hypothesis in CPA PLI area which provide better understanding to the risk management of accounting firms.(3)This paper is the first empirical study focusing on CPA PLI economic effects,which extends the literature of auditor litigation risk,audit fees and audit quality.CPA PLI is recognized as an effective approach to protect both the auditors and the investors.It is prevailing in major jurisdictions and develops on its way.The results of the paper have important referential significance for practice.(1)It provides information to the regulators to better understand pros and cons of CPA PLI and thus to propose more targeted regulations of information disclosure and supervision.(2)It provides reference to the judicial departments to improve legal system for civil liability and litigation of auditors.(3)Accounting firms can have guidance to improve internal risk management and audit quality control.(4)It provides information for investors and the public to better understand CPA PLI and they can use it to better protect the interest of the investors.