Report: Accounting Lawsuits Getting Pricey

Good news for anyone arguing for more investment in strong internal accounting controls: fresh research shows that companies are paying a lot more money to settle the lawsuits that follow when your weak accounting controls screw things up.

So says Cornerstone Research, an outfit that has been tracking the trends in class-action lawsuits for years. Its latest report looks at lawsuits over financial restatements, material weakness in internal controls, and other accounting issues. The number of new filings for 2022 is up, the number of settlements is up too, and the median settlement value nearly doubled — from $8.1 million in 2021, to $15.5 million in 2022.

Figure 1, below, tells the tale. We have a somewhat mixed message on new class-action filings last year, with a mild increase in the number of filings and a slight decrease in the damages that plaintiffs claimed they suffered. Cases settled in 2022, on the other hand, involved some much more expensive numbers. 

Looking at the larger picture, we are still below the long-term trend in class-action lawsuits, for both accounting-related and non-accounting cases alike. (See Figure 2, below.) That’s probably driven somewhat by the pandemic and its disruption to normal courtroom operations; and by the buoyant stock market of 2020 and 2021. 

Except, both the pandemic and the buoyant stock market have gone away; and we have all those companies that went public in 2021 or 2022 via SPAC, now entering 2023 with accounting weaknesses a-plenty because they never developed strong internal accounting processes in the first place. So it’s a safe bet that we’re likely to see more class-action lawsuits in the next few years, with weak accounting controls playing a starring role.

The Role of Material Weaknesses

One interesting detail in the report is that for the second consecutive year, fewer than half of all accounting lawsuits filed included allegations of internal control weaknesses. Usually a solid majority of accounting lawsuits involve such an allegation, although more often than not the plaintiff is alleging a material weakness even while the company hasn’t disclosed one.

In 2022, the lawsuits filed were different. We had only nine lawsuits alleging a material weakness without the company also announcing one; and 16 lawsuits where there was both an allegation and a company announcement of a material weakness. 

Cornerstone did say that while allegations of material weaknesses are common, the allegations aren’t associated with higher settlement amounts compared to other cases overall. 

Don’t Forget the Legal Costs

If you’re going to take a run at the CFO arguing for more investment in accounting systems, don’t forget to include legal costs in your calculations. Cornerstone has some interesting data on that point too.

For all accounting cases filed 2013 through 2018, roughly 46 percent were dismissed. (I’m not counting cases filed more recently because so many of them are still pending.) Well, those victories come at a cost: legal fees, as you wind your way through the courts. 

Plenty of those cases are dismissed swiftly (less than one year after filing), but plenty more take years to resolve. Figure 3, below, shows how long that time to dismissal took. Look at years such as 2013 or 2018, with many cases that lingered for two or three years before dismissal. Think of the hourly fees that outside counsel charges your company. Think of your audit firm’s fees too, because we all know that if your company gets dragged into costly litigation over accounting issues that your audit firm will be along for the ride, performing forensics or increasing its demands for testing or lord knows what else.

Moreover, Accounting cases settled in 2022 took more time to reach that settlement: an average of 3.7 years for cases settled in 2022, compared to 3.2 years in 2021.

These numbers add up. Even if your company wins dismissal of the case — are those millions spent on legal fees really going to be less than whatever it costs to configure your ERP software correctly or to automate your key accounting controls? Of course not.

That’s the real argument in favor of investing in strong internal accounting controls, including automation and audit management software and all the rest. Configuring all those systems is a tedious, exacting pain in the neck, but it’s still going to be less expensive than the damage of a half-baked set of internal controls that finally collapses.