Critically assess the current legal position of auditors in the UK and Ireland. Analyse the impact the current situation has on the competitiveness of the audit market and discuss some of the methods available to auditors to reduce their exposure to expensive litigation.
Auditors are liable for both criminal and civil offenses. Criminal offenses arise when the auditors violate a government-imposed law. It will be a dispute between the State and the auditor. On the other hand, civil offences dispute are always between the individuals and /or organizations. The last two decades have seen the large 4 auditing companies settling the claims. Deloitte paid $ 250 million for having negligently audited the insurance corporate “Fortress Re”.in 2005. PWC settled $ 229 m in a law suit filed by one of its audit client “ Tyco”, in 2007. The liability faced by auditing profession has therefore become a matter of serious concern in respect of both quality of audit and reputation of audit firm which impact on the financial burden to the auditing firms and competition in the “audit market” .
Audit is subject to provisions of Companies Act 2006 that can determine the auditor's qualifications, appointments, removal and duties. One important provision of the Companies Act 2006 under section 495 dealing with auditor's report on company accounts that have been issued knowingly, or recklessly. Section 507 of the Act is attracted if any item of “misleading, false, or deceptive” (p 1) materially. Therefore, it is clear that the auditor is criminally liable for knowingly or recklessly giving an opinion.
Auditors are liable for professional negligence, criminal acts, breaches of trust, and breaches of contract. Negligence occurs when an auditor concerned fails to exercise the required degree of care and skill for the circumstances of the case, which are expected of accountants and auditors. The auditors can defend themselves against any action for negligence by showing that there has been no negligence, or that the duty of care was rather on the plaintiff who had owed in the circumstances, or that no financial loss has been suffered by the plaintiff in the case of action in tort. As the third defense cannot be available to defend against a claim in contract but only for nominal damages, no such action is likely to be brought against the auditors. Recently substantial claims for negligence have been brought against auditors and accountants. In several cases, the claims may have arisen as a result of misunderstanding regarding the extent of responsibility the account or auditor was expected of while giving advice or expressing opinion. Hence, there can be disputes arising from the misunderstanding of the responsibility assumed and negligence in complying with the contractual terms. Section 310 of the Companies Act 1985 makes any contract or company article invalid if it exempts the auditor from, or to indemnify the auditor against, any liability for negligence, default, breach of duty or breach of trust. But, Companies Act 2008 enables auditors to restrict their liability in the case of statutory audit or work executed for the company through specific agreements with their clients. Section 534 to 538 of the 2006 Act, validates such agreements limiting the auditor's liability for any negligence, default, breach of duty, or breach of trust whilst an audit had been done.
There are three notable cases to be discussed below have led the audit profession to restrict its vulnerability to future liabilities. “Caparo Industries Plc (Caparo) v Dickman (1990)”, “Royal Bank of Scotland (RBS) v Bannerman” and “Johnstone Maclay (Bannerman) (2002)” are the cases that have shaped audit firms attempt to restrict their liability exposure. Caparo sued Touch Ross (later became part of “Deloitte & Touché”) for having sustained losses in the purchase of shares of Fidelity Plc relying on the Touch Ross certified accounts which later turned out to be overvalued. They also claimed the auditors of the company owed “ a duty of care” to its shareholders. But the claim could not succeed as the “House of Lords” ruled that auditors prepared accounts to be submitted to the original shareowners of a category and the audit did not have the information as to whom it was intended. . These cases prompted law-makers to bring legislation that auditors owed a “duty of care” to third parties also. The current guidance is that the loss to third party should be correlated to the auditor's failure. There must be the proximity of relationship between the audit party at fault and the person who has suffered loss. It should be fair and justifiable to levy penalty on the auditor firm The 2nd one involved similar circumstance of Caparo in the form of banking facility letter of APC about which the audit had knowledge and hence it was ruled that auditor had a duty of care even if the claimant is a third party especially in the absence of a disclaimer by the audit firm. The following examples would show that auditors' liability in such cases is misplaced. A) Anderson's case confined to the conduct of a U.S. firm; the collapse affected the global net work of Anderson, and it was beyond the control of the UK partners. B) During the mid 1990s, Binder Hamlyn, which was a mid-tier-firm, then lost heavily as the claim it contested and lost exceeded its capital and insurance and collapsed as a result. (C) Ernst & Young faced a significant claim from Equitable Life for having audited its accounts in the late 1990s negligently, incurred more than ten millions of pounds as legal costs although the claim was withdrawn in 2005. The Bank of Credit and Commerce International (BCCI) ‘s two auditors now with PWC & Ernst Young) paid £ 75 million in settlement of a claim from the BCCI.
Jointly and severally liable concept
Auditor’s liability both under criminal and civil law is now clear and far from controversy although penalties are still being contested. It is claimed that auditors can be found liable only if they have failed in their duties of performance with a professional manner along with the required care without any allegiance to its client. Hence, it is futile to argue that auditors cannot be held liable for their failures and losses suffered by their clients or third parties as a result. Although it admitted that auditors owe a duty of care for what they have audited or certified, the criticism is that fines and penalties levied are extremely high. The high cost of fines stems from the legal rule holding one as jointly and severally liable to multiple parties' culpability and the auditor has to bear the lion's share of the penalties for he alone is reachable among the many culpable parties. It is for the auditor to seek relief from the culpable parties. For instance , if a board member gives incorrect statement which the company management fails to detect due to deficiencies in oversight and the auditing entity conducts a haphazard audit resulting in a defective “audit opinion”, it is clear that all the parties are not correct. Share-owners could still try to recover only from the three parties. It is also because other individuals having culpability do not have sufficient assets with the result audit firm is held responsible on the principle of "jointly and severally liable" principle. Joint and several liability for auditor is regarded as a disciplining tool and implicit form of enforcement standards of auditing practice rendering auditors to pay the entire damages irrespective of the degree of involvement of the auditor. In other countries, such as Austria and Germany, auditor's liability is limited and is known as capped liability, in Spain, it is proportionate to the auditor’s responsibility. Unlike the UK decision in Caparo which established that auditor owed duty of care to his client, in France the position is reverse in that auditor is not only responsible to the audited company but also to its shareholders since French law emphasizes on the “auditor’s social role and public duty, liability to third parties” (p 174) as defined in tort law. The European Commission admits that the unlimited liability is a barrier to the auditing profession. It examines several options to limit such liabilities. A monetary cap is already in existence in EU countries like Austria, Belgium, Germany, Greece and Slovenia. Another option is the monetary cap based on the company size and fees charges by the company. However, durable option would be proportionate liability. In the absence of proportionate liability especially when some of the auditors are out of business, then the entire liability would fall on the remaining firms irrespective of their responsibility. On the other hand, proportional liability would render an auditor liable only for his share of loss. The proportionate liability would also encourage increased competition in the audit market. Auditors can have their risks fairly predictable if there is a liability cap. Mid-tier firms will then be able to compete with the Bog-4. A combination proportionate liability and caps on liability would prevent collapse another firm and also result in increased competition. The proportionate liability proposal to limit the auditors' liability is considered to address the "deep pocket syndrome" effectively and as the "fairest and most realistic option available". Those in support argue that the proportionality reduces the risk any audit firm leaving the market due to others' fault. The concept at the same time ensures that the auditors do not avoid liability for their own errors and mistakes. It has a neutral impact on competition in the audit market. It would encourage audit firms outside the Big-4 to enter into the listed companies market which will increase the companies' choice. Critics oppose stating that it would disrupt many national tort law systems, any limitation on auditor's liability would increase the investor's liability and increase the cost of capital, proportionality is not answer for protection against catastrophic claims and that court cannot estimate the degree of auditors' responsibility.
Management of exposure to liability
In spite of the above principle, auditors can avoid being held responsible for others mistakes. First, eschewing negligence at any cost by rigorous application of International Standards of “Auditing and the Code of Ethics for the Professional Accountants” besides being attentive to the “terms and conditions” of the agreement with clients. . International Standard on Auditing U.K. and Ireland (ISA) dealing with the auditor’s responsibility relating to other information in documents containing audited financial statement and the auditor’s report such as annual reports circulated to owners states that the auditor should respond appropriately towards any inconsistencies that could undermine the credibility of the said documents. The auditor has the right to revise the certified financial statements. If the material inconsistencies are discovered before the date of the audit report, the auditor should modify his opinion if the company refuses to revise. Suggestions of Limited Liability Agreements (LLAs) and Commercial Insurance Cover have proved to be ineffective since companies did not agree to LLAs and insurance premiums for commercial insurance cover was prohibitive.
Order of the Competition and Markets Authority (CMA) of September 2014 incumbent upon FTSE 350 audit committees under the provisions of the Enterprise and Regulatory Reforms Act 2013 requires the FTSE 350 companies to have their statutory audit fixed through a tender process at least once in ten years, following a competitive process. For example, an auditor appointed before June 1994 should be replaced by another auditor selected through a tender process .
Maastricht University’s Accounting Research Center (MARC) ‘s report titled The Value of Audit commissioned by a group of the six largest international firms states that audit is still a tool that lends credibility in a company’s financial statements and considered to meet the key expectations of the stakeholders. It has been rated as 7.3 by the stakeholders in meeting the expectations. However, the stakeholders feel that auditors can give more reporting on the company's risk management and internal controls rather than engaging in compliance-driven audit. They want less of compliance-driven audit and more of the audit on risk management and internal controls. The report comments that auditors only engage in defensive auditing and giving “boiler plate opinions” and have earned a reputation of highly cautious and conservative. In spite of being cautious and conservative, auditors run into catastrophic claims sending shock waves in capital markets. It is ironic that liability risk helps the big-4 firms to leverage a dominant position in the listed companies audit market. An argument to address the issue of liability is to encourage smaller and mid-tier firms to enter into the audit market and embrace high-risk work and thus promoting the public interest goal of enhanced competition in the audit market. The expectations of the stakeholders that audit should play a bigger role than merely engaging in compliance-driven audit would only lead to more exposure to liability which depends on the duty of care. The auditors must play wider role notwithstanding the risk of increased liabilities by insulating themselves by incorporating the firm so that partners are not held personally liable, though it is still a formidable liability for the firm due to possible catastrophic claims, damages awards, or trading losses that can instantly wipe out the firm itself. The UK Act 2006 allowed audit firms to enter into voluntary liability limitation agreements with their corporate clients. But this measure has not greatly relieved audit firms of the risk owing to the reluctance of the audit clients to enter into such agreements. Added to that the law commission has not agreed to replace the joint and several liability with liability based on proportionality for the reason that objection to the former is not unproven yet and does not convince departure from the principle of joint and several liability.
Ireland audit also shares the similar concerns of the auditing community of the U.K. In fact, Ireland’s situation is more acute in that the country’s company law bars limited liability companies or partnerships to become statutory auditors. With this, personal assets of auditors with no culpability can be appropriated. In the past, the Big 4 used to have unlimited insurance coverage and resources to cover possible losses resulting from catastrophic claims. Now it is not possible to underwrite with any commercial insurance for audit risks with the result the audit firms are making their own vehicles of insurance as self-insurance. However, such arrangement are not found to be adequate to meet the high levels of claims. Any claim of such a magnitude is sure to bankrupt the audit firm affected. In spite of the serious situation, any reform of the laws governing audit liability is not going to accord preferential treatment to the profession. The Irish economy has been robust and high quality and well regulated auditing profession has been one of the reasons for this outcome.
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