It is worth making the point that auditors are only found liable in cases where they have breached their responsibilities to perform work with professional competence and due care and to act independent of their clients. There is therefore little argument that they should face the penalties of their own failures and that parties that have suffered as a result should be able to seek adequate compensation.
The main criticism of the current system is that the penalties incurred by the audit profession are unfairly high. This arises from the civil law principle of ‘joint and several liability’ enforced in the UK (as well as the US). This means that even if there are multiple culpable parties in a negligence case the plaintiff may pursue any one of those parties individually for the entire damages sought.
For example, if a director fraudulently misstates the financial statements, the company’s management fail to detect this because of poor controls and the auditor performs an inadequate audit leading to the wrong audit opinion, it would be fair to say all three parties are at fault. Shareholders seeking compensation for any consequent losses, however, could try and recover the full loss from only one of those three parties.
“It is worth making the point that auditors are only found liable in cases where they have breached their responsibilities to perform work with professional competence and due care and to act independent of their clients. There is therefore little argument that they should face the penalties of their own failures and that parties that have suffered as a result should be able to seek adequate compensation.”
Given that many of the cases arise when companies are facing financial difficulties, as with the examples cited above, and that any individuals involved are unlikely to possess sufficient assets to settle the liabilities, the audit firm, who may be asset rich and possess professional indemnity insurance, is often the sole target for financial compensation.
Regardless of the perceived fairness, this situation does create a number of challenges for the profession, namely:
a. The increasing cost to the industry, firstly from defending and settling claims but also from spiralling insurance premiums.
b. The potential for consequent increases in audit fees to cover these rising costs.
c. The overall lack of sufficient insurance cover in the sector in comparison to the size of some of the claims.
d. The lack of competition in the audit market for large listed entities.
With regard to the final point, auditor liability is not the sole reason for the lack of competition in the audit of listed entities but it is a significant barrier to entering that market. Currently only the big firms have adequate insurance and asset cover to be able to audit an extensive range of listed clients. It may simply be too risky for smaller firms to take on such clients; one large negligence case could easily bankrupt a mid-tier firm.
Managing Exposure Liability
Audit Quality
There are a number of ways in which audit firms can manage their exposure to claims of negligence. Perhaps the most obvious is not being negligent in the first place. In practical terms this means rigorously applying International Standards on Auditing and the Code of Ethics for Professional Accountants and paying close attention to the terms and conditions agreed upon in the engagement letter.
Of course, improvements in quality controls in comparison to current levels would not happen without investment from the audit firms. With pressure to reduce audit fees it is unlikely that firms will want to commit to further increases in cost unless it is perceived that such action will lead to long-term reductions in legal and insurance costs.
Disclaimers of Liability
Disclaimers may not entirely eliminate liability to third parties but they do reduce the scope for courts to assume liability to them. It should be noted that whilst this should reduce the threat of litigation in the UK, this protection may not extend to other countries because the disclaimer is based on a ruling from a UK court case. It also provides no protection from the threat of litigation from clients under contract law.
Liability Limitation Agreements
Since 2008 auditors have been permitted, under the terms of the Companies Act, to use Liability Limitation Agreements (LLAs) to reduce the threat of litigation from clients. LLAs are clauses built into the terms of an engagement that impose a cap on the amount of compensation that can be sought from the auditor. These must be approved by shareholders annually and be upheld by judges as ‘fair and reasonable’ when cases arise.
Whilst this may sound straightforward it has created problems, including how to define the cap (i.e. as a fixed monetary amount, a multiple of the fee, proportionate liability on a case by case basis). It is also difficult to decide what is fair and reasonable when setting the terms of the engagement because this is done before any potential litigation, or the scale of potential litigation, is known to the auditor and the client. This is therefore open to the interpretation of the courts. At which point the level of compensation may as well lie at the discretion of the courts in the first place.
Another problem lies with the shareholders; what motivation do they have for agreeing to terms that could potentially reduce their ability to recover any losses they incur due to the negligence of other parties? Once again this may be perceived as a barrier to litigation that audit firms can hide behind, reducing the pressure to perform good quality audits.
All the methods described contribute to the management of auditor liability but it seems none of them has provided the protection the profession needs to become truly competitive. Remember, the profession is not asking for exemption from litigation rather that it does not shoulder the entire burden of litigation where others may also be to blame.
In June 2008, the European Commission recommended that member states find a way to limit auditor liability to try and encourage competition in the audit of listed companies and to protect EU capital markets. Given the different legal systems involved the recommendation leaves it to member states to determine an appropriate method but suggests that the solution:
1. Should not apply in cases of misconduct
2. Would be ineffective if it did not extend to third parties, and
3. Should ensure fair compensation of damaged parties.
Whilst no firm decision has been reached in the UK there are an increasing number of advocates for a ‘proportional’ system of liability replacing the ‘joint and several’ one. Under this proposal the audit firm would accept their proportion of the blame in a negligence case and would pay that proportion of the compensation. This system, as introduced in Australia in 2004, would ensure a fair outcome for the plaintiff without placing the entire financial burden upon the audit profession. It would also meet the EC recommendations listed.
Conclusions
Auditors can reduce their exposure to litigation but there is a rising groundswell of opinion that the audit profession has, for too long, borne the brunt of penalties for misdemeanours shared by other culpable parties. These penalties are prohibitive to competition, which may be damaging to capital markets. The Public Interest Oversight Board provides oversight of the IAASB, ensuring that the standards are in the public interest
Dr Dada Adefolami, MBA. PhD CPFAcct., is a Finance / Management Consultant and Certified Forensic Accountant ([email protected]; 08052043855)
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