Matters to be discussed:
(i) Auditor Liability: 'Fair and Reasonable' Punishment?
Types of Liability
Types of Liability
(ii) Criminal Offences
(iii) Civil Offences
(iv) Case History (Not complete yet)
(v) Joint and Several Liability (Not complete yet)
Managing Exposure to Liability
(vi) Audit Quality
(vii) Disclaimers of liability
(viii) Liability Limitation Agreements
(ix) Current Position
(x) Conclusion
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(i) Auditor Liability: 'Fair and Reasonable' Punishment?
1) Over past 2 decades, the bill for litigation settlement of Big Four audit firms
alone has run into billions of dollars.
2) Example:
Deloitte's 2005 settlement of $250m regarding its audit of insurance company
Fortress Re and PWC's $229m settlement in lawsuit. (Brought by the
shareholders of audit client Tyco in 2007.)
3) Auditor liability increasingly concerning (Both in terms of audit quality and the
reputation of the profession, but also in terms of the cost to the industry and
the barriers this creates to competition within the audit market.
Types of Liability
1) Over past 2 decades, the bill for litigation settlement of Big Four audit firms
alone has run into billions of dollars.
2) Example:
Deloitte's 2005 settlement of $250m regarding its audit of insurance company
Fortress Re and PWC's $229m settlement in lawsuit. (Brought by the
shareholders of audit client Tyco in 2007.)
3) Auditor liability increasingly concerning (Both in terms of audit quality and the
reputation of the profession, but also in terms of the cost to the industry and
the barriers this creates to competition within the audit market.
Types of Liability
(ii) Criminal Offences (Breach a government imposed law)
1) Auditors are bound by laws in the countries which they operate.
(Like an individual or organisation)
2) Under current Criminal Law = Auditors could be prosecuted for acts such as
fraud and insider trading.
3) Audit is also subject to legislation prescribed by Companies Act 2006.
(Include many sections governing who can be auditor, how auditors are
appointed and removed and the functions of auditor.)
4) S.507 of Co. Act = 'Knowingly, or recklessly causing a report under s.495
(auditor's report on company's annual accounts) to
include any matter that is misleading, false or deceptive
in a material particular'.
[Noteworthy Offence - Auditor could be prosecuted in a criminal court for
either knowingly or recklessly issuing an inappropriate audit opinion.]
(iii) Civil Offences (Governs relationships between entities and the state.)
1) 2 pieces of civil law = Contract law and the law of tort.
(Significance to audit profession.)
[This establish the principles for auditor liability to clients and to 3rd parties.]
2) Under Contract Law = Parties can seek remedy for a breach of contractual
obligations.
(Therefore, shareholders can seek remedy from an auditor, if they fail to
comply with the terms of an engagement letter)
3) Example:
- Auditor can be sued by shareholders.
(Which was the case in PWC settlement to Tyco shareholders.)
4) Under Law of Tort = Auditor can be sued for negligence.
(If they breach a duty of care towards a 3rd party, who
consequently suffers some form of loss.)
(iv) Case History
(v) Joint and Several Liability
Managing Exposure to Liability
(vi) Audit Quality
1) Auditor not being negligent in the 1st place.
= Rigorously applying International Standards on Auditing (ISA),= Apply the Code of Ethics for Professional Accountants, and
= Paying close attention to the terms and conditions agreed upon in the
engagement letter.
2) Improvements in quality controls in comparison to current levels would not
happen.(Without investment from the audit firms.)
[With pressure to reduce audit fees = 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)]
(vii) Disclaimers of liability
1) Outcomes of Bannerman case = Potential exposure of auditors to litigation
from 3rd parties to whom they have not
disclaimed liability.
(As a result = It become common to include a disclaimer of liability to 3rd
parties in the wording of the audit report.)
2) Disclaimer may not entirely eliminate liability to 3rd parties.
(But they do reduce the scope for courts to assume liability to them.)
3) This protection may not extend overseas because the disclaimer is based
on a ruling from a UK court case. (It provides no protection from the threat
of litigation from clients under contract law.)
[Noted that whilst this should reduce the threat of litigation in the UK.]
4) Critics of the 'Bannerman Paragraph' = Believe the presence of Bannerman
Paragraph devalues audit report.
(They argue that the disclaimer acts as a barriers to litigation = Reduces
the pressure to perform good quality audits in the 1st place.)
[It is plausible that this reduces credibility of the audit report in the eyes of
the reader.]
(viii) Liability Limitation Agreements
1) Under the terms of Companies Act = Auditors is permitted to use Liability
Limited Agreements (LLAs) (Since 2008)
[To reduce the threat of litigation from clients.]
2) LLAs = 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.]
3) Problem of how to define the cap:
- As a fixed monetary amount,
- A multiple of the fee, and
- Proportionate liability on a case by case basis.4) It is 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.)
[Therefore open to the interpretation of the courts = The level of compensation
may as well lie at the discretion of the courts in the 1st place.)
5) Another problem lies with the shareholders = What motivation do investors
have for agreeing terms that could potentially reduce their ability to recover any
losses they incur due to negligence of other parties?
(This may be perceived as a barrier to litigation that audit firms can hide behind,
reducing the pressure to perform good quality audits.)
(ix) Current Position
1) It seems none of the 3 methods provide the protection the profession needs
to truly become competitive.
[Profession is not asking for exemption from litigation, rather than it does notshoulder the entire burden of litigation where others may also be to blame)
2) In Jun 2008, 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.]
3) Suggestions to limit auditor's liability:
- Not apply in cases of misconduct.
- Be ineffective if it did not extend to 3rd parties, and
- Ensure fair compensation of damaged parties.
4) There are an increasing number of advocates for a 'proportional' system of
liability replacing the current 'joint and several' one.
(Whilst no firm decision has been reached in the UK)
5) Under 'proportional' system of liability = Audit firm would accept their
proportion of the blame in a
negligence case and would pay that
proportion of the compensation.
6) As introduced this system in Australia 2014 = Would ensure a fair outcome
for the plaintiff without placing the entire financial burden upon audit profession.
(Also meet EC recommendations listed above.)
7) No solution has been agreed upon in the UK and the debate continues.
(Currently)
(x) Conclusion
1) The potential costs and risks of auditing large, listed businesses may now beprohibitive for any firm of willing auditors outside of the Big Four.
(As there is an increasing trend of litigation that causing the audit profession
billions of pounds.)
2) Auditors can reduce their exposure to litigation.
(But there is a rising groundswell of opinion that the profession has, for too
long, borne the brunt of penalties for misdemeanours shared by other culpable
parties)
[These penalties are prohibitive to competition = May be damaging to capital]market.
3) There is a widespread agreement that this situation must change.
(Unfortunately, any decision on the nature and timing of such a change appears
to be a long way off.)
[Until such time the audit profession will simply have to bear the burden of
liability.]
