Auditor Liability Issues - Report Example

Auditor's Liability In the United Kingdom, companies are required to get their accounts and financial ments audited by external auditors. Thesestate guaranteed market of external audits are applicable to around 600,000 companies, schools, universities, trade unions, hospitals, government departments and charities who have to submit to an external financial audit by accountants belonging to one of the select accountancy trade associations. (Cousins et al, 1998) Contrary to the early reasons for having this law, state guaranteed market of external audits hasn't been able to provide a secure employment and niches for accountants. The failures and negligence of external auditing make it to the news headlines regularly. Scandals such as those of the Bank of Credit and Commerce International (BCCI), Barlow Clowes, Atlantic Computers, Coloroll, Ferranti, Homes Assured, Levitt, Queens Moat Houses, Resort Hotels, Eagle Trust, London United Investments, Maxwell and Polly Peck have resulted in loss of jobs, savings, investments, pensions and taxation revenues. (Mitchell et al, 1991) Problem of Auditor's Liability The audit of a company's financial statement poses a certain degree of risk for the auditors and the company. The auditors have to objectively audit a company that reflects a true picture of the company. Since the managers depend on the audit to help them understand the current scenario of the company to take future decisions, and investors use the audit to help them take investing decisions, the correctness of the audit carries high stakes for all. (Defintions) Until recently, auditors had unlimited liability towards the public incase of negligence, breach of contract or fraud. Due to this very law, there have been cases in the past that have wiped the company clean due to gigantic compensations. Following the collapse of a company, third parties would often attempt to recover their losses from a solvent and insured auditor. Faced with such claims, the common and civil law courts had to struggle between two conflicting interests: the public's interest in the independent and competent review of financial statements and the interest of the auditing profession in carrying out its function without the burden of a potentially overwhelming liability. (Khoury, 2001) The scandal of Enron and its audit company, Arthur Anderson, were the victims of improper auditing and impedance to justice. There were once the 'Big 8' auditing companies which now have been left with the 'Big 4' after a series of mergers. All over the world, these four companies control about 85% of the total audits. (Lawrence, 2006) Auditor liability has been an increasing concern for the auditing profession for a considerable number of years. Such large liabilities are unfair and unjust to auditors. Consequently, a number of jurisdictions in recent years have introduced measures aimed at reforming their auditor liability regimes. However with the communities becoming increasingly litigious, one wonders when the 'Big 4' would be left with the 'Big 3'. (Lawrence, 2006) Duty of Care Owed A duty of care is an obligation to provide a certain level of care to others depending on different circumstances to avoid injury to that individual or his property. Basically the relationship of the parties, the negligent act or omission is prevented by fore-sighting any loss to that individual. An auditor is expected to be able to foresee such acts and respond accordingly. In cases of unintentional negligence which results in losses, such an act will be regarded as having breached a duty of care and at this a time a duty of care is owed. (Solicitors, 2002) (Definitions) The English Law for duty of care was formed in the Scottish case of Donoghue v Stevenson 1932 SC (HL) 31. The general principles for duty of care to be owed included the presence of three points (Solicitors, 2002) 1. Does a duty of care exist The existence of duty of care depends on the type of relationship between the parties. An auditor of a company has a duty towards the shareholders of the company to portray correct accounts since the shareholders have the right to run the company (being its owners). 2. Is there a breach of that duty A liability only appears in those cases where the action breaches the duty of care and causes a loss or harm to the individual, where the loss was reasonably foreseeable. If the auditor fails to recognise such a loss due to negligence, then there is a breach of duty. 3. Did the breach cause damage or loss to an individual's person or property The liability is owed only in those cases where the breach of duty has resulted in some physical or economic loss. If an auditor's breach of duty did not yield any loss, then the auditor is not liable and hence the duty is not owed. In the Caparo Industries v Dickman (1990) case, the Lords said that a person can own a duty of care to avoid causing injury but economic losses cannot be imposed by such tests. The damage resulting from negligent misstatement will normally be confined to economic loss sustained by those who rely on the accuracy of the information or advice they receive as a basis for action. In advising the client, the auditors have a duty to exercise that standard of skill and care appropriate to his or her professional status, and will be liable both in contract and in tort for all losses which the client may suffer if there is a breach of that duty. (Defintions) Liability Liability is an obligation that a person is required to fulfill. In a case where that liability is not fulfilled, the person can be subjected to legal action depending upon the level of liability. Under the contract law, a person is liable to perform his/her duties and actions according to the signed contract. The parties under contract are legally bound and must adhere to the terms of the contract. It is basically a liability when an individual (auditor) fails to make things better by not rendering the expected performance, as in wrongly auditing the financial statements. The liability when used in torts, generally refer to those actions or negligent omissions that makes things worse. If an auditor negligently omits some information from the accounts of the company, the auditor may have breached the duty of care and thus would be liable to liability resulting from civil wrongdoings. (Defintions) The extent of liability differs in each and every case. Sometimes the liability can be limited if it is provided for in the contract. Until recently the auditors were exposed to unlimited liability and they could be sued for such high damages that even bigger companies could not sustain the heavy damages. (Beatson, 1998); (Wende, 2002) Reducing Auditor Liability Several points have been raised in the past to reduce or even protect auditors against liabilities. Some of the most practical and important points being deliberated all over the world are discussed below. Proportionate Liability The amount of information and involvement the auditors have in the say of the company's losses which audit failure has been judged to have played a part would be assessed and apportioned independently. The auditors would only be liable for the consequences of their own actions but not for the consequences of the actions of others. (Lambe, 2007) Contractual Limitation of Liability A point proposed by the UK government is to limit the liability by drafting contracts. This would permit auditors to agree liability limitation with individual clients and safeguard themselves by getting shareholder's approval for any liability limitation, by setting high thresholds for any agreed limits and disclosing of such contractual limits in the directors' report. This would give shareholders greater rights to question auditors at general meetings and much tougher penalties, including custodial sentences, for auditors found guilty of making 'reckless statements'. (Lambe, 2007) Liability Cap Statutory caps can be invoked on auditor liability. However a reasonable maximum amount of the cap would have to be set to claim and address ability to pay considerations. Such a system has the advantage of providing certainty and providing effectiveness against third parties not having a contractual relationship with the auditor. (Sukhraj, 2006) Limited Liability Partnerships LLPs are also being assessed by UK to protect the auditors. Incorporations and LLPs would provide some degree of protection for individual partners unconnected with loss claims relating to the audit of a particular client. However their draw back is it fails to address the issue of proportionate liability and does not cater to the risk of a 'catastrophic claim' to result in the failure of an individual audit firm. (Lambe, 2007) Changes in UK Regulations The rising concern for audit companies to share the fate similar to that of Arthur Anderson had started to cap the unlimited liability applicable to the auditors in cases of breach of conduct, negligence or fraud. Recently announced proposals by the UK Government aimed at reforming auditor liability have been welcomed cautiously by the auditing profession in that jurisdiction. Finally the acceptance of such unlimited hazards due to unlimited liability by the UK government has created the movement that unlimited liability is no longer sustainable (Lambe, 2007) The companies Act of 2006 received the royal accent after 10 years in deliberations. According to the Act, the auditors will be permitted to limit their liability for claims in negligence, breach of trust or breach of duty so long as the shareholders' have approved the limitation in advance. (Lambe, 2007); (Companies Act, 2006) Changes in Regulation in EU Like UK, the European Union is also under pressure to change its legal standing on the issue of limiting liability for auditors. Differences in the liability regime of the statutory auditor exist throughout the EU with some member states have a legal civil liability cap while others limit it with their contract. All EU Member States except Ireland allow auditors to adopt the structure of the limited liability company. This protects individual auditors from liability beyond their capital contribution to the company and allows partners (directors) with no involvement in a particular audit to protect themselves from civil liability. (Lambe, 2007); (Sukhraj, 2006) Conclusion With the public trend going towards a more litigious nature and with the courts awarding high penalties in damages, all professions including auditors are under intense pressure to scrutinise and recheck each financial statement of a company to avoid any liabilities. With the rising mal-practice insurance costs, auditors and accountants are leaving the field to join a less risky proposition. The scandal of Enron and Arthur Anderson's impedance of its obligations resulting it its dissolution have left auditing companies in the wake of any such events with themselves. Capping the unlimited liability may not be best alternative out there, since it is beneficial or the high end companies who can pay higher amounts while smaller companies cannot. However reforms like the Stanley-Oxley have benefited the middle tier companies for long. Proportionate liability looks a very feasible option that should be implemented all over to protect the auditing firms. Reforms taken in the Companies Act of 2006 in UK have resolved some of issues, however auditing industry needs to become more competitive for the betterment of auditing principles in the future. Works Cited 1. Beatson (1998). Anson's Law of Contract. 27th Edition. Oxford University Press, p.21 2. Cousins, J., Mitchell, A. and Sikka, P. Auditor Liability: The Other Side of the Debate. University of Essex, UK, Accessed on January 11, 2008 from www.essex.ac.uk/AFM/research/working_papers/WP98-01.pdf 3. Definitions Accessed on January 11, 2008 from www.wikipedia.com 4. Khoury, Lara (2001). The Liability of Auditors beyond Their Clients: A Comparative Study. McGill Law Journal. Vol. 46. Accessed on January 11, 2008 from www.lawjournal.mcgill.ca/abs/vol46/2khour.pdf 5. Lambe, Aidan (2007), Auditor Liability - Time for Reform. Volume 37. Number 5. Accessed on January 11, 2008 from http://www.accountancyireland.ie/dsp_articles.cfm/goto/1134/page/Auditor_Liability_-_Time_for_Reform.htm 6. Lawrence A.C (2006)., Too Big to Fail: Moral Hazard in Auditing and the Need to Restructure the Industry Before It Fails, Columbia University Law Review 7. Mitchell, A., Puxty, T., Sikka, P and Willmott, H., Discussion Paper No. 7, Accounting for Change: Proposals for Reform of Audit and Accounting, (London: Fabian Society, 1991). 8. Solicitors, Macroberts (2002). Duty of Care. JISC Legal. Accessed on January 11, 2008 from http://www.jisclegal.ac.uk/publications/Dutyofcare.htm 9. Sukhraj, Penny (2006). Auditor liability cap called for once again. Accountancy Age. Accessed on January 11, 2008 from http://www.accountancyage.com/accountancyage/news/2167427/auditor-liablity-cap-called 10. Wende, David (2002). Protecting the auditor from unlimited liability. Beyond Numbers. FindArticles.com. Accessed on January 11, 2008 from http://findarticles.com/p/articles/mi_qa3984/is_200210/ai_n9132887 Read More