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Home / ... / October 2005 / Auditor Liability - Time for Reform

Auditor liability has been an increasing concern for the auditing profession for a considerable number of years. It is now being recognised that excessively onerous liability regimes are unfair and unjust to auditors. Consequently, a number of jurisdictions in recent years have introduced measures aimed at reforming their auditor liability regimes.

Recently announced proposals by the UK Government aimed at reforming auditor liability have been welcomed cautiously by the auditing profession in that jurisdiction. Quite often, the 'devil is in the detail' with such proposals. However, what the move does demonstrate is the acceptance by the UK government that the current legal situation of 'joint and several liability', exposing the auditor, in effect, to unlimited liability is no longer tenable nor sustainable.

Perhaps it is time for the Irish authorities also to consider this issue.

THE ISSUE Auditor liability arises from the common law rules for civil liability (breach of contract, breach of statutory duty or tort) but claims are based on the failure of auditors to meet their statutory duties under the Companies Acts. The company which is audited may bring an action against the auditor and, in certain restricted conditions, third parties may also bring an action in tort.

Auditor liability cases tend to result from defective company accounts. In such cases those at fault may include: - those who have prepared the defective accounts; - if fraudulent actions have been involved, those responsible for the fraud; - company directors who have failed to put in place appropriate internal control mechanisms.

Joint & Several Liability The operation of 'joint and several liability' means that if a loss has occurred as a result of action or failure to act involving a group of people, and that loss would have been prevented if any member of that group had acted correctly, each is responsible for the whole loss. The flaw in this approach is that it takes no account of the degree of responsibility. So, for example, unintended oversight by an auditor could render it responsible for the whole of a loss which has resulted from intentional and concealed fraud by a company's directors.

In the Republic of Ireland, section 200 of the Companies Act, 1963 prohibits auditors and companies from taking any contractual steps to limit auditors' liability.

Partners in auditing firms are liable on a 'joint and several' basis for any claims arising from a successful action against the partnership. In effect this means that for audit firms, all partners, regardless of whether they had any involvement in the audit of a client, are liable to the extent of their personal assets for all of the losses arising, for example, from a negligence claim, including losses arising from the action, or inaction of others.

In practice, all auditing firms carry professional indemnity insurance cover which is normally subject to a cap. The existence of this cover coupled with unlimited liability has given rise in recent years to so called 'deep-pocket litigation' where auditors can often bear a disproportionate share of any damages awards (where others would not have the means to meet their share of damages).

It is, of course, legitimate that where auditors have been judged as negligent in their performance, they are financially liable. However, the risks of 'catastrophic loss' arising from huge claims are now posing a very real threat to the auditing profession.

CURRENT POSITION - POSSIBLE CONSEQUENCES - Reluctance on the part of auditing firms to undertake audit assignments for companies or entire industries which are perceived as 'high risk' or which are difficult to audit because they are new, are in innovative sectors, or are involved in complex transactions. - Ability of the auditing profession to attract and retain high quality people is increasingly giving cause for concern. - Competitive disadvantage suffered by audited companies as a result of being governed by national laws whose liability regimes are unfavourable to statutory auditors (ie costs of statutory audits in a highly litigious environment may be higher than elsewhere). - Insurance premiums (if insurance can be obtained at all) are likely to continue to increase with 'knock on' effects on the costs of audits. - Companies may be less disposed towards taking effective action against management failure. - Other parties in the corporate governance process, for example, institutional shareholders, may be less inclined to keep a sufficient watch of the companies they control.

In addition, there are a range of additional assurance services that auditors are keen to develop as part of the role they play in maintaining efficient capital markets, for example corporate governance issues, internal control issues, and corporate social responsibility. The threat of litigation is likely to dampen the development of such services in the market.

With the increasing move towards global harmonisation of accounting and auditing practices, differences in approaches to auditor liability within EU Members States are now receiving closer scrutiny.

Potential solutions include:

Proportionate liability Under such a regime, the responsibility of the auditor and the company for any losses in which audit failure has been judged to have played a part would be assessed and apportioned independently. Auditors remain liable for the consequences of their own actions but not for the consequences of the actions of others.

Contractual limitation of liability Limiting liability by contract is what has been proposed by the UK government. Draft clauses of the forthcoming Company Law Reform Bill will permit auditors to agree liability limitation with individual clients. Safeguards have also been included to provide protection for shareholders including: - shareholder approval for any liability limitation; - setting high thresholds for any agreed limits; - disclosure of such contractual limits in the directors' report. The quid pro quo for this reform includes giving shareholders of quoted companies greater rights to question auditors at general meetings and much tougher penalties, including custodial sentences, for auditors found guilty of making 'reckless statements'.

Liability cap Some regimes have statutory caps on auditor liability. For example, Germany and Austria have fixed statutory caps on liabilities arising from statutory audit work. Such a system has the advantage of providing certainty and providing effectiveness against third parties not having a contractual relationship with the auditor. Of course, any cap would need to establish a reasonable maximum of the amount of any claim and address ability to pay considerations.

Limited liability partnerships Incorporation and LLPs are both options that are available in the UK; while providing some degree of protection for individual partners unconnected with loss claims relating to the audit of a particular client, they fail to address the issue of proportionate liability nor indeed, the potential for a 'catastrophic claim' to result in the failure of an individual audit firm.

OTHER EU STATES Major differences in the liability regime of the statutory auditor exist throughout the EU. Some Member States have a legal civil liability cap; in others, auditors may limit their liability by contract. In such regimes, however, the caps would not apply in situations where there is wilful negligence or misconduct.

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. Keeping Ireland competitive is the mantra of our politicians, business leaders, and State enterprise agencies. Ensuring that Ireland's company law regime as it affects auditors compares favourably with regimes in other jurisdictions is as important as laws and regulations affecting the generality of businesses. If the current UK proposals relating to auditor liability are accepted by Parliament, we will have a situation on this island where audit firms in the Republic of Ireland will be faced with a significantly different model by which to conduct their business carrying much higher risks than their counterparts in Northern Ireland.

There has now been recognition and acceptance that the laws relating to auditor liability are in need of reform. For many years auditors in the Republic of Ireland and the UK have operated under common auditing standard and accounting standard frameworks. In a similar way, they have operated under a common audit regulation framework. Why, therefore, should there be any difference in the auditor liability regimes they have to cope with? It is time for Government and the soon to be established Irish Auditing & Accounting Supervisory Authority to pay serious attention to this issue.

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