EU Commission on Auditor Liabilities

Auditors are increasingly finding that they are being targeted by those who feel that they have been wronged by the quality of the financial accounts. Auditors are required to consider the financial accounts that are prepared by the company and to establish whether they believe that they give a true and fair representation of the underlying financial position. By ‘true’ they are looking for whether the transaction actually occurred and by ‘fair’ they are looking to ascertain whether the value of the transaction has been accurately recorded.

In the UK, there is a rule that liability for misstatement is joint and several between wrongdoers. This often results in auditors taking a much greater portion of the liability than would seem just. Auditors are often seen to have deep pockets due to their insurance policies and, as such, make more promising targets for those who believe that they have lost out financially due to the inaccuracy of the accounts^[1].

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Background to the EU Consultation on Auditor Liability

There have been widespread concerns over this practice, with many countries operating a more proportional approach where the extent of the blame dictates the extent of the liability. The European Union has shown particular concern over the potential reduction in competition that this lack of capped liability leads to. With the limit level of professional insurance policies playing a huge role in the company’s decision as to which auditor to appoint, this is thought to favour the larger auditors and exclude the smaller players from some of the larger lucrative contracts. It is also thought that this requirement presents such a great barrier to entry for auditor firms that there is a real danger that the audit market is not operating competitively.

The EU consultation undertook a study based on four possible options that were available to produce a cap for auditor liability. Firstly, they considered a monetary cap on a Europe wide basis. Secondly, they considered a monetary cap based on the size of the auditor firm. Thirdly, there was an option to produce a monetary cap based on a multiple of the audit fee and finally, they considered the option of member states entering into a policy of proportionate liability, which would require the courts to split the liability based on the level of responsibility for the breach and on a proportional basis. This could either be achieved through statutory provisions or through the contractual provision between the company and the auditor.

Upon consultation, the commissioners found that there was overwhelming support for the concept of having a cap on auditor liability, both from inside and outside the auditing profession. The Commission noted that the issue of auditor liability was not a new one, with consideration having been given, in 2001, to whether the extent of the differences between the countries in relation to auditor liability would prevent a single market across Europe. Although, at this stage, the substantial differences across jurisdictions were recognised, they were not thought to be so large that anything had to be done to rectify the position. However, since 2002, the large scale collapse of Arthur Andersen has occurred, bringing the issue of potential liability caps back into the forefront.

The Commission initially identified the potential problems that the current auditing regime causes in terms of market stability and competition within the auditing function. Considerable attention was paid to the issue of public interest and the need to have a stable auditing function which can be relied upon to be accurate. For an auditing function to be efficient, the company must be able to select an appropriate auditor for its business needs but still allow it to maintain the independence of the function so that the stakeholders can rely on the statements. It is accepted that auditors will not always be 100% accurate; however, they should be able to be relied upon as this is critical to the overall efficiency of the European capital markets.

Concentration of the Audit Market

The central importance of the auditing profession is not disputed, with investors relying on the financial statements in order to make investment decisions. However, the magnitude of the risk that auditors are exposed to is becoming increasingly worrying both for the auditors and for the general competitive landscape. Due to the nature of internationally listed companies, there are only four companies that are capable of providing the necessary auditing services. These are refereed to as the ‘Big Four’: Deloitte, KPMG, Price Waterhouse Coopers and Ernst & Young. It is not necessarily the expertise that prevents others entering the market, but rather the high level of professional indemnity that is required which is simply not cost effective for smaller firms entering the market. It is recognised that there is little or no chance of a new entrant into the market, yet there is a danger that any one of the four could be forced out of the market, at any point, thus further reducing the competition in large scale auditing. In reality, international auditing firms are not actually one large firm but are a network of smaller firms that recognise they are not able to manage the level of risk that is required for international auditing. With strict rules relating to auditing firms, it is unlikely that another network will emerge, making the international audit market particularly fragile^[2].

Auditors often become the target in cases of insolvency as they are the ones with the resources available to deal with any financial losses due to misstatement. It is this potential redress that offers investors a degree of confidence in the market and, therefore, it is seen as desirable that auditors are held to be liable in situations where they get it wrong. However, it is recognised that the current joint and several approach is simply inefficient and consideration should be given to alternatives.

For the auditing profession to be truly efficient, it is necessary for there to be a substantial degree of choice. This is not currently the case and effort should be made to ensure that the auditing options are widened so as to become accessible to other medium sized firms. One of the recognised ways of doing this is to have a liability cap or a proportionate regime so that the deep pocket syndrome does not restrict the choice of auditor to the hands of the big four^[3].

Extent of Risk for an Auditor

The major barriers for mid sized auditor firms are recognised as being the lack of available indemnity insurance and the large amount of potential risk that is involved when auditing large international firms. Clearly, an auditor has a duty towards the company itself, based on either contract or tort when it has behaved negligently or with wilful misconduct. The vast majority of cases are related to negligence and it is this area of liability that has generated the most interest from the European Commission^[4].

Liability is clearly owed to the client itself; however, this has also extended to be liability towards third parties, causing further barriers to entry for mid sized auditing firms. For a third party to bring a claim, it is necessary for there to be a causation link between the act of negligence and the damages suffered by the third party which, although difficult to prove, has resulted in some high profile payouts further jeopardising the chances of mid tier firms entering the international auditing market^[5].

At the heart of this widespread liability is the concept of joint and several liability. Under this process, a third party who has a claim against a director can also bring a claim against an auditor who has given an unqualified opinion as to the accuracy of the accounts. In a case of corporate insolvency, the directors rarely have any finances available to pay out third party losses, therefore, encouraging actions against the auditors who are seen to have ample financial backing. It is this high level of risk that the cap on liability is aiming to address.

Oppositions to an Auditors’ Liability Cap

Despite the overall acceptance of the need to do something to alter the balance of power within the international auditing market, one of the main objections was that placing a limit on liability would give the auditing profession a privileged position in comparison to other professions. A main aim of establishing a cap was to encourage mid sized firms to enter into the market and it is feared that a liability simply would not achieve this aim. Much of the exposure faced is outside of the EU (i.e. in the US)^[6] and, therefore, the cap would make little or no difference. Equally, the insurance requirements would remain high. A cap would not make the insurance requirement less; it would simply make it more ascertainable. There are also concerns that the cap would encourage poor performances and weaker audits. From a competitive point of view, those in opposition to the cap were concerned that such a move would reduce the competitive position of European companies in comparison to other international jurisdictions where no such cap exists.

Concerns were also raised that a cap on auditors’ liability would be contrary to the overall proposition of better regulation that the EU has been working towards, in recent years^[7].

Alternative Options

As it is accepted that the main reason for imposing such a cap would be to open up the international auditing market to other mid sized auditing firms; alternatives to a cap on liability were also considered by the EU because of the potentially negative competitive impact of such caps.

One of the possible options is to impose a compulsory insurance on audit firms. There is currently an insurance gap where the amount that an insurer is prepared to insure an auditor for is substantially less than the potential liability. Forcing the auditor to take out insurance to cover all losses would not be practicable due to the high level of potential risk. Therefore, the premiums would be prohibitively expensive, particularly for the smaller firms. Alternatives to funding this additional insurance would have to come from investors or the companies themselves.

Another approach would be to reduce the potential risk faced by auditors by introducing safe harbours. This would involve carving out certain areas from the potential liability of the auditor such as any external reviewers’ comments on the company or any future plans which have happened after the end of the financial accounting year. However, in doing this, there are fears that the underlying principle of professional judgment would be eroded in favour of formalised approaches to ensuring that as much of the safe harbour carve out could be enjoyed.

EU Recommendations

On considering all of these factors and a widespread discussion of the pros and cons of the possibility of a cap on auditors’ liability, the EU commission has established a proposal that aims to achieve the middle ground^[8].

When considering the four options as stated above (cap for all European audits, cap based on size of audit firm, cap based on the fee and a proportionate regime), the EU Commission concluded that a combination of a proportionate liability and an auditors’ cap on liability would make the foundations of their recommendations. The report advised member states to require a limitation to auditors’ liability to be established either through a statutory cap, a limitation based on proportionality or limitation of liability through the contract between the audit company and the auditor.

Proportional liability gained considerable support from the non-auditing respondents to the proposals as it was felt that this would deal with the issue of reliance on auditors’ deep pockets, but would also ensure that the quality of the audit would be maintained. The commission recommended that any member state implementing this approach should not set a specific proportion and should simply set the principle in place to be applied through the judicial processes, where necessary.

Unsurprisingly, the auditing profession preferred the concept of a cap on liability, arguing that it would have no long term impact on the quality of the audit and would allow mid sized firms to enter the market. This was not entirely followed by the EU Commission who preferred to suggest a principle of proportionate liability.

Based on all arguments, the EU Commission has advised a regime of proportionate liability across all member states.

Conclusions

The issue of auditors’ liability and how risk is apportioned has been raising concerns on an international level and has, therefore, become the subject of an EU Commission report. Currently, the international auditing market is heavily dominated by the big four accounting firms and several barriers of entry exist to prevent mid sized firms entering the market. Many of the barriers result directly from the fact that auditors are jointly and severally liable for misstatements in the financial accounts. Therefore, due to their deep pockets, auditors are often the main target for those taking actions against struggling companies^[9].

Based on this position, the EU Commission looked into the option of establishing a cap on liability (either statutorily or through contractual provisions). After careful consideration of all of the options, it was felt that a principle of proportionality would be the best approach, given all of the issues raised. It was concluded that proportionality would reduce the deep pockets issue, yet would still ensure that the level of quality of auditing work is maintained. This level of proportionality should not be cast in stone and should be established on a case by case basis. It is anticipated that this will provide sufficient security for the smaller auditors to compete on a level playing field with the domain that has traditionally been that of the big four firms.

Bibliography

Allen, Robert D., Hermanson, Dana R., Kozloski, Thomas M., Ramsay, Robert J., Auditor Risk Assessment: Insights from the Academic Literature, Accounting Horizons, 20, 2006

Clarke, Frank L., Dean, G.W., Oliver, Kyle Gaius, Corporate Collapse: Accounting, Regulatory and Ethical Failure, Cambridge University Press, 2003

Garner, Don E., McKee, David L., McKee, Yosra AbuAmara, Accounting and the Global Economy After Sarbanes-Oxley, M.E. Sharpe, 2008

Hay, David, Davis, David, The Voluntary Choice of an Auditor of Any Level of Quality, Auditing: A Journal of Practice & Theory, 23, 2004

Hillison, William, Pacini, Carl, Auditor Reputation and the Insurance Hypothesis: The Information Content of Disclosures of Financial Distress of a Major Accounting Firm, Journal of Managerial Issues, 16, 2004

Pacini, Carl, Hillison, William, Sinason, David, Auditor liability to third parties: an international focus, Managerial Auditing Journal, 15, 8, 2000

Pong, C.K.M., Burnett, S., The implications of merger for market share, audit pricing and non-audit fee income: The case of PricewaterhouseCoopers, Managerial Auditing Journal, 21, 1, 2006

Smith, Roy C., Walter, Ingo, Governing the Modern Corporation: Capital Markets, Corporate Control, and Economic Performance, Oxford University Press US, 2006

Soltani, Bahram, Auditing: An International Approach, Pearson Education, 2007

Footnotes

^[1] Pong, C.K.M., Burnett, S., The implications of merger for market share, audit pricing and non-audit fee income: The case of PricewaterhouseCoopers. Managerial Auditing Journal, 21, 1, 2006

^[2] Clarke, Frank L., Dean, G. W., Oliver, Kyle Gaius, Corporate Collapse: Accounting, Regulatory and Ethical Failure, Cambridge University Press, 2003

^[3] Soltani, Bahram Auditing, An International Approach, Pearson Education, 2007

^[4] Hillison, William, Pacini, Carl, Auditor Reputation and the Insurance Hypothesis: The Information Content of Disclosures of Financial Distress of a Major Accounting Firm, Journal of Managerial Issues, 16, 2004

^[5] Pacini, Carl, Hillison, William, Sinason, David, Auditor liability to third parties: an international focus, Managerial Auditing Journal, 15, 8, 2000

^[6] Garner, Don E., McKee, David L., McKee, Yosra AbuAmara, Accounting and the Global Economy After Sarbanes-Oxley, M.E. Sharpe, 2008

^[7] Hay, David, Davis, David, The Voluntary Choice of an Auditor of Any Level of Quality, Auditing: A Journal of Practice & Theory, 23, 2004

^[8] Smith, Roy C., Walter, Ingo, Governing the Modern Corporation: Capital Markets, Corporate Control, and Economic Performance, Oxford University Press US, 2006

^[9] Allen, Robert D., Hermanson, Thomas, Dana R., Kozloski, M., Ramsay, Robert J., Auditor Risk Assessment: Insights from the Academic Literature, Accounting Horizons, 20, 2006