Auditors and auditing

Probably the most significant change in the Act in terms of auditing requirements is the possibility for companies and their auditors to agree terms on liability by contract.

The move is a first step in the Government’s ongoing attempt to tackle concerns about competition in the audit market.  A study undertaken in April 2006 commissioned by the Financial Reporting Council and the Department of Trade and Industry confirmed that 97 per cent of companies in the FTSE 350 companies, and all but one of the FTSE 100, are audited by one of the ‘Big Four’ audit firms – Deloitte & Touche, KPMG, PricewaterhouseCoopers and Ernst & Young.  That concentration of large company audits in hands of just four companies, said the study, presented a huge risk to the market.

The Act, at SS.532-538, allows companies and their auditors to enter into a limited liability agreement which limits the amount of a liability owed by the auditor to the company ‘in respect of any negligence, default, breach of duty or breach of trust, occurring in the course of the audit of the company’s accounts, of which the auditor may be guilty in relation to the company’.  The terms for that agreement are outlined at S.535, but there are no specific stipulations as to how is should be drafted.  If must, though, cover no more than one financial year and must be authorised by the members of the company.  The Act does, in fact, contain an additional clause allowing the Secretary of State at a subsequent date to make regulations specifying, or prohibiting, certain provisions in agreements of this sort.

For private companies, the agreement may be approved in full or in ‘principle terms’ by ordinary resolution in general meeting.

The agreement may not limit the auditor’s liability to anything less than ‘such amount as it fair and reasonable in all the circumstances of the case’.  Significantly, in determining what is fair and reasonable, the parties concerned will be required to disregard any matters occurring after the loss or damage has been incurred or which affect the possibility or recovering compensation from others also liable.  In theory, then, auditors should not find themselves compelled retrospectively to contribute more than a proportionate share of the damage suffered.

Institutional investors will doubtless have a view on the terms of agreements of this sort, so it may be a good idea for companies to involve them while the discussions with the auditor are going on.

Among the passages on auditors’ rights and duties, meanwhile, is a provision which has caused a great deal of concern.  Section 507 makes it an offence for an auditor to include ‘knowingly or recklessly’ in his report ‘any matter that is misleading, false or deceptive’.  This includes guilt by omission, in the sense of failing to include a statement about inconsistencies between the accounts and accounting records and returns, that certain necessary information was not obtained or that directors wrongly took advantage of an exemption from their obligation to prepare group accounts.

The phrase ‘knowingly or recklessly’ has led to a great deal of speculation as to how far the courts may go in convicting an auditor of acting recklessly in circumstances where he believes he has acted honestly and in good faith.  There is a concern, too, that the provision could lead to a drop-off in the quality of corporate reporting, with auditors adopting a more defensive, risk-averse approach to their work, relying less on their professional judgment and more on a strict interpretation of the law – and, as a result, higher fees for their clients.

The Government has said that this new offence would only catch an auditor who was ‘aware that an action or failure to act carried risks, that they personally know that the risks were not reasonable ones to take, and that, despite knowing that, they went ahead’.  It is to be hoped, though, that more guidance will be issued in due course.

In another change, finally, the Act introduces a new regime for auditors’ resignation statements.  Auditors for unquoted companies are now required to make a statement of circumstances surrounding their ceasing to hold office (S.519), unless they consider there are no circumstances surrounding that resignation which should be brought to the notice of the company’s members or creditors.  The requirement to make a statement must be given no less than 14 days before the end of the time allowed for appointing an auditor if no looking for re-appointment, or no later than 14 days from the date on which they cease to hold office.

Auditors of listed companies and public interest entities must also notify the audit authorities whenever they cease to hold office.

William Booth, Editor, Chartered Secretary magazine

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