Keeping it all in proportion

Sarah Perrin discusses the implications of the Company Law Reform Bill

The Company Law Reform Bill, if introduced as drafted, will create a new era of proportionate liability for audit firms, as well as introducing a new criminal offence for individual auditors. How big an impact might these changes have?

Under the Bill, auditors can agree “fair and reasonable” limits on their liability to companies for audits, subject to annual shareholder approval. They can do this by reference to a fixed amount (a cap), or by whatever other criteria they think appropriate. However, the expectation is that most companies (certainly listed ones) will shy away from agreeing a cap, making a general proportionate agreement the typical outcome.

The inclusion of proportionate liability has, unsurprisingly, delighted the audit profession. “It’s definitely good news,” says Peter Wyman, head of professional affairs at PricewaterhouseCoopers, a long-time liability reform campaigner. “The Government has been good to its word.”

ACCA supports the principal of proportionate liability on the grounds that it is unfair for auditors to be pursued for 100% of any loss when they may only be partly responsible. “To have some formal upfront acknowledgement that there may be more than one party at fault, that’s fair,” says John Davies, ACCA’s head of business law. “It acknowledges that directors have their own responsibilities.” However, ACCA is not happy about auditors having the potential to agree a fixed cap. “Setting a cap at the outset would not be consistent with the concept of proportionate liability, which is supposed to be the ultimate driver behind this reform,” Davies says. “We made that point [to the Government] before the Bill was published, and have made it again since.”

Although investor bodies have expressed concerns about liability reform in the past, there now seems to be acceptance of change. “We support moves towards proportionate liability, though there is still more work to do on improving the quality and choice of audit,” comments Peter Montagnon, director of investment affairs at the Association of British Insurers. In recognition of such concerns, the Audit Quality Forum was set up to bring together representatives of the audit profession and accounts users, the idea being to try to improve understanding of the audit process and discuss related issues. Its current work programme includes research into fundamental issues, such as what people really want from the company audit.

Approval

Despite some reservations, the business community also seems reconciled to the introduction of proportionate liability. “We are prepared to accept it, rather than being totally happy with it,” says Patricia Peter, head of corporate governance at the Institute of Directors. “It will be interesting to see how it works in practice. There has to be shareholder approval.”

Peter wonders whether the profession were perhaps overselling their case with the argument that another Big Four firm might go bust without liability reform. However, she accepts there may have been a risk of firms not wanting to take on some audits. “It [proportionate liability] might act as pro-competitive because people feel they can expand,” she says. “I would hope it would open up the market.”

One of the less pleasing aspects of the Bill for the audit profession is its introduction of a new criminal offence for auditors of knowingly or recklessly causing an auditor’s report to include any matter that is misleading, false or deceptive in a material way. The offence applies to individuals (not firms) and conviction could result in a significant fine. Earlier draft clauses made a prison sentence possible, but that threat at least has been removed.

As Lovells, the solicitors, point out, the concept of recklessness potentially causes difficulty when applied in the context of an audit, which always involves an element of risk. If the same definition of recklessness is applied by the courts to this offence as to others, this would be a worryingly low threshold and could amount to a judgement on whether the auditor acted “reasonably”. “The concern is that an honest mistake could attract a criminal penalty,” says John Trotter, partner and head of Lovells’ professional negligence team. “People will have to be very careful in giving an opinion and checking very carefully all the data they had.”

Nevertheless, Davies believes that only a small minority of auditors might be affected - “a very small minority who are determined, for some reason, to sign off wildly misleading audit reports”. However, he expects it will serve to concentrate auditors’ minds, and could also raise their status in the world. “To give a consciously misleading audit report is seen as so important for society that only a criminal sanction is appropriate,” Davies adds. “That could serve to benefit the whole audit profession by highlighting just how important audit is.”

Volunteering information

Davies also points out that other recent reforms have strengthened the information-gathering powers that auditors have. “Directors have to state on the balance sheet that they have volunteered to the auditor all the information which they think is relevant to the audit,” he says. “This reduces the chance of auditors having the wool pulled over his or her eyes.” Auditors can also request information from employees, as well as directors, and from subsidiaries. “All these changes will increase the flow of useful information to auditors,” Davies says. “If the auditor has all the information he or she should need to carry out a thorough, professional audit, then really it’s up to him or her to complete the job.” If auditors do complete thorough, professional audits, then they shouldn’t be at great risk of facing a criminal charge.

It should not be forgotten that changes could be made to the Bill as it progresses through Parliament. For example, the original Bill would have created a statutory responsibility for listed companies to prepare an Operating and Financial Review. However, in his speech to the Confederation of British Industry conference at the end of November, just four weeks after the Bill was published, Chancellor Gordon Brown announced that this OFR obligation would be abolished. The accounting and auditing profession will therefore need to keep a close eye on the Bill’s progress; the clauses in the Bill now may not be the same as those enacted.

Sarah Perrin is an accountant and writer.