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Company law reform: auditor liability

Alex Tawanda Magaisa

THE next key issue in this series on the reform of company law to improve corporate governance lies in the area of the liability of auditors. The issue of auditor liability is hotly cont

ested across the world. This largely reflects the role that auditors play in the operations and regulation of companies across the world and the way in which some major auditing firms have been implicated in corporate disasters.

As in many countries that have an English-based company law, Zimbabwean company law requires companies to have a statutory audit each year. The primary responsibility of auditors is to check whether a company’s accounts show a true and fair view of the state of its affairs. The audit report is useful to shareholders, regulators and other stakeholders with an interest in the company. It is therefore important to ensure that the audit process is conducted in a proper way.

A key concern in many markets relates to the quality and effectiveness of the audit. Once this becomes questionable, it is very difficult to generate confidence among stakeholders. There are a number of key elements that can be put in place to maintain the quality of audits. These include enhancing the independence of the auditors from the companies that they audit as well as increasing competition in the audit market.

A key area of concern is that audit firms may also be involved in providing other non-audit work such as consultancy services to the companies that they audit. Where the relationships are so close, it may be difficult for the auditor to bite the hand that brings the food thereby compromising their independence. Competition in the audit market is vital because it provides a wider source from which companies can choose.

Where a few large companies hold a dominant position, it may result in a situation where the same group of firms is guaranteed work in particular companies. The close relationships that develop may perpetuate complacency and lack of innovation with the result that independence may also be compromised.

On the other hand, auditors are understandably concerned by the position of vulnerability to which they are exposed particularly when a company collapses. The concern is that when a company fails, auditors are often the easy targets on whom blame is imputed. They stand to shoulder huge amounts of liability whereas on closer analysis, such potential liability does not necessarily mirror their responsibility for the collapse of the company.

This is contrary to the fact that the people that are primarily responsible are those who are in charge of the company’s operations.

During the peak of the banking crisis in Zimbabwe, a number of writers and commentators appeared to place the bulk of responsibility on auditors. It may be that in those periods of distress members of the public also developed similar impressions against auditors. Quite understandably, auditors were not amused and issued rebuttals from time to time. Indeed, in some newspaper reports painted auditors as the principal culprits in the whole chaos. Of course, it is possible that there are key weaknesses in the audit market and the allegations may have some substance but so far nothing has been proven in a court of law.

That is not to say that everyone concerned should rest on his or her laurels. Instead, this should be an opportunity to take a closer look at the legal arrangements for the conduct of statutory audits. It is arguable that the legal provisions are archaic and insufficient for purposes of dealing with issues arising in the modern business environment.

A key point of interest that has been considered in the UK is whether there should be a cap on the extent of auditor’s liability for damage caused to the company as a result of the conduct of an audit. I shall share what the law reform efforts in the UK have yielded so far.

The principal proposal in relation to auditor liability is to introduce a rule based on the principle of proportionate liability between the company and the auditor. Shareholders will be allowed to agree to limit the liability of the auditor to an amount determined by the court to be just and equitable taking into account the extent of the auditor’s responsibility for the damage caused to the company.

The agreement will apply where the damage to the company is the result of the misconduct of an audit. There will be no agreement in advance to place a monetary limit on the auditor’s liability. The law will require the shareholders’ agreement on limitation each year before the conduct of each audit. There is also a further requirement to show the existing limitation agreement in the company’s annual financial statements. In addition, the auditor will be required to show in its own annual financial statements a list of all companies with which it has made agreements of limitation of liability. It will be a criminal offence to knowingly and recklessly give an incorrect audit opinion.

It seems that the aim of these reforms is to counter-balance the interests of the different stakeholders. Auditors have not got the cap on liability that they were seeking but simultaneously, they have been able to secure a measure of protection. Since they do have some bargaining power, it is likely that they will secure the agreements.

But ultimately, much will depend on the courts of law to determine what is “just and equitable” when considering the proportionate liability between the auditor and the company. It seems apparent however, that proving the criminal liability may be very difficult given that the state must prove that the auditor gave the incorrect opinion not only “knowingly” but also “recklessly”. While proving recklessness may not be that hard, it is certainly difficult to prove that the auditor would have “knowingly” given an incorrect opinion.

The Department of Trade and Industry in the UK is also consulting the public about the issue of non-audit services offered by audit firms to their clients. If the draft regulations are implemented, companies and their associates will be required to disclose information regarding the types of services that they have been given by their auditor and the auditor’s associates. The aim is to enhance the independence of auditors from their clients and to increase levels of transparency to prevent collusion, which has led to catastrophic consequences in the recent past. There is great concern because fees for non-audit work may exceed audit fees which means that the statutory audit becomes a peripheral issue in the bigger scheme of things.

Furthermore, there have been four specific proposals from auditors, clients and investors for improvements to audit quality and value by enhancing transparency and shareholder involvement in the audit process. These proposals are also under consideration in the law reform process. The four proposals are as follows:

*Publication of audit engagement letters — this will show content of the engagement letters to increase transparency and enable shareholders to know and understand the scope of the audit and terms of engagement;

*Shareholders’ rights to question auditors — the idea is that shareholders should be able to question auditors about the audit in advance of the annual general meeting or by writing to the auditor, via the company with reasonable questions and all queries must be connected to the auditors’ report or to the conduct of the audit;

*Publication of auditor resignation statements — this is to enable investors to be fully informed of and understand the reasons behind the resignation of an auditor. Currently the fear of legal action prevents full disclosure of reasons behind an auditor’s resignation. Shareholders may, through such resignations get more information about directors and the company’s operations than they would otherwise have; and

*Audit lead partner’s signature on audit reports — the proposal is that the lead audit partner should be required to sign and print his or her own name on the audit report in addition to the name of the audit firm undertaking the audit.

*Dr Alex T Magaisa specialises in corporate and financial services law and can be contacted at alex.magaisa@nottingham.ac.uk or wamagaisa@yahoo.co.uk

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