14 Oct 2019 04:43pm

Called to account: developments in auditors’ liability

According to the Financial Reporting Council (FRC), 25% of FTSE 350 audits do not meet its quality standards

Tech companies
Caption: The real test will be whether auditors are prepared to put their institutional relationships at risk

Carillion is a cautionary tale about the dangers of substandard audits: Carillion went into liquidation in 2018 with liabilities of nearly £7bn, over 2000 job losses, and a pension liability of about £2.6bn. Thomas Cook, Patisserie Valerie, Ted Baker, BHS and Quindell are other recent high-profile audit failures.

Other than increasingly large fines, what are the consequences when auditors get it wrong? From a litigation perspective, while auditors may be liable in criminal or contract law, recent cases have focused on tortious claims for negligence.

In AssetCo Plc v Grant Thornton UK LLP, for example, the High Court stated for the first time that auditors can be liable for a company’s trading losses caused by a negligent audit. Importantly, the Court rejected the submission that the audit failures were consequent on false representations made by the company as to the availability of certain information. However, the quantum of damages available to companies will be reduced by their contributory fault and any intervening acts (such as a decision to declare dividends). The case is likely to be appealed, though it should be noted that it echoes the CMA’s concerns that audit failures most frequently relate to a failure to challenge management and failure to obtain sufficient appropriate audit evidence.

Further substantial claims are in the pipeline, including a likely claim against KPMG in respect of its audit of Carillion.

Separately, anecdotal evidence suggests a growing concern amongst stakeholders that some auditors, faced with increasing regulatory and stakeholder scrutiny, may be delaying or withholding approval of financial statements not only for the legitimate purpose of seeking more information and better answers from management, but as part of their own risk-management strategy, intended perhaps to direct attention away from possible audit failures in prior years and more firmly towards management, or simply to disassociate themselves as far as they can from impending disaster.

Certainly the recent debacle at Sports Direct, when the company’s audited accounts were delayed multiple times, would not appear to fall within this category, with the auditors apparently having been told by management only at the very last minute of a huge potential tax liability, but stories are doing the rounds in the restructuring community, in particular, of what appears to be abnormally obstructive behaviour from auditors in delaying signing off accounts. If this conduct in itself were to lead to losses, for example by triggering a withdrawal of credit by suppliers, and were to be found to be unjustified, could it lead to further claims against auditors?

One thing is clear - despite its importance, stakeholders are rarely in a position to assess the quality of audits until it’s too late: audit failures typically become known only through insolvency or other indicia of financial problems (e.g. Thomas Cook’s three profit warnings in less than a year). An audit is neither the cause of nor antidote to corporate failure. However, auditors pronounce on the accuracy of a company’s financial performance and management’s assessment of its short-term future as a going concern; therefore, financial statements drafted as part of an external audit form a basis for investment decisions and shareholder scrutiny of management. To police the quality of the external audit, stakeholders are reliant on audit committees and regulators.

In that regard, the regulatory environment is set to change. Concerns about the audit industry has led to three separate government-commissioned enquiries: (i) Sir John Kingman’s review of the FRC; (ii) the CMA’s study in relation to audit quality, conflicts, choice and concentration of auditors; and (iii) Sir Donald Brydon’s review into the quality and effectiveness of audit, which is due by the end of 2019.The Government is expected to introduce legislation following its consultations on the responses to these reviews. The proposals include the introduction of mandatory joint audits and the replacement of the FRC with a new regulator (the Audit, Reporting and Governance Authority) with increased powers, including to hold audit committees to account. Importantly, they would also require auditors to show that they have ‘robustly’ challenged any going concern assessment from management and to explain how they came to their conclusions; something they are not currently required to do. The implementing legislation will also clarify the powers of the new regulator and associated litigation risk, such as joint and several liability in the case of mandatory joint audits.

A more rigorous examination by auditors of management’s conduct and assessments should flag up major concerns sooner and is to be welcomed by investors and others. The real test though will be whether auditors are prepared to dig in and put their institutional relationships at risk before the writing is already on the wall for the company and its shareholders, rather than violently slamming the stable door shut as the horse gallops off into the sunset.

Jason Yardley is a partner and Tobi Olasunkanmi an associate in Jenner & Block¹s Complex Commercial Litigation and International Arbitration practices.