Auditors' limitation of liability - are we really any further forward?

17/09/2009

By James Herbert, Partner and Head of Corporate & Commercial. Published in Accountancy Age.

Since 6 April 2008, auditors have been able to agree with a company whose accounts they are auditing a contractual limit on their liability to the company. Yet, almost eighteen months on, very few companies have actually entered into limitation of liability agreements (LLAs) with their auditors. In addition, it seems increasingly unlikely that the changes introduced under the Companies Act 2006 will be sufficient to deliver the wider public policy objectives of alleviating concerns relating to auditor concentration risk and enhancing competition within the UK audit market.

Legal background

The limitation must be fair and reasonable in the particular circumstances. A separate agreement is required for each year's audit and each agreement must be approved by the company's shareholders. In the case of a private company, its shareholders can agree to waive the requirement for approval.

The Act does not restrict the manner in which liability can be limited which means that, in principle, the contractual limits can be set in a number of different ways, for example:

• a limit based on the auditor's proportionate share of the responsibility for any loss;
• purely by reference to a "fair and reasonable" test; or
• a financial cap on liability, expressed either as a monetary amount or calculated on the basis of an agreed formula; or
• a combination of some or all of the above.

Putting LLAs on the agenda

Audit firms are finding it difficult to persuade their clients even to consider an LLA, not helped by the publicity surrounding the SEC's decision to prohibit UK companies registered with the SEC from entering into LLAs.

The difficulty arises in persuading directors of the benefits to their individual company in signing up to an LLA and that this is consistent with their statutory duties to promote the best interests of the company. This is despite the guidance issued by the FRC on LLAs which suggests a number of reasons why companies and their directors might conclude that it is appropriate for a company to enter into an LLA.

Smaller firms have more important issues to consider

The lack of LLAs is particularly acute amongst smaller firms. The reasons for this go beyond publicity issues and the reluctance of clients to contemplate LLAs, especially in a weak economic climate.

Amongst the smaller firms who carry out audit work, the increasing regulatory burden imposed on them (primarily in relation to quality assurance and continuing professional development) is a far bigger concern than the perceived risk of a claim arising from an audit. Increased regulation has also had an impact on the number of firms undertaking audit work with the number of registered audit firms in the UK falling by over 25% between 2003 and 2008.

The overall decrease can partly be explained by the increase in the audit threshold, resulting in a lower number of companies requiring an audit. However, for those firms who only do a few audits a year, the business case for them retaining their audit registrations is under increasing scrutiny.

Proportionality

The ISC and bodies such as the ABI and NAPF are supportive of LLAs providing for proportional liability or those providing for liability at a level which is fair and reasonable. However, they do not generally consider agreements which include an element of a fixed cap, however calculated, to be appropriate.

Significantly, limiting an auditor's liability on a proportionate basis provides no certainty in advance (either for the auditor or the company) as to what the auditor's liability will be if a claim arises. The extent of the auditor's liability will depend on the circumstances of the case and ultimately it will be left to the courts to decide the share of the loss for which it would be just and equitable to hold the auditor liable. Consequently, although the mid-tier firms are more supportive of LLAs based on proportionality as opposed to financial caps, the degree to which they can protect a Big Four firm from a catastrophic claim is questionable. The fear amongst smaller firms is that if financial caps were introduced, they may be at a level which they cannot match.

Where do we go from here?

Unless the contractual limits for LLAs are structured in such a way as to provide firms outside the Big Four with greater clarity and certainty as to their potential liability to companies in respect of audit work, LLAs in isolation are unlikely to be effective in boosting competition in the UK audit market. Whilst the "deep pockets" of the Big Four undoubtedly creates a significant barrier to entry for the mid-tier and smaller firms in trying to break into the audit market for listed and large private companies, the equally important issue is whether firms outside the Big Four have the requisite expertise to audit higher risk entities. This is questionable, particularly in relation to financial sector institutions.

If Government and legislators are to be successful in boosting competition in the audit market they will need to look again at the permissive (rather than obligatory) nature of LLAs. They will also need to consider how firms outside the Big Four can genuinely be expected to obtain the requisite experience to enable them to audit larger and high risk companies without carrying out joint audits alongside the Big Four. In the meantime, the fear of what would happen to investor confidence in financial corporate reporting if one of the Big Four were struck by a catastrophic claim remains and auditors, for the most part, remain in the unenviable position of being insurers of last resort. Until these issues are addressed it seems that smaller firms will be in no great hurry to push for the larger and higher risk audit work.

For further enquiries please contact James Herbert on 01892 510000 or email.