PracticeAccounting FirmsCan you still bank on an audit?

Can you still bank on an audit?

Running a business is all about building value and managing risk. It is the second aspect that caused my firm to take decisive action last week to change the wording of our audit reports.

The bare facts – albeit obscured by a blizzard of comment and interpretation – have been well rehearsed in the press. We announced that, with immediate effect, every audit report issued by PricewaterhouseCoopers on a UK client company will include additional language clarifying those parties to whom we owe a duty of care as auditors (the members of the company) and those to whom we do not (anyone else).

This additional language does not change our liability one iota from what everyone had understood it to be since the Caparo case in 1991.

So why did we do it? Because a recent ruling in a Scottish court meant we had to act – or leave our business open to unacceptable risks.

The ruling in question (Royal Bank of Scotland v Bannerman Johnstone Maclay) created a legal precedent with potentially explosive implications, because although not binding on an English court, it drew from leading English cases and so would be likely to have persuasive effect here.

The court found that the auditors were liable for losses incurred by a bank that claimed to have based its lending decision on the audited accounts of a company that subsequently failed. It thereby raised the prospect of banks using accounting firms to underwrite their own bad lending decisions.

There were specific factors in this case which enabled the judge to infer a duty of care between the audit firm and the bank, even though there had been no contact between them. This result is both unfair and dangerous.

Unfair because as auditors, we have a contract with our clients and their shareholders, but not with their suppliers or customers – including their banking providers. Several years ago, the Caparo judgement had established the accepted boundaries of auditors’ duty of care as being to the company and not to third parties.

The Bannerman judgement is dangerous because the audit profession would now face a potentially massive extension of its liability beyond what is commercially realistic.

If one purpose of the audit really were to be to underwrite banks’ lending to the corporate sector, the audit fee would be a hopelessly inadequate insurance premium.

The viability of the remaining large accountancy firms could be in question and this would be against the public interest.

To have taken this lying down would have been nothing short of negligent.

The judge in the Bannerman case had said the auditors could have protected themselves by writing to the banks specifically declaiming liability.

Our new wording does not change our responsibility for our audits. It is merely a clarification of our accepted and established duty of care to the shareholders. We have just as much liability to our clients as before. All we have done is prevent it from being unreasonably extended to others.

Some commentators have suggested that by delineating our liabilities more clearly, we have somehow devalued the audit itself.

Nothing could be further from the truth. As before, all auditors – ourselves included – are still liable to their clients if they are negligent in performing their work and losses arise as a consequence.

As for the importance of the audit, the violent market reaction to events at Enron and WorldCom demonstrated the critical role that independent, rigorous and credible auditing plays in sustaining confidence in the capital markets.

The value of good audits to the market as a whole is therefore clear, regardless of the precise nature of our legal liability.

  • Glyn Barker is head of assurance and business advisory services at PwC.

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