LIMITS TO EXTERNAL AUDITORS' LIABILITIES

Mr. Michael Rake, the international Chairman of KPMG, is a distinguished  personality in the global audit and accounting fraternity, who had spent many years in Dubai in the 1980s. In all my dealings with him, I have always found him to be incisive and able to give timely advice to his audit customers. It is refreshing to hear his views on accounting matters and he articulates them ably and well. His recent comments to the Financial Times illustrates that he does not shy away from taking issues head-on and ahead of time; so as to shape policies and regulatory actions and reforms.  Recently, he held forth on the Sarbanes Oxley Act in the U.S. and the fallout from the recent corporate scandals. He dwelt on the new measures contemplated by the authorities in the U.K. and in the U.S. with regard to defining auditors' liabilities; in the event that they are found culpable in corporate malfeasance. I have always followed these developments and his comments in this domain with abiding interest; just as the various fora that Mr. Abbas Mirza and his Institute's Chapter arrange in Dubai with such finesse, even if at the eleventh hour(s)!

The matter of limiting auditors' liabilities, no doubt, is caused by the scale of recent corporate misdeeds and the outcome of investigations therein.  Statutory / external auditors tend to complete their assignments over a few weeks, but the shareholders expect them to be watch-dogs that will ferret out forensically and follow through all the accounting evidence / financial records, that are even mildly indicative of violations of accounting standards or good financial control or suspicious transactions. All these expectations presuppose that the complex web of deceit that corporate chieftains weave, can be noticed, identified and unravelled in the course of a fairly short duration and routine audit review of transactions and accounting records that take place during annual audit cycles. This is wholly unreasonable and unfair to expect, given the resources and the rewards that are committed to this assignment.  Often, fairly junior auditors trudge through a massive volume of transactional data and can easily miss the wood for trees!  Senior audit managers or partners, in any case, rely on the routine checking and verification by the junior men at work. 

Fraud detection or tracking serious breaches of fiduciary and financial conduct ought not to be the accountability of the external auditors. In any event, auditors also rely on representations by the management of the corporations. Therefore, it would be excessive to expect them to be policemen and detectives.  Indeed, the Boards of Directors (BoDs) and / or major shareholders have the responsibility of ensuring that the operating management possess integrity, quality and credentials. The framework of checks and balances within the organization should be robust enough to bring to their attention any weaknesses and gaps in a proactive manner, as well as deviations (minor and major) as they happen. To foist this accountability solely on to auditors, would amount to a dilution of such responsibilities.  They also liaise with internal and regulatory auditors and can review their reports as well. Auditors do report to shareholders, but nevertheless need to work with the management of companies and present to their BoDs, their key findings and conclusions, by way of management letters and other communication.  But the issue here is really as to where one should pin financial liability; should things go sour.

A reasonable view is that as a professional service provider, the auditor is expected to diligently discover all breaches of duty and care and report them faithfully and in a timely manner. Depending on the severity of what is found to be in disorder, they can escalate such reporting to the senior management or the BoDs and / or shareholders / regulators / public / governmental authorities; as appropriate.

However, if  the statutory auditors are found to have connived with the management and / or overlooked explicit or glaring evidence that they ought to have discovered in their due-diligence processes of an audit, then they are clearly culpable. Similar is the case if conflicts of interest arose and these were not brought to the attention of the authorized committees / shareholders, in line with global best practices; updated by the Institute of International Finance. In matters of liability, as they crystallize, these factors will weigh heavily against the auditors.  But merely expecting them to be residual underwriters or insurance-providers for the outcome of a corporation's misdeeds, is perhaps  unjustifiable. Many internal audit firms take fidelity and other insurance against such risks, but this can never be equal to the potential liability that can arise in the event of serious offences committed by the likes of Parmalat and Enron.

In any event, such matters in legal terms may equate to "gross negligence and / or wilful misconduct". Most courts will interpret those terms in the case of qualified professionals, as having to practice / ensure much higher standards than an unqualified person. For instance, if a carpenter or a plumber or any other skilled worker were to be found negligent, it would be viewed less stringently than say an auditor, engineer or a software programmer, in their domains of specialization.

Nevertheless, all these can lead to a healthy and an interesting debate. Professional liability also needs to be viewed in the context of risk-taking and operational risks per se; as defined in the new Basle Capital Accord regime, which is widely encompassing. Shareholders who take equity risks cannot escape the fallout by expecting audit watch-dogs to become blood-hounds; unless they employ them specifically for forensic services.  The shareholders are entitled to place their trust in the directors that they elect and the Management of the company that the latter appoint.  Lawyers, accountants  and other advisors and professional service-providers cannot be expected to make good the shortfall suffered by equity risk-takers, except  to the extent of their contributory negligence and misconduct.

[The author is General Manager of Emirates Bank.  However, the views expressed in this article are not necessarily shared by the Bank].

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