Memorandum submitted by The Institute of Directors
Thank you for your letter of 25 March to George Cox, inviting the IoD to comment on any matters which we think relevant to the Treasury Committee's examination, in the light of the Enron collapse, of the financial regulation of plcs. George Cox has asked me to reply on his behalf.
Undoubtedly, the insolvency of Enron and a series of acknowledged failings by its auditor, Andersen, have prompted concerns about both the role and the supervision of auditors. At the same time, however, it is extremely important that any official response to these concerns is consistent with the overall company law review process.
There are four related matters which the IoD thinks important. These are:
1. REGULATION OF AUDITS
Under Part II, CA 1989 auditors must be registered, supervised by a Recognised Supervisory Body and apply technical standards of auditing which in practice are issued by the Auditing Practices Board, a subsidiary of the new Accountancy Foundation. We have no reason to think these technical standards are inadequate.
The recently established framework of accountancy regulation adds an independent element to the established self-regulatory regime of the accountancy profession. We welcome this. The new framework is to be looked at again in five years time, and we think it would be inappropriate and premature to try and judge its efficacy at this stage.
2. CONFLICTS OF INTEREST
In recent years there has been an increase in the amount of non-audit services provided by audit firms for the companies they audit. We regard this as a dangerous trend. It is very important, not only that auditors are independent of the company, but that they are seen to be so. Similarly, the public should have no doubt that an audit is done with integrity.
There may be a risk of compromising audit independence by selling consultancy services to audit clients. However, we agree with the view of the Company Law Review Steering Group, where the IoD played a part, that the new Ethics Standards Board, a subsidiary of the Accountancy Foundation, will shortly be able to play a key role in the regulation of non-audit work for audit clients. This should help to meet any concerns about the independence of audits. We would therefore wish to review their work before supporting a legal or regulatory ban on auditors providing non-audit services to their audit clients, particularly as it is not clear what to bannon-audit work covers a wide range of different services, ranging from tax advice, due diligence on acquisitions, to installing computer systems.
Some have suggested that longstanding auditor/client relationships are ipso facto bad, and therefore that there should be compulsory rotation of auditors every five years (say). Again, it is sometimes argued that companies should not hire accountants for their own staff who have worked as their auditors. We understand that the FSA is studying this matter, and we are content to await their considered views.
3. THE ROLE OF DIRECTORS
Technically, auditors are appointed by shareholders' resolution and their fees are similarly determined, but in practice directors significantly influence both, except in the most unusual circumstances. Whilst it is important to recognise that all directors have the same duties to the company, we would see an enhanced role for non-executive directors in the appointment and fee-fixing processes and in supervising the activities of the auditor. This would probably be via the audit committee of the board, which the Combined Code recommends should have at least three non-executive members. We would welcome developments in accepted good practice which raise the profile of the audit committee and help it address any disagreements between the management and the auditor and provide a rigorous check on the scope and results of the audit. One possibilitya practice already adopted in some companiesmight be that the committee from time to time meets with the auditor without executive board members present and that the auditor may request a meeting if he considers it necessary.
Directors are required in law to provide any information required by an auditor. Directors who recklessly or knowingly provide false or misleading information commit a criminal offence. It is argued by some, however, that a director's normal duty of care and skill should be extended so as to require him in addition to volunteer information which he (or a reasonable director) recognised as being material for the purpose of the audit, and that a breach of this duty should attract criminal penalties. Perhaps, also, just as auditors are exposed to professional negligence claims for financial loss caused by errors in accounts, a breach of duty by directors to assist the auditors should give rise to civil liability. We do not yet have a definitive view about the civil and criminal liability of directors for breaches of this particular duty of care.
4. THE ACCOUNTABILITY OF AUDITORS
We are aware that the Company Law Review has studied the accountability of auditors carefully and come to conclusions with which we broadly agree.
Under the Companies Act, auditors have a duty of care only to current shareholders in the company and only in respect of their governance rights as shareholders (the Caparo rule [1 All ER 533 1990]). It has been argued, however, that potential shareholders and actual and potential creditors, who perhaps base investment and credit decisions on the audit report, should also be able to sue auditors for deficiencies in the accounts.
However, if these latter groups are to be able to sue, then it seems reasonable that directors who prepare the accounts should also be liable. This would be a major extension of directors' duties and would also have implications for the general law of professional negligence and the apportionment of liability for financial loss.
A second difficulty is that such a new right of action may be open to abuse. Professional investors may seek recompense for poor investment decisions by laying the blame on failures by the auditors rather than on their own bad judgement. Determining whether an investor had done everything he reasonably could have in making his investment decision and deciding how much a part was played by the audit report are difficult and complicated issues for a Court to resolve.
We believe that further study is needed before any extension of the liabilities of auditors and directors is enacted. Extension of the duty of care in this way raises such wide considerations that it seems to be an appropriate field of study for the Law Commission.
I shall be pleased to provide any further information you require or to reply to any further enquiries.
8 April 2002