The European Commission is calling on the business community and national regulators to establish a uniform standard of capping auditing firms’ legal liability for their work, a tacit admission that the accounting industry in Europe is stretched too thin to endure any disruption to the Big 4 auditors.
Hoping to bring order to the mixed bag of liability codes across the EU’s 27 member nations, the Commission has proposed four choices for auditor liability, and wants stakeholders concerned with the issue to provide their views by March 15. The ideas are:
The introduction of a fixed monetary cap at the European level;
A cap based on the market capitalization of the audited company;
A cap based on a multiple of the audit fees;
“Proportionate liability,” which would have each party (auditor and audited company) liable only for the portion of loss that corresponds to the party's degree of responsibility.
Results of the public consultation could arrive perhaps as early as April (a summary and details for submitting comments to the EC can be found at right). That could then give rise to a recommendation to EU member governments; such a measure would be non-binding, but would be taken seriously.
McCreevy
Charlie McCreevy, commissioner for the EU Internal Market, underscored the need for action by recently warning of an increasing trend of litigation against auditors. “There is a real danger of one of the Big 4 being faced with a claim that could threaten its existence,” he said. Against that dire scenario, some EU governments—including Germany, Austria, Greece, and Belgium—have now capped auditors' liability. Others, such as Denmark and the Netherlands, have introduced or are introducing proportional liability combined with some limitations on who can sue auditors.
A Time Bomb
The Commission hopes for a speedy proposal on liability because it has already laid the groundwork for such a standard. Its Auditors Liability Forum, set up a year ago, assembled representatives from the Big 4, banks, academics, insurance companies, smaller firms and listed companies. In addition, EU member governments’ finance ministries were working together in the Auditing Regulatory Committee as well. The Commission is also aware of the U.S. Committee on Capital Markets Regulation (better known as the Paulson Committee) and its report in November recommending some sort of provision for auditor liability.
Schaub
Going back to early 2005, the risk of calamity in the auditing business was already being described by then-EC official Alex Schaub as “a time bomb.” The number of large auditing firms has steadily dwindled, from the Big 8 in 1992 to the Big 5 in 2002, and then the Big 4 after the post-Enron demise of the firm Arthur Andersen.
Last autumn, specific details were spelled out in a report from the consulting firm London Economics. The report (available in the box above, right) noted that the Big 4 firms in the EU faced 11 claims in the range of $200 million to $1 billion, and five claims of over $1 billion. Heightening the sense of threat, the consultancy found that the largest single loss that a firm in Europe could survive was approximately $700 million.
Potdevin
It's no surprise that global auditing associations agree with the premise. Jacques Potdevin, new president of the European Federation of Accountants, says his profession “agrees with the principle that statutory auditors must be held appropriately responsible for their statutory audit, but to no greater extent than is reasonable.”
Adams
Roger Adams, executive director the British Association of Chartered Certified Accountants, added, “We disagree strongly with those who say that it is only the threat of litigation that keeps auditors on their toes. ACCA’s preferred option … would be a system of proportionate liability.”
John Griffiths-Jones, joint chairman of KPMG Europe, says alignment along one pan-European standard “would be highly desirable.” Neil Lerner, head of global regulation at the same firm, adds that whatever recommendation the Commission makes, it would have to involve political negotiation with the EU national governments to avoid risk of their balking at specific measures. And, Lerner says, liability reform in the United States is also “absolutely crucial” because of the danger of class-action lawsuits there.
CATASTROPHIC CLAIMS
The excerpt below is from "Commission Staff Working Paper: Consultation On Auditors' Liability And Its Impact On The European Capital Markets," Directorate General for Internal Market and Services.
2.7 Short Term Measures: How To Reduce The Risk Of Further Concentration
In The Audit Market Due To Catastrophic Claims
The London Economics study concludes that the risk of a large settlement that Big 4
firms would have to assume themselves (i.e. without any insurance cover) has increased
substantially in recent years. A catastrophic negligence claim against them would mean a
real possibility that one of them would fail and disappear. The disappearance of a major
international player would perhaps not be a matter of public concern since it might be
expected that market forces would help to remedy any problems on the supply side.
However, according to the London Economic Study, the situation would seem to be
different for audit firms of listed companies:
The current concentration and lack of choice would be exacerbated further if one
of the Big 4 were to collapse. This could result in a major increase in the audit
fees for listed companies.
The huge liability risks might make the audit profession less attractive.
The adjustment to a Big 3 market structure would be very challenging. The
completion of statutory audits might be delayed, especially if the failure occurred
close to the company's year end.
Financial institutions could face more serious transition problems as the special
skills their audits require might severely restrict their range of choice for a new
auditor.
The overall cost of capital is unlikely to be directly affected even
if audit fees increase sharply as the share of audit fees in total operating costs is
small. But the cost of capital could be affected indirectly if the loss of one of the
Big 4 were to make investors lose confidence more generally in capital markets.
Given the limited availability of insurance and the large claims faced by all Big 4
firms, a second major audit network could also fail at the same time. A scenario
where the international audit market would be dominated by only the Big 2 is as
realistic as the Big 3 scenario. Investor confidence would fall significantly and
capital markets would probably react much more negatively than in the case of
the disappearance of one major network.
There is currently no possibility for mid-tier firms to enter this international audit
market in a meaningful way. There are also no prospects that this will change in
the near future
Source
Commission Staff Working Paper: Consultation On Auditors' Liability And Its Impact On The European Capital Markets (January 2007)
One voice that is not speaking particularly loudly on auditor liability might be shareholder groups; Institutional Shareholder Services Europe says it is much more focused on auditors disclosing how much they charge clients for auditing and consulting fees. According to Jean Nicolas Caprasse, Managing Director of ISS Europe, that issue might be one area where legislative attention is necessary.
“In fact … ISS has changed its voting policy in Europe this year,” Caprasse says. “We will recommend shareholders vote against the re-election of auditors or the ratification of their fees if the auditors’ fees for the previous fiscal year are not disclosed and broken down into at least audit and non-audit fees.”
How The Auditing Industry Gets By
A European Commission staff working paper released only last month sketched out how auditor liability has evolved recently, and noted that the cost of capital for businesses could suffer, “if the loss of one of the Big 4 were to make investors lose confidence more generally in capital markets.”
The report suggests the desirability of more audit firms allying their resources to offer the same capacities as the Big 4, and it is not the only voice calling for such re-alignment. Mid-sized firms such as Robson Rhodes, BDO Stoy Hayward, and Grant Thornton would all be natural candidates for such combinations. London Economics, however, stresses that those alliances “will take time” and cites unlimited legal liability as one factor that was holding them back. Jeremy Newman, managing partner in BDO International, which covers the EU, believes too much attention is given to saving the Big 4, and says liability reform based on proportionality would help the mid-tier most.
However, not everyone desires liability limits for auditors. Many public companies and institutional investors, for example, want to make sure audit firms can be held accountable for all their actions. A 2003 study by the U.S. General Accounting Office on accounting firm consolidation found that, “The liability to which accounting firms are subject also creates a form of
'insurance' to investors through an auditor’s assurance role, which provides investors with a claim on an accounting firm in the event of an audit failure.”
As for maintaining audit quality under any new legislative codes capping liability, the Commission’s working paper stresses the importance of public oversight, a concept introduced in the U.S. via the Public Company Accounting Oversight Board. Similar oversight is covered in the EU under new Directive on Statutory Audit. Furthermore, independent public oversight bodies have also been set up in other jurisdictions, such as in Japan, Canada and Australia. Others would follow.
The European Commission is encouraging cooperation among EU governments through the recently formed European Group of Auditor Oversight Bodies (EGAOB). In its working paper, the board notes that it has the option to facilitate uniform application of the principles on external quality assurance under Article 29 of the new statutory audit directive.
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