Equitable case is crucial for auditors

by

Prem Sikka
Professor of Accounting
University of Essex
(Published in Sunday Express Financial, 1 May 2005, p. 4)

 
British companies spend about £1.5 billion a year on compulsory audits by accountancy firms. What might one expect from company auditors, especially as they don't owe a 'duty of care' to any individual shareholder, creditor or policyholder?

The issues about auditor responsibility are central to the £2 billion lawsuit by Equitable Life against its auditors Ernst & Young. The informed legal opinion suggests that Ernst & Young are likely to owe a 'duty of care' to Equitable Life as a legal person. Therefore, most of the attention is likely to be focused on allegations of negligence for the audits from 1997 onwards. However, what counts as 'negligence' by auditors is a not a straight forward matter.

Despite growth of the corporate sector, capital markets, pension schemes, share ownership and promotion of company audits as a mechanism for checking corporate excesses, UK legislation says little about auditor duties and responsibilities. That matter is left to accountancy trade associations and the courts. However, very few aggrieved parties have the necessary financial muscle to mount a legal challenge to major accountancy firms. Over the last thirty years very few cases of auditor negligence have reached the courts and there is little clarity about auditor duties and standards of care relevant to our times.

In this vacuum, the Equitable Life case could be an important milestone. Whilst the primary responsibility for preparing company accounts rests with directors, auditors can?t justify their fees and social status by just claiming to be some ink-stained adder-uppers and rubber-stampers. Neither can they just rely entirely on whatever company directors tell them. Instead, auditors are appointed to form judgements and independently check and corroborate key parts of a company's accounts.

Nearly fifty years ago, late Lord Denning said that the "auditor's vital task is to take care to see that errors are not made, be they errors of computation, or errors of omission or commission, or downright untruths. To perform this task properly he must to come it with an inquiring mind - not suspicious of dishonesty, I agree - but suspecting someone may have made a mistake somewhere and that a check must be made to ensure that there has been none".

One might argue that in the light of frequent episodes about corporate excesses and proliferation of novel accounting practices that can produce a wide variety of alternative accounting numbers for the same basic data, the Denning standard of an 'inquiring mind' needs to be replaced by a 'suspicious mind'. This kind of approach has been legitimised by the Financial Services Authority in its regulation of banks and financial institutions. Under this, auditors have to do much more than simply rely on matters told to them by company directors and their advisers. It is not too unreasonable to expect auditors to detect and report material misstatements in accounts.

For its deliberations, the High Court would need to establish what exactly did Ernst & Young do before giving its opinion on Equitable accounts and whether that was reasonable in the light of contemporary expectations from auditors. Evidence for this would be provided by the files and working papers of the parties involved and a variety of expert witnesses that both parties are sure to call.

Whatever the outcome, the Equitable case would be of considerable interest not only to accountancy firms, lawyers and insurers, but also to ordinary people who are routinely invited to have faith in audits to safeguard their savings and pensions.