The European Commission and regulators in the US and the UK all fear that if another audit firm goes bust in the face of massive claims against it – or leaves the market because of financial and legal risks – the quality of corporate governance will be dramatically reduced. There would be a lack of firms in the market that can carry out the amount of assurance and other related audit-work demanded by the world’s biggest companies. As a result of lower quality audit work, regulators fear that investors would be more likely to dump stock, forcing companies to hold back on ambitious growth strategies. Consequently, they are beginning to recommend that some form of auditor liability limitation is introduced.

Given that in the UK, the big four audit firms audit 97 percent of FTSE 350 companies, the government has recognised that audit firms need some degree of protection. While unlimited liability is not to be ruled out completely, the government has made provision under the 2006 Companies Act for companies to decide for themselves if they would like to limit their auditor’s liability.   

Under sections 532-538 of the Act (which came into force on 6 April 2008) companies are permitted to limit the liability of their auditors by contract so long as a court would find them “fair and reasonable”. The Act states that for a liability limitation agreement to be valid it cannot cover more than one financial year and it must be approved by a resolution of the company’s shareholders. For public companies this must be done at a general meeting, while private companies have the option of using a written resolution, and for group companies this means each UK company in the group and not just the holding company.

At present, under English law, a company can recover all its loss from the auditor, even though others are also liable to it. This is known as “joint and several liability”. Under the Civil Liability (Contribution) Act 1978, the auditor may be able to claim a contribution from the others who are liable, but if the other parties were insolvent or had fled the country, the auditor would not be able to recover any money from them and would therefore have to pay the full amount of the loss – which will remain the case where liability limitation agreements are not signed.

However, the UK’s corporate governance watchdog, the Financial Reporting Council (FRC), published guidance at the end of June on the use of liability limitation agreements between companies and their auditors. While it says that each company must make its own decision as to whether to enter into a liability limitation agreement with its auditors, the FRC is believes that it would be “desirable” to consider doing so.

The Institutional Shareholders’ Committee (ISC), the UK’s powerful investment body made up of the of the Association of British Insurers (ABI), the Association of Investment Companies (AIC), the Investment Management Association (IMA) and the National Association of Pension Funds (NAPF), is generally supportive of auditor liability. But it has reiterated that agreements determining auditor liability should be “proportionate”, and that companies should recognise that they are not obliged to enter into agreements if they are not suitable.

UK businesses also seem in favour of limiting auditor liability. Clive Edrupt, spokesman on company affairs for the Confederation of British Industry (CBI), the UK’s leading business lobby group, says that the CBI is supportive of the move towards limiting auditor liability. “No other organisation is faced with the threat of unlimited liability if a claim by a client should ever be made, and we feel that it is appropriate that audit firms are not unduly discriminated against,” he says.

Naturally, the Big Four are solidly behind the move, arguing that the guidance is about maintaining audit choice and audit quality. But they have also said that any liability limitation agreement with a client will not automatically result in a reduction in the audit fee, as “fees are linked to the quality of work – not risks”.

The Big Four have also been very vocal in arguing that the UK must not be alone in taking the lead with regards to limiting auditor liability, and that the US and Europe must also follow suit.

As it stands – because the SEC has not yet approved them – auditors think that there are going to be very few UK-based companies with a US listing opting to sign them because they are not sure how US investors and regulators will react. Unless the SEC gives its backing to auditor liability limitation agreements – and there is no sign yet that it will do so anytime soon – large firms will steer clear of signing them.

Not everyone is enthusiastic about the prospect of public companies putting a cap on the amount of money they can reclaim from audit firms. As Prem Sikka, professor of accounting at the University of Essex, points out: “In the current financial crisis, all major banks received a clean bill of health from their audit firms even though they engaged in massive off balance sheet accounting and that around US$1.2 trillion of toxic debts may have been hidden.”

He also says that external audit firms do not need protection from unlimited liabilty because the fines they receive have been small in relation to their fee income. For example, Deloitte appeared in court as one of the auditors of Barings Bank following the frauds carried out by the trader Nick Leeson that lead to the bank’s collapse. The court decided that even though Deloitte had been negligent, it should only pay out £1.5m because the loss suffered by the bank was mainly attributable to the failure of management to institute proper internal checks and controls.

“Accountancy firms, EU commissioners and regulators routinely preach competition to everyone else, but go soft when it comes to dealing with auditing firms,” says Professor Sikka. “They could restrict the number of FTSE companies that any auditing firm can audit and thus create for space for medium-sized firms to advance. They could insist that some quoted companies should have joint audits and thus again create space for medium-sized firms. They could insist on compulsory retendering or company audits and rotation of auditors. They could invite new players to the audit market. The SEC or FSA could take charge of audits of banks and financial institutions.”

Unfortunately, he says, none of these proposals are on the radar of any regulator.