World auditing in state of turmoil

Press, 7 August 1985, Page 33

World auditing in state of turmoil

By

STELLA SHAMOON,

in the “Observer,” London

Tuesday, July 23, marked a historic event in British business. On that day, the accountants, Arthur Young, sued Mr Nigel Lawson, the Chancellor of the Exchequer, for libel. Arthur Young also sued the 8.8. C. and Channel 4 over the remarks Mr Lawson made on the air on June 20 concerning the problems of Johnson Matthey Bankers, with losses of SNZ66O million. Arthur Young were auditors to JMB before the bank's near collapse in September. At 4.30 p.m. on July 23, a writ was served on Arthur Young by JMB — now a wholly owned subsidiary of its “saviour,” the Bank of England. The writ from JMB claimed damages and interest from Arthur Young for alleged breach of contract andr negligence in the firm’s capacity as auditors and accountants to JMB over the financial years to March 31, 1982, 1983 and 1984. Andrew Darnell, a partner of Arthur Young, claimed that the Chancellor’s remarks to the media had gone “much further” than his statement to the House on the Johnson Matthey affair. In Darnell’s words: “The firm contends that such a statement seriously compromised Arthur Young’s position in any relevant proceedings.” This is the first time this century that the Chancellor has been sued. Mr Lawson told the House of Commons on June 20 that the Bank of England report of JMB “makes it clear that serious shortcomings in the management of JMB led to its collapse — over-expenditure of the loan book, heavy concentration of expenditure, and lack of adequate control systems. JMB was also guilty of serious misreporting to the supervisory authority.” Mr Lawson went on: “The circumstances described in the Bank’s reports must inevitably raise questions about the role of the auditor, Arthur Young.” Caparo seeks damages to cover losses estimated at more than $26.6M. This reflects the mounting tendency to sue auditors for negligence when things go wrong — as has long been the case in the United States. American lawyers will often provoke litigation by offering their services not for a fee but for a share of any settlement obtained. In the case of small to medium-size accountancy firms hit by litigation on this side of the Atlantic the consequences could prove lethal. Many will be wiped out. The traumatic aspect of legal action against accountants lies in their unlimited liability status. This means that the partners of firms which are sued have all their assets on the line — including their homes.

All major firms of accountants have indemnity policies estimated to amount to £IOOM ($266M) or more. But the recent spate of huge claims has caused a crisis in the insurance market. Accountancy firms cannot obtain adequate insurance, and the premiums they must pay have tripled. By way of example one firm enjoyed cover of £2SM ($66.5M) last year, on which it paid premiums of £ 100,000 ($226,000). This year it has been informed that its cover will be reduced to £SM ($13.3M), while the premium soars to £ 250,000 ($665,000). The accountancy profession claims that its member firms are being victimised unfairly. The argument is that the combination of unlimited liability and substantial insurance cover makes accountants an easy target. Mr lan Hay Davison, who left accountants, Arthur Andersen, to serve as chief executive of Lloyd’s, chairs

a working party on fraud at the Institute of Chartered Accountants. The brief is to cover; a) what is fraud?, b) what are the auditors’ responsibilities?, c) what additional powers do auditors require to probe fraud? As Mr Davison puts it: “There is no duty on the part of any citizen to report crime to the police. Currently, the advice of the Institute is not to act as informer and report crime to the police. That could change.” Mr Davison adds: “The auditor’s duty is to express an opinion on the accounts. If there is material fraud, then he has a duty to notice that and to report it. He is not there to detect immaterial fraud. If he finds it, he can advise the company, but he has no duty to inform anybody else.” According to Mr Davison: “The Institute guidance — and legal advice — has traditionally been not to inform the police. But this may change. There is no doubt that auditors would be protected by qualified privilege — provided there is no malice — were they to report fraud to the police.” Mr Davison insists: “But it would be fatal if it became a legal duty for auditors to report fraud. Then auditors would become a department of the police.” The Scottish certified accountants have already produced their recommenda-

tion on fraud. They argue that it is not the responsibility of auditors necessarily to detect fraud, but that if found it should be reported to the directors, and if the directors are involved it should be, reported under privilege to the City’s (London's) new supervisory bodies and to non-executive directors. There should, says the Scottish ICA, be at least two non-executive directors on the boards of financial groupings. The major accountancy firms appear to have become distinctly more careful in signing off accounts. The majors have special “quality control” departments made up of accounting gurus who scrutinise the opinions and run rigorous checks on conclusions. Such checks have become stricter in the light of recent litigation. But as one senior paartner of a leading firm puts it: “An accountant is accountable for negligence. But what the accountant should not be is an insurer.

If he had to check every transaction, he would have to have as many staff as the company he was auditing. An analytical reviewing and use of samples to draw conclusions are essential to the work. It is quite possible to do an industrious job and come away with the wrong answer.” In the words of Michael Blackburn, managing partner of Touche Ross: “It is intolerable that the auditor should always be presumed responsible for the misfortunes of the business community simply because we have taken out insurance cover.” The argument goes that company directors are subject to limited liability, and thus make unattractive targets for those seeking substantial redress through the courts. Touche Ross’s Blackburn and John Darby, of Arthur Young, are completing a study into the pros and cons of incorporation of accountancy firms. This would give them limited liability status and would offer some measure of protection to partners. The accountancy profession has enjoyed growth of 10 to 20 fold since the sixties, and is now uniquely positioned to play on its strengths in the fields of management consultancy, computer know-how, and corporate finance and taxation advice.

The reality is that auditing represents only some 40 per cent of the fee income of the “Big Eight" — Coopers and Lybrand, Peat Marwick, Price Waterhouse, Deloitte Haskin and Sells, Ernst and Whinney, Touche Ross, Arthur Young and Arthur Andersen. Whereas in the sixties the American McKinsey enterprise dominated the lucrative management consultancy field, Coopers and Lybrand now top the division, and the other major accountancy firms are well established in the field. The large firms are becoming larger via acquisition and internal growth, while the medium-size firms are being squeezed. Overheads rise and volume cannot keep pace with the march of the majors into straddling disciplined and allied fields of managemment, accountancy and finance. For the majors, business is stimulating and rewarding, but now there is a crisis. As a partner of one major firm puts it: “These suits will cause considerable damage. We are not aware that clients have resigned and switched firms. But getting business is all about your reputation in the City. That is how you get on the list for a large new issue or a privatisation or a piece of prestigious Government work. In the current litigious climate, you do not know whose name is being dropped from which lists.” The lack of independence of auditors at Lloyd’s, where millions of pounds vanished in a series of scandals to the apparent bewilderment of the accountancy profession, is now seen as a crucial factor. Reforms have been brought about. The question of what auditors call “materiality” is decisive. As one auditor put it: “Fraud is relative.” If £ 30,000 ($79,800) could not be accounted for at ICI, the auditor would not deem it material and would not disclose it in the accounts (although the matter would be reported to management). But if such an amount were found missing from a small firm it would be deemed a material fact, and would be reported in the accounts. The annual audit of a large company takes three to four weeks to complete. The auditors will visit the client during the year to ensure that the internal audit department of the company is employing correct procedures and matters are in order. If something in the accounts causes concern, an outside auditor should seek further explanation. But auditors rely heavily on information provided to them by clients. Critics charge that accountants should be made more accountable. While their primary function may not be to track down fraud, outside accountants should, nonetheless, take it upon themselves to apply more rigorous standards of interrogation of clients — towards whom, inevitably, relationships can grow distinctly cosy. Meanwhile, the accountancy profession is in a crisis. It can neither protect itself with limited liability nor obtain adequate insurance cover from the slings and arrows of charges of negligence. Unless some measure of protection is devised, and the accountants’ duties more clearly defined, many firms are in peril. — OFNS.

A legal duty to report fraud ‘would be fatal’