Liability regime must be remedied to ensure strong audit profession

Comment:When I left university in 1985, I was lucky, or so I thought then, to join what was then the largest of the Big Eight global accounting firms, Arthur Andersen. I thought myself even luckier when, in 1998, I was admitted to partnership in that firm, writes Conall O'Halloran.

Arising from Enron and events involving only the firm's Heuston office, Arthur Andersen no longer exists.

Even now, almost five years later, the speed with which Andersen went from being one of the then Big Five accounting firms, employing 85,000 people across 200 countries, to being closed for business is astonishing.

That was 2002; could there be another failure of a big firm? The simple answer is yes.

This is an issue exercising the mind of EU internal market commissioner Charlie McCreevy, and is behind the referral of the auditor liability issue by the Minister for Trade and Commerce, Michael Ahern, to the Company Law Review Group. It is also addressed in a recent publication by the Institute of Chartered Accountants in Ireland (ICAI), Auditor Liability - the reform imperative.

Data provided to London Economics in 2006, as part of its review of auditor liability undertaken for the EU, showed there were 16 cases in the EU where damages sought from the larger accounting firms were in excess of $200 million (€152.4 million). Five of these are in excess of $1 billion. In the recent Equitable Life case the plaintiffs were claiming damages in excess of €3 billion. If the plaintiff had succeeded, there would likely only be a Big Three today.

Understandably, perhaps, people assume the Big Four global brands carry sufficient insurance and capitalisation to cater for all eventualities. Unfortunately the reality is that, since the late 1980s, big audit firms have effectively become an uninsurable risk.

After a sustained period of underwriting losses between 1980 and 1992, when average losses outside the US cost insurers $2.66 for every $1 of premium received, almost all insurers exited the market, leaving the networks of large audit firms to set up their own captive insurance companies.

However, the resources of the audit firms, including the assets of their captive insurers, remain minuscule in comparison with the market capitalisation of their larger listed clients. So, while audit firms do pay significant amounts for insurance, it is a fallacy to imagine it could go any way towards meeting a single significant claim against the firm.

Consider what would happen in the event of a global failure of one of the remaining Big Four networks. The reduction of the Big Four to the Big Three would further reduce the choice available to larger corporates, a choice already restricted by independence requirements that could render some firms ineligible for consideration as auditors.

Of more concern is the possibility that the reaction of the remaining Big Three would be to resign from audits where the risk is considered unsustainable. The impact on capital markets would be extremely serious. In Ireland the impact on the financial services industry would be self-evident.

Across Europe, lawmakers and regulators have been responding by providing some protection for audit firms in the event of catastrophic claims. But in Ireland the problem remains particularly acute. Auditors of Irish companies are prohibited by law from incorporating, and the law requires Irish auditors to have unlimited liability in relation to audit work.

This, combined with the principle of joint and several liability, whereby auditors can be liable for the losses caused by others, exposes both the audit firm and the personal assets of partners to risk on every single audit.

By contrast, most EU member states have introduced some measure of reform by allowing audit firms to incorporate. More significantly, others have introduced statutory caps for liability for amounts ranging up to €12 million. The recent change in the law in the UK allows auditors to contract with their clients to limit their liability. Reform in Ireland needs to follow suit.

The availability of a strong audit profession is a core element in Ireland's recent economic success. Almost all major companies here are audited by Big Four companies. The current liability regime militates against competition in the sector and exposes our plcs and our funds industry to associated risk.

The liability regime in this State is based on the fallacy that audit firms can act as an insurer of last resort to capital markets.

While the issue may be complex, the remedy could be relatively simple. Statutory caps would protect the viability of auditing firms and would ensure the continuity of audit services to the market. An amendment to section 200 of the 1963 Companies Act would allow audit firms to agree liability limits with clients.

Amending Section 187 of the Companies Act to allow auditors incorporate would address the threat to the personal assets of auditors, thereby removing a disincentive to the best and brightest entering the audit profession.

Capital markets need a strong and vibrant auditing profession, and a regime that will not allow a single claim to wipe out a firm and devastate the supply of audit services to the market. We have delivered the former; the latter is now overdue.

• Conall O'Halloran is risk management partner at KPMG and a member of the Company Law Review Group