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CARDIFF UNIVERSITY
LAW
SCHOOL
LLM COMMERCIAL
LAW
2003/2004
«THE ROLE OF THE AUDITORS IN THE UK CORPORATE
GOVERNANCE»
BY
N'SEMY AUBIN
MABANZA
«THIS DISSERTATION IS SUBMITTED IN FULFILMENT OF
THE REQUIREMENTS FOR THE DEGREE OF LLM COMMERCIAL LAW »
SUPERVISOR: Dr TIM PRYCE-BROWN
ACKNOWLEDGEMENTS
I would like to thank my Supervisor Dr Tim Pryce-Brown for his
guidance and support during this research.
I would like to thank my wife Patricia for her love, care and
inspiration, without which this course would not have been possible.
TABLE OF CONTENTS
Chapter 1 Transparency in the UK Corporate
Governance
1 .1 Introduction
1.2 The Auditors and responsibilities
1.3 The Independence and Integrity of
Auditors
1.4 The Audit Committee in the UK
1.5 The Audit Committee in the USA
1.6 Current position under Common law: English
law and US law
1.7 Recent development of Auditors
liability
Chapter 2 Concept of «Good « Corporate
Governance in the UK
Chapter 3 Harmonisation of the European Company
law
Chapter 4 Conclusion
Bibliography
ABSTRACT
This paper traces the role of the Auditors in
the UK Corporate Governance.
It analyses the internal control and the
responsibilities of the auditors. The paper
identifies the importance of the audit committee under Common
law, particularly the
English law, and the US law.
The recent development of the auditors' s liability is
outlined. The concept of good
governance since the early period, as well as its
evolution within Europe is
illustrated. The implementation of the E C Directives in
the UK is also examined.
It is concluded that the role of the auditors need truth,
independence and objectivity
for the efficient functioning of UK corporate
governance. It is pointed that there
is not a single and perfect system of corporate
governance to monitor the audit.
It is also pointed that the current rules are
inadequate and unsatisfactory to protect
the interest of shareholders and others. It is
proposed that to avoid conflicts of
interest, individual rotation of auditors should be
absolute under new standards. It is
also proposed that the auditor should have a
permanent contact with all actors
who hold company information.
Chapter 1 Transparency in the UK Corporate
governance.
1.1 Introduction
The availability of accurate and up-to-date information on
company performance
1
is of fundamental importance. In the absence of reliable
accounting data, effective
shareholder supervision of management is impossible, as
the accurate pricing of
2
shares which is crucial to market modes of control. The
sudden collapse in recent
years of a number of well-known companies which, according
to their duly audited
accounts, were thriving, has focused attention on the
consideration scope for the
3
distorted presentation of financial information.
However, the modern English Company law contains
provisions to promote
transparency. S.384 of CA 1985 provides that every company
must appoint auditors
except companies which are exempt from the audit
requirement. An auditor is a
person appointed to examine the books of account and the
accounts of a registered
company and to report upon them to company members.
Normally, the auditor is
appointed by the director' s recommendation. However,
the relationship between
the auditor and the director's company is prone to
vulnerability. The close nature
of their relationship constitutes an important element
which has been implicit
in many debates of auditor independence. For many
years, external auditors
have contributed in a decisive way to the
development of welfare markets.
Moreover, the audit multidisciplinary links have put on
the market, on the edge of
the classic control, some worthy activities of
advising from non statutory
( lobbing for tax breaks, IT assistance,
representation of the internal audit).
1.J.E.Parkinson,'Corporate Power and Responsibility',p.161
2.ibid
3.ibid
This matter is very considerable. On the other hand, the
importance to fee income of
non- audit services has been identified as another factor for
criticism. For example,
in the Enron case, it has been widely reported that Andersen
received $25m in audit
fees and $27m for non audit services; there have been
many criticisms about the
potential conflict of interest faced by audit firms which
receive large consultancy
4
fees from their audit clients.
Concerns are expressed about how an auditor with a
statutory responsibility to
company shareholders can handle a commercial
relationship with the company's
5
management and remain impartial. In the UK, one of
the issues called by the
Cadbury Report was the establishment of the Audit Committee
and the development
6
of the effective accounting standards. Shaken by the
Andersen brutal scuttling,
the statutory dispositions of the profession has
strengthened quickly for a
7
better independence necessity, achieved in the USA by the
Sarbannes- Oxley Act.
On the other hand, the auditing firms themselves
have come up with the same
conclusion such as the rotation of auditors,
the splitting of their businesses
( non audit services and audit work), the
powers of the audit committees.
However, in the light of all these reports we have to note
that some problems remain
unsolved. This is not a unique issue. The auditors,
like solicitors, have to work
under rules adopted by the profession. However,
transparency by companies
management and auditors firms is important to
ensure impartiality in an audit
process, especially where auditors supply other
activities.
4.The Financial Times ,2001.
5.ibid
6.Cadbury Report ,1992 ,p.38 , para ,5.7
7.The Sarbannes- Oxley Act (SOA) is a US law passed in 2002 to
strengthen corporate governance and restore investor confidence. Act was
sponsored by US senator P. Sarbannes and US Representative M.Oxley (see http://
six signatutorial.com/Sox/Sarbannes-Oxley).
As in the case of directors, a company may by ordinary
resolution at any time remove
an auditor from office notwithstanding anything in any
agreement between it and him.
However, in accordance with the law, for the removal
of an auditor, special
safeguards are needed not only to protect him, but to protect
the company from being
deprived of an auditor whose fault in the eyes of
the directors may be that has
8
rightly not proved subservient to their wishes. In
other words, a company cannot
remove an auditor against his will without facing a
serious risk of a row at the
general meeting (and in the case of a listed
company, adverse press publicity)
9
and probably payment of compensation.
As a result of the encouragement from the Audit and
Accounting Issues Group and
the EC Commission professional guidance was changed to
require the rotation of
the audit engagement partner for listed firms at least
every five years and of other
10
key audit partners of listed firms every five years. Finally,
a breakdown in relations
between the auditor and the management may reveal
itself not in the removal,
11
but in the resignation of the auditor.
1.2 The Auditors and responsibilities.
Fundamental to Financial Statements, an audit is the
division of responsibility
between the management and the independent auditors.
Although the audit may
act as a deterrent, the auditor is not
responsible for preventing fraud or
12
errors. If the auditor identifies weaknesses
in the client's accounting
systems and internal controls which might result in
fraud not being detected, the
13
auditor should report these to management.
8.Gower and Davies , » Principles of Modern company law
» .
9.ibid
10.ibid
11.ibid
12.D.Walters and J . Dunn ,» Student ' s Manual of
Auditing the Guide to UK Auditing Practice ».
13.ibid
Under the Statement of Auditing Standards (SAS) 1101, it
is stated that 'Auditors
should plan and perform their audit procedures and
evaluate and report the results
thereof, recognising that fraud or error may materially
affect the financial statement'.
In practice, these provisions illustrate the limits of
the audit, also the division of
responsibility between the auditor and the audit clients. The
audit cannot be expected
14
to detect all errors or instances of
fraudulent or dishonest conduct.
The likelihood of detecting errors is higher than that
of detecting fraud, because
fraud is usually accompanied by acts specifically
designed to conceal its existence,
such as management introducing transactions without
substance, collusion between
15
employees or falsification of records.
One of the most important tasks of a total audit is
to report to the shareholders
significant matters that arise during an audit. The work of
the auditors carries out, and
the experience of the audit firm's partners,
managers and staff , is potentially a
source of greater value to clients; the
auditors should be positive and
constructive in conveying views and opinion to
clients; it is only through
16
effective reporting to management that
this value can be realised.
The audit report must include a statement of
the auditor's responsibility for
17
expressing an opinion on the financial statements,
this should be as follows:
«It is our responsibility to form an independent
opinion, based on our audit, on the financial statements and to report
our opinion to you».
14. D . Walters and J . Dunn ,' Student `s Manual of Auditing
: The Guide to UK Auditing Practice `.
15. D . Walters and J . Dunn , » Student ' s Manual of
Auditing the Guide to UK Auditing Practice ».
16. Gower and Davies , » Principles of Modern Company
law » .
17. Statements of Auditing Standard (SAS 100).
According to the Auditing Practice Board, audit of
financial statements is an
exercise whose objective is to enable auditors to
express an opinion whether the
financial statements give a true and fair view...of the
entity's affairs at the period
end and of its profit or loss ... for the period then
ended and have been properly
prepared in accordance with the applicable reporting
framework or, where statutory
or other specific requirements prescribe the term,
whether the financial statements'
18
present fairly'.
In practice, the auditor's potential civil liability for
negligence arises in contract or
Tort. When acting for the client, an auditor performs his
duties under a contractual
relationship with his company; if he is negligent in the
performance of his contractual
19
duties he may be liable to the company for loss
arising from negligence. If the
company is in liquidation, proceedings may be brought
by way of misfeasance
20
summons under section 212 of the Insolvency Act 1986.
In the UK, the duties of
21
auditors depend on the terms of the articles as well
as on the statutory provisions.
Under English law, the earlier cases discussed
extensively the auditor' s duties.
22
In Leeds Estate Co. v Shepherd, Stirling J.
pointed that :
`The duty of the auditor ...[is]...not to confirm himself
merely to the task of verifying
the arithmetical accuracy of the balance sheet,
but to inquire into its substantial accuracy, and to ascertain that it...was
properly drawn up, so as to contain a true and correct representation of the
state of the company's affairs'.
18.APB was established in 1991 to advance Standards of
auditing and to provide a framework of practice for the exercise of the
auditor ' s role ( See D . Walters & J . Dunn ) .
19.Boyle & Birds ' Company Law , p . 450 , 4 t h edition
2000.
20.ibid
21. C .Worth and Morse Company Law.
22 . (1887) 36Ch.D.787 at p.802.
23
In the Kingston Cotton Mill Co, Lopes
LJ defined an auditor's duties as follows:
`It is the duty of an auditor to bring to bear on the
work he has to perform that skill,
care and caution which a reasonably competent, careful
and cautions auditor would
use. What is reasonable skill, care and caution must
depend on the circumstances of
each case. An auditor is not bound to be a detective, or
as was said, to approach his
work with suspicion. He is watchdog, but not a
bloodhound. He is justified in
believing tried servants of the company in whom
confidence is place by the
company. He is entitled to assume that they are
honest, and to rely upon their
representations, provided he takes reasonable care. If
there is anything calculated to
excite suspicion, he should probe it to the bottom, but
in the absence of anything of
that kind he is only bound to be reasonably cautions and
careful.'
Moreover, an auditor may be liable for negligence to persons
relying on his report and
with whom he does not stand in a contractual or fiduciary
relationship. The Court of
Appeal in Candler v Crane Christmas had
held that a firm of accountants was not
liable in negligence to someone who had relied on a
report negligently prepared
by them and which they had known would be acted on by him,
and suffered loss as
24
a result, because there was no contractual
relationship between the parties.
However, more recently there is a tendency to
restrict the liability. In Caparo
Industries plc v Dickman, the House of Lords
considered the auditor's duty of care
25
to shareholders and potential shareholders. It held that the
purpose of the audit report
was to enable shareholders to exercise their property powers
as shareholders by giving
them reliable intelligence on the company' s affairs,
sufficient to allow them to
scrutinise the management' s conduct and to exercise
their collective powers to
26
control the management through general meetings.
23 .[1896]2 Ch279 ,also Re Equitable Fire Insurance Co
[1925]Ch 407.
24. [1951]2 K.b.164,CA
25. [1990]1 All ER 568.
26. R . Wareham , ' Tolley ' s Company Law'.
27
However, the Deloitte Haskins & Sells v National
Mutual life Nominees judgement
instead, the House of Lords confined the Common law
duty of care within the
statutory framework set by the Companies Act for company
accounts and their audit,
28
which by itself is a policy which has much to commend it.
In Electra Private Equity Partners v KPMG Peat
Marwick,a crucial initial issue is
that the special relationship does not require that the
auditor should consciously have
29
assumed responsibility. The Barings PLC v Coopers
& Lybrand case illustrate that
30
a number of different situations have been considered
in this light in the case law.
First, within groups of companies, the Courts have accepted
that it is arguable that the
auditors of a subsidiary company owe a duty of care to
the parent company, since
the auditors will be aware that the parent will rely
on the audit of the subsidiary
31
to provide accounts which reflect a true and fair
view of the group as a whole.
A second area of tortuous duty to
«third» parties involves the directors of the
32
Company by which the auditors have been engaged.
Although the Act presents the
compilation of the accounts by the directors and
their audit as consecutive and
separate events, in practice the two overlap, with the
directors finalising the accounts
33
at the same time as the audit is in progress
on the basis of draft accounts.
27.[1993]A.C.774,PC.
28.Gower and Davies , ' Principles of Modern Company law ' , p
. 584.
29.[2001]1 B.C.L.C.589,CA.
30.[1997]2 B.C.L.C.427,CA.
31.Gower and Davies , ' Principles of Modern Company
law'.
32.ibid
33.ibid
In addition, auditors who come into possession of
information about wrongdoing
during the course of their audit may be
obliged to report it to the relevant
authorities; auditing standards require auditors to
consider whether the public
34
interest requires such action. On the other
hand, the Court of Appeal,
in Sasea Finance Ltd v KPMG held that
on the basis of this professional
guidance, the auditor' s duties to the company
could embrace, as last resort,
35
a duty to inform relevant third parties of suspected
wrongdoing. For example,
where the auditors discovered fraud on the part
of those in control of the
company so that simply warning the company was
likely to be ineffective.
In practice, the test of the public interest
is used in order to give auditors
in such cases a defence to an action at Common
law by the company for
36
breach of confidence. However, the concern about the
independence and integrity
of auditors is based on the influence of non audit
services principally to the recent
corporate collapses.
1.3 The Independence and Integrity of Auditors.
The external auditor plays a critical role in
lending independent credibility to
published Financial Statements used by investors, creditors
and other shareholders as
37
a basis for making capital allocation decisions. Indeed, the
public's perception of the
credibility of financial reporting by listed entities is
influenced significantly by the
perceived effectiveness of external auditors in examining
and reporting on financial
Statements; while any consideration of the effectiveness of
external auditors involves
a wide variety of issues, it is fundamental to public
confidence in the reliability of
34 . A P B , Statement of Auditing Standards No.110.
35. [2000]1 All ER 676,CA.
36. Gower and Davies , ' Principles of Modern Company law
' .
37. '.Principle of Auditor Independence and the Role of
Corporate Governance in
Monitoring an Auditor' Independence'. International
Organisation of Securities
Commissions (IOSC),) October 2002.
financial statements that external auditors operate, and
are seen to operate, in an
environment that supports objective decision-making on key
issues fraying a material
38
effect on financial statements. In other words, the
auditors must be independent in
39
both fact and appearance.
The current English law for securing the independence of
auditors from management
have focussed to date mainly on placing the appointment,
remuneration and removal
40
of auditors in the hand of the shareholders. Everyone
concerned accepts the principle
that auditors must be objective and thus remain
independent from company
management. The regulatory framework in the UK in respect
of non-audit services
requires listed companies and other large companies to
disclose in the annual report
the amount of non audit services fees paid
to their incumbent auditor.
On the other hand, The Eighth Directive requires that
Company Auditors should
conduct audits with professional integrity and
independence. Moreover, the recent
Recommendation on Statutory Auditors' Independence
suggests that non audit
services disclosure should be further broken down into
assurance, tax advisory and
41
other, with details being provided as to the
composition of `other'. When acting,
auditors should comply with the ethical
guidance issued by their relevant
professional Bodies; each professional body has
published detailed guidance on
maintaining professional independence.
38 .'.Principle of Auditor Independence and the Role of
Corporate Governance in
Monitoring an Auditor' Independence'. International
Organisation of Securities
Commissions (IOSC),) October 2002.
39 .ibid
40 .ibid
41 .European Commission , 2002.
Solomon argued that the desire for auditors to compete on
price in offering a number
of services, as well as their desire to satisfy
their client's wishes, can lead to
42
shareholders interests being sidelined. Auditing
companies offer consultancy
43
services and IT services to the companies
that they audit . However,
as the Cadbury Report comments, such a prohibition
could increase corporate
costs significantly, as their freedom of choice in the
market would be restricted.
Consequently, the Cadbury Report stated that
companies should disclose full
details of fees paid to audit firms for non- audit
work, such as consultancy.
In 2003, the Smith Report was reluctant to deal with the
issue in a proactive manner,
44
the report stated that:
`... we do not believe it would be right to seek to impose
specific restrictions on the
auditors' s supply of non services through the vehicle of
Code guidance. We are
sceptical of a prescriptive approach, since we believe
that there are no clear-cut,
universal answers ... there may be genuine benefits to
efficiency and effectiveness
from auditors doing non-audit work'.
In the light of the Smith Recommendations, responsibility
for auditor independence
and objectivity is transferred on to the audit committee.
The audit committee plays a
key role in the financial reporting process in modern
company. The recent scandal
frauds in the UK and in the USA illustrated that
there are some common points
between the two systems.
42. J. Solomon and A . Solomon ,' Corporate Governance and
Accountability',2004.
43. ibid
44 . Smith Report,2003,p.27,para.3.5
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