Mind the expectation gap

“What on earth were the auditors doing?” is a familiar cry whenever the headlines include another high-profile entity that has either collapsed or been caught up in a serious financial scandal, or both.

In recent years, it has become increasingly common to see the names of accounting firms splashed across the media. COVID-19 has accelerated the trend of corporate collapses and seems also to have increased the need to find “someone to blame”.          

Leaping to the conclusion that the auditors must have been at fault is neither fair, rational nor sensible – and bringing claims will do nothing to help the post-pandemic climate, where economic recovery should be front of mind for every socially aware business and individual.

That is not to say there are no sub-standard audits. In some cases, losses could have been reduced, if not prevented – but for an auditor’s negligence.  For every such case, however, there are many thousands of good quality audits (even of companies that subsequently collapse or suffer fraud). So, the key message here is: look before you leap to conclusions!

From the auditor’s perspective, it is critical that their audits can stand up to scrutiny. From any claimant’s perspective, it is vital that they take the right advice before embarking on what may be a costly and fruitless attempt to recover losses on behalf of a company, investor or lender.

Did the auditor breach its duty of care?

A shake-up of the audit industry is on the horizon, but public perception of the majority has been marred by the actions of a minority. A closer look at the difference between what auditors are expected to do and what they are required to do – generally referred to as “the Expectation Gap” – is important.

Many critics argue that auditors should detect fraud, but currently this is not the responsibility of an auditor. An auditor is responsible for obtaining reasonable assurance – not absolute assurance – that the financial statements are free from material misstatement whether caused by fraud or error. An auditor must apply appropriate professional scepticism, but they cannot test every transaction within a company; it is not proportionate or reasonable for them to do so.

Notwithstanding the auditor’s current duties, a recent independent review into the quality and effectiveness of audit (the Brydon Report) points out: “Either audit is helping to reinforce deserved confidence in business, or it is not”.  The Brydon Report sets out many recommendations, including forensic accounting training, for auditors.

For the auditing profession, this is a clear mandate to design a better and more robust service that restores confidence in the practice, and the Government (BEIS) has issued a far-reaching consultation on the sweeping reforms recommended by Brydon and other reviews.

The consultation paper’s proposals include establishing a new corporate auditing profession and it sets out new obligations on auditors in respect of the detection of fraud.  However, the proposed changes won’t change the past and, driven in part by the economic impact of the pandemic, there are plenty of potential claimants who will want to investigate whether an auditor breached its duty of care and whether losses suffered by the entity can be recovered from the auditor.

Any potential claimant will need to bring together advisers who have strong accounting knowledge and relevant business experience, practical experience of audit in a senior role, and a deep understanding of the auditor’s duties and the required standards, as well as the relevant case law. It simply cannot be assumed, as it has on so many occasions, that the auditor is to blame (or even partly to blame) for any losses incurred.

Even if experts reach a view that the auditor breached its duty of care, that does not automatically mean that the auditor is responsible for any particular loss. The critical factor will be the counterfactual scenario.

In Manchester Building Society v Grant Thornton, the Court of Appeal found that Manchester Building Society made other commercial considerations before entering into the interest rate swaps and that Grant Thornton is responsible only for the foreseeable financial consequences of the advice and/or information that it gave being wrong.

The Court of Appeal found that Manchester Building Society had failed to prove that the loss would not have happened if Grant Thornton’s advice had been correct, and the Supreme Court is currently considering an appeal from the Manchester Building Society.

So what is a claim against the auditor worth?

Given the difficulties stacked up against claimants looking to bring claims against auditors, it makes sense for any potential claimant to consider very carefully what the value of its claim is likely to be before it embarks on any process; even a pre-action process will start to rack up costs because pre-action protocols front-load much of the work inherent in such a claim.

The claimant will already have much of the evidence it needs to assess what losses have been incurred by the entity since the date any negligence might have occurred. It will also be able to assess what actions the business would have taken but for any negligent advice or information it received. It will, of course, need to assemble the supporting evidence for all of this.

But even with that information, the calculation of any losses that can be attributed to auditor negligence is a complex matter. A notable recent development in this area was in AssetCo v Grant Thornton, where the Court found that AssetCo’s trading losses fell within Grant Thornton’s duty as auditor, but only because of a unique fact-pattern.

AssetCo’s business was considered to be unsustainable but for the fraudulent interventions and dishonest representations by senior management, which Grant Thornton failed to detect. If AssetCo’s business had been sustainable, this would have made it more difficult to draw a causal link between Grant Thornton’s negligence and AssetCo’s trading losses. This lack of a causal link was found in respect of losses relating to the misappropriation of company funds by an individual, and damages payable by GT were reduced accordingly by the Court of Appeal.

Conclusion

The complexities involved in auditor negligence claims, particularly in establishing legal causation and quantifying losses, demonstrate the dangers of assuming that corporate failures must be due to poor audit quality. Only those with the necessary accounting skills, business experience, auditing experience, loss quantification skills and knowledge of the legal landscape can help parties in such actions to make the right decisions when addressing such disputes.

The audit landscape is entering a period of accelerated change.  If the proposed reforms achieve their stated objective of enhancing audit quality and bring about greater clarity as to the respective roles and responsibilities of directors and external auditors, the number of claims in this space may well reduce in the future. In the meantime, and certainly, as the law stands at present, would-be claimants should proceed with caution and “Mind the Expectation Gap”.

This article originally appeared on the LIDW blog as part of London International Disputes Week