The role of the Auditors in the UK corporate governance
par N'semy Aubin Mabanza
Cardiff University, Law School - LLM (Master of laws) Commercial Law 2003
LLM COMMERCIAL LAW
«THE ROLE OF THE AUDITORS IN THE UK CORPORATE GOVERNANCE»
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
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
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.
The availability of accurate and up-to-date information on company performance
is of fundamental importance. In the absence of reliable accounting data, effective
shareholder supervision of management is impossible, as the accurate pricing of
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
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
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
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
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
of the effective accounting standards. Shaken by the Andersen brutal scuttling,
the statutory dispositions of the profession has strengthened quickly for a
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.
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
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)
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
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,
but in the resignation of the auditor.
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
errors. If the auditor identifies weaknesses in the client's accounting
systems and internal controls which might result in fraud not being detected, the
auditor should report these to management.
8.Gower and Davies , » Principles of Modern company law » .
12.D.Walters and J . Dunn ,» Student ' s Manual of Auditing the Guide to UK Auditing Practice ».
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
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
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
effective reporting to management that this value can be realised.
The audit report must include a statement of the auditor's responsibility for
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'
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
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
summons under section 212 of the Insolvency Act 1986. In the UK, the duties of
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.
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.
21. C .Worth and Morse Company Law.
22 . (1887) 36Ch.D.787 at p.802.
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
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
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
control the management through general meetings.
23 .2 Ch279 ,also Re Equitable Fire Insurance Co Ch 407.
24. 2 K.b.164,CA
25. 1 All ER 568.
26. R . Wareham , ' Tolley ' s Company Law'.
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,
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
assumed responsibility. The Barings PLC v Coopers & Lybrand case illustrate that
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
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
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
at the same time as the audit is in progress on the basis of draft accounts.
28.Gower and Davies , ' Principles of Modern Company law ' , p . 584.
31.Gower and Davies , ' Principles of Modern Company law'.
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
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,
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
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
The external auditor plays a critical role in lending independent credibility to
published Financial Statements used by investors, creditors and other shareholders as
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. 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
effect on financial statements. In other words, the auditors must be independent in
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
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
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.
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
shareholders interests being sidelined. Auditing companies offer consultancy
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,
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.
44 . Smith Report,2003,p.27,para.3.5