A FOCUS ON PURPOSE AND TRANSPARENCY
In February 2004, Morley Fund Management submitted its analysis1 on the state of
audit and auditor liability to the Department of Trade and Industry (DTI). This called
for the moves to change the liability regime applying to auditors to be suspended and
only taken forward as part of and based on wider reform of the UK’s audit framework.
Following its consultation and dialogue with interested parties the DTI has deferred
moves to introduce further changes to auditor liability pending more detailed
deliberations on wider audit reform and audit quality.
In response to that development, this paper sets out a summary of the proposals that
should be taken forward as part of those deliberations. The focus of these is three-
• to re-empower auditors to act more effectively in the interests of shareholders;
• to ensure that they are clearly able to do so, free from the significant, conflicting
pressures that have evolved; and
• as an extension of the above, revive the audit’s value as a key shareholder
In the interests of (relative) brevity, we have not sought to articulate again all the
trends and issues underpinning the need for these recommendations. These were
covered in the earlier analysis of audit and auditor liability. 1
We recommend these proposals to Government, the Financial Reporting Council, the
audit profession and other investors, as providing a clear basis for reform of the
Statutory Audit and to support auditors in acting on shareholders’ behalf.
1.1 Given the drive towards harmonisation and the adoption of international
standards, recognition of the critical differences between the financial
reporting and accountability frameworks of boards and auditors in the UK
compared to the US2 is important when considering reform of the UK’s audit
regime. In the US, despite attempts in the 1930s to adopt a framework
similar to the UK’s, they have taken a divergent and fundamentally different
approach. This reflects the limitations of Federal Law in its interaction with
State Law. The US approach is based in Federal Law under the 1933
: “Bringing Audit Back From The Brink: Auditor liability and the need to overhaul a key investor
protection framework” (February 2004).
: See “Where Economics meets the law – The financial reporting system of the USA compared to that of
other jurisdictions” Tim Bush (2004), Hermes Focus Asset Management Ltd
Morley Fund Management is a business name of Morley Fund Management Limited, registered in England No. 1151805. Registered
Office: No.1 Poultry, London EC2R 8EJ. Authorised and regulated in the UK by the Financial Services Authority and a member of the
Investment Management Association. Morley Fund Management is also a business name of Morley Fund Management International
Limited. Both are Aviva companies.
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Securities Act, which deals with the sale of securities, rather than in
incorporation law (as in the UK) which is the preserve of State Law. Unlike in
the UK therefore, the US system is not concerned with laws of property and
rights but, rather, is primarily concerned with market pricing, a ‘general-
purpose’ function. As a result the US system does not have the same
governance and stewardship function, or system of accountability, as the
1.2 The UK needs to retain and build on the existing approach to accounts and
audit established under the UK Companies Acts, with its focus on
accountability to and the interests of the ‘shareowners’. Any trend towards a
more US styled model that does not embody this, either in the UK or through
the EU, needs to be avoided.
Auditors’ duty of care and purpose
2.1 Under the UK system, Statutory Auditors should play an essential role in the
governance framework, with privileged access inside companies. In line with
Company Law and the House of Lords’ opinion in the Caparo case, auditors
need to act clearly and specifically on behalf of and in the interests of
shareholders. It is the key function of auditors to inquire, so far as possible,
into whether the financial information as to the company's affairs prepared by
the directors accurately reflects the company's position and provides a true
and fair view, in order:
(i) to protect the company itself from the consequences of undetected
errors or, possibly, wrongdoing; and
(ii) to provide shareholders with reliable intelligence on the company's
affairs, that is timely, relevant and sufficient to enable shareholders to
scrutinise management's conduct and disclosures and to exercise
their collective powers through general meetings.
This focus should be clearly embedded at the heart of the UK’s audit
framework and explicitly integrated into related standards and best practice.
2.2 It is important that regulators and those developing best practice standards
ensure that this fundamental focus can no longer be compromised by the
intervention of other interests, whether commercial or corporate in origin.
2.3 The current trend amongst some advisers and companies to intercede in or
abrogate this responsibility is illustrated in the following extract from a FTSE
100 company’s audit committee terms of reference:
“In executing [its] responsibilities the duties of the [Audit]
Committee shall be …in relation to the external audit… to
ensure that it is clear that the external auditor is ultimately
responsible to the Committee and the Group Boards, as
representatives of the shareholders”
3.1 Following on from the above, the UK framework needs to ensure that auditors
are clearly supported in exercising and evidencing the necessary professional
judgement, critical approach, level of objectivity and ability to expose
weaknesses, that is reasonably expected of them.
3.2 In that context auditor independence and the related professional and ethical
standards are particularly important and must support auditors in:
(i) focussing on acting with integrity, exercising objectivity and
(ii) doing so in the clear interests of the audit’s beneficiaries (the
shareholders), free from those pressures (e.g. management pressure)
and other factors (e.g. commercial conflicts) that might or do
compromise the auditors’ ability to make robust and unbiased
(iii) ensuring that discovered breaches, and other matters of emphasis or
concern etc, are reported (see section 7 below).
3.3 In this context, directors‘ control of the appointment and removal of auditors
needs to be revisited (see sections 4 and 5 below). The level of direct or
indirect management control or coercion that arises from the current
arrangements must be recognised for the issue that it is. This may
particularly be an issue where the revenues are significant to a business unit
in the accounting firm or the individual audit partner in question.
Appointment of Auditors
4.1 Consideration should be given to the introduction of alternative arrangements
for the appointment and oversight of auditors. A number of proposals have
been suggested in the ongoing debate and the practical merits of these
should be looked into with a view to addressing the kind of problems alluded
to in, say, section 3 and 5, as well as paragraph 4.2(iv) of this paper:
(i) drawing on other European experience, e.g. from Sweden,
shareholders representing at least ten percent of the issued shares, or
one-third of the shares represented at a general meeting, can move
that a special auditor be appointed for one year;
as well as others:
(ii) by a shareholder panel that acts as an oversight body for the audit; or
(iii) that auditors be appointed by a regulator (e.g. the FRC or the FSA);
4.2 In addition, the following measures should be introduced:
(i) disclosure of terms of engagement and related matters ahead of the
shareholder vote to (re)appoint the auditor;
(ii) disclosure of key tests/limitations to be used by the auditor e.g. how
‘materiality’ will be approached and defined, as well as the guidelines
and approach used in determining the significance of accounting items
and errors; and
(iii) clarity on how any areas the auditors identify as requiring additional
investigation/scrutiny should subsequently be agreed and funded.
Resignation and removal of Auditors
5.1 Clarity is also required on the reasons for a parting of the ways between an
auditor and a company. Current Section 390 letters (Companies Act 1985)
do not necessarily provide the coverage required nor do the ‘statement of
issues’ disclosures work effectively – this needs to be overhauled.
5.2 Consideration needs to be given to what other information is required to
ensure shareholders have a proper understanding of the reasons for auditor
turnover. This must not be limited to an obligation on auditors; it needs to
apply to companies as well.3
6.1 A key theme of the auditor’s duty shareholders is accountability. As part of
the focus on providing ‘reliable intelligence’, the right of shareholders to ask
appropriate questions of the auditors needs to be clearly established. In this
regard, the UK should look to introduce a mechanism similar in essence to
Section 250 of the Australian Corporations Act 2001 that enables
shareholders to put questions to the auditors. This should, however, go
further for UK purposes to avoid some of the limitations of that Antipodean
6.2 In summary, the Australian approach allows a member (shareholder) of the
company to submit a written question to the auditors that relates to the
content of the auditors’ report to be considered at the AGM or the conduct of
the audit of the annual financial report to be considered at the AGM. This
must then be made available to shareholders attending the meeting. The
company is obliged to allow:
(a) the auditors a reasonable opportunity at the AGM to answer the
written question(s); and
(b) shareholders to ask the auditors general questions about:
(i) the conduct of the audit;
(ii) the preparation and content of the auditors’ report;
: In recent case, involving a well known UK plc, management uncovered an unacceptable, previously
undisclosed and potentially material conflict of interest at the audit firm involving competing bids for an acquisition
that led to the auditor being changed. The issue only came to light after proactive engagement with the
(iii) the accounting policies adopted by the company in relation to
the preparation of the financial statements; and
(iv) the independence of the auditors in relation to the conduct of
6.3 The scope of such an arrangement should be extended to cover all work
undertaken by the auditors on an audit client, including work on internal
controls and the OFR. It is frequently argued that there are particular
synergies and benefits from having the Statutory Auditors undertake other
non-audit work and by extension this should be reflected in the scope of
shareholders’ ability to submit written questions.
7.1 Given the importance of the focus on shareholder interests, there should a
specific requirement for auditors always to attend listed company AGMs and to
be heard in any part of the meeting that concerns the audit/auditor. This should
apply even where the board has ‘removed’ the auditor or the auditor is
7.2 The UK should re-introduce/reinforce and enhance ‘matters of emphasis’
reporting. It not clear what has happened to the alternative opinions that seemed
to be used, albeit infrequently, until the early 1990s. These non-standard audit
reports broke down into 4 types:
(i) Inability to give an opinion because of a fundamental matter of
uncertainty, i.e. a total disclaimer.
(ii) Inability to give an opinion on a material issue of uncertainty, i.e.
subject to caveats, confirmation could be given.
(iii) Inability to give an opinion on a fundamental issue of disagreement,
i.e. in light of said issue confirmation could not be given.
(iv) Inability to give an opinion on a material issue of disagreement, i.e.
excluding said issue, confirmation could be given.
A healthy, vibrant audit market would have built on and enhanced this
framework, both in relation to unqualified and qualified opinions, rather than
reducing it to the point where such caveats are rarely seen. This is an area
where appropriate clarification and guidance is needed.
7.3 Auditors should provide affirmative confirmation that to the best of their
knowledge the company has applied/complied with the accounting policies it has
disclosed and outline any overrides or departures.
7.4 The Audit Engagement Partner should personally sign the audit report.
7.5 In looking further at what the Caparo duty on the provision of “reliable
intelligence” would entail in practice, one key aspect is for the audit standards
and report to be enhanced (recognising the need to ensure an appropriate
balance between management disclosure and auditor reporting) to bring clarity of
(i) Changes in accounting policies and their effect on financial
(ii) Explanations of deviations in cashflow and earnings.
(iii) Issues around revenue recognition and earnings management.
(iv) Key assumptions being used, changes to them and any
(v) Identification of any grey areas of interpretation and the issue they
(vi) Any other issues of potential concern (e.g. ‘old’ Cable & Wireless –
lien over cash and segmental reporting / e.g. ‘old’ Marconi – lien over
cash and option hedging exposures).
(vii) Effects of changes in treatment on executive remuneration (many
share schemes rely on, for example, EPS that is a key focus of
(viii) Any area where the auditor could not obtain all the information it
(ix) Disclosure of areas/issues which the auditor felt would have been
appropriate to shareholders’ interests to investigate further, but was
unable to undertake that work (e.g. time constraints or a refusal to
fund the extra work required), perhaps linked to enhanced matters of
emphasis reporting4. (Anecdotal evidence from auditors is that this
issue does arise and cause problems).
(x) Any other concerns that the auditor has that have not been addressed
that are relevant in relation to the duty and purpose outlined in
paragraph 2.1 above.
(xi) Any non-GAAP measures disclosed and used by management, along
with a comparison with GAAP (e.g. embedded value or various of the
adjusted earnings measures).
(xii) Enhanced ‘matters of emphasis’ reporting (see paragraph 7.2 above)
: See paragraph 7.2 above
7.6 The ‘Management Letter’ submitted to the Audit Committee or Board, by the
auditors, should be made available to shareholders. Before the Cadbury
Committee Report (1992), the Management Letter generally contained minor
housekeeping points only, on the basis that anything else was relevant for
shareholders. It was also issued after the accounts were signed off, which
had the implicit effect of ensuring it did not become a "private" auditors' report
to directors, that might bury bad news. This sadly no longer seems to be the
7.7 We suspect that the management letter has become a surrogate for matters
of emphasis, internalising issues that should arguably have been flagged and
addressed to shareholders. This is another facet of the concerns reflected in
paragraphs 2.2. and 2.3 above. This problem is illustrated in the
Management Letter that was published in the DTI inspectors’ report on the
failure of Transtec plc. The clues about the problems that brought the
company down can be found in that ‘private’ report.
7.8 There is an increasing regulatory focus on reducing reporting periods, which
is another US trend. However, this puts stress on the quality and delivery of
audits. The reality is that on any balance sheet the riskiest items are those
that are not settled e.g. stock, debtors etc. and this trend means there is less
time for things to come out in the wash. What appears to happen in the US is
that November is audited, then December is "rolled forwards" - fine if nothing
happened in December. Looking back it is worth noting that ‘old’ Cable and
Wireless was the fastest reporter in the FTSE100 in 2002. The effect of
proposed changes to the reporting cycles on the delivery of effective audits
should be considered.
8.1 In respect of the question of liability, the creation of an appropriate framework
that satisfies the focus in Caparo and ensures reliable intelligence is provided
to shareholders, would provide a proper basis from which to consider this
issue. We recommend the use of safe-harbour provisions that limit liability on
a proportional basis where auditors had acted promptly, in line with the
framework outlined in this paper.
8.2 In addition, the current scope under the Companies Act for management to
pressure/accuse the auditor on defamation, using shareholder funds, needs to be
examined and appropriate steps taken to ensure that it does not hinder or inhibit
the provision of “reliable intelligence” to shareholders as per Caparo. Auditors
should be protected from defamation suits by management where they are
providing information in good faith. This issue needs to be addressed for needed
enhancements to auditor’s accountability (e.g. scope for shareholders to ask
questions) and reporting (e.g. audit reports, resignation letters) to be effective.
Professional development and structure
9.1 Within reason, the key driver for investors is quality rather than cost. In that
context, there would be merit in the oversight bodies and the profession itself,
reviewing whether the arrangements around remuneration, retention and
development of audit staff are appropriate to deliver and maintain what should be
the ‘gold standard’ of the profession. The impending transition to IFRS has
highlighted instances where some of the more advanced companies have flagged
surprise over their auditor preparations, with audit staff being felt to have lagged
behind the company’s own internal training and transition programs.
10.1 Consideration should be given to the accounting treatment of the cost of the
statutory audit. This could be taken below the line, rather than above the line
as at present. It is after all a ‘shareholder’ cost.
10.2 Are people truly satisfied that an incoming auditor has full access to the
previous auditor’s engagement files and working papers? Arrangements
should be put in place to ensure work done for and on behalf of shareholders
is passed on to their incoming advisers.