Auditors were required to operate as sole traders or partnerships

Category: Accounting

In 1994, KPMG settled a $1.1 billion claim by the Victorian Government in relation to auditing the collapsed Tricontinental merchant bank, with a record payout of $136 million. The $3.9 billion claim against KPMG over the State Bank of South Australia collapse was settled in 1998 for an undisclosed sum. In 1995, the Court of Appeal in the AWA case reduced the damages from the $50 million originally claimed to $6 million, of which Deloitte was liable for $4 million and the company the balance. However, the legal and associated costs in defending the action are reported to have totalled more than $30 million, which led to the claim that the auditors would have been better off financially if they had settled out of court.

Prior to CLERP 9, Australia was falling behind the reforms to auditors' liability being adopted in other countries. For example, limited liability partnerships for audit firms have been introduced in the United Kingdom and United States, proportionate liability has been implemented in Canada and joint and several liability has been abolished or modified in a number of States in the United States.

The CLERP 9 reforms provide a balance between the risks for an auditor associated with carrying out the audit function and protecting the

public interest by:

• limiting the amount of damages that can be awarded against auditors by introducing a cap for professional liability;

• providing greater protection to auditors' personal assets by allowing them to incorporate and operate in a limited liability environment;

• providing a more equitable basis for allocating damages by replacing the principle of joint and several liability with the principle of

proportionate liability; and

• providing protection to users of the audit function by requiring auditors to have reasonable professional indemnity insurance cover.

These reforms to auditors' liability should enable an expansion in the scope of auditing and the reporting of the results.

In the CLERP 9 documents it was noted that corporate disclosure would be improved if auditors reported on areas such as governance, internal control and risk management. However, in the past, auditors have been reluctant to undertake engagements to report on these matters due to litigation risks. It is hoped that these reforms will make auditors more willing to undertake this type of work. If so, it will improve the quality of the audit function and should help to reduce the audit expectation gap between financial report users and auditors.

CLERP 9 Act Overview

The CLERP 9 reforms represent the most recent round of reforms implemented in Australia as part of the Howard Government's Corporate Law Economic Reform Program (CLERP). In March 1997 Treasurer Peter Costello announced the CLERP initiative which involved a review of key areas of regulation affecting business and investment activity.The objective of the CLERP 9 is to ensure business regulation is consistent with promoting a strong and vibrant economy and provides a framework which assists business to adapt with change.

The CLERP 9 emerged as a result of international debate on corporate governance , and the role and regulation of auditors more specifically as a result of events in the years 2001-2002, when numerous major companies in the such as Enron and in United States and HIH Insurance, One Tel principally as well as Ansett adn Pasminco in Australia collapsed.

The consequence of these events lead regulators to focus their attention on the contribution of those companies' auditors in these collapses, due to evidence of audit oversight and lack of transparency and accountability and the relevant audit firms being too close to their audited clients.

In the United States , Andersen the global accounting firm which subsequently collapsed under the weight of the scandal which transpired , signed off on Enron's financial reports which overstated the company's earnings by US$586 million over five years and had shredded a large volume of Enron's documents.

Measures under CLERP 9

Two measures introduced under CLERP 9 to deal with the issue of auditor's liability in relation to professional default are to firstly enable audit firms to incorporate so that the liability is restricted to the auditor(s) actually responsible. Secondly to introduce a system of proportionate liability in relation to damages and actions involving , but not limited to auditors concerning economic loss or property damage stemming from misleading and deceptive conduct.

Registration of audit companies

Prior to CLERP 9, only individuals could be registered as a an auditor under the Corporations Act 2001; companies could not be registered as auditors. Thus partnerships were the main business structure favoured by auditing firms. Consequently , given that audit partners are subject to unlimited joint and several liability for professional default, all the partners in the audit firm could be liable for losses caudes by another partner in the firm even if the they had no involvement in the particular conduct causing the loss.

As stated in the Explanatory Memorandum to the CLERP 9 Bill: The best way to overcome this liability issue was to give audit firms the option to incorporate, "which will help sheet home liability to those who are actually responsible...In addition , incorporation will give audit firms a broader range if options in determining how the business is structures and managed"

The new s 1299A of the ....requires that companies to apply to ASIC for registration as an 'authorised audit company'. ( NEED TO CHECK WHICH ACT AND WORDINGS). This application needs to be written and contain the prescribed information . Under s 1299B a company may only be registerd as an authorised audit company if:

Each of the directors of the company is a registered company auditor and is not disqualified from managing a corporation under Pt 2D.6;

Each share in the company is held and beneficially owned by a person who is an individual or the legal representative of an individual;

A majority of the votes that may be cast at a general meeting of the company attach to shares in the company that are held and beneficially owned by individuals who are registered company auditors;

ASIC is satisfied that the company has adequate and appropriate professional indemnity insurance , and;

The company is not an externally administered body corporate.

Proportianate Liability

The CLERP 9 Discussion Paper provided the following useful explanation of the distinction between joint and several liability and proportionate liability:

" Joint and several liability means that where the acts or omissions of a number of persons have each contributed to a plaintiff's loss , the full amount of that loss can be recovered by the plaintiff from any one of those persons"

" Under the proportionate liability principle , the liability of each defendant is in all circumstances limited to the extent to which that party is considered to be responsible for the loss. There is no right of contribution between various defendants , since none of them would as a general rule , be liable to pay to the plaintiff any more that the proper share owing by the plaintiff"

Prior to CLERP 9 reforms , audit partners in firms were jointly and severally liable for professional default within the firm, thus exposing each partner to unlimited liability.

Auditors had traditionally protected themselves from unlimited liability through professional indemnity insurance. However, as a result of the collapse of HIH , insurers in Australia adopted much tougher risk selection protocols which meant many auditors found it extremely difficult adequate insurance , or were paying much higher premiums to get the level of professional indemnity insurance they wanted. The result was that many auditing firms reduced the scope of the audit and other services provided to their clients , in order to be able to obtain insurance or obtain it at a reasonable rate.