Auditor’s Lose 3-2 after Extra Time

In recent years considerable evidence has emerged concerning a rather alarming phenomenon which has come to be known as the audit expectation gap. The audit expectation gap consists of differences between the perceptions of the duties and responsibilities of auditors held by the business community and the public generally as compared to the legal duties and responsibilities of auditors.

Given the above perception if it should happen suddenly or without any obvious warning that a company is in serious financial difficulty then it is likely to be presumed that the auditors are at fault in some way. Such perceptions have been heightened by adverse media publicity concerning auditors to the extent that public confidence in the auditing profession appears to be at an historically low ebb.

In recent years the reputation of the auditing profession has been further damaged by considerable media publicity concerning law suites against a number of audit firms and by the finings of a number of official inquiries into recent corporate collapses.

Although some recent criticisms of auditors may well be justified it also appears that the media and various interest groups have lost sight of the fact that the primary responsibility for every aspect of management of company’s affairs rests with its directors. The soon to be effective Companies Act 71 of 2008 legally ensures that the fiduciary responsibility of all company directors is to conduct the company’s affairs with care and integrity on behalf of all stakeholders and to take responsibility for the detection, investigation and prevention of fraud and error.

The unfortunate fact for auditors is that when directors abrogate their duties and companies fail or incur losses then in the eyes of society and even the courts auditors are convenient and vulnerable scapegoats. This could be likened to suing the fire brigade for arson or blaming the police for the levels of crime.

Many actions against auditors cry out for a defence of contributory negligence (on the grounds that that management have been negligent) but the courts have denied this defence to auditors. The primary cause of most corporate failures rests with inept or imprudent decisions made by management.

In 1987 Justice Rogers (an Australian Judge) stated that directors should bear their share of responsibility with respect to losses suffered by their company. He posited the view that it was socially and commercially unjust and inappropriate that directors should escape liability completely and that the full burden of responsibility should rest on the auditors.

This view was shared by a brave and visionary South African Judge who understood the potentially damaging effects of the audit expectations gap. Justice Ezra Goldstein’s ruling in the Thoroughbred Breeders Association v Price Waterhouse almost shut the audit expectation gap by upholding the view that the auditor should not be held liable for the negligence of directors.

The Supreme Court of Appeal like many goalkeepers in the 2010 world cup did not keep their eye on the ball and reversed the ruling made by Judge Goldstein and placed the entire blame for management’s negligence on the auditor’s. Little did the Supreme Court of Appeal realise that their judgement would place the future of the entire auditing profession in jeopardy.

In 2005 the Supreme Court of Appeal only by a 3-2 decision extended auditor liability in to a new age where auditors could become a different species. In 1896 the auditor was said to be a watchdog, in 1991 they become bloodhounds and it appears that if the Supreme Court of Appeals have their way auditors will become clairvoyants with the ability to disclose to their clients when they are negligent even when they have no idea that were negligent.

Three out of the five Judges of the Supreme Court of appeals ruled that Deloitte and Touché failed to warn the companies to whom they owed a duty of care that they were negligent. In other words negligence by silence.

The winning team of judges (three of them) explained in defence of their ruling that it must be remembered that we are dealing with a situation where the legal convictions of the community could well consider it unacceptable that an auditing firm which issued a seriously negligent report should escape the legal duty to speak with care concerning that report simply because it was, possibly even negligently, ignorant of the negligence of its report.

The losing team of judges (two of them) in the defence of their opinion asked of the winning judges the following: How can one disclose what one does not know?

The Supreme Court of Appeal was not unanimous and in fact the decision went into extra time and the entire future of the auditing profession in South Africa was decided by an odd goal. This split decision by equally learned judges clearly implies that the liability of an auditor is unresolved and is need of reform. The split decision indicates that the case law is complex and ill defined making it difficult for a court of law to give due consideration to the issues and sensitivities involved.

So where to now. In any business activity if the financial risks are perceived to outweigh the rewards the practice ceases to be regarded as viable. If auditors are to be judged on performance of their clients and any other persons the courts deem the auditors owe a duty of care this may well result in the demise of the profession and the ultimate losers will of course be the entire business and investor communities.

It may well be in the public interest to impose limitations on the liability of auditors and to limit the persons to whom they owe a duty of care so as to ensure that there is not a wholesale exodus from the ranks of the auditing profession and burden society even more. There needs to be a replay the decision made in extra time reversed. Judge Goldstein’s ability as a clairvoyant should passed on to the ultimate referee - the government. The law needs to be changed.