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Conflict rules for accountants and auditors: could they affect your business?
This month, we look at conflicts of interest in the context of the accountancy profession. First, we look at the common law rules relating to conflicts of interest between a firm and its existing and/or former clients. Then we consider the way accountants' professional rules may restrict an accountancy firm's freedom to provide different services to the same company.
In many ways, the issue of conflicts of interest is the same for accountants as it is for solicitors. The common law principles apply equally to both, and existing and former client conflicts raise similar issues. But there are a number of conflict problems that are specific to the accountancy profession, which arise because of the variety of services provided by accountants, coupled with their professional rules.
THE COMMON LAW
In IHL143 we provided an overview of the common law principles (see the feature by Brian Kilcoyne, p42) relating to existing client conflicts and former client conflicts.
As aptly demonstrated by a number of the cases on conflicts of interest that involve well-known accountancy firms, the professional/client relationship between accountants and their clients is largely a fiduciary relationship to which the principles of existing and former client conflict apply.
Existing Client Conflict
An accountant/client relationship will typically be a fiduciary relationship and, if so, the accountant owes the following duties to the client:
- loyalty (namely, to defend and advance the interests of the client);
- trust and confidence;
- disclosure (namely, the duty to disclose to the client all relevant information which is in, or comes in to, the possession of the accountant); and
- confidentiality (namely, to preserve information which is confidential to the client and not to disclose the same to third parties).
The accountant cannot simultaneously act for two or more clients if:
- those clients have interests which potentially conflict (unless both clients give informed consent for the accountant to continue to act) - the ‘double employment rule';
- the accountant is inhibited from discharging their fiduciary duties to one client as a consequence of the existence of fiduciary duties owed to the other client - the ‘no inhibition rule'; or
- an actual conflict of interest arises as a consequence of acting for two clients (even if both clients give informed consent for the accountant to continue acting) - ‘the actual conflict rule'.
Former Client Conflict
This conflict arises where an accountant acts for one client to which fiduciary duties are owed but has a continuing duty not to disclose confidential information belonging to a former client, which conflicts with the continuing duty of disclosure to the existing client. However, as explained in detail in IHL144 (see the briefing by Sohrab Daneshku, p43), if the former client's confidential information can be protected and adequate steps are taken to prevent inadvertent disclosure to the existing client (information barriers/Chinese walls within the accountancy firm, for example), it may be possible for the accountant to continue to act. However, the well-known case of Bolkiah v KPMG is a good example of a case where the court decided that confidential information could not be adequately protected by a Chinese wall.
Although recent cases suggest a slightly more relaxed attitude, the courts have taken a robust approach to conflicts of interest arising in the provision of accountancy services and appear to expect that accountants should have the same understanding of the common law principles as solicitors.
In-house lawyers will be familiar with these principles. What is perhaps less well-known, however, is the way in which the accountancy profession deals with conflicts of interest in its professional rules, and how those rules might impact on the operation of a business.
SERVICES PROVIDED BY ACCOUNTANTS
Professional accountants provide their clients with a wide variety of services, including:
- tax planning and representing corporate clients in hearings before, or disputes with, the tax authorities;
- management consultancy;
- litigation support services (including acting as expert witnesses);
- insolvency work (including accepting appointments to act as liquidator, receiver, administrative receiver etc);
- investment advice; and
- expert valuations (particularly of entire businesses or the shares of a business).
Although this presents accountants with a range of opportunities for work (and therefore fee income), it can also cause problems. In certain circumstances, accountants' professional rules prohibit them from providing a service when already engaged by the same company to provide a different service. This is where there is a risk that what is required of the accountant to provide the second service will create a conflict with the duties necessary to provide the first.
To demonstrate the extent and impact of these rules and to highlight some of the practical issues that ought to be considered by the directors of a company (with the assistance of, or in reliance on, the in-house lawyer) we will focus on the rules applicable when an accountant acts as auditor.
THE ACCOUNTANT AS AUDITOR
The Auditing Practice Board has issued a number of Ethical Standards. These expressly recognise that the primary purpose of a company's financial statements is informing a company's owners (the shareholders) about its state of affairs. They also assist shareholders in assessing the stewardship exercised by those who control the business of the company (the directors). The financial statements are prepared by the board of directors for the benefit of the shareholders (and other third parties) and an audit provides independent assurance to shareholders that the directors have prepared the financial statements properly.
Given that the auditors' primary objective is to provide shareholders with an independent view of the manner in which the board of directors has controlled the business, auditors risk incurring the directors' displeasure if the audit questions their conduct. If the accountants are simultaneously seeking engagement by the company for the provision of other services, this could give rise to the possibility that discharging their obligations as auditors may have a negative effect on the prospects of securing engagements for the provision of other services.
AUDITORS' ETHICAL STANDARDS
The Ethical Standards contain a good deal of material relevant to conflicts of interest in the way that they deal with the auditors' fundamental ethical principles of:
- objectivity; and
The principles of objectivity and independence are perhaps those with most relevance to potential conflicts of interest for auditors, but all three are worthy of some comments.
- Integrity - auditors must act, and be seen to act, with integrity. This requires not only honesty but a broad range of related qualities such as fairness, candour, intellectual honesty and confidentiality.
- Objectivity - described in the Ethical Standards as a state of mind that excludes bias, prejudice and compromise and which gives a fair and impartial consideration to all matters that are relevant to the task in hand. Objectivity requires that the auditors' judgement is not affected by conflicts of interest.
The need for objectivity requires that auditors express an impartial opinion in light of all the available audit evidence and their professional judgement. They should adopt a rigorous and robust approach being prepared, where necessary, to disagree with the directors' judgements.
- Independence - the freedom from situations and relationships which make it probable that objectivity is, or could be, impaired. Independence is related to, and underpins, objectivity. Independence relates to circumstances surrounding the audit, including the financial, employment, business and personal relationships between the auditors and their client. In evaluating the likely consequences of such situations and relationships, the test to be applied is not whether the auditors consider that their objectivity is impaired, but whether it is probable that a reasonable and informed third party would conclude that the auditors' objectivity either is impaired or is likely to be impaired.
Having identified the fundamental ethical principles which must be adhered to by auditors, the Ethical Standards also identify a number of ‘threats' to the auditors' objectivity and independence. It is these threats that might reasonably be regarded as constituting conflicts of interest for accountants acting both as auditors and in some other capacity for the same client.
THREATS TO AUDITORS' OBJECTIVITY AND INDEPENCE
The principle threats identified in the Ethical Standards are:
This arises when auditors have financial or other interests which might make them reluctant to take action that would be adverse to the interests of the company being audited or any individual in a position to influence the conduct or outcome of the audit. These might include where the accountancy firm is seeking to provide additional services to the company or is trying to recover outstanding fees.
This is when the results of a non-audit service provided by accountants that are also auditors are reflected in the amounts disclosed in the financial statements. For example, whilst acting as auditors, a firm may be required to re-evaluate non-audit work also performed by the firm. In this instance, the accountants may be, or may be perceived to be, unable to take an independent and objective view of the financial statements.
The accountancy firm carrying out the audit may also undertake work that involves making judgements and taking decisions which are the responsibility of the directors of the company. For example, the design, selection and implementation of financial information technology systems. In so doing, they may become so closely aligned with the views and interests of the directors that the auditors' objectivity and independence may be, or may be perceived to be, impaired.
An accountancy firm acting as auditor may also act as an advocate for the company in an adversarial context, such as representing the company before HM Revenue & Customs in disputes concerning the payment of tax. In doing so, the accountancy firm must adopt a position closely aligned to that of company management which creates both actual and perceived threats to the objectivity and independence of the accountants in their role as auditor.
Familiarity (or trust) threat
This happens when the auditors are predisposed to accept (or are insufficiently questioning of) the company's point of view, for example, when they have developed close personal relationships with the directors of the company.
This arises when the auditors' conduct is influenced by fear or threats, for example, from an aggressive and dominating individual at the company.
Impact on the in-house lawyer
It could be argued that it is incumbent upon the accountants to identify and raise potential threats, and that the principles set out in the Ethical Standards are of more interest to them than to an in-house lawyer. However, in-house lawyers should be aware of potential risks that might arise from courses of action proposed by the company's board of directors.
Common issues of ethics for auditors of particular relevance to in-house lawyers
Can gifts be given to the auditors by, or on behalf of, the company? Unless the value of the gift is modest (perhaps an inexpensive bottle of wine) the receipt of a gift by an auditor from the company is likely to create a self-interest threat.
Does it matter that the company has not paid invoices raised by the accountancy firm that acts as its auditor?
Where the amount unpaid is significant - either to the company or the firm of accountants - it is likely to be viewed as a loan by the accountant to the company, which also creates a self-interest threat.
Consideration is being given to appointing a partner in the firm of accountants that acts as the company's auditor, to the position of company secretary. Will this create a problem?
The accountancy firm cannot act as auditor if a principal in that firm is also an officer of the company. Such dual roles and responsibilities constitute a significant self-interest threat and a possibly a self-review threat.
Can a principal in the firm of accountants that conducts the audit own shares in the company?
Owning shares in a company for which the accountants act as auditor creates a clear self-interest threat to objectivity. If the shareholder is a principal in the accountancy firm, then that individual should dispose of the shares immediately. If the shareholder is an employee and has no involvement in the audit process or the management responsibility for audits, then the position is less serious and it may be possible for the accountants to continue to act as auditor. However, the individual must disclose their shareholding to their employer so that appropriate steps can be taken to avoid any threat, or perceived threat, to independence and objectivity.
Can the child of a principal in the firm of accountants appointed as auditors be appointed a director of the company for which the accountancy firm acts as auditor without creating a problem?
If the parent is a principal in the firm of accountants and the child becomes a director of the company, then there is a self-interest threat which would prohibit the accountancy firm from continuing in the role of auditor. The position would be different if the parent is not a principal and the child is not an officer or senior employee of the company. In this scenario, it may be possible to manage the self-interest threat by use of information barriers, for example.
THE ACCOUNTANT AS AUDITOR AND VALUER OF SHARES
In-house lawyers will no doubt be familiar with common pre-emption provisions applicable to shareholders in private limited companies, which provide that if a shareholder wishes to dispose of their shares they must offer to sell them to the other existing shareholders in the company before they are permitted to sell them in the open market.
Inevitably, the key question is the price at which the proposed seller must offer the shares to the other shareholders. Pre-emption provisions commonly provide that the price, reflecting market value, should be determined by the auditors of the company.
There is an obvious logic to such pre-emption provisions providing that the market value of the shares, and thus the price at which the proposed seller should offer shares to the other shareholders, should be determined by the auditors. The company's auditors would already be very familiar with the financial position of the company and ought, therefore, to be in a position to produce a valuation quickly and cheaply. There is, however, a problem resulting from the professional rules applicable to the auditor.
The Ethical Standards prohibit the auditors from accepting an engagement to provide a valuation where the valuation would both:
- involve a significant degree of subjective judgement; and
- have a material effect on the financial statements.
The Ethical Standards provide that, having regard to the ‘threats' outlined above, the principal threats to the auditors' objectivity and independence in such a situation are the self-review threat and the management threat. The self-review threat is considered too great to allow the auditors to provide valuation services which involve a significant degree of subjectivity that may have a material effect on the financial statements.
The difficulty this creates for the shareholders (and possibly the company), and which ought to be considered by the in-house lawyer, relates to the potential consequences of the auditor declining to carry out the valuation in accordance with the pre-emption provisions. Although there is no legal authority to assist in identifying the precise consequences, it appears possible that, in the absence of agreement between the shareholders as to the price, the proposed seller's shares become untransferable. Alternatively, the pre-emption provisions themselves could be void, so that the proposed seller is free to sell shares in the open market, even if this is contrary to the wishes of the continuing shareholders.
If the only means of resolving the issue is by application to the court, that will inevitably involve the uncertainty of litigation and the incurrence of legal costs, neither of which the shareholders or the company are likely to find desirable. If such problems are a possibility, the prudent course for the in-house lawyer is to amend the pre-emption provisions. These should then ensure that in the event that the auditors do decline to act as valuers, as they may have to by reference to the Ethical Standards, the valuation will be determined by an independent valuer appointed, in the absence of agreement, by the president of the Institute of Chartered Accountants.
The common law principles on conflicts of interest need to be understood by both accountants and in-house lawyers. But the common law does not tell the whole story. The rules of the accountancy profession can have a significant impact on the business of an in-house lawyer's company.
Care should be taken when preparing any agreement or business strategy which involves or makes reference to the company's accountants, particularly if they are the company's auditor, as the rules of the accountancy profession may frustrate what is being proposed. If, as may be the case with the involvement of auditors in the context of pre-emption provisions, agreements already exist which require some involvement
or activity by a company's auditor, it would be sensible to discuss those agreements with the accountants to ensure that they are free to act in the way envisaged. It is better to identify and resolve issues before attempts are made to enforce or rely upon provisions. If the provisions cannot be enforced there will be problems and, potentially, litigation.
Bolkiah v KPMG  2 WLR 215
By Clive Greenwood, a partner in the litigation and dispute resolution department, and joint head of the partnership and LLP law group, Lewis Silkin LLP.