Auditor Regulatory Breaches and Professional Negligence Claims

Professional Negligence Claims against Auditors

Problem: In a recent and striking development within the UK’s auditing sector, KPMG, a leading audit firm, has again found itself under intense scrutiny. Carillion, once a major construction and facilities management company with substantial government contracts, collapsed in 2018 with £7 billion in debts, causing significant disruptions across numerous projects. KPMG audited Carillion’s financial books from 2014 to 2016, claiming each time that the financial statements were true and fair. The core issue revolves around KPMG’s failure to conduct a sufficiently rigorous audit, which subsequently led to the publication of misleading financial statements.

Outcome: KPMG LLP and KPMG Audit PLC, along with two former partners involved in the Carillion audit, have been held accountable for these lapses facing the highest-ever penalty of £21 million for the audit of Carillion. The penalties by the Financial Reporting Council include substantial financial fines and non-financial sanctions which we will look at further below.

What is the Financial Reporting Council?

The Financial Reporting Council (FRC) is the UK’s leading regulator responsible for auditing, accounting, and actuarial standards. It seeks to ensure transparency and integrity in financial reporting and corporate governance. The FRC sets the UK’s Corporate Governance and Stewardship Codes, regulates auditors, and enforces adherence to professional standards and ethics in the accounting and auditing sectors. Key to its role is promoting high-quality corporate reporting and effective corporate governance to bolster confidence in the UK’s financial markets.

What is the relationship between the Financial Reporting Council and the Financial Conduct Authority?

The FRC and the Financial Conduct Authority (FCA) are both important in overseeing different parts of the financial world in the UK, but they have different jobs:

1. FRC’s Role: The FRC mainly focuses on the people and firms that audit company accounts. It makes sure these auditors are following the rules and doing their audits correctly. The FRC also helps set standards for how companies should report their finances.
2. FCA’s Role: The FCA is more about protecting consumers who use financial services, like banking and insurance. It watches over financial markets to make sure they are fair and works to stop financial crimes.

Even though they have different roles, the FRC and the FCA sometimes work together. For example, if there is a problem with how a company is reporting its finances, both the FRC (which checks the auditors) and the FCA (which monitors financial markets) might be interested. By collaborating, they help make sure companies and their auditors are honest and that the financial markets are safe and fair for everyone.

Requirements that accountancy and audit firms must follow and key legislation and rules

Accountancy and audit firms in the UK must adhere to a set of strict requirements and rules to ensure they operate fairly and transparently. These requirements are set by regulatory bodies like the FRC and the FCA to uphold the integrity of financial practices including:

1. Adherence to Accounting Standards: The FRC sets specific accounting standards, known as UK Generally Accepted Accounting Practice (UK GAAP) and International Financial Reporting Standards (IFRS). These standards dictate how financial information should be recorded and reported, ensuring consistency and clarity across all companies.
2. Auditing Standards and Ethics: Auditors must follow the UK Auditing Standards, which outline how audits should be conducted. These standards require auditors to be thorough, unbiased, and independent in their examination of a company’s financial statements.
3. Professional Conduct and Ethics: Both accountants and auditors are expected to adhere to high ethical standards. This includes acting with integrity, objectivity, and professional competence. They must avoid conflicts of interest and maintain confidentiality.
4. Regular Training and Qualifications: Professionals in this field must have appropriate qualifications and undertake regular training to stay updated with the latest practices and regulations.
5. Compliance with Anti-Money Laundering Regulations: Firms are required to comply with anti-money laundering regulations, including conducting due diligence and reporting suspicious activities.
6. Corporate Governance Compliance: The FRC’s UK Corporate Governance Code sets standards for good practice in board leadership and effectiveness, remuneration, accountability, and relations with shareholders. Companies are expected to follow these guidelines to ensure responsible business management.

FRC’s Findings against KPMG in its Audit work for Carillion

The FRC’s investigation revealed an “unusually large number of breaches,” with KPMG failing to adhere to “the most basic and fundamental audit concepts.”  Jon Holt, KPMG’s UK chief executive, admitted the audit work was “very bad,” citing incompetence among former partners and employees who neglected their responsibilities.

The transactions which caused complications from an audit perspective for KPMG involved complex arrangements between Carillion and its service providers, which were materially misrepresented in the financial statements.

1.Complex Transactions and Misrepresentation of Profits:

1. In 2013, Carillion altered its outsourced service provider agreements, leading to a series of complex transactions. These included the assignment of intellectual property rights, contributions to an exit fee, and other charges totalling £40.8 million over the contract’s life.
2. The cumulative effect of these transactions falsely inflated Carillion’s reported profit by £41 million in the 2013 financial statements​​.

2. Lack of Professional Scepticism and Risk Assessment:

1. KPMG failed to adequately assess the risk that these transactions were linked. Such a linkage would mean that the cash received from these transactions should not have been recognised as income earned in 2013, thereby inappropriately inflating the reported profit.
2. There was a failure to approach these transactions with the necessary degree of professional scepticism, particularly in assessing whether they were independent of each other and conducted at fair value​​.

3. Inadequate Audit Procedures and Failure to Detect Misleading Information:

1. KPMG did not perform sufficient audit procedures to provide appropriate evidence for concluding the correct accounting treatment of these transactions.
2. This oversight was compounded by KPMG’s failure to identify that the disclosures in Carillion’s 2013 financial statements might be misleading, despite being aware of the significant profit being recognised and the evidence suggesting that the intellectual property assignment was not at fair value​​.

The FRC’s findings against KPMG highlight a concerning lack of diligence and professional judgment in one of the most significant audits in the UK. The failure to detect and report the true nature of these complex financial transactions not only misrepresented Carillion’s financial health but also undermined trust in the auditing profession.

This case underscores the importance of rigorous audit practices, thorough risk assessment, and the necessity for auditors to maintain a high degree of scepticism, especially when dealing with complex and significant financial transactions.

Sanctions Imposed by the FRC

There were two decisions handed down by the FRC as part of its investigations into KPMG’s auditing of Carillion across the financial years.

Decision 1: Regarding Audits for Financial Years 2014, 2015, and 2016, and Additional Audit Work in 2017

KPMG LLP:

i. Financial sanction of £26,500,000, reduced to £18,550,000 due to cooperation and admissions
ii. A severe reprimand published
iii. Declaration that audit reports did not satisfy relevant requirements
iv. Order to take remedial action to prevent the recurrence of breaches.

Peter Meehan (Former Partner of KPMG LLP and Audit Engagement Partner):

i. Financial sanction of £500,000, reduced to £350,000 due to cooperation and admissions
ii. Severe reprimand published
iii. Exclusion from membership of the ICAEW for 10 years, concurrent with exclusion imposed in other proceedings

Decision 2: Regarding Audits for Financial Year 2013

KPMG Audit Plc:

i. Financial sanction of £3,500,000, reduced to £2,450,000 due to cooperation and admissions
ii. A severe reprimand published
iii. Declaration that the audit report did not satisfy relevant requirements.

Darren Turner (Former Partner of KPMG LLP and Audit Engagement Partner for 2013):

i. Financial sanction of £100,000, reduced to £70,000 due to cooperation and admissions
ii. Severe reprimand published.

KPMG was also required to pay the legal and administrative costs for both investigations, totalling over £5.3m.

Professional Negligence claim against the Auditors

Carillion’s collapse led to 3,000 job losses and turmoil across 450 public sector projects. Earlier this year, KPMG settled a £1.3 billion professional negligence dispute from Carillion’s liquidators, further highlighting the severity of the auditing lapses. The FRC’s annual enforcement review indicated a total of £40.5 million in fines for major accountancy firms, with KPMG’s £20 million sanction for the Carillion audit standing out as the highest-ever.

The FRC highlighted recurring issues in audit investigations, such as a lack of scepticism, insufficient evidence, planning, and documentation. It also outlined eight ongoing audit enforcement procedures, emphasising the growing importance of reliable environmental, social, and governance (ESG) information in investment decisions. Often regulatory outcomes can be used to assist to prove professional negligence claims for example against solicitors and auditors who are highly regulated professions.

Comments from our Expert Professional Negligence Lawyers in London

KPMG’s £20 million fine highlights the severe repercussions of its auditing failures. It focuses on the critical importance of staying alert to indicators of financial distress. Regular and comprehensive assessments of a company’s financial health, alongside a proactive response to warning signs, can address issues before they escalate.

The repercussions extend beyond financial penalties, as Carillion’s collapse resulted in substantial job losses and disruptions across numerous public sector projects. The FRC’s emphasis on ongoing challenges in audit investigations, including the need for increased scepticism, evidence, planning, and documentation, signals a broader industry concern. These all point to a systemic issue requiring industry-wide attention.

If you are concerned about an audit, please do not hesitate to contact our expert professional negligence lawyers in London for a Free Consultation on 0207 459 4037 or complete our online booking form.