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Financial Reporting Council considers the test for "misconduct"

20 May 2019. Published by Robert Morris, Partner and Matthew Watson, Associate

A recent Financial Reporting Council (FRC) Tribunal decision provides some welcomed clarity on the distinguishing features of misconduct and negligence for those in the accountancy profession.

The FRC's decision marks the latest development in the regulator's review into Baker Tilly's audit of Tanfield Group. Tanfield Group, a manufacturer of electric vehicles, was provided with an unqualified audit report from Baker Tilly for the year ending 31 December 2007. It became apparent that the goodwill value apportioned to the acquisition of a separate company, amongst other concerns, prompted the start of the FRC's investigations in September 2009.

During Tribunal hearings held in 2017 and 2018 it was held that the auditors of the Tanfield Group failed to identify discrepancies in the most significant items on the company's balance sheet. In summary, the issue for the FRC Disciplinary Tribunal was whether the identified failings amounted to misconduct.  The Tribunal's decision is the result of a near decade long legal process which included an unsuccessful judicial review application by the auditors to challenge the regulator's pursuance of an investigation. In this update we concentrate on the FRC's comments on the differences between misconduct and negligence.

Misconduct vs. Negligence

By way of background the FRC's rules and procedures set out that "Misconduct" is,

"an act or omission or series of acts or omissions, by a Member or Member Firm in the course of his or its professional activities (including as a partner, member, director, consultant, agent or employee in or of any organisation or as an individual) or otherwise, which falls significantly short of the standards reasonably to be expected of a Member or Member Firm or has brought, or is likely to bring, discredit to the Member or the Member Firm or to the accountancy profession."

 

The FRC grappled with the distinction between a finding of negligence and a determination of misconduct for the purposes of assessing whether the auditors should have signed off a "clean" audit report for the Tanfield Group.

One key area for contention in the Judicial Review application brought by the auditors was whether the FRC should have proceeded to a formal complaint in the first place. The auditors had submitted that the alleged misconduct fell within the category of conduct described in the FRC guidance as a ‘non-trivial failure’. On this basis the auditor argued that a 'non-trivial failure' did not meet the threshold of 'misconduct' in the FRC's accountancy scheme disciplinary arrangements.

At the FRC Tribunal the Executive Counsel submitted that whilst negligence was not misconduct, conduct which fell short of "gross incompetence" could nevertheless amount to misconduct. Whereas the auditors emphasised the need to beware of evidence which amounts to no more than an expression of opinion by an accountant as to what they would have done in the same circumstances, and the need to distinguish between best practice, acts or omissions "falling short" and acts or omissions "falling significantly short".

Both parties referred to the test as to whether a "responsible" or "reasonable" body of professional opinion could do as the accountant did, the "Bolitho Test" following Bolitho v City and Hackney Health Authority. The auditors submitted that there is scope for differing interpretations as to the meaning of the relevant professional standards and that more than one professional view may satisfy the Bolitho Test. Interestingly, there was an absence of consideration of the Courts' more recent interpretations of the test for negligence, such as in the case of Coutts v O'Hare for instance where the judge moved away from the test in Bolitho. In more recent times the Courts have questioned whether the test for negligence should be more focussed on what a claimant would be expected to be told to put them in an informed position as opposed to whether an individual has met the commonly accepted practices.

Notably, the FRC held that, "it is not bound to unquestionably accept the evidence of an expert as to what reasonably competent auditors would do in any given circumstances". The FRC was unpersuaded by the auditors' position that, "another way of testing the position is to ask whether the shortcomings are so serious that they would undermine public confidence in the accountancy profession". The FRC stated that this "adds a gloss" on the wording of the relevant rules which refers to conduct that "is likely to bring discredit to the Member or the Member Firm or to the accountancy profession" as a separate basis for a finding of misconduct.

The Tribunal's Assessment of the Correct Approach

Following a detailed review of the differences between misconduct and negligence the Tribunal considered that the appropriate approach to determining misconduct was as follows:

  1. Step One

    Start by considering the position of each respondent in respect of each allegation and ask whether the conduct relied upon justifies a "falling short" criticism. This requires consideration of whether no reasonable or responsible body of opinion could support the conduct.

    To the extent that the answer to above question is "no" then that it is the end of the matter.

  2. Step Two

    Next, to the extent that the Tribunal considers that one or more criticisms of falling short are established, then for each allegation the Tribunal will consider whether in fact the conduct is not merely serious but sufficiently serious to cross the threshold into significance so as to justify a finding of misconduct.

    The FRC's decision makes clear that ultimately the judgment as to whether an individual's actions amount to misconduct will be at the discretion of the regulator. The views and opinion of accountancy experts in contested regulatory hearings will be useful but not decisive. The two step test as referred to above may however provide a useful tool in defending regulatory actions against accountants in circumstances where an individual's actions although sub-standard do not cross the bridge to amounting to "misconduct" if it can be shown their errors were not sufficiently serious.

The FRC's recent Tribunal decision comes at a time when the FRC remains in the spotlight following the scathing criticisms of the regulator in the Kingman Independent Review of the FRC. The Government has also publically committed to abolishing the FRC and replacing it with a new regulator, the "Audit Reporting and Governance Authority" (ARGA). In a recent letter from the CEO of the FRC to the Secretary of State for Business, Energy and Industrial Strategy the FRC noted it remains "committed to addressing deficiencies in audit and reporting quality vigorously through our supervisory and enforcement roles". It will have to be seen whether the regulator's recent promise will result in the FRC taking a harder line in future regulatory reviews.