Discuss about the Auditing, Assurance Services and Ethics Process.
This report seeks to shed light on the subject of auditor liabilities that tend to arise on account of the losses borne by the users. While there are a host of users of financial report, however, shareholders and creditors are the two significant stakeholders whose interest is highly impacted by any misreporting. Considering the role of auditors in the bankruptcy of businesses as has been witnessed in the GFC (Global Financial Crisis), the concept of auditor liability for the losses of the user groups has gained currency. In this context, the liquidation of investment bank Lehman Brothers was indeed a watershed event. The given report carries an in-depth analysis of the auditor liability concept in the wake of GFC like events. Additionally, it also offers a host of recommendations to auditors on how to ensure that their respective liability remains minimal in case of a future GFC.
There is no denying the fact that the adverse impact of GFC has been felt by all sectors of economy but unarguably the sector that has borne majority of the brunt are the organisations involved in financial services and products in the developed nations (Shefrin and Shaw, 2016). As a result, the so called invincible firms also succumbed to the mounting liability burden and had to file for bankruptcy. Arguably, the biggest name in this regard was that of Lehman Brothers. In relation to Lehman Brothers, while there are a plethora of factors coupled from untamed greed to financial statement misrepresentation that could be held responsible, but the role of auditors is undeniably one of the contributory factors. This is primarily because the bankruptcy did not just happen in a particular quarter but was the result of malicious practices being practiced over a longer period. Prominent amongst these was the usage of 105 Repo which the auditor of the company E&Y failed to capture in their report which clearly indicates towards negligence or fraud (Leung, Coram & Cooper, 2012).
HBOS is another financial organisation based in the UK which became bankrupt as a result of the GFC. However, GFC merely exposed the reckless lending practices which the company adhered to and were the real cause of failure. The company did not provide due consideration to the underlying creditworthiness of the prospective lender but rather extended loan facility on the back of rising asset prices which could serve as an effective collateral. This effectively led to the diminishing financial position which the auditors failed to capture before the actual damage was done (Caanz, 2016).
The role of the external auditor with regards to organisational progress and sustainability cannot be undermined as these adequately capture the various risks and verify the contents of the financial statements. This role assumes a greater responsibility in the modern financial markets where there are complex products whose implications are difficult to understand by the stakeholders and there is an increasing reliance on services offered by auditors. Considering the importance of their role, it is apparent that the auditors have a duty towards both their users and client and must uphold professional standards at all time (Gay and Simnett, 2012). The performance of the audit function with prudence and adequate care would ensure that the interest of both client and users is safeguarded which the auditors must seek to aim (Arens et. al., 2013).
In case of any negligence or intention wrongdoing observed by the auditor, common law prescribes liability for the auditors on account of non-compliance of their respective fiduciary duties along with professional standards. The key auditor liabilities are highlighted below.
Apparent from the name itself, this seeks to capture the auditor liabilities that tend to arise primarily on account of negligence on part of auditor leading to losses for the users (Caanz, 2016). The auditors have a duty to care directly towards the users as well as their clients and hence must conduct their work with skill and adequate due diligence. Failure to do may lead to breach of this duty which may cause significant losses to clients and users alike. In wake of this, the negligent auditors may have to pay damages for the losses caused due to their negligent conduct (Arens et. al., 2013).
Auditors would be subject to criminal liabilities only when they conduct fraud i.e. indulges in intentional wrongdoing. This usually transacts through the formation of a quid pro relationship between the external auditor and management which has severe adverse implications for the interest of the users specially shareholders (Gibson and Fraser, 2014). In such cases, the stakeholders who suffer loss could initiate legal proceeding against the defaulting auditor. Also, in certain cases the client may press charges against the concerned auditors if they fail to deliver the expected professional standards (Lindgren, 2011).
It is noteworthy that liability of auditor tends to be proportional to the resultant losses that is caused to the host of user groups and the client which may arise either due to intentional misconduct (fraud) or misconduct by mistake (negligence). Currently in the Australian context, there is capping of the auditor liability to 10x the audit free obtained from the given client. However, this amount is significantly lower in comparison to the quantum losses suffered by the user groups and hence in accordance with proportionate liabilities concept, there is a strong case either to increase the cap or to remove it all together (Cheung & Kandiah, 2016).
A key observation which was made during the bankruptcy of various financial institutions during GFC was the fact that these organisations collapsed despite having an unqualified audit report within the past year. This clearly raises questions on the intent and underlying relevant of the auditing profession as the professionals are supposed to act as alarm bells and indicate the users about the potential risks (Humphrey, Loft & Woods, 2009). The unqualified remark by the external auditor on the audit report is indicative of the fact that the underlying firm has adhered to the relevant accounting norms and has managed to faithfully represent the financial performance (ASIC, 2016). The importance of this opinion is apparent from the fact that an auditor on account of incorrect opinion offered on purpose, could have to face criminal proceedings (Arens et. al., 2013).
The statements outlined above can be validated on account of the host of cases that the auditor of Lehman Brothers i.e. E &Y had to face from the investors in the aftermath of the bankruptcy of the company. In this context, it is noteworthy that the company deployed plenty of dubious accounting practices which led to misrepresentation of liabilities in a systematic manner but the auditors failed to highlight this. A critical example in this regard is Repo 105 usage which has tremendous adverse implications for the accurate financial performance representation but the issue was not raised in the audit report. E&Y eventually closed the lawsuit by agreeing to a settlement amount to the tune of $ 10 million in 2015 (Freifeld, 2016). It is noteworthy that this is not an isolated case of lawsuit being initiated against auditor in case of bankruptcy of the client. With regards to the auditing of a Chinese firm Sino-Forest, Ernst and Young (E&Y) was at the receiving end as substandard audit claims were filed by the aggrieved investors when the firm became bankrupt. The audit report produced by E&Y did not indicate any concern with regards to the falling financial performance and hence auditor failed in the duty. As a result, E&Y has to pay a sum of $ 118 million for settlement of the claim. A similar lawsuit was settled in Australia by PWC (PricewaterhouseCoopers) in 2013 when it made a payment of AUD 67 million to placate the duped investors of Centro Retail (Aubin, 2013).
It is significant to note that the various firms which became bankrupt during the GFC had a common issue in terms of financial statements representation. As a result, their financial statements in the audited reports did not accurately and fairly reflect the outstanding liabilities in the form of various non-balance sheet items and complex derivative contracts. Besides, there was stretching of asset valuation through creative accounting so as to present a healthy financial position in order to support the artificially high stock price. Moreover, these institutions were also characterised with weak internal controls which failed to provide any credible resistance to wrong and fraudulent business practices (Soh and Bennie, 2011). It is evident from the above discussion that the auditor through audit procedures must avoid any material misrepresentation of financial performance and simultaneously ensure relevance of services for the users. To ensure correction of the any lapses, corrective measures need to be adopted by the external auditor failing which a qualifying remark should be given in the audit report. It is requisite that the auditor must carry out the job entrusted with utmost skill and care as the external auditor tends to act as the last line of defence.
Additionally, auditors also have to provide evidence to highlight that the external auditors does not share any quid pro quo understanding with the client’s management. This is critical when the auditors may be accused of intentional misrepresentation or fraud (Gay & Simnett, 2012). This is apparent from the various arguments presented in the proceedings pertaining to the Pacific Acceptance Corporation v. Forsyth (1970) 92 WN (NSW) 29 at 65 case. It was debated that the prime determinant of the auditor liability would be auditor’s conduct based on which it would be detected whether fraud or negligence is present or not (Serperlaw, 2016). In order to prevent auditor liability, it is essential that the auditor must carry out the audit job with utmost professionalism and skill so as to produce relevant audit reports.
With regards to asset valuation, one key concern is whether the auditor should provide estimated value of the asset on the basis of certain assumptions and besides, ascertain if the company’s valuation of the same asset lies in that range or not. In this process, if the auditor comes across some discrepancies, then these must be reflected in the auditor report. In performance of these complex tasks, it is essential that along with the underlying professional skills, the auditor also needs to capitalise on the rich experience (Caanz, 2016). However, considering the increasingly volatile financial markets and ever complex products, it becomes challenging for the auditors also to provide an accurate and object valuation. Hence, in such cases, the audit limitations should also be provided due reference to (Leung, Coram & Cooper, 2012).
A critical business assumption pertains to the going concern which prescribes that the business is likely to continue in the long run and has no concerns in the short run which could potentially lead to its closure. In instances, where the client faced cash crunch, liquidity concerns may be present and this needs to be extended in the annual report of the company by the directors (Taylor, Tower and Neilson, 2010). With regards to the director assessment of business and the underlying review also, the auditor needs to opine as part of the audit report as the guidance provided by the management enables the investors to make investment decisions. The above information tendered by the auditor enables providing relevant information to the stakeholders in a timely basis thus enhancing decision making and preventing future losses (Xu et al., 2013). In case the directors fail to produce this assessment or produce a misrepresented version, then the auditor would need to tender a qualified opinion. If there is failure on auditor’s part with regards to fair representation of significant uncertainty in the audit report, then this would amount to negligence on part of the auditor. With regards to GFC, the critical issue is to determine whether some information regarding the going concern risk was indeed present and whether the same was appropriately captures in the audit report or not. This would go a long way in determining the underlying auditor liability during liquidation of firms at difficult times such as GFC (Arens et. al., 2013).
Also, a key role in determination of auditor liability is played by the internal controls which are in place so as to minimise the incidence of financial misrepresentation. Since the auditor also needs support of the internal controls, hence it is essential that these should be functional which would minimise the risk of lapses in the audit process. The internal controls have come to light in a big way in the aftermath of the GFC as most companies observing bankruptcy had very weak or non-existent internal controls which also led to the increasing liabilities burden that effectively led to the demise of the business (Taylor, Tower and Neilson, 2010). Further, it is expected that in the future, the importance of the internal controls would grow and would also impact the overall auditor liability (Azim, 2012).
It is apparently evident from the discussion carried out above that role of auditor cannot be undermined in ensuring fair and accurate financial performance representation. Their role has shot to limelight during the recent bankruptcies observed in the GFC. While, the external auditor has duty to care towards the client towards the client and users, but in wake of increasing complexity and subjectivity in the assessment, it is imperative that the able support of functional internal controls and related procedures needs to be extended. Further, the corporate governance framework exhibited in various companies also needs to be strengthened through benchmarking. This is likely to act as a defence to the abuse of the powers by the higher management especially the executive directors (Caanz, 2016).
The companies also need to take appropriate measures so as to keep the business risk under control and the directors should adhere to their duties as highlighted in the Corporations Act 2001. However, the auditors also need to mend ways and take proactive measures in line with professional conduct so as to ascertain that independence should not be compromised in any manner (Arens et. al., 2013). Also, in view of increasing complexity, it is essential that the auditors must undergo constant professional training for skill upgradation so as to ascertain that they could perform the audit accurately and reduce the overall subjectivity. This would ensure that an accurate estimation of the various assets and underlying liabilities may be made in time and associated risks captured in the audit report. This would enable the auditors to minimise their liability in case of any future bankruptcy (Gay & Simnett, 2012).
References
Arens, A., Best, P., Shailer, G. and Fiedler, I. 2013. Auditing, Assurance Services and Ethics in Australia, 2nd ed., Sydney: Pearson Australia
ASIC 2016, Financial Reports. [Online] Available at: https://asic.gov.au/regulatory-resources/financial-reporting-and-audit/preparers-of-financial-reports/financial-reports/ (Accessed 25 January 2017)
Aubin, D. 2013, Analysis: Knives out for auditors as class actions go global, Reuters Website, [Online] Available from https://www.reuters.com/article/us-usa-accounting-lawsuits-idUSBRE92K0QB20130321 (Accessed 25 January 2017)
Azim, M. 2012, Corporate Governance Mechanisms And Their Impact On Company Performance: A Structural Equation Model Analysis, Australian Journal Of Management, [Online] Available from https://aum.sagepub.com/content/early/2012/07/30/0312896212451032.abstract (Accessed 25 January 2017)
Caanz, S. 2016, Auditing And Assurance Handbook 2016 Australia, 3rd ed., Sydney: John Wiley &Sons
Chung, J, Farrar, J , Puri, P and Thorne, L 2010, Auditor Liability To Third Parties After Sarbanes-Oxley: An International Comparison Of Regulatory And Legal Reforms, Journal of International Accounting, Auditing and Taxation, 19(1), pp. 66–78
Cheung, J. and Kandiah, S. 2016, Audit Negligence: Who Is To Blame When It All Goes Wrong, Kordamentha Website, [Online] Available from https://www.kordamentha.com/docs/for-publications/issue2011-04-auditnegligence.pdf?Status=Master (Accessed 25 January 2017)
Gay, G. and Simnett, R. 2012, Auditing and Assurance Services in Australia, 5th ed., Sydney: McGraw-Hill Education
Freifeld, K. 2016, Ernst and Young Settles With N.Y. For $ 10 Million Over Lehman Auditing. Reuters Website, [Online] Available from https://www.reuters.com/article/us-ernst-lehman-bros-idUSKBN0N61SM20150415 (Accessed 25 January 2017)
Gibson, A. and Fraser, D. 2014. Business Law, 8th ed., Sydney: Pearson Publications
Humphrey, C., Loft, A. and Woods, M. 2009, The global audit profession and the international financial architecture: Understanding regulatory relationships at a time of financial crisis, Accounting, organizations and society, 34(1), pp.810-825.
Leung, P., Coram, P. and Cooper, B.J. 2012, Modern Auditing and Assurance Services. 4th ed., New York: John Wiley and Sons
Lindgren, K.E. 2011, Vermeesch and Lindgren’s Business Law of Australia, 12th ed., Sydney: LexisNexis Publications
Serperlaw (2016) Liability Of Auditors In The Common Law System: Australian Position. [Online] Available from https://www.serperlaw.com/about-us/publications-and-articles/liability-of-auditors (Accessed on 25 January 2017)
Shefrin, H. and Shaw, L. 2016, The Global Financial Crisis and its Aftermath: Hidden Factors in the Meltdown. 4th ed., London: Oxford University Press
Soh, D. and Bennie, N. 2011, The Internal Audit Function: Perceptions Of Internal Audit Roles, Effectiveness And Evaluation, Managerial Auditing Journal, 26(7), pp. 605 – 622
Taylor, G., Tower, G. and Neilson, J. (2010), Corporate Communication Of Financial Risk, Accounting & Finance, 50(2), pp.417-446
Xu, Y., Carson, E., Fargher, N. and Jiang, I. 2013, Responses By Australian Auditors To The Global Financial Crisis, Accounting And Finance, 53(1), pp. 301–338
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