Quality Of Auditing And Assurance: Understanding Potential Auditor Liability

Concept of Auditor Liability

Discuss bout the Quality of Auditing and Assurance.

In the ongoing scenario, there is a growing trend as per which there is greater integration across the globe in the economic sphere which is increasing the overall dependence on nations on the other countries especially the developed nations.  As the global environment is intrinsically dynamics, the change in global business environment tends to have a profound on the business fortunes of companies based in various geographies. This was apparently at display during the global financial crisis when the downturn that started in US engulfed the whole world and the companies based in remote corners of the world. While there is still wide debate on the exact causes of the global financial crisis with reasons ranging from excessive greed, recession in macroeconomic conditions and lack of regulation, there is no denying the fact that the global financial crisis led to huge loss in the investors wealth (Humphrey, Loft and Woods, 2009).

A set of stakeholders that faced the wrath of investors were the financial auditors who were labeled as one of the main culprits especially in the collapse of big firms such as Lehman Brothers. In the aftermath of the failure of the big firms, the auditors had to face class action from the various suits of investors in order to claim losses. The given report aims to provide an enhanced understanding with regards to the potential auditor liability in case of such a global crisis happening in Australia which can lead to the liquidation of a major firm.

The potential research questions that the given research aims to respond to are highlighted below.

What is the concept of auditor liability and its importance in case of liquidation of firm?

What are the prudent processes through which this liability by be managed by the auditors?

In order to provide credible answer to the above research questions, the following research has been carried out in the context of the global financial crisis.

It is well established that external auditor’s role in pivotal with regards to ensuring that the financial strength of the company remains intact. In the wake of the recent liquidation cases and the consequent losses faced by investors, there is an surge in the auditor liabilities as users tend to hold the auditors responsible for the losses suffered by them as they claim that the auditors had failed in their duty of ensuring that misstatements in financial statements and the material question in the going concern of the firm was not captured (Leung, Coram and Cooper, 2012). A sound audit has the responsibility to correctly and accurately represent the existing financial statements, risk associated with the ongoing business to the firm so that users can take prudent decisions with regards to continuous engagement with the firm (Arens et. al., 2013).

Negligence liabilities

With regards to common law, the potential auditor liabilities have been viewed in the light of two main aspects i.e. negligence and fraud which leads to failure on the part of auditor to fulfil their fiduciary duties.

The auditors tend to face liability is case their conduct has been negligent which has caused losses to the users and/or the client (Caanz, 2016). The professionals involved in audit profession have a duty to care towards the various stakeholders and hence they must discharge this duty with utmost skill and professionalism so as to minimise their liability at a later stage. With the increasing size of global firms, more money is at stake and so are the losses in cases of firms collapsing and hence the auditor’s liability are becoming more significant with every passing day (Arens et. al., 2013).

With regards to misrepresentation by the auditors, potential auditor liabilities may lead to civil or criminal offence essentially based on the materiality of the misrepresentation and more importantly the underlying intent. The auditors when conducting audit need to need to comply with the relevant statutes (such as Section 50, Corporations Act 2001 along with professional guidelines and standards) in order to ensure that audit done is apt and relevant. When the auditor acts in a negligent manner, then the resulting offence would be civil and essentially come within the ambit of tort law and categorised as civil offence (Gibson and Fraser, 2014).   However, if the auditor is found to have established a quid pro quo relationship with the management of the client with the intention of committing fraud and duping the investors, then it would amount to fraudulent misrepresentation and the auditor would be charged with a criminal offence (Gay and Simnett. 2012).

While the current practice adhered in Australia is that the maximum auditor liability is capped (usually to 10 times the audit fee received from the client), there is increased clamour in the wake of recent liquidation of organisation, that the system of proportionate liabilities be introduced for the auditors. As per the concept of proportionate liabilities, there would be potentially no capping of the auditors liability and same would depend on the extent of damages undergone by the various aggrieved parties that file lawsuit against the auditor (Caanz, 2016).

The financial crisis had an adverse impact on the business environment globally and led to the enhancement of the default risk associated with various businesses especially those in financial sector. Due to the inherent turbulence in the economy, the auditors profession is also impacted as the underlying business risk enhances which may raise material questions with regards to the going concern assumption and hence needs to be reported to the users in a timely manner. Due to underlying rise in volatility, the liability of the auditor also undergoes an increase at such junctures (Todea and Stanciu, 2009). When these organizations tend to collapse and enter liquidation, the auditors have to face lawsuits from the investors who suffer losses. This was also the case in the aftermath of bankruptcy filed by Lehman Brothers.

Criminal and civil offence liabilities

The auditor of Lehman Brother was Ernst and Young which was involved in a lawsuit brought about by the investors. While acting as the auditor to the failed firm, the company choose to overlook various shoddy accounting practices which were far from accurate and therefore acted in a negligent manner. This led to a selective understatement of the pending liabilities using innovative tool such as Repo 105 which misrepresented the company’s financial position and the looming doubts with regards to the going concern.  However, the same was not reported by the firm as it weeks before the crisis, the auditor had issued an unqualified audit opinion to the company. The lawsuit was finally settled in 2015 as the auditors had to pay a sum of $ 10 million (Freifeld, 2016). In fact this is not an isolated but rather a trend of class action lawsuit is to be seen in the recent times For instance, in Canada, E&Y had to pay a claim of $ 118 million in 2010 for carrying out substandard audits with regards to a Chinese company named Sino-Forest which collapsed and investors suffered losses. Further, PWC (PricewaterhouseCoopers) ended up paying AUD 67 million for settling a class action lawsuit with regards to lapses in audit and potential fraud in the audit of Centro Retail (Aubin, 2013).

During the GFC, majority of the financial institutions that collapsed had a common characteristic whereby the financial statements was not a true representative of the outstanding assets and liabilities of the firm as there was understatement of potential liabilities coupled with overstatement of asset values. Also, for hiding the losses made, there was unrestricted use of derivatives instruments which surprisingly was never questioned by the auditors (Leung, Coram and Cooper, 2012).. Besides, the firm’s followed unhealthy corporate governance norms coupled with dysfunctional and ineffective internal controls which led to the compounding of business risk and eventually led to the failure. However, amidst all this, the auditor apparently was silent which hints at quid pro quo relationship with the client and thus justifies the various law suits that followed (Soh and Bennie, 2011).

It is evident that the auditor needs to take proactive measures to ensure the faithful representation of the company’s financial position. In the event that the firm’s management fails to disclosure potential assets and liabilities, it may be treated as fraud and the auditor needs to inform about the same to the appropriate authorities (Chung et. al., 2010). If the auditor is not able to detect the same, and the investors are harmed, then the auditor would have to face potential liabilities. In order to manage these, the auditor needs to establish two things. Firstly, it needs to be established that there existed no quid pro quo relation between the client and auditor whereby the auditor intentionally chose to overlook the various risk and material misstatement. Secondly, it needs to be established that the conduct of the auditor was not negligent and the auditor has used all the available professional skills and safeguards so as to represent an accurate and faithful representation of the financial statements (Cheung and Kandiah, 2016). This was apparent from the decision reached in the Pacific Acceptance Corporation v. Forsyth (1970) 92 WN (NSW) 29 at 65 case where it was argued that the potential liability of auditor in bankruptcy cases is essentially determined by analysing the presence of fraud and negligence in the conduct of the auditors  (Serperlaw, 2016).

Proportionate liabilities

A critical assumption with regards to any business is going concern which indicates that the firm is expected to continue doing business in the near future as they are no issues which may lead to closure. However, in situation when there is a significant liquidity crunch that is exhibited, insolvency risks may get enhanced and the same needs to be captured in the financial statements by the directors (Taylor, Tower and Neilson, 2010). In accordance with relevant auditing standards, it is imperative that such assessments are reviewed by the auditor and reflected as part of the audit report. Such a measure is pivotal in situations such as financial crisis where such risks are typically potent (Xu et al., 2013).

In order to avoid incidents such as the Lehman fall, it is imperative that more emphasis should be given on the stability in organizations.  During the global financial crisis, there was persistent imbalance with regards to various securities along with the economic system as a whole since demand plummeted and oversupply become dominant. While there is little that can be done at the time of the crisis, it is imperative that preventive measures must be undertaken when the economy is growth at a robust pace (Arens et. al., 2013). The auditors must act more proactively with regards to understanding the long term implications of  particular policy move by the organization an ensure that its likely impact both in the short term and the long term must be appropriately captured in the financial statements. These disclosures would ensure that the users of the financial statements are made aware of the likely implications of risky practices which may or may not materialize in the future (Chadha, 2015).

Further, in relation to carrying out the audit for companies that have a high degree of business risk, auditors need to go the extra mile in their audit procedures so as to ensure that the risky practices are appropriately represented in the auditors’ report (Gay and Simnett, 2012). Besides, it is also worthwhile for the auditors to avoid in offering consulting services to such clients which in the future may reflect to a quid pro quo relation and compromise the independence of the auditors. This is imperative so that the auditors do not face conflict of interest with regards to their work which also provides confidence to the users with regards to underlying utility of audit opinion (Humphrey, Loft and Woods, 2009).

Potential Auditor Liability During Financial Crisis

However, probably the most prudent measure that could provide defense to auditors is superior training and exposure with regards to conducting audit. A significant step in this direction is to ensure that the audit members understand the business model of the client in depth which would lead to improvement in the quality and utility of the audit opinion. Besides, there understanding of various financial products should also enhance so that they could potentially value the given asset or liability with greater accuracy. Also, the professional standards of auditing as prescribed by various professional bodies need to be strictly adhered to by the professionals as unethical behavior on the part of some auditors leads to a tragedy of commons whereby the whole profession is looked at with suspicion (Inácio and Mota, 2014). Besides, it is imperative for the auditors to actively engage with the management of the company on an ongoing basis so as to gain superior understanding of the likely performance of the company going forward and also the various risk factors that the auditors need to focus on so as to reduce the overall audit risk. There are also suggestions with regards to the standardization of the audit process for ensuring quality but the same may prove to be counter-productive in the modern business world where flexibility is required (Pal, 2010).

Conclusion

On the basis of the above discussion, it is apparent that the auditor liability is essentially within the parameter of legislation and if the auditors are found to be indulging in any malpractices, a lawsuit can be filed against them by the client. The performance of the auditor with regards to its services is a critical factor contributing to the overall success of the company. In situations involving financial crisis, there is high turbulence in the operating environment which leads to higher incidence of systemic instability and as companies fail, the investors tend to suffer losses. In such cases, there is a rise in the auditor liability as there is lack of transparency in the system since the financial statements and the audit opinion tends to present an inaccurate picture which does not highlight the real liabilities of the company. In such scenario, the investors aim for the auditor to provide quality services which provide early indications to investors with regards to malpractices.  But as indicated in case of Lehman Brothers, in such situations the auditors are often found wanting as the liabilities comes into public domain when the ship has already sank and therefore there are accusations with regards to auditors being negligent in their job.

In order to ward off the liability that stems from such crisis, it is imperative that the auditors need to be more proactive in their conduct. In this regard, it is imperative that the audit firms must take measures so as to enhance the overall understanding of the business by the audit team through frequent consultations with the management. Additionally, investment must be done on the training and education of auditors so that they possess cross functional skills which are more suitable in the auditing of dynamic modern day businesses. Besides, greater emphasis must be lent on ensuring that the auditor independence is not compromised and a high ethical professional standard is displayed. Thus, with increasing transparency, skills and more proactive behavior driven through ethical auditing practices, the auditors can minimize any potential liability associated with failure of businesses in situations such as global financial crisis (Al-Khaddash, Al Nawas and Ramadan, 2013).

It is apparent that the auditors play a crucial role in ensuring the stability of the financial systems by highlighting the faulty business practices in a prudent manner. Hence, more research needs to be done with regards to ensuring that the early signs of stress in the organizations could be identified at an early stage. The exact improvements that the audit firms need to make in their underlying procedures needs to be studied with reference to the global practices that are adhered to in different parts of the world. Additionally, alternative models with regards to auditing must also be explored through various studies so that the relevance of the information extended by auditors increases (Al-Khaddash, Al Nawas and Ramadan, 2013). Also, the role of professional practices and ethics codes on the overall adherence of ethical audit practices also needs to be explored so as to ensure that atleast there is no quid pro quo relation between the auditors and the client as it proves devastating for the future of audit profession (Humphrey, Loft and Woods, 2009).

References

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