Auditing and Assurance : Global Financial Crisis

Introduction

The given report aims to introduce the legal underpinnings of the potential liabilities of the auditors in wake of the losses caused to the user groups especially the shareholders of the company who tend to invest their money on the basis of the audited financial statements of various companies. This issue has taken centre stage in the wake of a host of businesses going bankrupt during the recent GFC (Global Financial Crisis) and thus the interests of the investors were adversely impacted. The concept of auditor liability has been interlinked with the incidence of GFC with special mention of the Lehman Brothers liquidation. Besides, various recommendations based on the research have been concluded which can enable that this liability can be managed in wake of a similar financial crisis occurring in Australia.

GFC Impact

GFC has had a profound impact on the overall economy but there is unanimity that the worst suffering was receipt by the financial sector and specially the organisations belonging to this sector conducting their business in developed countries (Shefrin and Shaw, 2016). The various financial firms that were earlier supposed to be icons succumbed to their liabilities and this included huge names including Lehman Brothers and HBOS. In context of Lehman Brothers, a host of reasons contributed to the failure including greed and unethical conduct of the executives, high incidence of use of CDS or Credit Default Swap and misrepresentation in financial statement for concealment of losses. Besides, there is no denying that auditor also played an enabling role in pushing the firm to the brink of failure as the adverse impact of various creative accounting jugglery tools like 105 Repo was not captured in the financial statements or the audit report by Ernst and Young (Leung, Coram & Cooper, 2012).

Another example of downfall of a financial institution is that of HBOS which was a banking giant based in UK. The failure of the company could be attributed to the unhealthy practices adhered to by the company while lending as it was driven more by the b

This contributed to the weakening of the balance sheet which was not appropriately captured and reflected by the financial statements of the company thus raising questions regarding auditors’ conduct (Caanz, 2016).

Auditor’s liabilities under law

The role played by an external auditor in regard to continued well-being of the organisation cannot be ignored and in wake of the increasing flexibility in accounting that certain companies are showing, this significance is on the increase. The liability of the auditors primarily arise as the auditors tend to have responsibility and duty towards both the client and also the wide user base consisting of shareholders, suppliers, creditors, regulators and society at large (Gay and Simnett, 2012). For enhancing the possibilities of the auditor adhering with the underlying expectations of these stakeholders, the auditor liabilities have risen as they play a key role in ensuring that early warning signs are available to users. If an audit is performed with due care, it is highly likely to represent the accurate financial performance of the firm and also the underlying risks to the same (Arens et. al., 2013).

As per common law, auditor liability may arise on account of fraud or negligence on the part of the auditors which in turn leads to failure in the discharging of the relevant fiduciary duties. The prominent liabilities in this regard are mentioned as follows.

Negligence liabilities

As the name suggests, the origin of these liabilities could be traced on account of negligent behaviour of the auditor based on which investors and other users tend to lose money and hence sue the auditors for the recovery of the same (Caanz, 2016). As the audit professionals have a duty to care towards not only their client but also their wide user base, thus by acting negligently, there is a breach of duty. As the potential losses suffered by the various user base has grown in size, the issue of auditor liability has also gained increasing clamour with users demanding accountability of behalf of auditors (Arens et. al., 2013).

Criminal and civil offence liabilities

The criminal liabilities with regards to auditor would arise in the event that an intention fraud is committed by auditor. This typically takes place in the form of quid pro relationship with the management where the interests of the shareholders are severely jeopardised (Gibson and Fraser, 2014). In the event of financial statements being misrepresented, the potential stakeholders to whom a duty to care is extended could file for recovery of losses in the form of tall claims. The liabilities are not initiated from the user’s side and may also be brought about by the client especially in case of negligence leading to material misrepresentation in the statements. Since, the client auditor relationship is bound by an explicit contract, thus the potential liabilities on account of the service standards not being met would be driven by the contract and the relevant provisions in this regard (Lindgren, 2011).

Liability of misrepresentations

As per tort law, liability arises for auditors in case of material misrepresentation irrespective of the fact whether this has been carried out on purpose or unknowingly as the losses are suffered in either cases (Davenport & Parker, 2014). It is imperative that the auditors should take requisite precautions while giving opinion so as to ensure that no material misrepresentation does occur in the financial results. This is imperative considering the wide user base that tends to relies on the audit opinion as a certificate which provides authenticity to the financial results presented on an annual basis (Leung, Coram & Cooper, 2012).

Proportionate liabilities

In regards to this concept, the auditor liability needs to be linked proportionally to the losses of the various stakeholders who suffered due to the negligence or fraud on the part of the auditor. In Australia, current the auditor liability is capped at a factor of 10 of the audit fees derived by the auditor from a particular client, however, there is increased clamour with regard to switching to proportionate liabilities with no upper limit (Cheung & Kandiah, 2016).

GFC and Auditor liabilities

One of the common features during the days when GFC was at its peak was the collapsing of financial institutions despite the presence of the latest unqualified audit report. Without doubt, this matter is extremely serious and raises significant questions with regards to the relevance and ability of the audit professionals (Humphrey, Loft & Woods, 2009). This is because the issue of an unqualified audit report indicates that the auditor is authenticating that the organisation’s financial statements are prepared in accordance with the applicable accounting standard and also the organisational position presented by these is fairly accurate (ASIC, 2016). Also, this indicates to the various users that the auditor is in agreement with the usage of accounting policies deployed by the client to record the various transactions and key balances. This opinion is critical which can be gauged from the fact that if an incorrect opinion is tendered by the auditor and if the same was carried out on purpose, then criminal proceedings may be initiated against the auditors (Arens et. al., 2013). 

The above is validated from the various cases filed by the aggrieved shareholders that were initiated against Ernst and Young which was the external auditor of Lehman Brothers at the time of its collapse. In their tenure when they acted as the auditor, the audit firm hailed various shoddy accounting practices deployed by the firm which were outrightly misleading since they systematically misrepresented the liabilities and gave an overall boost to the company’s financial position. One of such accounting policies was the usage of Repo 105 and it is unfortunate that the auditor never highlighted the potential implications on the financial statement of this practice. Eventually, the lawsuit was settled by the firm in 2015 with a settlement amount of $ 10 million

 (Freifeld, 2016). There are other instances also when class action lawsuit have been initiated by shareholders to recoup the loss on their investments. For example, the same firm (i.e. Ernst and Young) in Canada had to settle a claim to the tune of whopping $ 118 million when it was accused of conducting audits that were below the requisite quality standards for a Chinese client named Sino-Forest which went bankrupt and the audit report provided no clue beforehand with regards to the dwindling financial position of the firm. Also, in a case from Australia in 2013, PWC (PricewaterhouseCoopers) had to pay a settlement amount of AUD 67 million in relation to class action lawsuit filed by the aggrieved investors of Centro Retail against both the company and their auditors (Aubin, 2013).

One of the key striking features of those institutions that could not survive the GFC is the fact that there was sever misrepresentation in the financial statements of these companies as they failed to reflect on the burgeoning liabilities that were already outstanding in the form of derivative contracts and off balance sheet items. Also, the underlying assets valuation was stretched so as to enhance the financial position of the organisation and provide comfort to investors. Further, most of these organisations had sloppy internal controls as faulty business practices continued unabated (Soh and Bennie, 2011).

As discussed above, the auditor needs to ensure that the no material misrepresentation happens in the financial statements presented by the company. In the event that certain assets or liabilities are not disclosed by the company, this essentially is categorised as fraud and requires that auditor takes proactive steps to report the same to the concerned authority so that appropriate corrective measure can be undertaken. If any fraud is not detected by the auditor, the auditor could still avoid liability by proving that no negligence was observed while carrying out the audit and appropriate audit tests were performed in line with the potential audit risk. Besides, the auditor also needs to prove that it shares no quid pro quo relationship with the higher echelons of management and therefore in not intentionally misrepresenting the financial statements (Gay & Simnett, 2012). The above understanding was hailed in the arguments stated in the Pacific Acceptance Corporation v. Forsyth (1970) 92 WN (NSW) 29 at 65 case where it was argues the auditor liability would be determined by taking into consideration the conduct of auditor and the presence of negligence and/or fraud (Serperlaw, 2016). The key requirement to avoid any liability is that the auditor while carrying out the audit has to display prudence in giving a professional and informed audit opinion which has relevance for the users and client alike.

One issue is in context of valuation of asset where it is reasonable for the auditor to estimate a broad range of valuation based on realistic assumptions and then check whether the valuation of the asset done by the company belongs to the range decided by auditor or not. If the auditor which conducting this process does notice certain discrepancies, then it is imperative to capture these in the report of the auditor. While performing this task, the auditor needs to rely on all the wide experience besides professional skills (Caanz, 2016). The subjectivity in asset and liability valuation in certain cases becomes do high that accurate estimates become difficult and therefore such situations may refer to the inherent audit limitations and are to be considered in the right spirit (Leung, Coram & Cooper, 2012).

One of the key assumptions with regards to the business is the going concern assumption as per which it is generally assumed that the business would not shut down in the future and continue to operate. But in situations when liquidity threats are faced by the company, the risk of liquidation enhances and the same needs to be captured in the financial statements by the directors of the company (Taylor, Tower and Neilson, 2010). The auditor on his/her part needs to review any potential assessment given by the directors in this regard which also needs to be reflected in the audit report. This is likely to enhance the overall awareness levels of stakeholders in relation to the going concern level of the company (Xu et al., 2013). If the directors of the company do not release such an assessment or issue a wrong assessment of the same, then the audit needs to give an audit opinion that in adverse and should not offer an opinion which is unqualified. However, in case the auditors fails to represents this material uncertainty as part of the audit report, then it would be fair to conclude that indeed negligence is reported by the auditor. At the time of determining the auditor liability in the backdrop of GFC, it is imperative to consider if there was certain information with the auditor in the context of material issues in relation to going concern by still kept these unreported (Arens et. al., 2013).

Further, the internal controls need to be robust as their role in preventing misrepresentation in the financial statements is quite critical. Further, the auditor also regularly relies on these internal controls and hence strengthening these could be a step in the right direction. This aspect has become critically important especially after the GFC as the dysfunctional internal controls were without doubt a contributory reason to the enhancement of the overall business risk to such levels where the liabilities outstripped the existing assets (Taylor, Tower and Neilson, 2010). Hence, going forward, the internal controls have a critical role to play which would enhance the overall audit quality (Azim, 2012).

Recommendations

Based on the above discussion, it is apparent the auditor plays a significant role in ensuring that misrepresentation does not happen in financial statements. With the rise in insolvencies especially during the GFC, the role of auditor and potential liabilities assumed is in the limelight, Further, to ensure that audit quality improves, the robustness of the internal audit procedures and policies needs to be improved so that there is adequate support for the external auditor as the initial auditing is performed by the audit committee. Also, it is advisable that the corporate governance practices that the firm follow should be improved as this ensures that there are reasonable checks and balances to the power of the executive directors especially in the form of non-executive directors those who tend to act in the interest of the smaller shareholders (Caanz, 2016). Besides, the companies also need to prudently manage business risk in line with the mandate given by the shareholders and should not aim for abnormal profits in the short term while threatening the survival of the firm in the long run. The auditors on their part need to ensure that their independence is not compromised and also various professional standards and ethical codes are complied with. Additionally, the auditors continuously need to update their knowledge and skills especially with regards to the latest financial products that keep on entering the market place. This is imperative so that the auditor could provide a reasonable estimation of the value of these complex products along with outlining the associated risks (Gay & Simnett, 2012).

References

Arens, A., Best, P., Shailer, G. & Fiedler, I. 2013. Auditing, Assurance Services and Ethics in Australia, 2^nd eds., Pearson Australia, Sydney

ASIC 2016, Financial Reports. Available at: https://asic.gov.au/regulatory-resources/financial-reporting-and-audit/preparers-of-financial-reports/financial-reports/ (Accessed: 8 September 2016).

Aubin, D 2013, Analysis: Knives out for auditors as class actions go global, Reuters Website, Available online from https://www.reuters.com/article/us-usa-accounting-lawsuits-idUSBRE92K0QB20130321 (Accessed on September 17, 2016)

Azim, M 2012, ‘Corporate Governance Mechanisms And Their Impact On Company Performance: A Structural Equation Model Analysis’, Australian Journal Of Management, Available online from https://aum.sagepub.com/content/early/2012/07/30/0312896212451032.abstract (Accessed on 17 September 2016). 

Caanz, S 2016, Auditing And Assurance Handbook 2016 Australia, 3^rd eds., John Wiley &Sons, Sydney

Chung, J, Farrar, J , Puri, P & 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, Vol.19, No.1, pp. 66–78

Cheung, J & Kandiah, S 2016, Audit Negligence: Who Is To Blame When It All Goes Wrong, Kordamentha Website, Available online from https://www.kordamentha.com/docs/for-publications/issue2011-04-auditnegligence.pdf?Status=Master (Accessed on 17September 2016). 

Davenport, S & Parker, D 2014, Business and Law in Australia, 2^nd eds., LexisNexis Publications, Sydney

Gay, G. & Simnett, R. 2012, Auditing and Assurance Services in Australia, 5^th eds., McGraw-Hill Education, Sydney

Freifeld, K 2016, Ernst and Young Settles With N.Y. For $ 10 Million Over Lehman Auditing. Reuters Website, Available online from https://www.reuters.com/article/us-ernst-lehman-bros-idUSKBN0N61SM20150415 (Accessed on 17 September 2016). 

Gibson, A & Fraser, D 2014. Business Law, 8^th eds., Pearson Publications, Sydney

Humphrey, C, Loft, A & 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, Vol. 34, No.1, pp.810-825.

Leung, P, Coram, P & Cooper, BJ 2012, Modern Auditing and Assurance Services. 4^th eds., John Wiley and Sons, New York

Lindgren, KE 2011, Vermeesch and Lindgren's Business Law of Australia, 12^th eds., LexisNexis Publications, Sydney

Serperlaw (2016) Liability Of Auditors In The Common Law System: Australian Position. Available online from https://www.serperlaw.com/about-us/publications-and-articles/liability-of-auditors (Accessed on 17 September 2016)

Shefrin, H & Shaw, L 2016, The Global Financial Crisis and its Aftermath: Hidden Factors in the Meltdown. 4^th eds., Oxford University Press, London

Soh, D & Bennie, N 2011, ‘The Internal Audit Function: Perceptions Of Internal Audit Roles, Effectiveness And Evaluation’, Managerial Auditing Journal, Vol. 26, No. 7, pp. 605 – 622, 11

Taylor, G, Tower, G & Neilson, J 2010, ‘Corporate Communication Of Financial Risk’, Accounting & Finance, vol. 50, no. 2, pp.417-446

Xu, Y, Carson, E, Fargher, N & Jiang, I 2013, ‘Responses By Australian Auditors To The Global Financial Crisis’, Accounting And Finance , vol. 53, no.1, pp. 301–338