forensics matters Audit negligence: Who is to blame when it all goes wrong? Publication No

Transcription

1 Audit negligence: Who is to blame when it all goes wrong? Publication No

2 Audit negligence following the GFC The recent collapses of Allco, Westpoint, Centro, Storm Financial, Opes Prime, ABC Learning, and Babcock & Brown in Australia and Feltex in New Zealand, are just a few of the thousands of corporate collapses in the wake of the global financial crisis. The auditing profession has come under intense scrutiny, with increased litigation involving auditors. A common issue in the above corporate failures is the quality of the audits conducted in those companies. Because audit failures may give rise to erroneous or misleading financial statements, a common perception is that auditors are responsible for the loss of billions of dollars by stakeholders. The perception that auditors have deep pockets and the expectations gap result in auditors frequently being sought after in an attempt to recoup losses. But what liability do auditors have for professional negligence and breach of statutory obligations in such circumstances? In this article we consider the issue of auditor negligence, including whether shareholders, investors and other third parties can hold the auditors responsible for a corporate collapse; and examine the accounting and other requiring investigation to determine fault. We also consider the recent Centro case and what reliance the directors of a company may place upon its auditors. Jason Cheung is a Senior Executive Analyst and joined the Forensics team at KordaMentha in March At KordaMentha, Jason s work includes disputes, forensic accounting and fraud and financial investigations. Sasikala Kandiah is a Manager and joined the Forensics team at KordaMentha in November Sasikala s work at KordaMentha involves forensic accounting, fraud and financial investigations and disputes. Page 1

3 1What is the role of an auditor? To understand auditor liability in relation to a client and its financial statements, the respective roles of management and the auditor must first be appreciated. Management is responsible for recording the results and position of the business through the use of financial statements. This often involves making significant accounting estimates and judgments, as well as determining the most appropriate accounting treatments within the framework of accounting standards and generally accepted accounting principles. The auditor, who is objective and knowledgeable in the areas of auditing, accounting and financial reporting, evaluates and expresses an opinion on whether the financial statements have been fairly presented. The audit is conducted according to Auditing Standards and the audit firm s own policies and procedures. This enhances the level of confidence of users of the financial statements. However, the public places its own expectations upon auditors. These expectations are often beyond the scope outlined by auditors, leading to what is known as an expectations gap between responsibilities and consequent fault in a collapse. What is the expectations gap? A significant issue regarding the usefulness and reliability of an audit is the so-called expectations gap. The International Organization of Securities Commissions defines this as: The difference between what the public and users of financial statements perceive the role of an audit to be and what the audit profession claim is expected of them during an audit. Members of the public, including investors and creditors, often expect that: Auditors are primarily responsible for the preparation and presentation of financial statements A clean audit opinion provides absolute assurance over the accuracy of the financial statements and guarantees the entity s future solvency Auditors perform a 100% check over all items recorded in the accounts Auditors are to provide early warning regarding the possibility of a corporate collapse An auditor s role includes detecting all fraud. Within the auditing profession, auditors perceive their role as planning and conducting an audit to obtain reasonable (as opposed to absolute) assurance that the financial statements are free from material error and fraud. Reasonable assurance does not certify or guarantee the accuracy of the financial statements. Page 2

4 2How can audit negligence arise from corporate failures? A common theme giving rise to litigation involving audit negligence is the use and reliance on the audited financial statements by third parties, rather than the auditors client company. It is often the case that a third party such as a supplier or financier relies on the information from audited financial statements in the course of its decision to engage in business with an entity. Eventually, the entity may become insolvent resulting in an inability to repay its creditors and investors. The audited financial statements relied upon by the third party may then appear to have been erroneous or misleading as the entity did not perform as anticipated based on the rosy picture portrayed by the financial statements. This throws the quality of the audit into the spotlight. Third parties often view auditors as having deep pockets as it is likely they are still solvent after the client company has become insolvent. In addition, auditors have insurance to indemnify for professional negligence, though subject to limits. Consequently, it is common for third parties to attempt to recover their losses by considering or initiating litigation against the auditors. However, determining ultimately which party is at fault is a complex task, which often requires forensic accountants to review the work undertaken in the audit. [See Section 3]. Recent Cases Sons of Gwalia Ltd (admin apptd) v Margaretic [2007] HCA 1 In 2008, a scheme of arrangement was approved by the High Court of Australia in order to pool funds to return to creditors and shareholders from the company, directors and the auditors. Westpoint In 2009, three auditors agreed to enforceable undertakings not to practice for up to two years and a $67.5 million settlement was reached in early 2011 due to failing to comply with Australian Auditing Standards. Feltex In 2010 in New Zealand, the auditor was required to pay a $150,000 fine for failing to disclose a debt in the financial statements. This case was later cited in Centro, where the directors argued their duties could be discharged by reliance being placed on the auditors to detect errors and misstatements in the financial statements. Centro is discussed further on the following page. Allco In late 2010, the auditor agreed to an enforceable undertaking not to practice for nine months and paid a fine of $10,000 for failing to comply with Australian Auditing Standards. Lehman Brothers (USA) It was found that there was sufficient evidence to support a possible claim that the firm s auditor had been negligent and that Lehman could pursue claims against the firm for professional malpractice. Lehman s auditor is fighting fraud charges for, among other things, allegedly failing to adequately follow up on a whistleblower s claim that Lehman was misstating the value and size of its assets. Other examples of recent cases include MFS, ABC Learning, Bill Express and Babcock & Brown. Page 3

5 Centro The audited financial statements of Centro Properties and Centro Retail Group were found to contain errors totalling over $2 billion in debt classifications in addition to failing to account for guarantees of USD1.75 billion. In June 2011, the directors were found to be in breach of their duties as they cannot delegate their responsibility for overseeing the company s financial affairs to management or auditors. The outcome of auditor performance and negligence, if any, is pending. The Centro directors sought to rely upon the Feltex decision in New Zealand where the judge concluded that the Feltex directors did take appropriate steps to obtain advice (from management and the auditors) upon which they relied as they were entitled to do whilst describing that the New Zealand regulator s should have done it themselves proposition was unrealistic. The Centro directors submitted that they were reasonably entitled to place reliance on the processes which Centro had put in place for the purposes of ensuring that the financial statements were accurate and in accordance with the Accounting Standards, with the view that accounting and auditing are specialised fields. Justice Middleton, the presiding Judge in this case, stated that although directors are entitled to rely upon specialist advice, whether a director has taken all reasonable steps will depend upon the circumstances of the case and an analysis of the facts before the Court. Undoubtedly, what is encompassed by taking all reasonable steps will differ depending upon the entity, the complexity of the entity s business and the internal reporting procedures within the entity as well as the nature of the task the director is obliged to undertake. However Justice Middleton did not take the view that the directors should have done it all themselves and become familiar with the complexities of various accounting standards. In the Centro case, Justice Middleton found that: Directors are entitled to rely upon others and there was no suggestion in the Centro case that the reliance on others was not warranted or that the trust in those whom the directors had relied upon was misplaced; As discussed in our first article on this topic, each director, armed with the information available to him, was expected to focus on brought before him and to seriously consider such and take appropriate action. This task demands critical and detailed attention, and not just going through the motions or sole reliance on others, no matter how competent or trustworthy they may appear to be; and Directors cannot substitute reliance upon the advice of management [or auditors] for their own attention and examination of an important matter that falls specifically within the Board s responsibilities as with the reporting obligations. The [Corporations] Act places upon the Board and each director the specific task of approving the financial statements. Consequently, each Board Member was charged with the responsibility of attending to and focusing on Centro s accounts and, under these circumstances, could not delegate or abdicate that responsibility to others. Source : Page 4

6 3The future of audit liability Auditor liability is an area of increasing significance, particularly in light of the changing and widening of auditor obligations in Australia imposed by Common Law, statute law, regulators and professional bodies. An area that should be given more focus is the expectations gap, as minimisation of the gap may result in a clearer examination and investigation of fault, prior to proceedings being launched. This can be achieved through an increase in awareness of the auditor s role by stakeholders, including an understanding of an audit and its outcomes. Misunderstandings of auditing terminology, for example materiality, reasonable assurance and sampling often add to the confusion. The introduction of CLERP 9 provisions has assisted in limiting audit liability, specifically proportionate liability resulting from negligent misrepresentations from misleading and deceptive conduct and audit firms now having the ability to be incorporated. Further to this, it was legislated to allow a national based statutory cap for audit liability by way of the Treasury Legislation Amendment (Professional Standards) Act. The Treasury, as noted in its paper Audit Quality in Australia - a Strategic Review (March 2010), believes that Australia s audit regulation framework is robust and stable and, as a key driver of audit quality, can be considered to be in line with international best practice. The Australian Securities and Investments Commission also recently published its latest audit firm inspection report in June 2011 regarding the period and discovered that 17% of large audit firm engagement files did not contain sufficient appropriate audit evidence and for other firms it was 31%. Areas for improvement were in three key areas: Sufficiency and appropriateness of audit evidence; Level of professional scepticism in key areas of judgement; and Evidence on audit engagement files about the nature, timing and extent of engagement quality control review. What should be considered as part of an investigation into audit negligence? We find that the below are key issues to review as part of an investigation into audit negligence: What scope is included in the audit contract between auditor and firm? For example, was the audit firm retained to prepare the financial statements as well as audit them? What procedures and work was required in the firm s audit manual and audit standards? Was the audit planning adequate? Were issues followed up from the prior year? Whether other technical accounting advice was sought by the directors? What judgements were made about audit scope, sampling and reliance upon controls What documentation standards were applied by the audit firm, including the use of electronic audit files? What is the location of copies of these? What were the key areas of audit judgement? How were these resolved? Page 5

7 4Conclusion In recent years, the auditing profession both in Australia and around the World has been the subject of litigation by third parties seeking to recoup their losses. As a result, this has highlighted the significance of audit quality and its role in enhancing market confidence. Litigation has often resulted from a corporate collapse which consequently gives rise to accusations of breach of statutory obligations and professional negligence by auditors. As such, auditor liability is currently a major focus for professional, judicial and legislative law reform bodies. However, there is also much need for a broadening awareness of the auditors role and the commercial and economic realities of the marketplace by stakeholders. Though the auditor s role is important in ensuring the adherence to Accounting Standards and the presentation of the financial statements, as recent case law has highlighted, it is also important to note that directors of a corporation cannot delegate or abdicate their responsibilities to others when it comes to specific obligations. For example, the Centro case found that though directors are entitled to place reliance on the advice of others (including management and auditors), they cannot substitute reliance upon this advice for their own attention and examination of an important matter that falls specifically within their responsibilities as with reporting obligations. The answer to resolving questions concerning whether the respective responsibilities of management and auditor have been fully discharged, often lies in a close examination and investigation of the conduct of an audit. Page 6

8 About the author Sasikala is a Manager and joined the Forensics team at KordaMentha in November 2010, having previously worked in a similar role with KPMG LLP, UK. Sasikala s work at KordaMentha involves forensic accounting, fraud and financial investigations, and disputes. Sasikala Kandiah Manager Sydney Tel: [email protected] Jason Cheung is a Senior Executive Analyst and joined the Forensics team at KordaMentha in March 2011, having previously worked in audit with KPMG, Sydney and in corporate insolvency. At KordaMentha, Jason s work includes disputes, forensic accounting and fraud and financial investigations. Jason Cheung Snr Executive Analyst Sydney Tel: [email protected] This publication, and the information contained therein, is prepared by KordaMentha Forensics s and staff. It is of a general nature and is not intended to address the circumstances of any particular individual or entity. It does not constitute advice, legal or otherwise, and should not be relied on as such. Professional advice should be sought prior to actions being taken on any of the information. The authors note that much of the material presented was originally prepared by others and this publication provides a summary of that material and the personal opinions of the authors. Limited liability under a scheme approved under Professional Standards Legislation. Page 7

9 KordaMentha Forensics Whatever the factual, accounting, financial or e-discovery issues that arise, our forensic expertise and experience can bring clarity of thought, objectivity and clear communication of ideas to help find the facts, understand the relevant issues and clarify the financial and other impacts in a cost-effective way. Dispute analysis Independent accountancy expert witness Consulting accountancy expert Experts pursuant to dispute resolution clauses Court-appointed referee Data analytics Suspicious activity analysis Data exploration Data assurance Process optimisation Forensic accounting and investigations Fraud and accounting manipulation investigations Corruption investigations with regards to FCPA, UK Bribery Act, and other anti-corruption legislation Regulatory investigations Corporate and internal investigations Investigations training Forensic technology Computer forensics E-Discovery Fraud risk management Development and review of fraud risk policies Fraud risk assessment Fraud, corruption and ethics awareness training Whistleblower consulting services Corporate and business intelligence Contacts Melbourne Owain Stone [email protected] Dispute Analysis Forensic Accounting Forensic Technology Sydney Andrew Ross [email protected] Dispute Analysis John Temple-Cole [email protected] Dispute Analysis Singapore Matthew Fleming [email protected] Robert Cockerell Executive Director [email protected] Fraud Risk Management Richard Bennison [email protected] Fraud Risk Management Andre Menezes Executive Director [email protected] Data Analytics Lily Yap Director [email protected] Dispute Analysis Nigel Carson [email protected] Forensic Technology Page 8