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ACC707 Auditing And Assurance Services 5

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  • Course Code: ACC707
  • University: Kings Own Institute
  • Country: Australia

Question:

Topic: The critical analysis of a Australian company with audit issues which lead to its failur.


Task details:

Your group is required to choose a formerly listed failed Australian company that had audit issues. Critically analyse how the auditors failed to fulfil their duties and responsibilities.

You must discuss at least three key audit issues that arose in the case such as auditors' independence, professional and ethical behavior and audit quality. Critically evaluate whether the auditors performed adequate audit risk assessments, identified the key audit issues and obtained sufficient audit evidence to support their audit opinion. You must provide your own recommendations for further improvements in the auditing profession.

 

Answer:

Introduction

Over the years, many large corporate collapses and business failures took place in the business sector of Australia such as HIH Insurance, Ansett Australia, OneTel and Harris Scarfe. Therefore, the corporate sector of Australia had to face many adverse long-term impact of these business failures and corporate collapses; and the auditing profession has been majorly affected with the same (Betta, 2016). This report emphasizes on the discussion of the reasons and procedures in which the auditors of HIH Insurance failed in discharging their duties and responsibilities in the most appropriate manner. HIH Insurance went into provisional liquidation on 15 March 2001 because of its inability of paying its debts as they fell due. For the projected shortage amounted to be between $3.6 billion and $5.3 billion, the collapse of HIH Insurance became the largest corporate collapse in the history of Australia. This collapse also led to an investigation by the Royal Commission for the thorough assessment of the reasons of HIH Insurance collapse (Crockett and Ali, 2015). As this report brings discussion on various aspects associated with the collapse of HIH Insurance, it aims at discussing three key audit issues in the HIH Insurance collapse. This report also involves in analysis whether the audit partner of HIH Insurance, Arthur Andersen, performed sufficient procedures for assessing the audit risk of HIH Insurance. Based on the outcome of the report, this report involves in providing certain recommendations for improving the auditing profession.

Key Audit Issues that Arose in HIH Collapse

Failure of Arthur Andersen, the audit partner of HIH insurance, played a key role in the business failure of the company. The audit of HIH Insurance by Arthur Andersen raised certain key fundamental issue of the auditing profession which pushed the company towards its collapse. Three of such issues are discussed below:

 

Lack of Auditor’s Independence

The independence of Arthur Andersen was a major highlighted issue in the audit of HIH Insurance. The Board of Director of HIH Insurance employed three former members of Arthur Andersen. One member of Arthur Andersen who was the beneficiary of continuous benefit from the audit firm, was made Chairman by HIH Insurance and the company also appointed him in the audit committee only seventeen months after his retirement (Ball, Tyler and Wells, 2015). Another member of the audit firm who had been the engagement partner for the firm was appointed as the Chief Financial Officer (CFO) by HIH Insurance only the day after he resigned from the audit firm. HIH Insurance appointed the third partner to its Board of Directors only five months after he retired from an important role in the audit engagement of HIH Insurance for the last 25 years. Furthermore, in the year 1999, there was a replacement of Arthur Andersen’s long standing audit engagement partner of HIH Insurance after he had meeting with the non-executive director when senior management was not present (Knechel, 2016). By taking into account the close relationship of Arthur Andersen with HIH Insurance and the audit firm’s unhesitating acceptance of the outcome of both internal audit and work of consultant, it can be said that Arthur Andersen was not independent in the audit of HIH Insurance for 1999 and 2000 audits (Roy and Saha, 2018). It was also mentioned that there was huge pressure on the audit partners of Arthur Andersen for maximizing profit by the provision of non-audit services. It was mentioned by one of the partners before the Royal Commission that there would have been adverse impact on the firm’s ability of promoting the delivery of non-audit services to HIH Insurance in case he demanded for exercising independence and professional scepticism through resisting the proposal of the management (Roy and Saha, 2018).

Lack of Professional Scepticism

Incontrovertibly, the business failure of HIH Insurance is one of the auditor’s failure. It is informative to mention in this context that Arthur Andersen employed a mechanism of assessing the client’s risk between the years 1998 and 2001 and this mechanism consistently pointed HIH Insurance as a maximum-risk client. Therefore, in accordance with the internal operational manual, Arthur Andersen was required to employ prolonged risk management procedures and to frame a formal plan for managing the risks regarding the same (Van Akkeren and Buckby, 2017). Given the exceptionally high level of materiality of any possible misstatement regarding the provision of future claims, it was required by the own police of Arthur Andersen to thoroughly review the financial reports of HIH Insurance. Strangely, the audit firm relied on the excerpts of the six months reports of HIH Insurance by taking into consideration very limited details of the developed audit methodology and assumptions. At the same time, no expert assistance was taken by Arthur Andersen in assessing these excerpts (P?unic? and Iovu, 2019). Although it was the principle failure of Arthur Andersen to unquestionably accept the internally developed report of HIH Insurance, it also formed an example of the absence of thoroughness in conducting the audit. Moreover, heavy reliance of Arthur Andersen was there on the internal audit procedures employed within HIH Insurance, even the audit firm put its reliance on these internal audit processes without evaluating or testing the internal audit function. Most importantly, Arthur Andersen did not take into consideration the deficiencies identified in the internal audit function of HIH Insurance and even through it was required by it to conduct evaluation and testing as suggested by its own operational manual (Kleinman and Lin, 2017).

 

Ineffective Role of Audit Committee

An audit committee is considered as an essential portion of the corporate governance mechanism of the large corporations; and the main responsibility of an audit committee can be seen in supervising the corporate reporting process within the organization and communicating effectively with the external auditors. However, in HIH Insurance, no guideline or practice was followed regarding its audit committee. Groffrey Cohen, the Chairman of HIH Insurance was also the Chairman of its audit committee which was absent the corporate governance principle. Great majority of the meetings of the committee was attended by him along with other senior managerial employees (Asiriuwa, et al., 2018). It was mentioned by Mr White, counsel assisting the Royal Commission that there was not any reason as per the evidence for the meeting between the auditor and the members of the audit committee in the absence of management. Therefore, it can be understood that usual practice was not adopted by the management of HIH Insurance and this also questions the impartiality of its audit committee. A possibility has been considered by the Royal Commission that Arthur Andersen might have been pursued by the audit committee for complying with the management accounting treatments (Lessambo, 2016). Therefore, the presence of an audit committee within HIH Insurance failed to ensure that the company’s accounts as well as the audit of the accounts provide true and fair status of HIH Insurance’s financial reality. Maybe the reason was the involvement of the audit committee of HIH Insurance along with the absence of independence of its members that prevent the actual role of the audit committee and management team of the company. However, the business failure of HIH Insurance has made it clear that the mere existence of an audit committee is not adequate for safeguarding company’s corporate reporting (Iqbal and Kakakhel, 2016).

 

Whether the Auditor Performed Adequate Audit Risk Assessment

The Royal Commission identified the Audit Objectives and Procedures Manual (AOP) of Arthur Andersen as a mechanism to provide primary evidence of the auditing principles and practice adopted by the audit firm while conducting an audit engagement. It is interesting that this AOP did describe the business audit methodology that Arthur Andersen used to adopt. As per the requirement, it was required for Arthur Andersen to conduct an initial appraisal through using a software package named SMART. During the period between 1998 and 2001, this mechanism assessed HIH Insurance as a maximum-risk client as per the SMRT assessment software. As per the detailed particular requirement of the AOP, it was required to activate detailed audit requirements and control processes during conducting an audit where the client had been assessed as a maximum-risk client. However, it was found by the Royal Commission that Arthur Andersen was involved in a little evidence gathering process regarding the risks identified during the audit of HIH Insurance even in the presence of the correct identification of HIH Insurance as a maximum-risk client as per its own risk assessment system (Alrshah, 2015).

In this manner, the audit firm faced major failure to address certain key accounting anomalies in HIH Insurance. These accounting issues could be seen in four aspects; they are future income tax benefit related accounting, accounting for deferred acquisition costs, accounting for deferred information technology costs and accounting for goodwill (Hay, Stewart and Botica Redmayne, 2017).

A key doubt must arise on the firm’s ability of realising future income tax related benefits in case a tax loss is incurred by a business organization. Despite the suggestion of using a virtual certainty test, the audit partner of Arthur Andersen used a test for assessing the presence of a reasonable ground of believing that HIH Insurance would be able in continuing profitability in near future. In actual, Arthur Andersen failed to acquire adequate audit evidence on this under AUS 502 that would require it to issue qualified audit opinion (Alizadeh and Zannone, 2016).

Similar aspect can be seen in the accounting of deferred acquisition costs. By violating the actual accounting treatment for this, the audit partner of Arthur Andersen did not perform any work in relation to assess the recoverability of deferred acquisition costs and considered  it as a matter of professional judgment upon the historical profitability of HIH Insurance. This also contributed to obtain inadequate audit evidence as per AUS 502 (Mukhlasin, 2018).

No particular accounting standard for the accounting treatment of deferred information technology costs was there at the time of the business failure of HIH insurance, SAC 4 suggested a test for comparable to the deferred acquision costs; and it was mentioned in that probable and reliable measurability needs to be there in the future economic benefits. This also raised question on the role of the audit partner of Arthur Andersen to acquire adequate audit evidence in this aspect (Sule, Yusof and Bahador, 2019).

There were also major questions associated with the accounting for goodwill by Arthur Andersen. The test was about whether there would be evaluation of future benefits and whether it would be possible to measure the goodwill on reliable basis. As at June 2000, an astounding 50% shareholders’ funds of HIH Insurance was represented by the goodwill. At the same time, it is also a matter of controversy to which the poor Allianz transaction can be attributed to the failure of audit in HIH Insurance. The management of HIH Insurance supplied Arthur Andersen with basic detail of the transaction. Even if it is not the responsibility of the auditor of signal commercial prudence of the business decision of the clients, but the auditor is responsible for assessing whether the client will be able to continue as a going concern in future. However, a deficiency of professional scepticism was displayed by Arthur Andersen; the audit firm showed an enthusiasm of embracing the Allianz transaction as a solution regarding critical audit issue in the 2000 audit of HIH Insurance by not acquiring adequate audit evidence on the transaction and its possible financial magnitudes (Carson, Fargher and Zhang, 2016).

 

Recommendation on Further Improvement in the Auditing Profession

Based on the whole discussion, certain recommendation is provided below:

  1. Major absence of professional scepticism can be seen in the collapse of HIH Insurance and therefore, it is recommended to strengthen professional scepticism for improving the audit profession. In order to develop this, it is required for an auditor to make presumptions of the presence of management fraud during the initial phase of audit. Since all firms are susceptible to financial statement fraud, it is recommended to the auditor to undertake initial assessment of the extent of susceptibility of the firm to commit fraud.
  2. Since overall quality of the audit was a major concern in the audit failure of HIH Insurance, the recommendation to the auditors is to put more focus on performing high-quality audit in every aspect of audit engagement. In order to conduct an high quality audit, the recommendation to the auditors is to put increased emphasis on three aspects which are performing surveying audit procedures, investigating unseal financial entries and establishing close link with the audit committee.
  3. It is also recommended to the auditors that they should put more concentration on the audit of interim financial reports of the companies as initiation of most of the fraud can be seen in interim period. The key reason is that the management of the firms have the capability of influencing the time to executive certain financial transactions along with their recording in appropriate financial accounts. Therefore, the auditors are required to undertake audit tests in the areas of cut-off dates of the transactions and others.
  4. Ineffective role of the audit committee can be seen in HIH Insurance and it is recommended that an audit firm is needed to discuss about the susceptibility of fraud in financial reporting and chances of misappropriation of assets with the audit committee. Furthermore, it is also recommended to the audit firms to take into consideration the communication of client’s management with the audit committee on the strengths or weaknesses of internal control.
  5. Auditor’s independence was another major issue in the collapse of HIH Insurance; and therefore, the recommendation to the auditors is to assess as well as identify the threats to audit independence and to involve in applying necessary safeguards to reduce those threats to an acceptable low level. Moreover, the auditors are recommended to become aware of the stations which can develop conflict of interest and maintain distance from those situations for not letting the auditor’s independence be impaired.

Conclusion

Among many issues, three crucial issues that backed the audit failure of Arthur Andersen in HIH Insurance audit are lack of auditor’s independence, lack of application of professional scepticism and poor role played by the audit committee. Another major reason of the audit failure in HIH Insurance was the ineffective planning of the whole audit by Arthur Andersen. Despite of knowing the fact that HIH Insurance was a maximum-risk client, Arthur Andersen did not feel the necessity of acquiring adequate audit evidence on four certain key financial aspects such as going concern risk assessment, accounting for goodwill, deferred acquision costs, deferred technological costs and others. As per recommendation, the main areas of recommendation include improvement of audit committee, enhanced auditor’s independence, ensuring the audit of interim financial reports, enhanced application of professional scepticism and increase in the effectiveness of audit committee. It is suggested to the auditors in today’s world to take lessons from the business failure as well as audit failure of HIH Insurance since this will help them in raising the overall quality of audit performed.

 

References

Alizadeh, M. and Zannone, N., 2016, March. Risk-based analysis of business process executions. In Proceedings of the Sixth ACM Conference on Data and Application Security and Privacy (pp. 130-132).

Alrshah, A.M., 2015. An empirical analysis of audited financial statements reliability: Mediating role of auditor quality. International Journal of Finance and Accounting, 4(3), pp.172-179.

Asiriuwa, O., Aronmwan, E.J., Uwuigbe, U. and Uwuigbe, O.R., 2018. Audit committee attributes and audit quality: a benchmark analysis. Business: Theory and Practice, 19, pp.37-48.

Ball, F., Tyler, J. and Wells, P., 2015. Is audit quality impacted by auditor relationships?. Journal of Contemporary Accounting & Economics, 11(2), pp.166-181.

Betta, M., 2016. Three Case Studies: Australian HIH, American Enron, and Global Lehman Brothers. In Ethicmentality-Ethics in Capitalist Economy, Business, and Society (pp. 79-97). Springer, Dordrecht.

Carson, E., Fargher, N. and Zhang, Y., 2016. Trends in auditor reporting in Australia: A synthesis and opportunities for research. Australian Accounting Review, 26(3), pp.226-242.

Crockett, M. and Ali, M.J., 2015. Auditor independence and accounting conservatism. International Journal of Accounting & Information Management.

Hay, D., Stewart, J. and Botica Redmayne, N., 2017. The role of auditing in corporate governance in Australia and New Zealand: A research synthesis. Australian Accounting Review, 27(4), pp.457-479.

Iqbal, K. and Kakakhel, S.J., 2016. Corporate Governance and its Impact on Profitability of the Pharmaceutical Industry in Pakistan. Journal of Managerial Sciences, 10(1), p.74.

Kleinman, G. and Lin, B.B., 2017. Audit regulation in an international setting: Testing the impact of religion, culture, market factors, and legal code on national regulatory efforts. International Journal of Disclosure and Governance, 14(1), pp.62-94.

Knechel, W.R., 2016. Audit quality and regulation. International Journal of Auditing, 20(3), pp.215-223.

Lessambo, F., 2016. The international corporate governance system: Audit roles and board oversight. Springer.

Mukhlasin, M., 2018. Auditor Tenure and Auditor Industry Specialization as a Signal to Detect Fraudulent Financial Reporting. Academy of Accounting and Financial Studies Journal.

P?unic?, M. and Iovu, C., 2019. Internal audit–A key process for diminishing the risk of fraud. AMIS IAAER 2019, p.52.

Roy, M.N. and Saha, S.S., 2018. Statutory auditors’ Independence in select corporate accounting scandals since 1990: A comparative study. In Statutory auditors’ independence in protecting stakeholders’ interest (pp. 121-171). Palgrave Macmillan, Cham.

Sule, S., Yusof, N.Z.M. and Bahador, K.M.K., 2019. Users’ Perceptions on Auditors’ Responsibilities for Fraud Prevention, Detection and Audit Expectation GAP in Nigeria. Asian Journal of Economics, Business and Accounting, pp.1-10.

Van Akkeren, J. and Buckby, S., 2017. Perceptions on the causes of individual and fraudulent co-offending: Views of forensic accountants. Journal of Business Ethics, 146(2), pp.383-404.

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