Professional Negligence In Auditing: Criteria And Risks (essay).

Criteria for Winning a Professional Negligence Case in Auditing

Professional negligence in auditing ascends when the auditor fails in performing their duty which might lead to loss or damage to the client. As per the provided scenario, HFH has been the audit partner of Bubblehike for the last 20 years, and it regularly provides the client with non-financial reporting services, known as non-audit services. It implies that a large proportion of HFH’s total revenue comes from Bubblehike through the provisions of audit and non-audit services. As per Section 410.3 A1 of APES 110, HFH’s dependence on Bubblehike makes it concerned about losing Bubblehike as a client, which might create self-interest or intimidation threats to audit independence (apesb.org.au, 2022). Due to the potential of these risks, the possibility cannot be ignored that HFH ignored considering the effect of the unsold and defected inventories on auditing and accepted the management’s representation about the inventory valuation to retain Bubblehike as a valued client. The reason could be HFH’s self-interest in the client or the direct or indirect pressure of the client’s management to accept the management’s representation. Hence, a fair possibility is there that HFH has been negligent in Bubblehike’s audit.

For Heifer to win their case against HFH, four key criteria must be proved.

First, Heifer must prove that HFH owed a duty of care to them. In this context, the case of “Royal Bank of Scotland (RBS) vs Bannerman Johnstone MacLay (Bannerman) (2002)” can be presented. In this case, it was advocated that Bannerman (the auditor) owed a duty of care to RBS as Bannerman would have been aware of RBS’s intention of using the audited accounts as a foundation for lending decisions (accaglobal.com, 2022). Likewise, HFH would have been aware that Heifer would use the audited financial statements as a base to make the buoying decision since HFH has been Bubblehike’s auditor for the last 20 years. It would help Heifer prove that HFH owed a duty of care to them.

Second, it must be proved that the duty of care is breached. It is easy to prove that HFH only relied on the management’s representation instead of performing any audit procedure for inventory (Brasel et al., 2016).

Third, it must be proved that Heifer suffered a real loss, and Heifer must present the loss in monetary value.

Fourth, Heifer must prove that the financial loss was because of the negligence of HFH.

Assumed the enormous size of some inventories, the auditor of HFH had the scope of using an Active Data Analysis command for conducting the inventory audits instead of only relying on the management’s representation. The auditor could use such data analysis command for identifying possible obsolete inventory, slow-moving inventory, reconciling the count of inventory with the general ledger, performing sampling, inventory valuations and testing the inventory dates (accaglobal.com, 2022). As a result, the auditor may have identified the issues of inventory overstatement.

1. Intense competition in the hardware industry represents a key business risk as it puts more stress on Bunyip’s management to generate profit. It also represents the likelihood that it may lose its market share to these competitors (Ullah et al., 2016).
2. The legal action presents another business risk for Bunyip as failure in this legal action may require it to pay a substantive claim. As a result, the company's operating performance and financial position may be adversely impacted (ASA 315, 2022).
3. The strategy of Bunyip to offer value-added services to the clients to retain the client base creates a major business risk. This is because of the adverse impact of the strategy on its ability to register adequate gross profit. Failure of the company to register adequate gross profit exposes the company to make an overall loss if it is not able in covering the operating expenses.
4. The failure of Bunyip’s higher-margin products to fetch a higher amount of sales is another business risk for the company. It is because the company will not be able to make an adequate amount of profit because of this inadequate sale (Hudakova et al., 2018).
5. Bunyip is exposed to another business risk in the form of the company's difficulty to make payments to two of its major suppliers. It is a business risk as it may affect their relationship with those suppliers if it fails to pay their dues in time.

1. Even in the presence of the business risk due to intense competition, the net profit ratio of Bunyip increased to 5.4% in 2021 from 4% in 2020. This unusual increase in net profit is an indicator that the management might have overstated the net profit by overstating sales revenue or understating some major expenses (ASA 240, 2022). Hence, further investigation is required.
2. The legal action makes it probable that Bunyip may have to pay the major hardware chain if it loses the legal action, requiring a legal provision. If the payment is possible instead of probable, Bunyip must disclose a contingent liability. If Bunyip does not do the same, risk over the completeness of any provision or the required disclosure of contingent liabilities is there. Hence, further investigation is required.
3. The new business strategy of Bunyip contributed to a decrease in its gross profit from 18% in 2020 to 16.2% in 2021. It implies that Bunyip may be paying more for its inventories or charging less to the customers. Therefore, the reasonableness of the cost of goods sold by the company should be critically reviewed in further investigation.
4. Inadequate sales from the higher-margin products contributed to a decrease in the inventory turnover ratio from 4.5 times to 4 times. Since it is an indicator of obsolete or slow-moving inventory, it should be investigated further (Dritsas & Petrakos, 2018).
5. Since Bunyip’s current ratio decreased to 2 from 2.5, and it is lower than the industry average, it may be unable to pay them on time. It requires further investigation as it is an indicator of going concern issue.

References

APESB. (2022). APES 110 Code of Ethics for Professional Accountants (including Independence Standards). Retrieved 6 April 2022, from https://apesb.org.au/uploads/home/02112018000152_APES_110_Restructured_Code_Nov_2018.pdf

ASA 240. (2022). Auditing Standard ASA 240 The Auditor's Responsibilities Relating to Fraud in an Audit of a Financial Report. Retrieved 6 April 2022, from https://auasb.gov.au/media/cyloqabg/asa_240_12_21.pdf

ASA 315. (2022). Auditing Standard ASA 315 Identifying and Assessing the Risks of Material Misstatement. Retrieved 6 April 2022, from https://www.auasb.gov.au/admin/file/content102/c3/ASA315_03-20.pdf

Brasel, K., Doxey, M. M., Grenier, J. H., & Reffett, A. (2016). Risk disclosure preceding negative outcomes: The effects of reporting critical audit matters on judgments of auditor liability. The Accounting Review, 91(5), 1345-1362.

Dritsas, S., & Petrakos, G. (2018). Risk of Material Misstatement in Fluctuated Economic Environments: The Case of Greece. International Business Research, 11(6), 243-248.

https://www.accaglobal.com, A. (2022). Auditor liability | ACCA Global. Retrieved 6 April 2022, from https://www.accaglobal.com/an/en/student/exam-support-resources/professional-exams-study-resources/p7/technical-articles/auditor-liability.html

https://www.accaglobal.com, A. (2022). Data analytics and the auditor | ACCA Global. Retrieved 6 April 2022, from https://www.accaglobal.com/in/en/student/exam-support-resources/professional-exams-study-resources/p7/technical-articles/data-analytics.html

Hudakova, M., Masar, M., Luskova, M., & Patak, M. R. (2018). The dependence of perceived business risks on the size of SMEs. Journal of Competitiveness, 10(4), 54-69.

Ullah, R., Shivakoti, G. P., Zulfiqar, F., & Kamran, M. A. (2016). Farm risks and uncertainties: Sources, impacts and management. Outlook on Agriculture, 45(3), 199-205.