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Global Financial Crisis

Describe about the Auditing and Assurance for Accounting Failure and Governance.

The financial audit is the process of examining the financial statement according to the audit standard. The aim of this report is to develop an understanding about the auditor’s potential liability as a result of global financial crisis. The financial crisis started in the year 2008 in US and after that it had spread all over the world. Further, the auditors have been also responsible at the time of global financial crisis due to lack of indecency, objectivity and expertise, and they also failed to escalate the malpractices of business institutions. Finally, the report concludes with useful recommendations to the auditors in order to minimize such global financial crisis in future.

Financial crisis started in 2008 as global financial crisis.  It has been considered as one of the worst financial crisis in the world. Financial crisis of 2008 had happened because of housing bubble burst that means giving loan to the people who were not creditworthy (subprime), who may have difficulty in repay the loads. Due to this, around the world all stock market had fallen, many large financial institutions went bankrupt and the government in even the wealthy countries had come up with salvage package to relieve their financial system (CANSTAR, 2016). Lehman Brothers is the largest bankruptcy case in the history of US. On 15 September 2008, Lehman Brothers filed for the bankruptcy. It collapsed with $639 billion assets and $619 billion debts. This case provides an understanding of the risk that included in the business of Lehman Brothers and how they neglected it. This case also highlighted several facts about how the auditors may fail in executin their roles and responsiblities effectively.

On the other hand, the bankruptcy of the Lehman Brother marked the starting of a new phase in the global financial crisis. In context of the financial crisis, Australian government was the first country that declared its motivation budget to fight with the inflation that was the major problem in the local economy. At the same time, most of the central banks successfully implemented the extra ordinary monetary policies for bringing the interest rates near to zero to avoid the economics collapse, and to promote the growth and inflation in the world. Due to the negative interest rate, it produced a strong positive effect on the consumption (Forbes, 2016). These crisises raised several issues along with raising the issue of Auditors’ liabilities in such cases.

Auditors Liability under law

 PricewaterhouseCoppers (PwC) one of the big four accounting and auditing firm, who failed to detect the problem to cut off. It was found that several companies had hidden billion dollars losses with the blessing of big four auditors and auditors role was seriously neglacted in such situation. In 2008, America Federal Deposit Insurance Corporation had sued the PwC for $1 billon, because it did not detect the fraud in Colonial Bank, and that went bankrupt in 2009. In September 2008, American international group collapsed because they could not afford to pay for all of the mortgage defaults in US. There were many financial institutions that were severely affected and collapses due to financial crisis such as- NetBank (USA), American Home Mortgage (USA), Terra Securities (Norway), American Freedom Mortgage Inc. (USA) and many more (The Economist, 2016).

Auditing is a significant element in the current business market position. There is no doubt that auditors have become simple target to blame for the commercial collapses in the current years. In a company, an auditor grasps a position of great responsibility to perform certain duties, which are assigned to him by the management. Auditors are generally liable in the situation, when they do not act with the proper care and skills that is mention in auditing standard. The liabilities of auditors can be described as below-

An auditor is appointed in the firm to perform certain responsibilities. For this, auditors must take a reasonable care to execute their duties in the company. Due to the negligence of the auditors, client suffers some losses, than auditor may be held liable. Civil offences established the principles of auditor towards the client and third party, respectively. An auditor is responsible for detecting the misstatement and fraud in the business (ACCA, 2016). If an auditor shows clean views on financial statement, even after knowing the real picture then an auditor can be blamed for the fraud. According to the Rusch Factors, Inc v. Levin (1986) case under common law established that auditor was found liable due to ordinary negligence to third party, although the auditor was well aware of the fraud in the financial statement (O’Brien, 1986).

Meaning of third party is all parties such as investors, creditors banks and government, who depends upon the financial position and the financial information that are required by them to make decisions related to the investment in the business. According to the common law, an auditor is not responsible toward third party for an accidental negligence. But an auditor may be responsible to third party, if auditor makes statements with the motive of influence to the third party. According to the Australian corporation law, an auditor’s duty of care will be influenced by the expert view and confirmation of mechanism and skilled auditor in context of practices and standards of the profession (Gay and Simett, 2015). According to the common law, there is a contractual relationship between the auditor and third party. This relationship is called “the privacy of the contract” that refers a relationship between auditor and client for professional service.

Liabilities for civil and criminal activities

In some cases, there may be accidental liability of the auditors towards the third party, when there is a “primary beneficiary relationship” between the client and auditor. In this regard, audit is done with a particular objective so that third party can make particular decision. In this situation, third party can be able to prove the primary beneficiary relationship with the auditor. This way, third party will have right to sue the auditor just like client. According to the landmark case Ultramares Corporation v. Touche (1931) under common law is established that auditor can be liable for the third party beneficiaries for ordinary negligence (Koppelman, 2014).

According to the Australian corporation law, English law, and common law an Auditors liability is increasing due to change in the auditor’s responsibilities. Proportionate liability has been arising due to negligent misrepresentation from “misleading and deceptive liability” of auditor. In addition to this, objective of the proportionate liability was to ensure the liability of all suspects in the ratio of their contribution for the claimant loss (Johnstone et al., 2015). In this situation, auditors can be sued for the negligence by the creditors and shareholder of the companies, because companies are bankrupt and they unable to congregate their responsibility.

In context of proportionate liability, it does not include a reduction of auditor’s liabilities with relation to conduct the audit and preparation of audit report. The auditor’s liability is not reduced due to the proportionate liability because it allows them to rely blindly the data provided by the management. But the real situation is that errors in the financial statement are partly due to the carelessness of the company and its directors.

For example, if the director of the company is deceitfully misstates the financial statement of the business, management is not able to detect this due to poor control and auditor performs an insufficient audit because of wrong audit opinion. In this situation, it would be clear to say that all the three parties are at fault. So shareholders can be sued the auditor on partly basis (ACCA, 2016).

The term ‘auditor liability’ has become more complex in the recent times, which calls for various considerations and responses. Auditors have some broader liabilities to assume responsibilities towards the entities that they audit. Recent global financial crisis in particular, have increased the potential liability of auditors in determining the violation of laws and regulations.  Also, the American Institute of Certified Public Accountants (AICPA) has introduced a wide range of new statements on Auditing Standards, which have pointed out the liabilities of auditors regarding detection of irregularities and material errors in financial statements of an entity (Xu, Y et al., 2013). The Australian auditing standards closely aligned with International auditing standards. In order to fulfil its responsibilities, the Australian Law states that auditors must possess necessary skills and knowledge to solve financial matters. Moreover, auditors need to be highly reliable so that they can identify significant misstatements resulting from management fraud. In response to the series of legal actions brought against auditors, concern over the auditors’ responsibilities has also increased in Australia.

Legal liability of auditor towards client

Various major companies like Enron and WorldCom had collapsed in the United States during the financial crisis, which arouse due to accounting irregularities. Financial Statements of Lehman revealed profits for every year, from 2005 to 2007. However, Lehman’s involvement in the mortgage crisis in September, 2008, had badly affected its profitability, due to which the bank had collapsed. The event had created potential legal liabilities on its accounting firm Ernst & Young (Carnegie et al., 2014). The Court had found that the accounting firm Ernst & Young had failed to scrutinize Lehman’s bookkeeping. Some tactics were used by the Lehman Brothers inside the bank to hide $50 billion in order to show low debt-level of the bank in its balance sheet. As a result Ernst & Young had faced potentially damaging civil litigation by private plaintiffs or the Securities and Exchange Commission or criminal charges by the Justice Department.


However, Audition Profession of Australia has stated that primary role of detecting financial fraud is of the management of the entity and the auditors’ role is to give ‘true and fair’ view on those financial statements. International Standard on Accounting (ISA) 200 makes the auditor responsible for issuing their opinion on the financial statements of the company (Alexeyeva and Svanström, 2015). Auditing Standards of Australia identify financial liability of auditors of an entity to obtain and provide reasonable assurance regarding accuracy of financial statements of that entity. The fact that employees and management of an entity may attempt to conceal material errors and irregularities in their financial statements, does not change the responsibility of auditors for successful financial audit engagement. Auditors are also responsible for ensuring quality control of work and audit work.

Another liability of auditors is to make corrections and corresponding adjustments in financial statements. Auditor’s liability is also related to compliance with the reporting of accounts.

According to Australian law, an auditor may be held liable for negligence, if the third party has suffered loss as a result of auditor’s negligence in reviewing company’s accounts. In the case ‘Columbia Coffee & Tea Pty Ltd & Anor v Churchill & Ors t/a Nelson Parkhill’, the Supreme Court decided that the liability of auditors had arisen because third party had relied upon the negligently audited financial statements. As held in the case of Lehman Brothers, Ernst & Young became liable to pay $8.5 million fine to Securities and Exchange Commission.

Proportionate Liability of Auditor

According to Australian Auditing Standards, there is a difference between an error and fraud. An error is made unintentionally. No personal gain is expected the person who commits an error (Carnegie et al., 2014). In contrast, a mistake which is made deliberately is called a fraud. In the global financial crisis, which had occurred in 2007, wrong presentation of assets and liabilities in the financial statements of Lehman Brothers was the main reason. If an error or fraud results in significantly influencing the users’ decisions, it may cause a potential liability on the auditor of that entity (Filip et al., 2015). For example, the Enron scandal led to the bankruptcy of the Enron. The company was recognized as one of the biggest audit failure. Enron’s auditing firm was made liable for applying irrelevant standards while conducting the company’s accounts. It resulted in the collapse of Enron, due to auditors’ negligence. Also, Enron’s audit committee was later criticized for not having technical knowledge and skills related to accounting issues.

In addition to this, WorldCom’s scandal, in 2002, became one of the worst corporate crimes in US history. As a result, the C.E.O of the company was imprisoned for 25 years and also the company paid $750 million to the Securities & Exchange Commission (Barker, 2015). The global financial crisis showed various evidences where due to lack of auditor’s independence, objectivity, and expertise, the quality of audit was influenced to a great extent (Donald et al., 2016). In light of the cases held, it is clear that auditors had failed to perform their duty due to which financial crisis occurred globally.

According to Australian Standards, it is an auditor’s responsibility to correctly evaluate valuation of assets of the entity and to maintain proper functioning of the market (Liu and Webb, 2016). Auditors are also responsible for reducing the risk of information gaps in the market. 

Conclusion

From the above discussions, it is concluded that the financial crisis that had occurred in 2008 had posed threats on the existence of various banks and financial institutions of the world. It had also put question on the objectivity and knowledge of external auditors. The discussions also reflect the role of auditors in financial instability and plaintiff’s losses in the corporate world. It is also explored that the potential liabilities of auditors has become a serious issue that has a part in creating illiquid markets worldwide.

Potential Auditors’ liability in context of Global Financial Crisis

A challenging environment has been created by global financial crisis for companies and their auditors. By increasing auditors’ responsibilities such crisis can be reduced to a great extent. Further, in order to overcome these challenges, some useful recommendations are being provided. Auditors should increase their professional scepticism in order to deal with increasing litigation risk in the corporate world (Paul, 2016). Auditors should plan and review their strategies in order to respond effectively to audit risks. The auditors should try to obtain appropriate evidences and if it becomes difficult or the client seems to be risky, the auditor should quit that client (Gay and Simnett, 2015). They should increase their audit efforts so as to enhance propensity to deliver modified audit reports, if required. Also, certain effective regulatory requirements should be implemented by audit committee of Australia, in order to monitor auditors’ activities and practices. Moreover, only adhering to auditing standards is not enough, auditors should also make continuous improvement in audit quality so as to reduce audit risk and consequent drastic results significantly.

Reference

ACCA (2016) Auditor Liability. [Online]. Available at: https://www.accaglobal.com/in/en/student/exam-support-resources/professional-exams-study-resources/p7/technical-articles/auditor-liability.html (Accessed: 16 September 2016).

ACCA (2016) Joint and several liability. [online]. Available at: https://www.accaglobal.com/in/en/student/exam-support-resources/professional-exams-study-resources/p7/technical-articles/auditor-liability.html (Accessed: 16 September 2016).

Alexeyeva, I., and Svanström, T., (2015) The impact of the global financial crisis on audit and non-audit fees: Evidence from Sweden. Managerial Auditing Journal, 30(4/5), pp.302-323.

Barker, K., Grantham, R., and Swain, W. (2015) Law of Misstatements: 50 Years on from Hedley Byrne v Heller Hart Studies in Private Law. UK: Bloomsbury Publishing.

CANSTAR (2016) Global Financial Crisis – What caused it and how the world responded. [online]. Available at: https://www.canstar.com.au/home-loans/global-financial-crisis/ (Accessed: 16 September 2016).

Carnegie, G.D., and O’Connell, B.T., (2014) A longitudinal study of the interplay of corporate collapse, accounting failure and governance change in Australia: Early 1890s to early 2000s. Critical Perspectives on Accounting, 25(6), pp.446-468.

Donald, S., Bateman, H., Buckley, R., Liu, K., and Nicholls, R., (2016) Too Connected to Fail: The Regulation of Systemic Risk within Australia's Superannuation System. Journal of Financial Regulation, 2(1), pp.56-78.

Filip, A., Labelle, R., and Rousseau, S., (2015) Legal regime and financial reporting quality. Contemporary Accounting Research, 32(1), pp.280-307.

Forbes (2016) Potential Pitfalls Of Negative Rates. [online]. Available at: https://www.forbes.com/sites/fidelity/2016/06/23/potential-pitfalls-of-negative-rates/#1abd65de6c74 (Accessed: 17 September 2016).

Gay, G., and Simnett, R., (2015) Auditing and Assurance Services in Australia. US: McGraw-Hill Education Australia.

Johnstone, K., Gramling, A., and Rittenberg, E.L. (2015) Auditing: A Risk Based-Approach to Conducting a Quality Audit. Australia: Cengage Learning.

Koppelman, E.L. (2014). Recent Limitation of Doctrine of Liability for Negligence to Third Parties. St. John's Law Review, 5(2),  p.6.

Liu, L., and Webb, S.B., (2016) Laws for Fiscal Responsibility for Subnational Discipline: International Experience. Applied Economics and Finance, 3(1), pp.118-137.

O’Brien, C.N. (1986) the legal environment of the accounting profession, North Atlantic Regional Business Law Review, vol. 19, pp. 102-119.

Paul, E. (2016) Australian Political Economy of Violence and Non-Violence. Germany: Springer.

The Economist, (2016) Accounting scandals. [online]. Available at: https://www.economist.com/news/briefing/21635978-some-13-years-after-enron-auditors-still-cant-stop-managers-cooking-books-time-some (Accessed: 17 September 2016).

Xu, Y., Carson, E., Fargher, N., and Jiang, L., (2013) Responses by Australian auditors to the global financial crisis. Accounting & Finance, 53(1), pp.301-338.

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