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Impact of GFC (Global Financial Crisis)

Describe about the Auditing and Assurance for Potential Liabilities.

The focus of this report is on the auditor’s potential liabilities that are owed towards the various stakeholders especially their clients. These have come to the forefront ever since the Global Financial Crisis and the loss to investors due to bankruptcy of a host of companies including giants such as Lehmann Brothers. The underlying concept of auditor liability especially in the wake of global financial crisis has been discussed through the medium of this report. Finally, recommendations have been offered in order to potentially reduce this liability through enactment of proactive measures.

The impact of the GFC was widespread and not limited to a particular geography or economy. However, one of the worst sufferers in this crisis were the global financial institutions especially those based in developed nations (Shefrin and Shaw, 2016). This is apparent from the collapse of various global financial firms such as Lehman Brothers, American international group, HBOS and other financial institutions which until then were considered too big to fail. With regards to Lehman Brothers, there were a plethora of contributory reasons to failure including the misconduct on the part of executives, high usage of CDS along with falsification of the financial statements. Additionally, the role of auditor in the failure can also not be undermined since the external auditor at the time i.e. Ernst and Young failed to capture the impact of innovative tools such as 105 Repo to the stakeholders (Leung,  Coram & Cooper, 2012).

Besides, a large UK based banking institution that failed to survive the crisis was HBOS which failed due to company’s indulgence in imprudent lending driven more by the future  prospects of real estate prices that the innate creditworthiness of the investor. 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).

An external auditor plays a crucial role in ensuring sustainability of financial strength in the organisation as creative accounting is being increasingly used to manage expectations of shareholders. Auditor liabilities refer to the underlying responsibility that audit professionals have towards the company as well as the user base particularly the shareholders (Gay and Simnett, 2012).  In order to ensure that the auditors comply with their responsibilities in the best possible manner, there has been an increase in their underlying liabilities in the recent times especially as their role in timely detection of financial jugglery has become clearer. A sound audit tends to faithfully represent the financial position of the company along with the risk associated and ensures that sustainability and stability of business is maintained (Arens et. al., 2013).

Auditor’s Liabilities under Law

In common law, liability for auditors can be explained on the basis of incidence of fraud and negligence and hence leads to underperformance with regards to the discharge of fiduciary duties.  These liabilities are briefly highlighted below.

These liabilities tend to arise when the conduct of the auditor is negligent as a result of which the investors tend to suffer damages in terms of losses (Caanz, 2016). The audit professionals need to ensure that professional care is extended to the interests of the organisations and also the users and any negligence in the same implies auditor liability. In such cases, the damage caused to the client and user would be recoverable from the auditor. In the recent times, there has been an increase in these liabilities for the auditors as investors and clients have become more intolerant towards such lapses considering the high stakes involved (Arens et. al., 2013).

Criminal and civil offence liabilities

The above liabilities tend to arise if the auditor violates the relevant rules and regulation that are in place to ensure that the audit achieves the intended objectives. In case, of violation of the relevant statues that too with intent to commit fraud, criminal offence is deemed to have occurred

(Gibson and Fraser, 2014).  Thus, when there is misrepresentation of financial statements, the users or any other stakeholder can file a claim for losses. Further, liabilities may also be levied in case the client faces loss on account of material misstatement. There is a contract between the auditor and client and in case of violation of the terms or the level of service not being to the quality standards that are expected, then potential civil liabilities could be brought about on the auditors. This is because they are obliged to discharge their contractual obligations in a faithful manner (Gay & Simnett. 2012).

In accordance with tort law, the auditor would be held liable for any error resulting in the auditing especially if the same is misrepresented either intentionally or unintentionally (Davenport & Parker, 2014). It is the duty of the auditor to ensure that there is no misrepresentation with regards to the financial statements of the company as the investors along with other stakeholders for decision making tend to rely on the opinion tendered by the auditor. As a result, if the various users tend to suffer a loss which is attributable to the misrepresentation in the financial statements, then liability has to borne by the auditor for the losses assumed by the users (Leung, Coram & Cooper, 2012).

Negligence Liabilities

Proportionate liabilities

As per this concept, the liability of the auditors is directly proportional to the quantum of the losses suffered by the shareholder or any other user who relied on the financial statements when taking decision.  In Australia, the auditor is held liable for the loss to the shareholder even though in majority of the states, the liability of the auditor is capped at an amount equal to 10x the audit fee paid by the respective client (Caanz, 2016).

During the GFC, it was a common sight that financial institutions went bankrupt even though they all had a common feature in the form of audit reports that were unqualified. Clearly, this is a serious issue as it undermines the utility of the auditor’s report.  An unqualified audit report implies a declaration by the auditor with regards to the financial statements being compliant with the relevant accounting standards and also presenting a picture of the organisation that is free from any misstatement (ASIC, 2016).  Besides, such an option also implies the agreement of auditor with the accounting policies and norms that are adhered by the given organisation. The importance of this opinion is apparent from the fact that in the event of giving a false or incorrect opinion, the auditor potentially could face criminal proceedings if such an opinion was tendered knowingly (Arens et. al., 2013). 

This is evident from the class suit that was brought against the auditors (Ernst and Young) after the bankruptcy of Lehman Brothers. While acting as the external auditors of Lehman Brothers, Ernst and Young indulged in endorsement of various dubious accounting practices which were misleading as they selectively understated the outstanding liabilities and therefore provided a positive bias to the financial position to the company. The audit firm has to settle the lawsuit by agreeing to make a payment of $ 10 million (Freifeld, 2016). A common feature with most of the financial institutions that went bankrupt during the GFC is that their financial statements did not completely and accurate record the underlying liabilities they had. Also, in the balance sheet of some institutions, the asset value had been purposely inflated.  Besides, in order to hide their losses, they used financial jugglery through the use of derivatives. The failure of internal controls was also witnessed with dubious corporate governance practices being adhered to. There seemed to be a money making cartel going on where right from the senior management to external auditor had a stake at the expense of the owners (Soh and Bennie, 2011).

Criminal and Civil Offence Liabilities

The auditor is bestowed with the duty of ensuring that all the underlying assets and liabilities of the organisation are completely and fairly represented in the financial statements. Non- disclosures of assets and liabilities by the company’s management amounts to fraud and same needs to be brought to the notice of the relevant authorities by the external auditor. In case of non-detection of fraud by the auditor, the auditor in order to escape liability needs to prove that there was no quid pro quo relation with the management and also no negligence was observed with regards to deployment of audit strategy and related plan (Gay & Simnett, 2012). This was established in the verdict of the Pacific Acceptance Corporation v. Forsyth (1970) 92 WN (NSW) 29 at 65 in which case the judge opined that the liability of the auditor is limited to whether the underlying conduct was negligent or not (Serperlaw, 2016). The auditor at the time of conducting the audit needs to exhibit prudence and ensure that all the aspects are taken into consideration. In order to opine on whether requisite care was shown by the auditor, Section 50, Corporations Act 2001 is pivotal (Gibson & Fraser, 2014).

With regards to asset valuation, it is imperative that the auditor must reasonably estimate a set of possible range within which the value should lie and then ascertain if the company’s values lies in that range or not. If in the process, the auditor finds uncertainties, then the same is highlighted in the auditor report. In such estimation, it is imperative that the auditor must use his/her experience and professional skill (Caanz, 2016). However, in certain cases, the underlying subjectivity tends to be very high with regards to estimates and hence this situation refers to as the inherent limitations of the process. It is imperative that the auditor must be well verse with the company’s business which enables him/her to better understand the potential risks (Leung, Coram & Cooper, 2012).

However, the auditor’s scope of work does not merit discussion of the future price of the asset and is limited to opining on the accuracy of the financial statements with regards to capturing the business transactions that have already taken place. The audit quality has been dwindling in the recent times and has been severely questioned. There have been several liquidations and bankruptcies such Allco, Storm Financial , Westpoint etc. that have brought the issue of auditor negligence at the forefront (Cheung & Kandiah,  2016).  Considering that the suppliers and creditors tend to form relationship with the client based on their financial statements, the insolvency of the company could mean losses to these parties and hence the auditor negligence and inefficiency is directly responsible for their losses (Chung et al., 2010).

Liability of Misrepresentations

As per the going concern assumption, it is normally assumed that the business would continue being operational in the future. However, when the company faces potential crunch in liquidity which can lead to company’s liquidation, then it is imperative that directors must represent this in the financial statements of the company (Taylor, Tower and Neilson, 2010). As per the relevant Australia Standards of Auditing, the auditor must review such assessment on the part of directors and ensure that the same is captured in the audit report so that the users are aware of any potential uncertainty with regards to going concern status  (Xu et al., 2013). In the event that the directors fail in their duty of issuing a correct assessment about the same, then the auditor must give an adverse audit opinion rather than giving an unqualified opinion. However, if the auditor does not capture any material uncertainty with regards to going concern in the audit report, then there is negligence on the part of the auditor. With regards to ascertaining auditor liability in wake of financial crisis, the court would consider whether the auditor had information about the material uncertainties with regards to going concern and left them unreported (Arens et. al., 2013).

Additionally, considering the key role that internal control systems play in ensuring that financial statements are correct and complete, the auditor must also opine on the effectiveness of internal controls and offers pragmatic suggestions on strengthening the same. This has assumed immense importance in the aftermath of GFC where the weak internal control was one of the major reasons for exposure to risky investments and lack of prudence in extending money to investors (Taylor, Tower and Neilson, 2010).  It is imperative that enough emphasis must be laid on the internal controls which act as a first line of defence even before the auditor pitches in (Azim, 2012).

An example of a case where the inherent business risk led to the downfall of the company is Storm Financial. The company acted as a financial planner for the various clients it had. It provided them an advice whereby they should assume more debt and in the process the company ended up maximising its own fees. However, the underlying risk that the investors are assuming by exposure to these securities was not advised to the clients. As a result, the clients lost huge amount of money which the company could ill afford to pay and eventually the company collapsed (Washington, 2016).

Proportionate Liabilities

It has been observed that the liquidation of companies is on the rise and in this the role of auditor is usually found to be significant. With regards to managing the resultant auditor liability, it is recommended that internal audit systems must be strengthened in the organisations so as to minimise the overall risk of misstatement. Besides, sound corporate governance norms should also be obeyed by the companies which would ensure that the powers of top management would be kept in check by the presence of non-executive directors (Caanz, 2016). Further, businesses on their part should assure that they do not resort to overly risky business practices which put a question mark over the going concern of the firm. Simultaneously, the auditors on their part need to more proactive with regards to highlighting these potential dangers in a proactive manner so that interests of the users are safeguarded.  Also, there is a need for improvement in the auditing standards along with the ethical conduct of the auditors especially at a time when the profession is facing credibility woes (Gay & Simnett, 2012).

Besides, going forward it is also advisable that proportionate liability must be adopted going ahead instead of capping the liability at a particular amount. This would ensure that the incidence of malpractices on the end of the auditors would undergo a reduction. Besides, in wake of the complex business models and financial products, it is imperative that the audit professionals continuously update their skills so that the relevance of the profession continues and the auditor is able to actually understand the high the various risks associated with the business of the client (Arens et. al., 2013).

References

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

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, 3rd 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, 2nd eds., LexisNexis Publications, Sydney

Gay, G. & Simnett, R. 2012, Auditing and Assurance Services in Australia, 5th 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, 8th eds., Pearson Publications, Sydney

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

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. 4th 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

Washington, S 2016, Collapse Of Financial Planner Was Inevitable. Sydney Morning Herald, Available online from https://www.smh.com.au/business/collapse-of-financial-planner-was-inevitable-20100527-whtv.html  (Accessed on 17 September 2016). 

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

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