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To what extent should external auditors be legally accountable for the consequences of client fraud where they negligently fail to detect it?

• What is the current stance on auditors’ accountability? Are they legally accountable
• Find the regulations on audit liability
• Look at the historical developments of the laws around this area
• Try to provide a balanced argument of more legal responsibility or less
• Find examples of where auditors have been sued in fraud cases

Background

Cases of fraud have become a very complex issue in the age of technology, as well as more and more complex to detect when the fraud collusive in nature, plus performed by senior managers who are liable in hiding the fraud. In this line, external auditors have claimed that the exposure of fraud must not be their accountability. Regardless of the way the fraud is noticeable, it is classically hard for external auditors to detect because the executors undertake steps to intentionally cover up the resultant irregularities (Dewing & Russell, 2004). In the case of negligence by the external auditor in failing to detect the fraud, the client is needed to actually prove that the auditor failed in detecting the fraud and that the actual loss to the client occurred because of the negligent actions of the external auditor (Zhao, Yen & Chang, 2004).

The legal responsibility of external auditors has been found to have many rules that govern the elements that form accountability, for instance, the occurrence constituting the auditor’s accountability, parties claiming auditors’ error plus the succeeding dimension of the harm incurred.  The external auditor is accountable for getting practical assurance, which the financial statements, assumed as a whole, are open from material misstatement, whether due to fraud or mistake. Thus, the auditor has some accountability of taking into consideration the risk of misstatement in financial statements because of fraud. Chief scandals, which have affected the accounting profession in the latest years, have normally been due to fraud (Erickson, Hanlon & Maydew, 2008). Consequently, in order to uphold self-assurance in the occupation, it is imperative for auditors to comprehend their responsibility towards the avoidance plus detection of fraud. Thus, it is imperative to acknowledge the fact that a scheme is an illegal act, and it is not the responsibility of an external auditor to ascertain whether a fraud has really took place. In many instances, it has been found that external auditors are not needed by the law to detect client crime, which is out of the scope of these external auditors. The principal responsibility of detecting fraud in firms is linked to the senior management and not the external auditor (Alabede, 2012).

Discussion

Within the model of the corporate governance, the company’s management is accountable for preparing the annual financial statement featuring the operating outcomes and the fiscal spot of the firm. The principal responsibility for the prevention and detection of fraud cases based on the legal provision can be difficult to attain since external auditors do not have the legal obligation to detect a crime. Nonetheless, such financial statements can lack trustworthiness plus shareholders can barely consider the data contained therein. Additionally, the audit process hugely depends on information, which is provided by the client whose financial statements are being audited (Churyk, Lee & Clinton, 2008). The external auditor’s responsibility is to only test the information provided by the client through observation, inquiry, and independent confirmation. But the external client solely relies on the information provided by the client. The auditor has the role of maintaining a degree of “professional scepticism”, and not takes everything at face value. This implies that the client or company should provide accurate data or otherwise prove the case of negligence on the part of the external auditor and actual loss incurred. To conquer the problem of trustworthiness of financial statements, an external auditor who is independent of the senior management is selected to examine the data in the financial statements, as well as report the results to the shareholders. The risk of not detecting a material misstatement due to fraud is greater than the risk of not detecting one due to the fault. This is attributed to fraud that can entail complicated and cautiously organized fraud tailored to cover it, like forgery, an intentional letdown to proof transactions or deliberate misrepresentations being presented to the external auditor. Collusion can cause the external auditor to consider that audit proof is compelling when it is, in reality, forged (Skousen, Smith & Wright, 2009).

Whilst annual financial audits are the most widespread anti-fraud control put in place, external auditors are not liable in any way in detecting frauds unless the client proves beyond a reasonable doubt that there was negligence in the part of the auditing process. The nature of the organizations to blame the external auditors on the frauds is founded on the misunderstanding of the nature of the financial audit, placing too much dependence on the needed processes undertaken to identify the prospect that fraud has occurred and not been detected. An external auditor’s accountability is to communicate a view on the financial statements and to make sure that documents presented are free from material misstatement (Uzun, Szewczyk & Varma, 2004). Thus, these auditors do not communicate a judgment on the efficiency of the organization’s internal control systems, unless the client proves that the auditor exhibited negligence while undertaking the auditor that resulted in an actual loss. Rather, the external auditors consider the control systems of the client applicable to the preparation, as well as a fair presentation of financial statements and undertake procedures meant to identify the possible fraud risks, which have been surfaced in audit planning (Crawford & Weirich, 2011).

Current Stance and Legal Accountability

The external auditor’s liability in contract (privity of contract) for negligent work would rely on the client’s capability to (primarily) prove negligence and (secondly) prove the actual loss accrued because of the actions of the auditor. Thus, the auditors’ negligence will be judged based on the degree to which the auditor followed the process based on the level to which the auditor complied with the accepted best practice. This means that the negligence will be judged based on whether the external auditor followed the approved audit standards. In many cases, an external auditor will be liable whenever a formal contractual relationship exists with the said client; negligence by the external auditor may be proved, and a loss by the client of the contract may be ascertained. Therefore, in essence, if negligence is not proved in the case of the external auditor, then they are not legally accountable for the detection of the fraud. Consequently, the law allows the external auditor to create a judgment as to whether the financial statements provide reasonable information where the external auditor has been presented to audit and it is not the duty of the external auditor to detect fraud. Consequently, in the case of negligence raised by the client for the audit process, the client should prove that there was negligence and there was the actual loss incurred (Elder, Beasley & Arens, 2010).

The external auditor should not be anticipated to unearth all fraud committed in the firm because the external auditor was not an insurer or guarantor, except is anticipated to carry out an audit with practical skill plus duty care in the circumstances. Consequently, the principal responsibilities of detecting a fraud in organizations lie on the management and not the external auditors. This implies that the external auditors are not responsible for any legal responsibility unless negligence is proved without reasonable doubt by the client. In practice, the external auditor or independent auditor usually deals with a suspected other than established fraud case. In addition, fraud, in whatever nature, as well as a guise, should be detected originally, because detection is a vital prerequisite of rooting out any sort of (Chen, Firth, Gao & Rui, 2006).

Historical Developments of Audit Laws and Regulations

There are many developments in Singapore that have seen the evolution of the auditing profession through different laws and amendments. In addition, the responsibility of the external auditor has not been described from the beginning. During the 18th century, auditors argued that fraud detection is not the objective of the audit process (Hendy, 2018). Thus, the responsibility of the auditors is to report to the shareholders all untruthful activities that had took place and which impacted the property of the details of the financial statements. Thus, the Singapore Accountancy Convention (SAC) has been developed to promote the auditing process in Singapore. The Accounting and Corporate Regulatory Authority (ACRA) is the nationwide controller of business entities, auditors along with corporate service providers in Singapore. ACRA has been instrumental in promoting the development of businesses in addition to the public accountancy profession. As a result, the new regulatory measures provided by SAC were developed after reviewing by ACRA of audit inspection insights gleaned from a decade of audit inspections carried out under its Practice Monitoring Programme (PMP). The Monetary Authority of Singapore (MAS) proposed legislation through the parliament in 2016 to consider Singapore Banking (Amendment) Bill 2016 that sought to include amendments to promote bank’s corporate governance. The amendment was designed to order banks to remove the external auditor for the unacceptable discharge of statutory responsibilities.

In Singapore, SAC offers that any stipulation in the firm’s articles or in an agreement where it looks to exempt firm’s auditor from any form of liability, which could otherwise connect to the external auditor in line with any case of negligence (Khurana & Raman, 2004). This implies that the auditors might desire to restrict their legal responsibility in other activities can be inspired by the fresh (hugely United Kingdom) verdicts. The Swynson v Lowick Rose (High Court, 2014) is a case court that demonstrates the liability of the auditors. The director of the company claimed that the auditors owed him individually a duty of care. Accordingly, the court established that the auditor owed no duty to the directors and the company. This reduced the scope for third parties (clients) from implicating auditors on the duty of care towards legal accountability. The auditors’ client, in this case, was the firm, and the court was not willing to establish existence of any individual duty of care was owed to any third party. This underscores the claim of the thesis of the paper that external auditors do not have a legal responsibility to detect client fraud (Chen, Li & Wang, 2011).

There are a number of cases of fraud that has seen auditors sued by clients because they failed to detect fraud during the audit process. For instance, PwC, which is a global auditor, was sued for around $5.5 billion over its crash to detect enormous fraud in the unsuccessful Colonial Bank. In this case, TWB executives were accused of falsifying data in collusion with the Colonial Bank. Thus, the conclusion of this led to an enormously susceptible business situation, which made the bank powerless to withstand the global financial crisis faced in 2008 (Herrara, 2016). For six years since 2002, PwC external auditors gave the bank a bill of clean health until the bank crashed in 2009. This was a case of failed auditing process to identify a fraud that was going on and also collusion of the executives. This is not the only case where debtors are taking on auditors. There are investors sued Deloitte and other professional services companies for $44 million over their alleged failure on failure on detecting fraud in the failed investment firm, Arquitas. TWB was arguing that PwC had a duty towards them to report any evidence of fraud. A primary tenant of PwC’s defence in the case was that TWB was not a client and thus, it did not hold a duty of care to them (Webb, 2016).  As law360 reports, the trustees base their case around the Supreme Court’s 1984 verdict that claims that an auditor assumes a public responsibility transcending any employment responsibility with the client and owes ultimate allegiance to the company’s creditors and stockholders  and to the investing public. This raises the question of the responsibility of auditors: must they be tasked to stop financial fraud (Bedard, Deis, Curtis & Jenkins, 2008).

Conclusion

It is clear that external auditors have no legal responsibility to undertake the task of fraud detection.  The organization can develop the necessary control measures that may be used to detect and prevent non-management fraud. This is because of the fact that management fraud entails escaping internal control processes and often dodges uncovering until the firm has suffered irrevocable harm. These fundamental audit concepts are important to the responsibilities of the corporate officials, since it is the officials along with the directors who bear the ultimate responsibility of ensuring that the information provided to the external auditor is accurate. It is their duty to ensure that the internal control systems produces accurate, as well as reliable information regarding the client financial statements. Therefore, it is the responsibility of the corporate officers and directors to ensure that individuals providing the external auditor with information-data that is both empirically verifiable and less-verifiable nuances of business conditions along with prospective-are totally truthful and honest.

References

Alabede, O. J. (2012). The Role, Compromise and Problems of the External Auditor in     Corporate Governance. Research Journal of Finance and Accounting. 3(9); 114-126.

Bedard, J. C., Deis, D. R., Curtis, M. B. & Jenkins, J. G. (2008). Risk monitoring and control of   audit firms: A research synthesis. Auditing: A journal of Practice & Theory. 27 (1);187–    218.

Chen, F., Li, Q. & Wang, X. (2011). Financial Reporting quality and investment efficiency of      private firms in emerging markets. The Accounting Review. 81 (4); 1255–1288.

Chen, G., Firth, M., Gao, D. & Rui, O. (2006).Ownership structure, corporate governance, and     fraud: evidence from China. Journal of Corporate Finance. 12(3); 424-48.

Churyk, N. T., Lee C. C. & Clinton B. D. (2008). Can we detect fraud earlier. Journal of Strategic Finance. 90 (4); 79.

Crawford, L. R., & Weirich, T. R. (2011). Fraud guidance for corporate counsel reviewing            financial. Journal of Financial Crime. 18(4); 347-360.

Dewing, I.P & Russell, P.O. (2004). Accounting, auditing and corporate governance of European            listed countries: EU policy development before and after Enron. Journal of Common      Market Studies. 42 (20), 289-319.

Elder, J. R., Beasley S. M. & Arens A. A (2010). Auditing and Assurance Services. Person            Education, New Jersey, USA.

Erickson, M., Hanlon, M. & Maydew, E. L. (2008). Is there a link between executive equity         incentives and accounting fraud? Journal of Accounting Research. 44(1); 113-43.

Hendy,N. (2018). Should auditors be held liable if they miss fraud? In The Black. [Accessed        22.10.2018].

Herrara, C. (2016). Largest lawsuit against an auditor goes to court for $5.5 billion. Miami            Herald. [Accessed 22.10.2018].

Khurana IK & Raman KK. (2004). Litigation risks and financial reporting credibility of Big4       versus non Big 4 audits: Evidence from Anglo-American countries. The Accounting review. 79 (2), pp. 473–495.

Skousen, C. J., Smith, K. R. & Wright, C. J. (2009). Detecting and Predicting Financial    Statement Fraud: The Effectiveness of the Fraud Triangle and SAS no. 99. Corporate      Governance and Firm Performance Advances in Financial Economics.13(2); 53–81.

Uzun, H., Szewczyk, S. & Varma, R. (2004). Board composition and corporate fraud. Financial Analysts Journal. 60 (3); 33-43.

Webb, J. (2016). PwC Sued For Missing $2.9 Billion Scam: Do Auditors Have a Public    Responsibility To Prevent Fraud? Forbes. [Accessed 22.10.2018].

Zhao, N., Yen, D. C. & Chang, I.C. (2004). Auditing in the e-commerce era. Information Management & Computer Security. 12(5); 389-400.

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