a) How would you assess the business risk of HIH Insurance Limited? b) List several inherent risk factors effecting HIH at the financial report level and whether they would have contributed to an increase or decrease in the inherent risk assessment.
Sydney solicitor Bruce Dennis will be coordinating a class action for some 600 HIH shareholders against the auditors Andersens (as the firm is now known). In addition, HIH's liquidator, Tony McGrath of KPMG Peat Marwick is also likely to seek to recover funds for HIH creditors.
Discuss the facts and findings of relevant court cases that Andersens should refer to in determining the likelihood of the partnership being held liable to: 1) clients 2) creditors.
b) What conditions need to exist for a negligence action to be upheld?
The HIH board of directors includes three former partners of the audit firm Arthur Andersen. In the past decade, Andersens has earned more than $8 million from auditing HIH books and $7 million for other services.
Why would HIH have wanted to hire prior members of its external audit team? b) What are the advantages of having the same firm provide both the auditing and consulting services?
Indicate whether these circumstances represent a violation of ethical standards and give reasons for your answer. d) Outline the primary recommendations for audit reform proposed by the Ramsay Report and CLERP 9. What impacts do you feel these changes will have on the practice of auditing?
Inherent Risk factors at the level of Financial Reporting
Business risk refers to risk in business at any point of time. A business risk occurs in any business because of the different strategies followed by the management and their reactions towards the business environment that is internal and external environment. In this type danger situation it can be said the business is moving towards the losses than earnings from its operations. The business risks are of many types that is strategic risk, compliance risk, operational risk, reputational risks (Brumfield, 2010 and Jolly, 2013).
In the given case under consideration, the business risks that are identified are strategy risk and operational risk. These risks can be ascertained by analyzing the procedures and operations of the company which has been followed by company management. The company was incorporated in the year 1968 with name of CE Health International and the first major investment was done by Winterthur in the year 1995 resulting in change of name of company to HIH Winterthur. Winterthur has sold the shares of the company in the year 1998 and the name of the company finally changed to HIH Insurance Limited. The Winterthur withdraws his investment in the company because of the operational business risk in the company. The company was doing investment in highly risky assets. The company had acquired the shares of FAI at a price higher than the book value from the one of the related party of the company that is non executive director. Also, the company has invested in Marine and General Insurance which were also providing high risk to company’s portfolio. In addition to this wrong strategic decision by the management of the company, the company has written of all the investment of FAI which has been done on premium in the year 2000. Also, the company had incurred to huge losses in near future resulting to which the company went into liquidation. In order conclude, the company’s business risk can be evaluated by its break down and its non ability to pay its stakeholders (Jiangbo, 2003 and Sadgrove, 2011).
Being one the most important audit risk factor, inherent risk is the situation of danger happens in any company due to the mistake at the lower level of management and is related to the chances of having misappropriated information at the financial statements level. These risks are generally occurring in the company having complex financial strategy and depend upon the judgment and estimates made by the accounting personnel of the company (Colbert, 2014).
For the company like HIH Insurance Limited, inherent risks are the most common audit risk present. The complexity of the HIH and its dynamic change in management decision is reason behind the Inherent risk in the company. The inherent risks are generally assessed by the auditors considering:
- Knowledge and Experience of Auditor
- Types of Business transaction done by the company
- Complexity of Company
- Opinion made by auditor about the industry in which company operates
- Assets owned by the company
For doing the above assessment, auditor has to ascertain the inherent risk factors. The following are the Inherent risk factors present in the company under consideration:
- Complexity of Transactions- the Company has made very diverse and complex investment in the shares of the different insurance companies. The business combinations done by acquiring the volatile share of FAI, Marine, and Fire Insurances led the company in huge losses. Also, the employee’s compensation claims and their calculations increases the degree of inherent risk in the company.
- Structure of Management – The major factor in relation to risk is frequent change in the management of the company. In the year 2000 and 2001 major change related to the Board member takes places. Even the resignation of CEO Ray Williams increases the level of danger in the company.
- HIH Company is suffering from the huge financial crunch resulting in misstatement in financial statements to meet certain requirement of investors.
The above factors have increased the contribution in the assessment of inherent risk by the auditor of the company (World Bank, 2006).
Liability to Clients and Creditors – Relevant Case Findings
The audit of the company is done with view of framing an opinion on the affairs of the company without biased approach in true and fair manner. The external auditor who is the outside party has been appointed by the shareholders of the company to give reporting on the matters of the company so that the stakeholders can have true picture of the working of the company. Thus, the auditor has huge responsibility of giving reporting in fair manner after considering due professional care and contract requirements.
The liability of Clients arises if the auditor does not fulfill the requirements listed in his engagement letter and reasonably there are changes that auditor has neglected the professional due and care while performing his duties.
The liability to creditor arises if the auditor does not take into the consideration the requirements of creditors while reporting about the financial matters of the company. The creditors are generally interested in getting their payment from the company.
The following cases and their findings which held auditor liable towards the clients and creditor are:
- AWA Limited Vs. Daniels ,1995- In the given case, the auditor breach the requirements of the engagement letter by not reporting to board of directors about the weakness in internal control in relation to the transactions involving foreign currency. The minimum care and due diligence is require from the auditor and thus can be held liable towards the creditors of the company.
- Ultramares Corporation vs. Touche, 1932- In this case auditor has not performed all his duties and responsibility before giving opinion about the affairs of the company. So the courts held the auditor liable towards the client.
- Donoghue Vs. Stevenson, 1932- In the case the auditor has not report about the fraud done in the company and the courts held that liability of auditor arose as the fraud was not reported giving the company edge over creditors (Tata, 2010).
The audit has to be performed with reasonable care and skill by auditor. The parties to the financial statements amused that the auditor has fulfilled all his duties and responsibilities while framing an opinion on the financial and non financial matters of the company (Brumfield, 2010). The conditions which shows that auditor has not completely fulfill his duties and responsibility laid down by rules and regulations and engagement letter are:
- The auditor does not use the professional skepticism
- The auditor does not audit the full year books of account and does not choose the reasonable sample.
- The senior partner does not review the work done the junior staff that has less knowledge and experience.
- A proper audit trail of documents has not been created during the course of audit.
- Excessive reliance on the internal control procedures followed by the client.
- The does not report the matters of inefficiency to proper level of management.
- Fails to take deeper actions if there is suspicion of fraud and error.
- Not followed the guidelines of audit laid down by professional standards.
- Not plan the audit before the start of audit.
- No bifurcation of the audit and non audit services and the staff in relation to these services.
External audit team is the outside persons who help the stakeholders of the company in getting the necessary information about the company from his reporting. In the given case study, the HIH Company wanted to hire the prior member of its external audit team because of the following reasons:
- The first and foremost benefit HIH Company has that the prior audit team members have full knowledge about the history and business of the company. The auditor has the necessary experience about the policies and procedures adopted by the company resulting in good reporting on the financial matters of the company by the auditor.
- On the prior auditor, there is good reliance of the officers of the company on the prior auditor and this enhances the chances of detection of frauds and error at early stage.
- The prior auditor, since already known to the company policy and procedures able to apply all the relevant audit procedures before reporting. This reporting increases the trust of the stakeholder.
- If the HIH Company will engage the old auditor, then the cost of hiring of the same auditor will be less as training cost to get the knowledge of business of client is less.
The different authorities like Corporation Act 2001 and Auditing and Assurance Board in Australia prohibits the auditor to performs both auditing and consultancy services as it may hamper the independence of auditor and objectivity level of auditor will get decrease. But there are certain benefits if the company takes auditing and consultancy services from the same audit firm as follows:
- The auditor will have good understanding of client business policies and procedures and able identify the occurrence of key risks at the early stage. This may reduce the chances of having reduced undetected misstatement on the financial statements of the client.
- The experience gained by the auditor while doing consultancy work will enhances his skill in applying the professional care at the time of audit. This also increases the quality of the audit as auditor able to expertise in the procedures of the company followed in relation to taxation, accounting, etc.
- If the auditor performs only audit services then the firm cannot grow at such level when it provides both audit and non audit services. The audit firm will have financial security by providing both auditing and non auditing services. This also reduces the threat of intimidation of auditor independence by the company
- The pace of reporting will fast if the auditor performs auditing and consultancy services as the auditor does not require third party expert advice in relation to the information systems employed by the company.
- The cost to the company will get reduce if the same auditor performs both auditing and consultancy services (Verschoor, 2012).
Ethical standards as laid down by the Australian Auditing Standard Board helps the auditor to apply professional judgments in fulfilling the professional requirements as lay down by the standards. These standards helps the auditor in reporting that can be easily understand by the universally in the world. In the case under study, the circumstances represent the violation of theses ethical standards are:
- By having the same person for auditing and consultancy services, the integrity of the auditor gets hurts. There are the chances of the self review threats on the independence of the auditor.
- If the prior auditor is appointment by the company, there may be chances that he will not apply due professional care and competence in reporting the affairs of the company.
- The confidentiality of the auditor can be hampered if he hides his mistake which he has done at the time of providing the consultancy services.
- With the good relation with the personnel of the company, there may be chances that the auditor will not behave in the professional manner and gets familiar with the officers of the company.
- Proper documentation is base for successful audit reporting. In this situation, auditor may not prepare the full documentation as he thinks it knows the policies and procedures of the company.
- The threat of advocacy is also present in situation where the auditor is familiar with the top level management of the company.
The audit reforms refer to the changes in audit regulatory environment to enhance the quality of reporting by the auditor on the financial and non financial matters in true and fair manner. The government of Australia in Corporate Law and Economic Reform 9 along with Ramsay Report lay down the purpose of corporate disclosures, Independence of Auditor, Strengthening of Quality of Reporting and Current requirements of different stakeholders from auditor’s reporting which helps in increase the quality of work of auditor. The reforms are as follows:
- Continuous Disclosures- The mandatory requirement of reporting by auditor about the company after fixed time period. This enables the early detection of mistakes and the application of corrective actions by the company as well as auditor.
- Remuneration Report- The compulsory requirement of the remuneration report as the part of the annual report by the board of the directors of the company.
- Non auditing Services- The assurance team should be different if the audit firm is giving the non audit services to the same client.
- Shareholders Obligation- The regulatory identify certain areas where the shareholders has to take decision apart from the management of the company.
- Peer Review- The auditing of the audit firm by the panel of the personnel at the regulatory board was also one of the roles changing reform in audit (Robinson, 2003).
Brumfield, C.A., (2010) “Business risk and the audit process”. Journal of Accountancy, 155(4), pp.60-68.
Colbert, J.L., (2014). “Inherent risk: An investigation of auditors' judgments”. Accounting, Organizations and society, 13(2), pp.111-121.
Jiangbo X, (2003), “HIH Insurance Limited: Corporate Governance and Corporate Excesses”, Australian Financial Review, pp 05-09
Jolly A, (2013),Managing Business Risk”, Ernst and Young, pp 8-16
Pany K, (2010), “Legal Liability of CPAs”, Tata Mc Graw, 4, pp 1-30.
Robinson A, (2003), “HIH Report and CLERP 9”, Allens Arthur Robinson, pp 1-5.
Sadgrove K, (2011), “Guide to Business Risk Management”, Gover Publishing, 8th Edition, pp 25-41
Verschoor C, (2012), “Pros and Cons of using External Auditors for Internal Auditing and Other Services”, Q Finance, pp 1-9
World Bank, (2006), “HIH Case Study on Corporate Governance”, The Australian Financial Review, pp 05-38
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