Read the Case study is based on HIH Insurance Limited: Business risk and Inherent Risk Assessment, Legal Liability, Ethics. and answer the following questions :
"It is difficult for an insurance company to go broke in the space of a year, let alone a few months" Sydney Morning Herald, May 19–20, 2001.
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.
a) 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:
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.
a) 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?
c) 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?
Background and overview of the case study
When someone starts the business then he has to take the risk. Without any risk no business can smoothly function. But the risk should be at such level which can be controlled and mitigated easily so that the continuity and the perpetuity of the business does not hamper. Risk may be of any kind like risk of having losses, risk of having the sudden removal or vacation of the position of the key managerial personnel, risk of having the loss of stock, loss due to non receipt of payment of debtors and sudden closure of the company due to changes in the external environment of the company including that of the stakeholders and shareholders of the company. In the given case study the business risk has been identified and assessed from the very beginning. It is mentioned that in the year 1995, the company CE Health International is merged in the year 1995 with Winterthur Insurance Company into a resultant company – HIH Winterthur and in the year 1998 Winterthur gets separated and the new name come into existence as HIH Insurance Limited. He has withdrawn himself from the company only because of the fact that HIH Company has engaged itself in such practices that can lead to several losses to the company in all the spheres. It entails that the company has high degree of investment risk. This is majorly due to inefficient and inappropriate investment strategy adopted and followed by the company (Jiangbo, 2003).
The same fact of having higher degree of investment risk is supported when the company has written off the amount of investment amounting to $ 400 million in the books of accounts for the year ending 2000 after purchasing the FAI Company from the Rodney Adler at the premium in the year 1998. The decision of purchase has been made without the discussion at the board meeting and without carrying any diligence. Further due to investments in the high risky areas including the marine, aviation and natural disasters the company has suffered the huge amount of losses. It includes hundred million dollar from the film losses, huge losses from the typhoon in Florida, losses from hailstorm that has happened in the Sydney and etc. This has created the remarkable point in the history of the Insurance Sector Industries. Thus, in this way the business risk can be identified by going through each part of the case study.
Identifying and assessing business risks
The factors that contribute towards the happening or non happening of any event are described by the risk in the better manner. Risk is defined as the likelihood of any event to occur and risk factors are the factors responsible for having the risk element present in the business. Risk in the financial statement and accounts balances level are of three type’s inherent risk, control risk and detection risk. In the given case study more emphasis has been laid on the inherent risk. Inherent risk is the risk defined as the possibility of having material misstatements in the financial statements of the company due to the inherent limitations present in the internal framework of an organization. These inherent limitations are not emerged in a particular year rather it occurs because of the practice the company is following since its inception.
Because of the above said inherent limitations, the companies have usually gets ended up with the liquidation or winding up or shut down. In order to reduce the same, the company shall have sound internal control system and that too with the regular external checks.
Following are the inherent risk factors (World Bank, 2006):
- Ethical Management– If the management does not possess the moral principles of how to conduct the business, etc then the degree of having the presence of inherent risk will be high. As in the given case the acquisition of FAI has been made without board meeting and evaluation of the acquired company.
- Experience of the Management and Changes in the Structure -Inexperienced people at the top management will have the effect of having wrong financial report and very frequent changes in the key managerial personnel will gives an intuition of having wrong practices done in the company. In the given case, Winterthur immediately resigns when the company was involved in the wrong practice of investing in very high risky proposal. Thus, this will also contribute in increase of assessment of inherent risk.
Auditors are regarded as the people who are eligible to authenticate the financial matters of the company and on the basis of which the users of the financial statements take the useful and meaningful decision like stakeholders on the basis of the annual report of the company gets ready to provide the guarantee or provide loans or ready to invest the amount without any doubt. As per the Corporations Act 2001 clubbed with the Australian regulatory framework the auditor will be liable for the damages if any caused to the parties to the company because of the auditor’s report issued by the auditor of the company.
The liability of auditors of the company arises from the major four sources and these are:
- If the auditors violates any of the provisions or clauses mentioned in the engagement letter accepted by both the client and the auditor
- If the auditor does not exercises the professional due care and the due diligence and if the auditor performs the functions as grossly negligent
- If the auditor knows that the financial statements misrepresents the actual facts and even after that deceit the third parties and
- The event listed and specified in Securities Act of 1933 and Exchange Act of 1934.
In regard to the following court cases and relevant finding, Andersen will have high chances of liability towards the client and the creditors:
- In the case of Ultramares Corporation vs. Touche reported in the year of 1931 which is the landmark case in the history where it was held that auditors can be held liable for performing the work with ordinary negligence and being grossly negligent.
- In the case of Credit Alliance Corporation vs. Arthur Andersen and Co reported in the year 1985, it was held that the auditors must be aware about the purpose of financial statements towards the third parties (Tata, 2010).
In this view, the auditors are fully liable towards client and creditors.
Negligence is the act conducted by the persons and entails the failure on the part of that person to exercise due diligence and professional care. The act of negligence may be ordinary or grossly. The Ordinary negligence occurs when the auditor does not perform the functions in accordance with the applicable accounting standards and auditing standards. The Grossly negligence occurs when the auditor performs the function without having any concern for the third parties and even if the damages were caused to them. These definitions itself provides the factors that are relevant for favoring the negligence caused by auditors. As per the code of conduct of Chartered Accountants issued by the Institute of chartered accountants, if the auditor is found guilty of any negligence on his part then he will be liable to cover the damages and losses caused to the parties of the clients. Here the negligence includes the following:
- Failure to check the part of financial statements of the company knowing that the content of the same is not faithful and true.
- Failure to exercise the professional due care while vouching the expenses or the verification of the receipts.
- Failure to adopt the substantive audit procedures along with the additional audit procedure.
- Failure to check the books of accounts before authenticating the financial statements of the company.
- Behave grossly negligently and not applying the professional skills and knowledge and skepticism that the auditor has gained over the period of his work experience and over the duration of the course.
Apart from the above listed factors, there are other factors which make the auditor to behave in the particular manner and behave as grossly negligently. Thus, these are the conditions which are required for favoring the grossly negligent to the auditors.
External audit is the audit conducted by the outsider audit firm engaged by the company for
Authenticating the financial statements of the company and that too for inclusion in the annual
Report for the year end. Company becomes familiar with the external audit team as the time passes and on their regular visits to the office of the company. By hiring the members of the external audit team including those who have worked earlier also will serve the company with the following benefits:
- The external audit team member will be conversant with the working of the organization and is familiar with him.
- The member of external audit usually possesses rich experience and knowledge in regard to the financial reporting matters of the clients.
- The management can easily develop cordial and healthy relationship with the audit team member by working with them on the regular basis. Also there will be the chances of having the mismanagement of the operations of the company and thus the probability of having the embezzlement or any fraud will be more.
Thus, in this way the HIH Insurance Limited wants to have the prior members of the external audit team.
Corporations Act of the country provides that the firm who is doing the audit of the company shall not perform the non audit function otherwise the independency of the auditor will get affected in many ways. But in the today’s world, the audit firm usually performs the audit function clubbed with the non audit function including the consultancy services. The benefits which the company will get are as follows:
- The major advantage is the firm providing the same services auditing and consultancy will be able to gain deep understanding of the business of the company along with the internal control system and information system. This further help the company in getting the efficient and effective services from the audit firm not only in the financial matters but also in terms of other consulting matters including internal audit, accounting and secretarial services.
- The firm will already have the experienced staff which can perform both the works auditing as well as non auditing services. It hereby explains that the firm will not be required to charge the extra cost for familiarizing or training the employee which in turn benefits the company also (Verschoor, 2012).
Each and every company shall follow the ethical practices within the framework of the company. Ethical practices refer to the application of the moral principles and defined code of conduct of the performance of the employees including those charged with governance of the company. Such practice will ensure not only the smooth functioning of the company but also provides how reliable the company’s affairs are being managed by the management.
Yes, the circumstances referred in the case study exhibits that the ethical standards have been violated in total. It is because of the following:
- HIH Insurance Limited has acquired the FAI Company without taking the approval from the board and without having the valuation or due diligence before acquisition.
- Winterthur has resigned from the company only after having the clear picture that the company is not considering its financial position rather keep on going investing in the high risky areas.
Jiangbo X, (2003), “HIH Insurance Limited : Corporate Governance and Corporate Excesses”,
available at https://www.seiofbluemountain.com/upload /product/201010/2010jjfzh05a8.pdf accessed on 15/4/2017.
Robinson A, (2003), “HIH Report and CLERP 9”, available at https://www.allens.com.au/pubs/pdf/ma/focgmay03.pdf accessed on 15/04/2017.
Tata Mc, (2010), “Legal Liability of CPAs”, available at https://www.google.co.in/url?sa=t&rct=j&q=&edata-src=s&source=web&cd=1&cad=rja&uact=8&ved=0ahUKEwjK0NmumajTAhUExLwKHWGmBq0QFgghMAA&url=http%3A%2F%2Fwww.wou.edu%2F~beebej%2FBA%2520451%2FChap004.ppt&usg=AFQjCNGebMKLW15csyn2X3G5e-qmyqHjEA&bvm=bv.152479541,d.dGc accessed on 15/04/2017.
Verschoor C, (2012), “Pros and Cons of using External Auditors for Internal Auditing and Other
Services” available at https://www.financepractitioner.com/auditing-best-practice/pros-and-cons-of-using-external-auditors-for-internal-auditing-and-other-services?full accessed on 15/04/2017.
World Bank, (2006), “HIH Case Study on Corporate Governance”, available at https://www.iaisweb.org/modules/cciais/assets/files/pdf/061004_C1
-9_hih_corpgov_round01.pdf accessed on 15/04/2017.
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