Discuss about the International Standard on Auditing.
In recent years the auditing profession has been encountering many criticism and difficulties, due to corporate failures or collapses which are being linked with allegations of professional negligence and breach of their statutory duties. The auditor is said to be the watchdog of financials and thus it is the duty of an auditor to exercise reasonable skills and apply professional skepticism while auditing company’s financial statements, and owe a duty of care to the interested users of financials and thus can be possibly held liable to them when they have acted carelessly or negligently.
International standard on auditing (ISA) 700 provides the standards on auditor’s opinion and reporting and requires that the auditor should evaluate the financials and express his opinion on them stating whether the financial statements are prepared, in all material respects, in accordance with the requirements of applicable financial reporting. The standard also requires that while framing his opinion on the financial statements, the auditor should also be reasonably assured that the financials are free from material misstatements and should draw his conclusion based on the audit evidences obtained in accordance with ISA 330 and in accordance with ISA 450 i.e. in respect of uncorrected misstatements which may be material, individually or aggregate.
But ISA 200 also protects the auditor stating that the audit of financials and other related documents does not relieve or escape or absolve the liability of the management or those who are charged with governance of their own liabilities or responsibilities.
Having discussed that, in the above case it is given that the auditor has issued an unqualified report for the year ended 30th June 2012 wherein the Company Impulse was suffering liquidity problems with a drop in their debtor’s turnover and inventory turnover. The auditors did not put any extra efforts in regard to valuation of assets nor was an adequate provision was made in the books so as to show a correct and true position of financials. This has caused an overvaluation of assets and thus the profits have been overestimated by such amount where the company was having liquidity crisis. This scenario calls for reasonable care and vigilance on part of the auditor as the management is always in a unique position to perpetrate fraud and thus manipulate entity’s profitability or project ability and since accounting provisions and estimates involve high level of judgment they are an important subjective area of fraud or misstatement. In this case the auditor should have reviewed the accounting estimates and provisions made by the management and even if they seem to be reasonable individually, the auditor shall evaluate the same as a whole to ensure that they are provided reasonably. Having done that i.e. if the auditor proves that they have acted in good faith and with due diligence and they have sufficient evidences so as to regards to valuation of such assets or estimates made by company they cannot be held liable for further misstatements as the audit have always the audit risk involved in it calling inherent risk and auditor cannot guarantee the cent percent full proof truthiness of financials. However if otherwise is proved that the auditor were negligent towards provision calculation they can be held responsible.
Secondly the Company has obtained a large loan from a finance company Easy Finance Limited (EFL) in August 2012 to provide additional working capital and the Finance Company has relied upon the audited financial report without performing an independent appraisal or credit worthiness of the Company. Consequently the company was placed in liquidation in December 2012 and EFL have been alleging that the auditor they have not dealt adequately with the financials and the EFL have not given the loan if the auditor report was qualified.
The auditor owes specific responsibility to the management through the engagement letter where he shall be responsible for material misstatements and professional negligence or carelessness when he has not performed his duties with adequate reasonability, objectivity and integrity. The audited financials are used by various stakeholders and as such auditor indirectly owes responsibility towards them too as the users can place reliance upon the audited financials for their intended purposes. In case the auditor is able to reasonably prove the basis of his conclusion as mentioned in the audit report and shows sufficiently that he has conducted audit in accordance with the required accounting and audit framework, his work cannot be challenged either by the management or the third party. In addition, nowadays it is common practice to include a standard disclaimer of liability to third parties in the auditor report which is quite effective as it prevents the auditor from the tortuous unlimited liability or unlimited exposure to third parties, and thus reduces their answerability to third parties as the auditor report is prepared for a limited and a specific purpose and the finance company cannot use it as the sole basis for financing the Company. However in the given case, the question is silent whether the auditor has provided the same in his report but the same may be assumed in the question for better interest of auditor.
In nutshell the Finance company cannot straightforward blame the auditor King & Queen and solicit them as it is a general misconception that auditors are responsible for the financials because in actual they are prepared and adopted by the management and at the yearend statutory auditor conducts his audit on the basis of materiality and frames his opinion on them for a definite purpose in accordance with the audit objective and client requirement while the users can use financials for multiple purposes and thus cannot strictly place reliance on the report for the purpose other than the specific purpose for which it is made.
Having regards to this, the judgment in the case law Barclays Bank PLC v Grant Thornton UK LLP  EWHC 320 (Comm), 18 February 2015 has laid emphasis on the fact that when the auditor has given the disclaimer in his report, it would not be just or fair to impose the duty on auditors as the same is reasonable. Similarly In Canada, Hercules Managements Ltd. v. Ernst Young,  2 S.C.R. 165 (“Hercules Managements”) the concerns about the auditor’s indeterminate liability was addressed, and it was held that the auditors were not liable to plaintiff as the plaintiff used the statements for their own personal investment decisions and not for the precise purpose for which the report was prepared and neither the auditor has knowledge about the same. Similarly there are number of landmark cases which have given a shape to the way in which auditors can reduce their exposure to the unlimited liabilities and seek a valid shelter and deal with the law of tort in the auditing profession. Some of the most notable case includes Caparo Industries Plc (Caparo) v Dickman (1990) and Royal Bank of Scotland (RBS) vs. Bannerman Johnstone MacLay (Bannerman) (2002). In the former case the auditor was unaware of the purpose for which the plaintiff is using the audited statements and thus claim made by plaintiff was unsuccessful. However in second case the auditor were aware about the plaintiff’s intention to use the audited accounts as a basis for lending decision and thus were held liable as now they owe duty of care to them.
As discussed above, it is well mentioned that the auditors owe a liability or responsibility of care to third party where a) the latter is either known to the auditor, or is a party to engagement letter or is a member of limited class of parties and b) the third party is using the auditor’s report for the specific or precise purpose for which the auditor has prepared the report.
In the second case, if the auditor King & Queen have been informed of the fact that the EFL is intending to finance the Company Impulse and they were relying on 2012 audited financials, in that case the purpose of the report would have assumed a different shape and the auditor might have done further financial diligence or have undertaken additional activity so as to assess the liquidity position of the company and have issued its opinion accordingly. Or otherwise have asked the EFL to have an independent appraisal too and a disclaimer that they should not strictly rely on their report. In this case where they are advising the EFL for the credit worthiness of the Company on basis of which the EFL gives loan, in that case the EFL can held the auditor liable for their professional negligence or carelessness and can sue them accordingly because the purpose for which the audit report is being used has changed and auditor is aware that the same is going to be used for loan giving purpose.
Auditor independence is a critical or sensitive issue for the profession of auditing as it has a direct impact on the quality of audit. The independent auditor assumes the responsibility to public and thus owes ultimate fidelity to the shareholders of the company and other stakeholders because they are said to be the watchdog of the company’s financial and other matters. If the auditors do not remain independent, it impairs the quality of audit and thus they may not or less likely to report misstatements or errors or frauds in the financials. As a result of which it reduces the reliance placed by interested users on such audited statements.
Independence describes the relation between auditor and his client and the mindset or approaches which the auditor should follow to perform his audit work.
The International Standard on Auditing (ISA) 200 provides that the auditor is required to follow the relevant ethical requirements, which include those pertaining to independence. Part A and Part B of the International Ethics Standards Board for Accountants’ Code of Ethics for Professional Accountants (IESBA Code) describes independence as comprising of two important aspects i.e. the real or actual independence (independence of Mind) and perceived independence ( independence in appearance ) which are different from each other.
Independence of Mind or the real/actual independence explains the state of the mind of the auditor which allows him to express his opinion independently ie without being influenced by any external factors. This enables him to exercise his professional judgment and thus allowing the auditor to act with integrity and conduct the audit work with professional skepticism and objectivity. This type of real or actual independence helps the auditor to deal with a specific situation without compromising with his quality and maintain the required level of independence.
Independence in appearance or perceive independence describes the situation about what the third parties perceive as being independent. It means that how a reasonable and well informed third party can conclude about the independence of the audit firm’s or its member and by virtue of this, is assured about his/her integrity, professional vigilance and objectivity and ensures that the same has not been compromised.
Both these forms together are important to achieve the goals of independence as they enable the auditor to form an audit opinion without compromising the audit quality. The actual and perceived independence are essential because sometimes it is difficult to assess the mindset of auditor and thus questions can be raised on his integrity; while simultaneously it is important to note that the auditor’s objectivity must be beyond the question. When two forms combine together where on one hand auditor adheres to ethical codes and on other hand people also perceive auditor’s independence, this reduces the overall risk of auditor to act otherwise than independently and thus adding more credibility and reliability to auditor’s report.
For each of the above independent situations list any professional standards and regulatory requirements breached and discuss possible alternative courses of action the auditor should have taken in order to properly discharge their professional responsibilities.
Section 140 of International Ethics Standards Board for Accountants’ Code of Ethics for Professional Accountants (IESBA Code) provides the principle of confidentiality which imposes limitation or obligation on the auditor to keep his client’s information in secrecy and not to disclose the same unless required under the law or under some authority and the same should not be used for their personal advantage or advantage of third parties. In the given case the audit assistant Bob has used the clients financials for his assignment which prime facie is not misuse of clients information , however he is using the data without the company’s permission for his personal interest and thus breaching principle of confidentiality. The better course of action for Bob is to take a written permission from the client that he intends to use the financial figures of company for his academic purpose and that the management has no issues with the same.
Section 220 of ISEBA Code deals with the principle of conflict of interest where the auditor should be vigilant to ensure that there should not be any circumstances or events which poses threat or causes conflict of interest and thus may give rise to risks regarding the non-compliance of fundamental principles. This threat to objectivity or independence or confidentiality may arise when the auditor performs certain services for his client whose interests are conflicting or may cause overlapping of work or are related to each other. In the given case Wendy who is engagement partner on Ace Limited audit has performed the secretarial duties for the same company which is a conflict of interest as an auditor is an independent party in all respects and thus should not be associated with the company. Therefore Wendy should immediately resign from such secretarial post and ask the company to make some other arrangements as this is a breach of independence.
The above case should be seen within the spectrum of Section 240 (Fees and Other type of remuneration), 260 (Gift and Hospitality) and Section 350 (Inducements) of ISEBA Code. In the given case the auditor Chan & Associates have accepted the office furniture in full consideration of their outstanding fees, although the furniture is worth 50% of the balance as the client is experiencing financial difficulties. The acceptance of such kind of consideration in kind is nothing but the fees for the professional services and since the company is under financial difficulties, accepting such lower fee cannot be called unethical as the auditor has waived off the fees considering the financial situation of the company which can be regarded as general prudent business decision. However Classic Reproductions has also offered 25% shareholding in an unrelated listed company as a thank you present which seems to be a sort of gift or inducement. Such an offer in general gives rise to threat to compliance with the fundamental principles or may question the objectivity. If such gift seems to be reasonable and the auditor is reasonably ensured that management is not doing an attempt to influence their actions or decisions through such inducement or offer, or such kind of thank you gifts will not encourage any illegal behavior or it is not an attempt on management part to put the auditor in same influential position, then in such cases the auditor may conclude that there is no significant threat to audit quality and thus can be accepted in normal course of business. Since in above case at present the Chan & Associates is not the auditor of the company, it may be assumed that the shares which were offered were given in ordinary course of business and not for manipulating the auditor, the same seems to be acceptable and thus neither the client nor the company is wrong in their positions.
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