forensics
matters
Audit negligence:
Who is to blame when it all goes wrong?
Publication No. 11-04
forensics
matters
Audit negligence following the GFC
The recent collapses of Allco, Westpoint, Centro, Storm Financial, Opes Prime,
ABC Learning, and Babcock & Brown in Australia and Feltex in New Zealand,
are just a few of the thousands of corporate collapses in the wake of the global
financial crisis. The auditing profession has come under intense scrutiny, with
increased litigation involving auditors. A common issue in the above corporate
failures is the quality of the audits conducted in those companies.
Because audit failures may give rise to erroneous or misleading financial statements,
a common perception is that auditors are responsible for the loss of billions of
dollars by stakeholders. The perception that auditors have ‘deep pockets’ and
the ‘expectations gap’ result in auditors frequently being sought after in an
attempt to recoup losses. But what liability do auditors have for professional
negligence and breach of statutory obligations in such circumstances?
In this article we consider the issue of auditor negligence, including whether
shareholders, investors and other third parties can hold the auditors responsible
for a corporate collapse; and examine the accounting and other matters
requiring investigation to determine fault. We also consider the recent Centro
case and what reliance the directors of a company may place upon its auditors.
Jason Cheung is a Senior Executive Analyst and joined the Forensics team at KordaMentha in March 2011.
At KordaMentha, Jason’s work includes disputes, forensic accounting and fraud and financial investigations.
Sasikala Kandiah is a Manager and joined the Forensics team at KordaMentha in November 2010. Sasikala’s
work at KordaMentha involves forensic accounting, fraud and financial investigations and disputes.
Page 1
forensics
matters
1
What is the role of an auditor?
To understand auditor liability in
relation to a client and its financial
statements, the respective roles
of management and the auditor
must first be appreciated.
Management is responsible for recording the
results and position of the business through the
use of financial statements. This often involves
making significant accounting estimates and
judgments, as well as determining the most
appropriate accounting treatments within the
framework of accounting standards and
generally accepted accounting principles.
The auditor, who is objective and knowledgeable
in the areas of auditing, accounting and
financial reporting, evaluates and expresses
an opinion on whether the financial statements
have been fairly presented. The audit is
conducted according to Auditing Standards and
the audit firm’s own policies and procedures.
This enhances the level of confidence of
users of the financial statements.
However, the public places its own expectations
upon auditors. These expectations are often
beyond the scope outlined by auditors,
leading to what is known as an ‘expectations
gap’ between responsibilities and consequent
fault in a collapse.
What is the ‘expectations gap’?
A significant issue regarding the usefulness
and reliability of an audit is the so-called
‘expectations gap’. The International
Organization of Securities Commissions
defines this as:
“The difference between what the public and
users of financial statements perceive the role
of an audit to be and what the audit profession
claim is expected of them during an audit.”
Members of the public, including investors
and creditors, often expect that:
„„Auditors
are primarily responsible for the
preparation and presentation of financial
statements
„„A
‘clean’ audit opinion provides absolute
assurance over the accuracy of the
financial statements and guarantees the
entity’s future solvency
„„Auditors
perform a 100% check over all
items recorded in the accounts
„„Auditors
are to provide early warning
regarding the possibility of a corporate
collapse
„„An
auditor’s role includes detecting all
fraud.
Within the auditing profession, auditors perceive
their role as planning and conducting an audit
to obtain reasonable (as opposed to absolute)
assurance that the financial statements are free
from material error and fraud. Reasonable
assurance does not certify or guarantee the
accuracy of the financial statements.
Page 2
2
forensics
matters
How can audit negligence arise from
corporate failures?
A common theme giving rise to litigation
involving audit negligence is the use and
reliance on the audited financial statements
by third parties, rather than the auditors
client company.
It is often the case that a third party such as a
supplier or financier relies on the information
from audited financial statements in the
course of its decision to engage in business
with an entity. Eventually, the entity may
become insolvent resulting in an inability to
repay its creditors and investors. The audited
financial statements relied upon by the third
party may then appear to have been erroneous
or misleading as the entity did not perform as
anticipated based on the rosy picture
portrayed by the financial statements. This
throws the quality of the audit into the spotlight.
Third parties often view auditors as having
‘deep pockets’ as it is likely they are still
solvent after the client company has become
insolvent. In addition, auditors have insurance
to indemnify for professional negligence,
though subject to limits. Consequently, it is
common for third parties to attempt to recover
their losses by considering or initiating
litigation against the auditors.
However, determining ultimately which party
is at fault is a complex task, which often
requires forensic accountants to review the
work undertaken in the audit. [See Section 3].
Recent Cases
Sons of Gwalia Ltd (admin apptd) v
Margaretic [2007] HCA 1
In 2008, a scheme of arrangement was
approved by the High Court of Australia in
order to pool funds to return to creditors and
shareholders from the company, directors
and the auditors.
Westpoint
In 2009, three auditors agreed to enforceable
undertakings not to practice for up to two
years and a $67.5 million settlement was
reached in early 2011 due to failing to comply
with Australian Auditing Standards.
Feltex
In 2010 in New Zealand, the auditor was
required to pay a $150,000 fine for failing to
disclose a debt in the financial statements.
This case was later cited in Centro, where the
directors argued their duties could be
discharged by reliance being placed on the
auditors to detect errors and misstatements in
the financial statements.
Centro is discussed further on the following
page.
Allco
In late 2010, the auditor agreed to an
enforceable undertaking not to practice for
nine months and paid a fine of $10,000 for
failing to comply with Australian Auditing
Standards.
Lehman Brothers (USA)
It was found that there was sufficient evidence
to support a possible claim that the firm’s
auditor had been “negligent” and that Lehman
could pursue claims against the firm for
“professional malpractice”. Lehman’s auditor
is fighting fraud charges for, among other
things, allegedly failing to adequately follow up
on a whistleblower’s claim that Lehman was
misstating the value and size of its assets.
Other examples of recent cases include
MFS, ABC Learning, Bill Express and
Babcock & Brown.
Page 3
forensics
matters
Centro
The audited financial statements of Centro
Properties and Centro Retail Group were
found to contain errors totalling over $2 billion
in debt classifications in addition to failing to
account for guarantees of USD1.75 billion. In
June 2011, the directors were found to be in
breach of their duties as they cannot delegate
their responsibility for overseeing the company’s
financial affairs to management or auditors.
The outcome of auditor performance and
negligence, if any, is pending.
The Centro directors sought to rely upon the
Feltex decision in New Zealand where the
judge concluded that the Feltex directors did
take appropriate steps to obtain advice (from
management and the auditors) upon which
they relied as they were entitled to do whilst
describing that the New Zealand regulator’s
“should have done it themselves” proposition
was unrealistic.
The Centro directors submitted that they were
reasonably entitled to place reliance on the
processes which Centro had put in place for
the purposes of ensuring that the financial
statements were accurate and in accordance
with the Accounting Standards, with the view
that accounting and auditing are specialised
fields.
Justice Middleton, the presiding Judge in this
case, stated that although directors are entitled
to rely upon specialist advice, whether a
director has taken all reasonable steps will
depend upon the circumstances of the case
and an analysis of the facts before the Court.
Undoubtedly, what is encompassed by taking
all ‘reasonable steps’ will differ depending
upon the entity, the complexity of the entity’s
business and the internal reporting procedures
within the entity as well as the nature of the
task the director is obliged to undertake.
However Justice Middleton did not take the
view that the directors should have done it all
themselves and become familiar with the
complexities of various accounting standards.
In the Centro case, Justice Middleton found that:
„„Directors
are entitled to rely upon others
and there was no suggestion in the Centro
case that the reliance on others was not
warranted or that the trust in those whom
the directors had relied upon was misplaced;
„„As
discussed in our first article on this
topic, each director, armed with the
information available to him, was expected
to focus on matters brought before him and
to seriously consider such matters and take
appropriate action. This task demands
critical and detailed attention, and not just
‘going through the motions’ or sole reliance
on others, no matter how competent or
trustworthy they may appear to be; and
„„Directors
cannot substitute reliance upon
the advice of management [or auditors] for
their own attention and examination of an
important matter that falls specifically
within the Board’s responsibilities as with
the reporting obligations. The [Corporations]
Act places upon the Board and each
director the specific task of approving the
financial statements. Consequently, each
Board Member was charged with the
responsibility of attending to and focusing
on Centro’s accounts and, under these
circumstances, could not delegate or
‘abdicate’ that responsibility to others.
Source : http://www.austlii.edu.au/cgi-bin/sinodisp/au/cases/cth/FCA/2011/717.html?stem=0&synonyms=0&query=%22centro=%22centro
Page 4
forensics
matters
3
The future of audit liability
Auditor liability is an area of increasing
significance, particularly in light of the changing
and widening of auditor obligations in Australia
imposed by Common Law, statute law,
regulators and professional bodies.
An area that should be given more focus is
the expectations gap, as minimisation of the
gap may result in a clearer examination and
investigation of fault, prior to proceedings
being launched. This can be achieved
through an increase in awareness of the
auditor’s role by stakeholders, including an
understanding of an audit and its outcomes.
Misunderstandings of auditing terminology,
for example materiality, reasonable assurance
and sampling often add to the confusion.
The introduction of CLERP 9 provisions has
assisted in limiting audit liability, specifically
proportionate liability resulting from negligent
misrepresentations from “misleading and
deceptive conduct” and audit firms now
having the ability to be incorporated. Further
to this, it was legislated to allow a national
based statutory cap for audit liability by way
of the Treasury Legislation Amendment
(Professional Standards) Act.
The Treasury, as noted in its paper “Audit
Quality in Australia - a Strategic Review”
(March 2010), believes that Australia’s audit
regulation framework is robust and stable
and, as a key driver of audit quality, can be
considered to be in line with international
best practice. The Australian Securities and
Investments Commission also recently
published its latest audit firm inspection report
in June 2011 regarding the 2009-10 period
and discovered that 17% of large audit firm
engagement files did not contain sufficient
appropriate audit evidence and for other firms
it was 31%. Areas for improvement were in
three key areas:
„„“Sufficiency
and appropriateness of audit
evidence;
„„Level
of professional scepticism in key
areas of judgement; and
„„Evidence
on audit engagement files about
the nature, timing and extent of
engagement quality control review.”
What should be considered as part of an investigation into audit
negligence?
We find that the below are key issues to review as part of an investigation into audit negligence:
„„What
scope is included in the audit contract between auditor and firm? For example, was
the audit firm retained to prepare the financial statements as well as audit them?
„„What
procedures and work was required in the firm’s audit manual and audit standards?
Was the audit planning adequate?
„„Were
issues followed up from the prior year?
„„Whether
„„What
other technical accounting advice was sought by the directors?
judgements were made about audit scope, sampling and reliance upon controls
„„What
documentation standards were applied by the audit firm, including the use of
electronic audit files? What is the location of copies of these?
„„What
were the key areas of audit judgement? How were these resolved?
Page 5
4
forensics
matters
Conclusion
In recent years, the auditing profession both in
Australia and around the World has been the subject
of litigation by third parties seeking to recoup their
losses. As a result, this has highlighted the
significance of audit quality and its role in enhancing
market confidence.
Litigation has often resulted from a corporate collapse
which consequently gives rise to accusations of
breach of statutory obligations and professional
negligence by auditors. As such, auditor liability is
currently a major focus for professional, judicial and
legislative law reform bodies.
However, there is also much need for a broadening
awareness of the auditors’ role and the commercial
and economic realities of the marketplace by
stakeholders. Though the auditor’s role is important in
ensuring the adherence to Accounting Standards and
the presentation of the financial statements, as recent
case law has highlighted, it is also important to note
that directors of a corporation cannot delegate or
‘abdicate’ their responsibilities to others when it
comes to specific obligations. For example, the
Centro case found that though directors are entitled
to place reliance on the advice of others (including
management and auditors), they cannot substitute
reliance upon this advice for their own attention and
examination of an important matter that falls specifically
within their responsibilities as with reporting obligations.
The answer to resolving questions concerning whether
the respective responsibilities of management and
auditor have been fully discharged, often lies in a close
examination and investigation of the conduct of an audit.
Page 6
forensics
matters
About the author
Sasikala is a Manager and joined the Forensics team at KordaMentha in
November 2010, having previously worked in a similar role with KPMG
LLP, UK. Sasikala’s work at KordaMentha involves forensic accounting,
fraud and financial investigations, and disputes.
Sasikala Kandiah
Manager
Sydney
Tel: +61 2 8257 3096
skandiah@kordamentha.com
Jason Cheung is a Senior Executive Analyst and joined the Forensics
team at KordaMentha in March 2011, having previously worked in audit
with KPMG, Sydney and in corporate insolvency. At KordaMentha,
Jason’s work includes disputes, forensic accounting and fraud and
financial investigations.
Jason Cheung
Snr Executive Analyst
Sydney
Tel: +61 2 8257 3041
jcheung@kordamentha.com
This publication, and the information contained therein, is prepared by KordaMentha Forensics Partners and staff. It is of a general
nature and is not intended to address the circumstances of any particular individual or entity. It does not constitute advice, legal or
otherwise, and should not be relied on as such. Professional advice should be sought prior to actions being taken on any of the
information. The authors note that much of the material presented was originally prepared by others and this publication provides a
summary of that material and the personal opinions of the authors.
Limited liability under a scheme approved under Professional Standards Legislation.
Page 7
forensics
matters
KordaMentha Forensics
Whatever the factual, accounting, financial or e-discovery issues that arise, our forensic expertise
and experience can bring clarity of thought, objectivity and clear communication of ideas to
help find the facts, understand the relevant issues and clarify the financial and other impacts in
a cost-effective way.
Dispute analysis
„„
„„
„„
„„
Independent accountancy
expert witness
Consulting accountancy expert
Experts pursuant to dispute
resolution clauses
Court-appointed referee
Data analytics
„„
„„
„„
„„
Suspicious activity analysis
Data exploration
Data assurance
Process optimisation
Forensic accounting and
investigations
„„
„„
„„
„„
„„
Fraud and accounting
manipulation investigations
Corruption investigations with
regards to FCPA, UK Bribery
Act, and other anti-corruption
legislation
Regulatory investigations
Corporate and internal
investigations
Investigations training
Fraud risk management
„„
„„
„„
„„
„„
Development and review of
fraud risk policies
Fraud risk assessment
Fraud, corruption and ethics
awareness training
Whistleblower consulting
services
Corporate and business
intelligence
Forensic technology
„„
„„
Computer forensics
E-Discovery
Contacts
Melbourne
Owain Stone
Partner
Robert Cockerell
Executive Director
Dispute Analysis
Forensic Accounting
Forensic Technology
Forensic Accounting and Investigations
Fraud Risk Management
+61 3 8623 3410
ostone@kordamentha.com
+ 61 3 8623 3355
rcockerell@kordamentha.com
Sydney
Andrew Ross
Partner
Richard Bennison
Partner
Nigel Carson
Partner
Dispute Analysis
Forensic Accounting and Investigations
Forensic Accounting and Investigations
Fraud Risk Management
Forensic Technology
John Temple-Cole
Partner
Andre Menezes
Executive Director
Forensic Accounting and Investigations
Dispute Analysis
Data Analytics
+61 2 8257 3051
aross@kordamentha.com
+61 2 8257 3077
jtemplecole@kordamentha.com
+61 2 8257 3040
rbennison@kordamentha.com
+61 2 8257 3080
ncarson@kordamentha.com
+61 2 8257 3023
amenezes@kordamentha.com
Singapore
Matthew Fleming
Partner
Lily Yap
Director
Forensic Accounting and Investigations
Dispute Analysis
Forensic Accounting and Investigations
+65 6593 9363
mfleming@kordamentha.com
+65 6593 9329
lyap@kordamentha.com
Page 8