Audit Exam Revision lectures wk 10-11 PDF

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Week 10 Lecture 1Auditor liability  Do you think auditors should be held liable and made to pay damages to stakeholders in the event of a company collapse?  Which actions the auditor can be held liable for?  Which third parties auditors are liable to?  Is it joint, several (EU and US) and/or pro...

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Week 10 Lecture 1 Auditor liability  Do you think auditors should be held liable and made to pay damages to stakeholders in the event of a company collapse?  Which actions the auditor can be held liable for?  Which third parties auditors are liable to?  Is it joint, several (EU and US) and/or proportional liability?  What are the rules to allocate litigation costs between parties?  What are implications/issues for the profession?  Legal liability regimes of auditors and exposure to litigation will vary internationally.  You need to justify your answer! Auditor's liability

Civil liability  In the UK  UK Company law did not allow limiting liability it – auditors should be held liable for their own actions  But recently after much lobbying by the profession - ways of limiting liability have emerged  Civil Liability of auditors can be through Contract Law or law of delict/tort

 Contract Law – sue for breach of contract; therefore shareholders can seek damages from the auditor if they fail to comply with the terms of the engagement letter  Delict/tort – sue for negligence if the auditor breaches a duty of care to a third party who consequently suffers some form of loss whereby reference to Case Law required Civil liability  Prime concern(s) of the profession  Joint and several liability  Indemnity insurance required by auditors, and not by others involved in the FR process  Auditors appear to be sued on their ability to pay rather than degree of fault  Indeterminate number of actions would potentially be sought with indeterminate Level of damages  The bad publicity that results when there is allegations of auditor negligence in the courts  Everyone pays with increase in fees and insurance premiums  Harsh liability environment impacts on auditing in the public interest deterring new audit firms & reducing audit market competition Civil liability Famous cases relating to third party liability which is established if a duty of care is owed to a 3rd party  Donaghue vs Stevenson in (1932)  Candler vs Crane Christmas & Co. (1951)  Hedley Byrne & Co. vs Heller and Partners Ltd. (1964)  JEB Fasteners Ltd. vs Marks Bloom & Co. (1981)  Twomax Ltd. and Goode vs Dickson, McFarlane and Robinson (1982)  Caparo Industries plc vs Dickman and Others (1989) Civil liability  Several cases involving alleged auditor negligence have been heard since Caparo.  Although these have not changed the law relating to whom the auditors owe a duty of care in general, they are useful because they illustrate ways in which plaintiffs attempt to distinguish between the case they have brought and the Caparo case.

Disclaimer  ICAEW recommend a disclaimer and issue suggested wording (January 2002) “This report is made solely to the company’s members, as a body, in accordance with Section 235 of the Companies Act 1985. Our audit work has been undertaken so that we might state to the company’s members those matters we are required to state to them in an auditor’s report and for no other purpose. To the fullest extent permitted by law, we do not accept or assume responsibility to anyone other than the company and the company’s members as a body, for our audit work, for this report, or for the opinions we have formed.”  PWC add a disclaimer to audit reports (December 2002) “We do not, in giving this opinion, accept or assume responsibility for any other purpose or to any other person to whom this report is shown or in whose hands it may come save where expressly agreed by our prior consent in writing” Disclaimer  ACCA confirmed its preliminary view that not a proportionate or appropriate response devalues the audit report (February 2003). Also, the disclaimer is based on UK law, so it is not effective for international audits. “[S]tandard disclaimers were not necessarily an appropriate or proportionate response to the Bannerman decision. Their incorporation as a standard feature of the audit report could have the effect of devaluing the audit report and also cause problems for third parties and regulators – the SEC in the US has already expressed concern over their adoption by auditors in the UK” Limiting auditor liability  Traditional structure of an audit firm in UK  Joint and Several Liability arguably leads to “Deep pocket” syndrome  Lack of sufficient insurance cover  Many stakeholders  Potentially huge claims  Contested meaning of audit quality  Challenging what constitutes reasonable assurance as the audit opinion is not an absolute assurance

This all feeds into the Audit Expectations Gap between what auditors are required to do and the level of assurance they can give and what stakeholders expect them to do Minimising potential liabilities  Observe client acceptance procedures – screen clients and review existing clients  Have Engagement Letter explaining responsibilities of directors and auditors  Perform audit work properly – use documents only for intended purpose  Document work and decision and review processes  Have quality control system – hot/cold reviews  Take legal advice  Use disclaimers where appropriate in audit report  Agree with company to limit liability in respect of their audit (Companies Act 2006)  Use of corporate form – Limited Liability Partnerships (with shareholders only liable for unpaid share capital) Auditing Standards and Professional Conduct  Compliance with auditing standards and ethical standards would seem to be a reasonable defense if auditors are to resist a claim for damages (arguably they indicate audit quality)  BUT Limitations to the use of standards as a means of defense are:  Do not cover all areas of auditing  Contain the principles and general guidance, leaving scope for interpretation and implementation  Represent he auditing profession’s view of good practice but what the courts believe to be good practice is what matters  Professional body rules on professional conduct and discipline Out of Court Settlements  WHAT/WHEN: a payment made by the auditor to a 3rd party before a case goes to trial  HOW: agreement is reached where the out of court settlement (often undisclosed) is calculated as a % of alleged damages (some £000 millions – see Patisserie Valerie)  WHY settle when auditor believes no negligence:  court judgements are subjective and sometimes they will “get it wrong”

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court judgements are not always predictable trials are time consuming and therefore costly Insurance may not cover the alleged damages It is often easier and less costly to settle out of court

How do Out of Court Settlements impact the Audit Profession?  Costly – in terms of both auditors time and legal fees. Damages and settlements reduce auditors’ profit(estimated to be 1% of turnover - in 2019 Big 4 turnover was estimated to be $155 billion)  Increased uptake of insurance – however, this is not often adequate or even appropriate; for example Arthur Anderson post Enron  Reputational damage  Settlement means that the dispute is not made public and the opportunity to set a legal precedent is lost  Others are encouraged to sue!

Week 11 Lecture 1 The Audit Expectations Gap  “The difference between the expectations of those who rely upon the audit reports concerning what auditors do and what they are perceived to do”  The common element in various definitions of the audit expectations gap is that auditors are performing in a manner at variance with the beliefs and desires of interested parties (stakeholders)  The gap comprises several gaps between the views of auditors and those of a number of stakeholders, some of whom are powerful, others weak, lacking economic power. Different elements of the audit expectations gap  A performance gap  A deficient standards gap – standards are not high enough  A deficient performance gap – auditors don’t perform in accordance with standards  A reasonableness gap – unreasonable public expectations (see also Gray, Manson & Crawford, chapters 2&20 – introduction to the Audit Expectations Gap) Deficient performance gap  Two possible reasons for deficient performance  lack of auditor competence - lack of care, lack of knowledge and lack of experience.  lack of practitioner independence - programming, investigative and reporting independence. Deficient standards gap  The deficient standards gap is the gap between what auditors can be reasonably expected to do and what the profession and the law asks them to do.  It is difficult to assess what is reasonable, particularly as views may change over time.  Two issues causing most controversy in relation to ‘deficient standards’ have been fraud and going concern.  Lack of Professional Independence

The reasonableness gap  Arises because people expect more from an audit than it can actually give in practical terms  For example, some stakeholders may believe that the auditor examines every transaction, whereas the auditor tests on a sample bases after determining risk. Are the stakeholders expectations reasonable?  For example, auditor’s are not responsible for detecting fraud. Stakeholders expect them to. Is this a deficient standards gap, deficient performance gap, or a reasonableness gap? Changing Expectations The components of the various elements within the expectations gap are constantly changing:  Changing role of auditors and expansion of duties  Flexibility within auditors duties  Changing expectations within society surrounding the role of the auditor

Week 11 Lecture 2 Structure of the practicing profession and further considerations on independence  Professional Oversight Board, June 2018. Key Facts and Trends in the Accountancy Profession https://www.frc.org.uk/getattachment/27725654-8bd9-4623-a410ef1661a69649/Key-Facts-and-Trends-2018.pdf  Gives a good current overview of the audit profession including membership of the UK professional bodies, list and structure of the larger audit firms, fee income, big 4 fee income etc Contemporary Perspectives on audit  The objective of an audit – is it achievable?  The purpose of an audit - Agency theory; requires annual audit by independent experts  Auditors operating as guardians and commercial agents – conflicts of interest  Regulatory framework, Audit Reporting and Liability arrangements  Traditional methodologies for traditional transactions  The prevailing nature of the audit expectations gap Critique of modern auditing “seeks to encourage debate by focusing on three issues which are deeply embedded within the current auditing practices”: • Appropriateness of the basic auditing model to deliver an independent audit • Audit Quality focuses on standards and methodologies and neglects the organisational and social context of auditing • Audit-ability of new forms of financial transactions using traditional audit methodologies • Sikka et al.(2009) The auditing model: “….is fundamentally flawed as it makes auditors financially dependent upon companies and persuades them to prioritise their own economic interests at the expense of other[s]” (p136) • Dependency on client for fees and profits • Ineffective shareholder participation in appointment and remuneration of auditors

• Acquiescence to client; not disclosing relevant information to the shareholders • Using audit relationships to develop and sell consultancy • Sikka et al.(2009) Audit Quality: Audit quality associated with appropriate techniques, working papers, compliance with standards and use of ‘expert’ auditors, but…  Little attention to social and organisational context of auditing:  Profit motive (setting fees; staffing; time budgets)…potentially compromising quality for profit.  Audit approach  Customer service motive  Career structure and rewards  Liability concessions  Sikka et al.(2009) Audit Quality  Remember – AQ is premised on competence and independence of the auditor  “Big firms no longer carry out audits. They audit in helicopters and circle clients from a few thousand feet and take pictures. No one gets out of the helicopter and kicks the tyres. It’s no longer audit…”  Former ICAS President; cited in Sikka et al.(2009), pg 145 Auditability: “Traditionally auditors have conducted ex-post audits and the main objective has been to verify income, expenses, assets and liabilities, which have generally been the outcome of past transactions.  However, the intensification of finance capitalism has produced new complex financial instruments whose value depends on uncertain future events and market volatility.  It is doubtful that auditors have the requisite expertise to deal with the challenges posed by shifts in capitalism”. (p137)  “…the conventional audit is probably no longer worth paying for!!” (p149)  Sikka et al.(2009) Suggestions for reform - Sikka et al.(2009)  Strengthen independence/ involve the state: Ban on selling non-audit services; Continuous audit - regulatory and financial matters

 Greater transparency and disclosure of audit practice – methodologies, budgets and staffing etc.  Increased state regulation on ‘sensitive’ industries  Acknowledgement that some types of transaction cannot be audited  Extend accountability responsibilities Domination of international audit market by Big 4…’there are too few to fail’ Advantages  Wide ranging expertise  Global facilities  Can invest in expensive systems and necessary IT to meet needs of international clients Disadvantages  Lack of competition and choice, particularly for large companies Jurisdiction  Increasing Internet trading – organisations are based in many jurisdictions e.g. Google – invoices from low tax country (Ireland) but operates across borders and has head office in another country (California, USA)  This reinforces Big 4 argument that only they can audit such organisations  How do auditors monitor legality of transfer pricing of goods, cross border trading, movement of funds into and out of jurisdictions with high levels of secrecy?  Does this create a cartel of audit firms and a cosy relationship between Big Audit and Big Company? Cryptocurrencies and blockchain Use of blockchain to process transactions. Blockchain is a crowd managed distributed secure database. It allows consumers and suppliers to connect directly Uses cryptography to keep exchanges secure, blockchain provides a decentralized database, or “digital ledger”, of transactions that everyone on the network can see. This network is essentially a chain of computers that must all approve an exchange before it can be verified and recorded. The technology can work for almost every type of transaction involving value, including money, goods and property. Its potential uses are almost

limitless: from collecting taxes to enabling migrants to send money back to family in countries where banking is difficult. The medium of exchange in blockchain transactions is Bitcoin Cryptocurrencies and blockchain(2)  Challenge to the auditor is how to verify transactions –or do they need to in a blockchain as all members of the chain must accept transaction?  Is being used for money laundering (allegedly)  It needs a lot of computing power to duplicate or monitor these transactions  Value of Bitcoin – how to account for it? Value fluctuates as it has no real existence – it is a traded commodity. How Have these concerns been Addressed  Corporate Governance Standards for Companies  Audit Firm Governance Code  Revision of Auditing Standards  Revision of Ethical Standard  The Statutory Auditor and Third Country Auditors Regulation 2016 (SATCAR 2016)  Brexit??  Competition and Market Authority – The Big 4 https://www.theguardian.com/business/2018/dec/18/big-four-accountinggroups-escape-breakup-threat-from-cma  Other changes and developments happening all the time...