Lecture 9- Fraud, legal liability and audit expectation gap

According to ISA 240, fraud is "[blank_start]intentional[blank_end] act by one or more [blank_start]individuals[blank_end] among management, those charged with governance, employees or third parties, involving use of [blank_start]deception[blank_end] to obtain an [blank_start]unjust[blank_end] or [blank_start]illegal[blank_end] advantage"

Managerial fraud or fraud by those charged with governance is [blank_start]significant[blank_end] when looking at [blank_start]audit[blank_end] because if it is somebody who is completing fraud at that level, it is possible that it could be important in context of [blank_start]financial statements[blank_end]. Therefore, if they are [blank_start]manipulating[blank_end] or trying to change [blank_start]financial information[blank_end] that is being presented that could result in [blank_start]material error[blank_end]. This is more difficult for auditors to [blank_start]detect[blank_end] because you have senior people in processes & procedures trying to [blank_start]prevent[blank_end] fraud being found

When looking at fraud it can also involve participation of [blank_start]third parties[blank_end]

[blank_start]Management[blank_end] has responsibility for fraud detection. They are responsible for such [blank_start]internal control[blank_end] that they determine “is necessary to enable [blank_start]preparation[blank_end] of financial statements that are [blank_start]free[blank_end] from material misstatements, whether due to [blank_start]fraud[blank_end] or [blank_start]error[blank_end]” (ISA 210)

[blank_start]Auditor[blank_end] also has responsibility for fraud detection. However, their [blank_start]primary[blank_end] responsibility is not to detect [blank_start]fraud[blank_end] but there is reasonable expectation of detecting [blank_start]material misstatements[blank_end] in financial statements arising from [blank_start]error[blank_end] or [blank_start]fraud[blank_end]

ISA 240 says "to identify & assess [blank_start]risks[blank_end] of material misstatement of [blank_start]financial statements[blank_end] due to fraud & to obtain sufficient appropriate [blank_start]audit evidence[blank_end] regarding assessed [blank_start]risks[blank_end] of material misstatement due to fraud, through [blank_start]designing[blank_end] & implementing appropriate responses

Board of directors’ responsibilities in preventing fraud include: maintaining sound [blank_start]internal controls[blank_end], [blank_start]safeguard[blank_end] shareholders’ [blank_start]investment[blank_end] & company [blank_start]assets[blank_end] & finally prevent & detect [blank_start]fraud[blank_end] & [blank_start]error[blank_end]

Responsibilities of directors to prevent fraud include: developing an appropriate [blank_start]control environment[blank_end] (tone at top), establishing [blank_start]strong[blank_end] & [blank_start]effective[blank_end] system of [blank_start]internal control[blank_end], encouraging strong [blank_start]ethical environment[blank_end] & developing [blank_start]code of conduct[blank_end], establishing an [blank_start]audit committee[blank_end] & reporting on effectiveness of company’s [blank_start]internal control[blank_end] system

Fraudulent financial reporting achieved by [blank_start]manipulation[blank_end], falsification, suppression or [blank_start]alteration[blank_end] of accounting [blank_start]documents[blank_end] or [blank_start]records[blank_end], [blank_start]misrepresentation[blank_end] or [blank_start]omission[blank_end] of transactions or events, [blank_start]misapplication[blank_end] of accounting [blank_start]principles[blank_end] & inappropriate [blank_start]classification[blank_end] or [blank_start]disclosure[blank_end] in accounts

If [blank_start]non-directors[blank_end] are involved in fraud & error, auditors should report to [blank_start]directors[blank_end]. If [blank_start]directors[blank_end] are involved, they should consider reporting to [blank_start]audit committee[blank_end]. If there are senior people & option of reporting to audit committee is not [blank_start]independent[blank_end], auditors should seek [blank_start]legal advice[blank_end] & report suspicions to [blank_start]third parties[blank_end]. Auditors should [blank_start]document[blank_end] process until it is satisfactorily resolved

Auditors are liable under [blank_start]criminal[blank_end] & [blank_start]civil[blank_end] law. [blank_start]Civil[blank_end] liability is most important form of liability in practice, particularly liability to [blank_start]third parties[blank_end]. This can be sparked by factors such as: cost of [blank_start]indemnity insurance[blank_end], many actions being brought against [blank_start]auditors[blank_end], level of damages demanded by [blank_start]plaintiffs[blank_end] & bad [blank_start]publicity[blank_end] as result of alleged [blank_start]negligence[blank_end]. Here we need to think about how [blank_start]case law[blank_end] & how law is set out to look at auditors liabilities to [blank_start]third parties[blank_end] & to understand how that has developed over last 60 years

One 'Act' that is in place when looking at criminal liability that [blank_start]accountants[blank_end] & [blank_start]auditors[blank_end] can potentially face criminal charges is [blank_start]Theft Act 1968[blank_end]. This provides that individuals commit an [blank_start]offence[blank_end] if they gain or cause someone to [blank_start]lose[blank_end] by: destroying, concealing, falsifying documents/records required for [blank_start]accounting[blank_end] purposes & [blank_start]supplying[blank_end] information making use of records or documents known by them to be materially [blank_start]false[blank_end], [blank_start]misleading[blank_end] or [blank_start]deceptive[blank_end]

Another 'Act' that is in place when looking at criminal liability that [blank_start]accountants[blank_end] & [blank_start]auditors[blank_end] can potentially face criminal charges is [blank_start]Fraud Act 2006[blank_end]. Person can be guilty of [blank_start]fraud[blank_end] in three ways: fraud by [blank_start]false representation[blank_end], fraud by failing to [blank_start]disclose information[blank_end] & fraud by [blank_start]abuse of position[blank_end]

Third 'Act' that is in place when looking at criminal liability that [blank_start]accountants[blank_end] & [blank_start]auditors[blank_end] can potentially face criminal charges is [blank_start]Companies Act 2006[blank_end]. Auditors who knowingly or recklessly issue an [blank_start]audit report[blank_end] that is misleading, false or deceptive: guilty of [blank_start]criminal[blank_end] offence. Also, auditors commit [blank_start]criminal[blank_end] offence if they fail to provide [blank_start]statements[blank_end] in audit report of certain [blank_start]circumstances[blank_end]. Finally, business carried on for fraudulent purposes, anyone knowingly party is liable to [blank_start]fine[blank_end] or [blank_start]imprisonment[blank_end], or [blank_start]both[blank_end]

With civil liability, if auditors have given clean [blank_start]opinion[blank_end] on financial statements which turn out not to be [blank_start]true[blank_end] & [blank_start]fair[blank_end], user who loses through [blank_start]reliance[blank_end] on statements may feel [blank_start]auditors[blank_end] are one of those at fault. So when looking at opinion process, auditors give an [blank_start]opinion[blank_end] & not [blank_start]guarantee[blank_end] that financial statements are [blank_start]true[blank_end] & [blank_start]fair[blank_end]. But company, shareholders or others may [blank_start]sue[blank_end] them for damages to compensate for any [blank_start]loss[blank_end] they have suffered as result of alleged [blank_start]negligent[blank_end] work

For action of negligence to [blank_start]succeed[blank_end], it must be shown that auditors owed [blank_start]duty of care[blank_end] to person bringing action. Auditors having [blank_start]contractual[blank_end] relationship with company & can be [blank_start]sued[blank_end] by company under [blank_start]contract[blank_end] law. But many liability cases have been brought by [blank_start]third parties[blank_end], under tort & case law has developed as result

One distinct phase that case law is seen in is [blank_start]pre Caparo case[blank_end]. In 1951 case, early case law suggested that if there was [blank_start]no[blank_end] contract between [blank_start]accountants/auditors[blank_end] & [blank_start]third parties[blank_end], they owed [blank_start]no duty of care[blank_end]. In 1963 case, where [blank_start]auditors[blank_end] knew or should have known about third party, & [blank_start]third party[blank_end] intended to rely on their report, they owe [blank_start]duty of care[blank_end] to that party. Following this case, [blank_start]auditors[blank_end] could not be held [blank_start]liable[blank_end] where [blank_start]third party[blank_end] was not known to them. In 1981 &1983 cases, it was suggested that if [blank_start]auditors[blank_end] should reasonably have [blank_start]foreseen[blank_end] that someone would rely on audited accounts, they could be [blank_start]liable[blank_end] even if they had not known person. In 1987 case, it was suggested that too great an emphasis had been placed on [blank_start]foreseeability[blank_end] & not enough to existence of close & direct [blank_start]relationship[blank_end]

In Caparo case, case was to determine if [blank_start]auditors[blank_end] of company, owed [blank_start]duty of care[blank_end] to Caparo Industries who had [blank_start]invested[blank_end] in company & [blank_start]lost[blank_end] money as result. Basic principles of Caparo case were: while it may be [blank_start]foreseeable[blank_end] that persons are likely to [blank_start]rely[blank_end] on financial statements, relationship between auditors & those persons are not close & direct enough to satisfy [blank_start]test of proximity[blank_end], any duty owed by auditors is to shareholders as [blank_start]class[blank_end] rather than as [blank_start]individuals[blank_end], liability should not be imposed on [blank_start]auditors[blank_end], as this would lead to liability that cannot be [blank_start]quantified[blank_end] because of time & identity of its beneficiaries

One part of three part test Caparo case established to establish duty of care is reasonable [blank_start]foreseeability[blank_end] of damage. [blank_start]Defendant[blank_end] must be able to [blank_start]foresee[blank_end] that damage could occur as result of [blank_start]misstatements[blank_end]. This is not thought to be [blank_start]difficult[blank_end] to determine

Another part of three part test Caparo case established to establish duty of care is relationship of [blank_start]proximity[blank_end]. There must be [blank_start]proximity[blank_end] between plaintiff & defendant. This is said to be lack of defined test for [blank_start]proximity[blank_end] & this may lead to [blank_start]uncertainty[blank_end] as to when [blank_start]duty of care[blank_end] exists. Recently [blank_start]proximity[blank_end] has become more central in legal decisions

Third part of three part test Caparo case established to establish duty of care is [blank_start]fairness[blank_end]. Court must consider it [blank_start]fair[blank_end], [blank_start]just[blank_end] & [blank_start]reasonable[blank_end] to impose duty of care on [blank_start]A[blank_end] for benefit of [blank_start]B[blank_end]

Proximity will exist between A & B if in making statement, A knew: statement would be [blank_start]communicated[blank_end] to B, statement would be [blank_start]communicated[blank_end] in relation to particular [blank_start]transaction[blank_end], B would very likely [blank_start]rely[blank_end] on statement when making [blank_start]decision[blank_end] with respect to [blank_start]transaction[blank_end] & B acted on statement to their [blank_start]loss[blank_end]

Another distinct phase that case law is seen in is [blank_start]post Caparo case[blank_end]. Cases since Caparo illustrate ways in which [blank_start]plaintiffs[blank_end] attempt to [blank_start]distinguish[blank_end] between case they have brought & Caparo case. Interesting feature of latter case is that it led to now common [blank_start]practice[blank_end] of adding to wording of standard audit report [blank_start]paragraph[blank_end] disclaiming responsibility to [blank_start]third parties[blank_end]

Audit expectation gap- "Auditors are performing in manner which is in [blank_start]variance[blank_end] with [blank_start]beliefs[blank_end] & [blank_start]desires[blank_end] of others who are party to or interested in audit”. So it is difference between [blank_start]expectations[blank_end] of those who rely upon [blank_start]audit reports[blank_end] concerning what auditors do & what they are [blank_start]perceived[blank_end] to do

There are protagonists (parties with different [blank_start]expectations[blank_end]) in relation to [blank_start]audit[blank_end] process. They include [blank_start]stakeholders[blank_end], [blank_start]politicians[blank_end], [blank_start]regulators[blank_end] & [blank_start]academics[blank_end]

Possible reasons for deficient performance gap include: lack of [blank_start]competence[blank_end] i.e. lack of [blank_start]care[blank_end], lack of [blank_start]knowledge[blank_end] & lack of [blank_start]experience[blank_end] & another is lack of [blank_start]practitioner[blank_end] independence i.e. [blank_start]programming[blank_end], [blank_start]investigative[blank_end] & [blank_start]reporting[blank_end] independence

Deficient standards gap- Gap between what auditors can be reasonably [blank_start]expected[blank_end] to do & what [blank_start]profession[blank_end] & [blank_start]law[blank_end] [blank_start]asks[blank_end] them to do. With these specific areas, auditors would look at [blank_start]fraud[blank_end] & [blank_start]going concern[blank_end]

To address (reduce) expectations gap that exists there has been [blank_start]expansion[blank_end] of auditors duties, [blank_start]flexibility[blank_end] of auditors duties & society’s [blank_start]changing[blank_end] expectations