Chapter 14 Auditors’ Liabilities
Chapter Summary
1.Directors’ Responsibilities in Preparing Financial Statements
1.1The auditor’s report should state that management is responsible for the preparationand the fair presentation of the financial statements in accordance with the applicablefinancial reporting framework and that this responsibility includes:
(i)Designing, implementing and maintaining internal control relevant to thepreparation and fair presentation of financial statements that are free frommaterial misstatement, whether due to fraud or error;
(ii)Selecting and applying appropriate accounting policies; and
(iii)Making accounting estimates that are reasonable in the circumstances.
2.Fraud and Errors
2.1HKSA 240 states that error is an unintentional misstatement in financial statements, including the omission of an amount or a disclosure. Examples of errors are:
(a)a mistake in collecting or processing data from which financial statements are prepared;
(b)an incorrect accounting estimate or classification arising from management’s misinterpretation regarding the outcome of a litigation against the company; and
(c)an omission in reviewing the stock record for unsold stocks so as to value them at the lower of cost or market value for inventory.
2.2HKSA 240 defined fraud (欺騙) as an intentional act by one or more individuals among management, those charged with governance, employees, or third parties, involving the use of deception to obtain an unjust or illegal advantage. Thus, fraud involves two elements:
(a)motivation to commit fraud:
Refers to fraud that may be committed because management is under pressure to achieve an unrealistic earnings or his or her reward is based on the level of changes.
(b)perceived (認識到的) opportunity to commit fraud:
exists when an internal control could be circumvented (規避).
2.3 /Test your understanding 1
Fraud refers to an unintentional act by one or more individuals among management, those charged with governance, employees, or third parties, involving the use of deception to obtain an unjust or illegal advantage. The primary responsibility for the prevention and detection of fraud rests with the auditors.Required:
Identify TWO errors from the above statement and make corrections to them.
(4 marks)
(HKIAAT Paper 8 Auditing December 2003 B2(III))
(A)Enquiries of management for fraud when planning the audit
2.4According to HKSA 240, when planning the audit, auditors should make enquiries of management:
(a)to obtain an understanding of management’s assessment of the risk that the financial statements may be materially misstated as a result of fraud;
(b)to obtain an understanding of the accounting and internal control systems management has put in place to address such a risk;
(c)to obtain knowledge of management’s understanding regarding the accounting and internal control systems in place to prevent and detect error;
(d)to determine whether management is aware of any known fraud that has affected the entity or suspected fraud that the entity is investigating;
(e)to determine whether management has discovered any material errors.
(B)Auditor’s responsibility of communication
2.5If the auditor has identified a fraud or has obtained information that indicates that a fraud may exist, the auditor should:
(a)communicate these matters as soon as practicable to the appropriate level of management.
(b)make those charged with governance and management aware of material weaknesses in the design or implementation of internal control to prevent and detect fraud.
(c)where there are any other matters related to fraud to be discussed with those charged with governance of the entity; for example, actions by management may be an indicative of fraudulent financial reporting.
(C)Circumstances that indicate the possibility of fraud
2.6HKSA 240 provides the following examples of circumstances indicating the possibility of fraud:
(a)problematic (有疑問的) or unusual relationships between the auditor and management;
(b)conflicting or missing evidence;
(c)internal control is weak;
(d)management’s integrity is questionable.
2.7In appendix 1 of HKSA 240, the fraud risk factors are further classified, based on the three conditions generally present when misstatements due to fraud occur, into:
(a)incentives/pressures;
(b)opportunities; and
(c)attitudes/rationalizations.
2.8Following examples of risk factors that may lead to fraudulent financial reporting:
(a)incentives/pressures:
(i)financial stability or profitability is threatened by economic, industry, or entity operation conduction such as:
(1)significant decline in customer demand.
(2)operating losses and recurring negative cash flows making threat of bankruptcy.
(ii)excessive pressure exists for management to meet the expectation of third parties due to:
(1)financial position and profitability expectations of investors, creditors, bankers, and analysts.
(2)marginal ability to meet exchange listing requirements or debt covenant (契約) requirements.
(iii)personal financial situation of management and those charged with governance that is affected by the financial performance of the entity; examples are:
(1)significant portion of management’s compensation being contingent upon aggressive operating results.
(2)personal guarantee of debts of the entity.
(iv)excessive pressure on management or operating personnel to meet financial targets such as sales volume, profitability level.
(b)opportunities
(i)the nature of industry or the entity’s operation provides opportunities to engage in fraudulent financial reporting.
e.g. significant unusual or highly complex transactions including non-arm’s length transactions, related party transactions, operations in tax-haven jurisdictions.
(ii)there is ineffective monitoring of management as a results of domination or ineffective oversight by management over the financial reporting process and internal controls.
(iii)there is a complex or unstable organizational structure.
(iv)internal control components are deficient as a result of inadequate monitoring, high staff turnover, and ineffective accounting and information system.
(c)attitudes
(i)an interest b management in minimizing reported earnings or increasing the entity’s stock price.
(ii)ineffective enforcement of the entity’s ethical standards and internal controls.
(iii)a practice by management of committing to analysts creditors, and other third parties to achieve unrealistic forecasts.
2.9Appendix 1 of HKSA 240 provides the following examples of risk factors that relate to misstatements arising from misappropriation of assets:
(a)incentives/pressures:
personal financial obligations or adverse relationship with the company makes management or employees who handle or have access to cash or other assets are susceptible to theft.
(b)inadequate internal controls over assets:
(i)inadequate segregation of duties, independent checks and approval and oversight of management.
(ii)inadequate physical control over assets, including the selection of appropriate employees with access to assets.
(c)attitudes
(i)not aware of the needs to monitor or reduce risk relating to misappropriation of assets and to correct the control deficiencies.
(ii)behavioural problems that may indicate assts have been misappropriate, such as, dissatisfaction of employees.
2.10 /Test your understanding 2
When planning and performing audit procedures and evaluating and reporting the results, the auditors should consider the risk of material misstatements in the financial statements resulting from fraud and error.In considering the risk of material misstatement resulting from fraud, the auditors should consider whether fraud risk factors are present that indicate the possibility of either fraudulent financial reporting or misappropriation of assets.
The fact that fraud is usually concealed can make it very difficult to detect. Nevertheless, using their knowledge of the business, the auditors may identify events or conditions that provide an opportunity, a motive or a means to commit fraud, or indicate that fraud may already have occurred. Such events or conditions are referred to as “fraud risk factors”.
Required:
(a)Enquiries of management may provide useful information concerning the risk of material misstatements in the financial statements resulting from employee fraud. What are the matters that auditors may ask management in the planning of an audit? (4 marks)
(b)Define audit risk and name its components.(4 marks)
(c)Give EIGHT examples of fraud risk factors relating to management’s characteristics and influence over the control environment. (8 marks)
(d)Discuss the actions to be taken by auditors if they have identified a fraud.
(4 marks)
(Total 20 marks)
(HKIAAT Paper 8 Auditing December 2003 B3)
2.11 /
Test your understanding 3
When planning and performing audit procedures and evaluating and reporting the results, the auditors should consider the risk of material misstatements in the financial statements resulting from fraud and error.During the course of the audit of the financial statements of Alligators Family Ltd, the audit team identified the following misstatements in the financial statements.
(i)An incorrect accounting estimate arising from misinterpretation of facts.
(ii)Intentional misapplication of accounting policies relating to revenue recognition.
(iii)Alteration of cashbook entries to embezzle receipts from customers.
(iv)A mistake in the application of the disclosure requirement of HKAS 24 “Related Party Disclosure”.
During the planning phase of the audit of the financial statements of Big Cats Family Ltd, the following information was obtained.
(i)The five members of the company’s management team determined all operating and financial decisions.
(ii)All members of the company’s management team have been with the firm since 1990.
(iii)The management of the company attempts to meet profit projections through the use of budgets.
(iv)The company’s profitability has been much lower and more inconsistent than other businesses in the same industry.
(v)The rate of change in the industry in which the company operates has been slow.
(vi)The company is organized in a decentralized form, and management monitoring of branches occurs whenever a branch indicates it has encountered a difficulty.
(vii)The company has diversified its operations in a new line of business and this has led to a variety of new accounting issues and transactions for which generally accepted accounting principles provide only limited guidance. However, management understands the nature of the transactions involved.
(viii)There is a lack of an appropriate system of authorization and approval of transactions in the purchases of office supplies.
Required:
(a)Distinguish between fraud and error. Give ONE example for each of them.
(4 marks)
(b)Referring to each of the misstatements (i) to (iv) from the audit of Alligators Family Ltd, state whether the misstatement constitutes a fraud or an error. (4 marks)
(c)Give FOUR reasons explaining why auditors are able to obtain only reasonable assurance that material misstatements in the financial statements will be detected. (4 marks)
(d)Referring to each of (i) and (viii) from the audit of Big Cats Family Ltd, state whether these matters are fraud risk factors as defined in HKSA 240.
(8 marks)
(Total 20 marks)
(HKIAAT Paper 8 Auditing June 2005 B3)
3.Auditors’ Liabilities
(A)Liabilities under statutes
3.1Liabilities under statute fall under two main headings:
(a)civil liability; and
(b)criminal liability.
3.2Civil liability arises out of misfeasance (不法行為) proceedings under the Companies Ordinance. This is an action brought by the liquidator, or the receiver, or any creditor, in the event of a winding-up. The normal claim is for recovery of the loss suffered by the company.
3.3Criminal liability – Government official can prosecute (起訴) an auditor for knowingly issuing an incorrect audit report under the criminal liability.
(a)Theft Ordinance – that is the destroying, defacing (銷毀), concealing (隱瞞) or falsifying (偽造) any records required for accounting purposes.
(b)Prevention of Fraud (Investment) Ordinance – that is the inducing (產生誘導作用), or attempting to induce, another person to invest by making any statement which he knows to be false or misleading.
(c)Companies Ordinance– there are various provisions which make an officer of the company liable on default to fines and/or imprisonment.
(B)Liability under common law
3.4The usual claim brought under common law is a claim of negligence. Such claims are generally made where a client considers the auditor’s work to have been carried out in a manner which constitutes a breach of due professional care.
3.5Negligence means some acts or omissions that occur because the person concerned failed to exercise professional care and skill which is expected of auditors.
3.6Claims for negligence generally arise when an auditor has failed to
(a)exercise appropriate professional care; and
(b)discover a defalcation (盜用公款) or fraud and the company has suffered financial loss subsequent to the audit.
3.7Circumstances where an auditor may owe a duty of care not only to his client but also to a third party:
(a)Advice or information is given by the auditor to a third party.
(b)The auditor is aware or intends that the advice or information will be communicated to the third party directly or indirectly.
(c)The auditor is aware of the specific transactions or the purpose which the third party has in mind.
(d)It is likely that the third party rely on the advice or information for that transaction or purpose.
3.8Four factors in determining what is a reasonable standard of care for an auditor:
(a)Applying the most up-to-date accounting and auditing standards;
(b)Adhering to all standards of ethical behaviour laid down by the relevant professional institutes;
(c)Being aware of the terms and conditions of his appointment as set out in the engagement letter and as implied by law;
(d)Employing competent staff who are adequately trained and supervised in carrying out their duties.
(C)Auditors’ defences (辯護) against suits
3.9Lack of duty – the CPA claims that there was no implied or expressed contract to perform the duty. In this case, a well-written engagement letter is one of the most important means in which the audit can reduce the likelihood of adverse legal actions.
3.10Contributory negligence (過失相抵) – exists when the client’s own action prevents the auditor from discovering the cause of the loss. For example, client’s management does not provide sufficient information and explanations for verifying a particular item on the financial statements, and as a result, the auditor cannot identify whether that item is materially misstated or not. The auditor can discharge his duty by giving a qualified audit opinion in his report.
3.11Non-negligence performance – the auditor claims that the audit was performed in accordance with the standards prescribed by HKICPAs. Even if there are material misstatements uncovered by the auditor, he need not to be responsible if the audit is conducted properly.
3.12Absence of causal (因果關系的) connection – the client must be able to show that there is a close causal connection between the auditor’s breach of the standard of due care and the damages suffered by the client in order that he or she can successfully sue the auditor.
3.13Defenses against third party suits – basically the above four defenses are also available in third-party suits.
3.14 /Test your understanding 4
Auditor’s liabilityWong & Wong was the external auditor of Forest Ltd for the financial year ended 31 December 2003, and issued an unqualified audit opinion on 31 March 2004. Solely based on the 2003 unaudited accounts, Rainfall Ltd acquired Forest Ltd for $1,000,000 on 10 January 2004. Six months later, Rainfall Ltd sold all the shares in Forest Ltd to Woodland Ltd for $1,500,000. Woodland Ltd appointed another auditor for Forest Ltd. One year later, Forest Ltd went bankrupt. Woodland Ltd sued Rainfall Ltd for $2,000,000, representing the sum of consideration paid for the acquisition of Forest Ltd and the further capital injected to Forest Ltd. Rainfall Ltd then sued Wong & Wong for a breach of professional care and asked for a compensation for a financial loss of $2,000,000. Wong & Wong’s legal representative advised Wong & Wong to settle the lawsuit for $500,000.
Required:
Identify the error(s) for the statement above, explain why these are the errors, AND correct them. (4 marks)
(HKIAAT Paper 8 Auditing December 2004 B2(II))
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