Audit notes-Risk and materiality

1. Kenny recently joined the public accounting firm of Hamid, Krishnan & Co. as an audit assistant after obtaining an accounting degree. He quickly established a reputation for thoroughness and a steadfast dedication to following prescribed auditing procedures to the letter. On his third audit for the firm, Kenny examined the supporting documentation for 200 disbursements as a test of acquisitions, receiving, vouchers payable and cash disbursement procedures. In the process he found twelve disbursements for the acquisition of materials with no receiving reports in the documentation. He noted the exceptions in his working papers and brought them to the attention of the senior-in-charge. Relying on prior experience with the client, the senior-in-charge disregarded Kenny’s comments and nothing further was done about the exceptions.

Subsequently, it was learned that one of the client’s purchasing agents and an accounting clerk were engaged in a fraudulent scheme whereby they diverted the receipt of materials to a public warehouse while sending the invoices to the client. When the client discovered the fraud, the conspirators had obtained approximately RM200,000; RM150,000 of which was recovered after the completion of the audit.

Required:
Discuss the legal implications and liabilities to Hamid, Krishnan & Co. as a result of the facts just described.

The accounting firm, Hamid, Kishan & Co. is potentially liable to its client because of the possible negligence of it agent. The audit senior-in-charge apparently has failed in carrying out his duties within the scope of his employment. To be successful in a legal action for negligence, there must be proven the following elements: Duty of care.

Breach of the duty of care.
Reliance.
Financial loss.
The exceptions in the purchase and disbursements transactions have been brought to his attention, but he did not investigate further. The senior-in-charge is governed by the usual professional standards in auditing, that is, he should perform his duties according to the requirements of the prevailing standards. When the exceptions constituted six percent of the vouchers payable examined, it is questionable whether he has conducted the audit properly and obtained the necessary audit evidence. The main issue is whether the duty of reasonable care was breached when the senior-in-charge failed to probe further the twelve disbursements without receiving reports. On the question of causation, the plaintiff would have to substantiate whether further actions by the senior-in-charge would have disclosed the fraud.

If the plaintiff can establish both the lack of due care and the causation relationship, recovery for negligence will be available. If there were a finding of negligence, liability would be limited to those losses that would have been avoided if reasonable care has been exercised by the senior-in-charge. 2. Your firm has recently been appointed as auditors of Bina Industries Bhd. Bina is a company which is listed on Bursa Malaysia. The company has been fairly profitable and its shares are traded actively on the stock exchange. You understand that for audit of listed entities, there are certain “whistle blowing” duties under the Securities Industries Act (SIA).

Required:
a. Describe the “whistle blowing” duties of auditors under the SIA.

“Whistle blowing” duties of auditors for listed corporations under the Securities industry Act 1983 (the Act): If an auditor, in the course of the performance of his duties as an auditor of a listed corporation, is of the professional opinion that there has been a breach or non-performance of any requirement or provision of the securities laws, a breach of any of the rules of the stock exchange or any matter which may adversely affect to a material extent, the financial position of the listed corporation, the auditor shall immediately submit a written report on the matter: in the case of a breach or non-performance of any requirement or provision of the securities laws, to the Commission; in the case of a breach or non-performance of any of the rules of a stock exchange, to the relevant stock exchange and the Commission; or in any other case which adversely affects to a material extent the financial position of the listed corporation, to the relevant stock exchange and the Commission.

b. What is the extent of protection accorded to the auditor under this section of SIA?

Protection accorded under the Act:
According to section 99E(2) of the Act, no auditor shall be liable to be sued in any court for any report submitted by him in good faith and in the intended performance of any duty imposed on the auditor under this section.

c. For the audit of listed entities, the Securities Commission may require the auditors to perform additional work in respect of the audit. Describe the additional work.

Additional work required by the Securities Commission, at any time during or after an audit: (1) submit such additional information in relation to his audit as the Commission may specify; (2) enlarge or extend the scope of his audit of the business and affairs of the listed corporation in such manner or to such extent as the Commission may specify (3) carry out any specific examination or establish any procedure in any particular case; (4) submit a report on any matter referred to in (1) to (3) above; or (5) submit an interim report on any matter referred to in (1) to (4) above.

The Commission may specify the time within which any of such requirements shall be complied with by the auditor and may specify the remuneration which the listed corporation shall pay to the auditor in respect thereof. 3. RS Bhd went into receivership in 2005, after incurring a deficiency in shareholders’ funds of over RM50 million. The deficit is due to trading losses in the past 5 years and the writing off in 2003 of some non-existent investments and receivable. The liquidators of RS Bhd are now suing the former auditor of the company for breach of contract and negligence. The auditors conceded that they had not carried out adequate procedures to verify the investments and receivables and had relied mainly on the chief executive’s written representations and assurance. However, the auditor claimed that they are not liable for the loss because the loss was not caused by their negligence.

Required:
How can the liquidators of RS Bhd satisfy the causation issue and establish that the auditor’s negligence has resulted in the loss of the company? Are they likely to succeed?

To establish that the auditors’ negligence has caused the loss of the company, liquidators of Bhd can claim that if the auditor had performed their work with due care, the company would have caused a receiver to be appointed earlier, instead of carrying on the business until 1991. It can claim that the overstatement in investments and receivables had presented a very misleading picture of the true financial position of the company. If the company has appointed a receiver when the non-existence of the assets were discovered, the company would have avoided the subsequent trading losses and the increase in the deficiency in the shareholders’ funds. This is the basis of claim brought by the plaintiffs in the case of Cambridge Credit Corporation Limited v Hutcheson (Australia, 9 ACLR 545)

4. Wan & Co. is the auditor of Jung Sdn. Bhd, a company that trades in cosmetic and health care products. Upon completion of the audit, the auditors supplied Jung with 20 copies of the audited financial statements. The audit firm knew in a general way that Jung wanted that number of copies of the auditor’s report to furnish to banks and other potential lenders. The financial statements in question were misstated by approximately RM500,000. Instead of having a net worth of RM400,000, the company was insolvent. The management of Jung had falsified the books to avoid bankruptcy. The assets had been overstated by RM400,000 of fictitious investments and RM100,000 of non-existing inventory. The audit failed to detect these fraudulent entries. Edison, a major supplier, relied on the audited accounts and extended a loan of RM200,000 to Jung Sdn Bhd. he seeks to recover his loss from Wan & Co.

Required:
Will Edison be able to recover his loss from Wan & Co.? Discuss.

To recover his loss from Wan & Co. in a case of negligence, Edison has to establish the four elements of negligence:
1. The auditors owed him a duty of care.
2. The auditors breached the duty of care.
3. Edison suffered financial loss.
4. There is a causal relationship between the breach and his financial loss.

In this case, Edison is a third party user. Based on the principle of Caparo Industries, the duty of care does not extend to investors. even if the third party can establish that it has made investment decision on the strength of audited financial statements, there is no duty of care based on proximity. On the second issue, the plaintiff has to establish that the auditors have not exercised the required due care and as a result failed to detect the overstatement in the financial statements. Legal cases have held that the auditors should pay due regard to fraud in the course of an audit.

It would be easier to induce negligence if the failure to detect the fraudulent practices was caused by inadequate audit procedures The auditors’ defence would be that they had carried out their audit with due care in compliance with the required professional standards. Edison has suffered financial loss as a lender in this case since he has extended the loan and is unable to recover the loan. However, he has to establish that there is a causal relationship between the breach of duty and his loss by showing that he had relied on the negligently audited financial statements in extending his loan.