ACCA P7 Chapter 2 Professional Responsibility and Liability

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Chapter 2

Since the clarity project in 2009, all ISAs now conform to a standard format:

• Introduction
• Objectives
• Definitions
• Requirements
• Application and other explanatory information

Fraud and error

Fraud comprises both the use of deception to obtain an unjust or illegal financial advantage and intentional mis-representations affecting the financial statements by one or more individuals among management, employees or third parties.

Fraud is also 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.

Fraud risk factors are events or conditions that indicate an incentive or pressure to commit fraud or provide an opportunity to commit fraud.

Error would be unintentional mistakes in financial statements (including the omission of an amount or disclosure).

When planning the audit, auditors should assess the risk that fraud or error may cause the financial statements to contain material misstatements. Based on this risk assessment, auditors should design their procedures so that they have a reasonable expectation of detecting material misstatements arising from fraud or error.

Responsibility for the prevention and detection of fraud rests with the management and those charged with governance.

They should create a culture of ethics and honesty within the entity.

This culture should be actively reinforced by active oversight by those charged with governance by:

Considering the potential for controls to be over-ridden

Considering other inappropriate practices eg aggressive earnings management

It is more difficult to detect misstatements arising from fraud rather than from error

Fraud can involve sophisticated and well-organised schemes

• Forgery
• Deliberate failure to record transactions
• Intentional mis-representations
• Collusion – particularly at management level

The auditor’s ability to detect fraud depends on a combination of factors

• skill of the fraudster
• frequency and extent of the manipulation
• relative size of the amounts manipulated
• degree of collusion
• seniority of those involved

The auditor should enquire of management about:

Management’s assessment of the risk that the financial statements may be materially misstated due to fraud including:

• Nature
• Extent, and
• Frequency of these assessments

management’s procedures for identifying and responding to risks of fraud including:

• specific risks identified by management
• risks brought to their attention by others, and
• classes of transactions, account balances or disclosures for which a risk is likely to exist

communications by management with those charged with corporate governance concerning the processes adopted for the identification and response to risks

communications by management with employees concerning their views about business practices and ethics

discussions with the internal auditors

Procedures when there is an indication that fraud or error may exist:

When auditors become aware of information which indicates the existence of fraud or error, they should obtain an understanding of the nature of the event and the circumstances in which it has occurred. They should aim to gain an understanding of the possible effects on the financial statements.

The auditors should document their findings and communicate them to the appropriate level of management. This would usually be the board of directors or the audit committee.

Reporting to third parties

Auditors should also consider whether the matter should be reported to a proper authority in the public interest (e.g. regulatory or enforcement agencies).

If, after obtaining legal advice, the auditors conclude that the matter ought to be reported to an appropriate authority in the public interest, they should notify the directors in writing of their view and, if the entity does not report the matter or is unable to provide evidence that the matter has been reported, they should report it themselves.

Where a suspected or actual instance of fraud casts doubt on the integrity of the directors, auditors should make a report direct to the proper authority in the public interest without delay, informing the directors in advance.

The following matters should be taken into account when deciding whether disclosure is justified in the public interest:

• the extent to which the suspected or actual fraud is likely to affect members of the public
• whether the directors have rectified the matter or are taking, or are likely to take, effective corrective action.
• the extent to which non-disclosure is likely to enable the suspected or actual fraud to recur.
• the seriousness of the matter; and
• the weight of evidence and the degree of the auditor’s suspicion that there has been an instance of fraud.

Professional liability

An audit firm owes a duty of care to their client, the entity.

They may also owe a duty of care to third parties who rely upon the financial statements. In recent years the question of whether the auditor owes a duty of care to third parties has been controversial and the subject of considerable media attention.

An auditor may be liable in tort to a third party where:

• a duty of care exists (legal neighbours/proximity);
• that duty has been breached (ie auditor has been negligent)
• third party has relied on the auditor’s work
• financial loss has been suffered
• the loss suffered was caused by the third party’s reliance on the auditor’s negligent work.

The Caparo case

The key case is the Caparo Industries case. In 1987, Caparo Industries plc brought an action against two of the directors of Fidelity plc and their auditors, Touche Ross. During 1984, Caparo invested in and eventually acquired control of Fidelity plc. They alleged that the financial statements they had relied upon overstated the profits. The case went to the House of Lords where it was decided that proximity did not exist. The Lords stated that an essential element of proximity is that “the defendant knew that his statement would be communicated to the plaintiff, either as an individual or a member of an identifiable class, specifically in connection with a particular transaction or transactions of a particular kind and that the plaintiff would be very likely to rely on it for the purpose of deciding whether or not to enter upon that transaction”. The claim by Caparo Industries was rejected.

The ADT case (1996)

ADT acquired control of Britannia Securities Group who were audited by Binder Hamlyn. Before ADT made a bid, they had a meeting with one of the partners from Binder Hamlyn. At this meeting, the partner was asked if he stood by the results of the 1989 audit. After the take-over, ADT alleged that these financial statements were misstated and sued Binder Hamlyn for £65 million. They believed that the meeting between themselves and the partner created proximity. The judge agreed and Binder Hamlyn were ordered to pay the £65 million in damages together with £40 million in interest.

Limiting auditors’ liability

The auditing profession is concerned about the extent of their liability to third parties. They argue that they are unable to get sufficient insurance cover to meet the level of claims.

The following suggestions have been put forward as possible methods of reducing liability.

Incorporation

Limited Liability Partnership

Capping Liability

Incorporation would protect the partners from personal bankruptcy. However, the firm itself could be forced into liquidation. Further, there could be adverse tax implications and the firm would need to publish financial statements and be subject to an audit.

Limited Liability Partnerships (LLPs) would permit the partners to avoid personal liability for the debts of the firm. Legislation has been enacted allowing LLPs in the UK.

It has been suggested that auditors should be able to limit the amount of their liability for an individual audit. The maximum amount could be based on some multiple of the audit fee. This is currently not permitted for audit work by the Companies Act 2006 but it is permitted in other countries such as Germany.

Expectation gap

This term is used to describe the difference between the expectations of those who rely upon audit reports, concerning audit work performed, and actual work performed.

Contributing factors

The expectation gap arises due to:

lack of competence,

lack of independence, and

lack of education

The profession’s response to accusations of a lack of competence are:

rules on the issue of practicing certificates

post qualification educational requirements (CPE and CPD)

monitoring of audit activity

disciplinary procedures following investigation of apparent audit failures

It may be difficult to separate lack of competence and lack of independence. Technical competence and honesty or independence are clearly inter-related.

Misconduct

Misconduct refers to acts which are likely to bring discredit upon an ACCA member, the ACCA or the profession itself.

Convictions relating to the personal life of members and students such as obtaining money or goods by false pretences, forgery, theft and other offences involving dishonesty amount to misconduct.

The Investigations, Disciplinary and Appeals committees will decide each case on its own merits.

Penalties imposed will reflect the view which the committees take in respect of the individual offences and the seriousness of the matter.

Professional indemnity insurance (PII)

Members or firms who wish to hold an ACCA practising certificate must hold PII and fidelity guarantee insurance (FGI) in respect of all partners, directors and employees.

PII must provide cover in respect of all civil liability incurred in connection with the conduct of the firm’s business. FGI must include cover against any acts of fraud or dishonesty by any partner, director or employee in respect of money or goods held in trust by the firm.

For example, in the UK the lower limit of indemnity on PII in respect of each and every claim shall be:

21/2 times the relevant total income subject to a minimum of 100,000GBP and a maximum of 1.5 million GBP

Insider dealing

Insider dealing involves the buying or selling of shares by a person connected with a company who, when doing so, is in possession of specific information which is not generally known but which would be likely, if made public, to have a significant effect on the market price of the shares.

Clearly an auditor is in possession of such information. It would be unethical for an auditor to use that information for personal gain.

Money Laundering

A process whereby the proceeds of criminal activity are converted into assets appearing to have a legitimate origin

Usually involves 3 distinct phases

Placement of the funds into legitimate business activity

Transfer of money from business to business ( or place to place ) to conceal its original source

Integration – the money takes on the appearance of having come from a legitimate source

Proceeds of Crime Act 2002 seeks to control money laundering by the creation of 3 categories of criminal activity

Laundering ( maximum 14 years prison and / or fine )

Failure to report ( maximum 5 years prison and / or fine )

Tipping-off ( maximum 5 years prison and / or fine )

The offence of failure to report relates only to individuals acting in the course of business – for example, accountants