Auditors Liability In Global Financial Crisis Essay

Question:

Discuss about the Auditor’s Liability in Global Financial Crisis.

Answer:

Introduction

Auditing is defined as the process of examining the books of accounts and certifying the financial statements of the entity based that examination. The audit is conducted by the members of an independent accounting body of a country (Gray and Manson, 2007). For example, the companies registered and operating in Australia are required to get their accounts audited by a practicing member of CPA Australia. The auditor owes duty to perform their work with integrity and objectivity to the owners of the company and to the public at large. In the circumstances of breach of fundamental principles of integrity and objectivity, the auditor becomes liable towards civil as well as criminal liabilities (Gray and Manson, 2007). This report is about an investigation carried out to find out the liabilities of the auditor in the cases of global financial crisis. The global financial crisis implies an economic mishap that affects all the countries around the world. The finical crisis always takes place exploiting the weaknesses in the governance and regulatory system of one country and then it becomes global financial crisis by spreading across the globe. In the context of this, the aim of this report will be to find out the liabilities of the auditors in the global financial crisis by identifying their role in the financial sector.

Common Reasons for Major Corporate Collapses and Global Financial Crisis

The common reason which has been found in all major corporate collapses is the failure of corporate governance (Clarke, Dean, and Oliver, 2003). Whether it is Enron, WorldCom, Tyco, or Lehman Brothers, the reason for failure of these big corporations was one that is weak governance system. The collapse of Lehman Brothers that occurred in the year 2008, affected the US economy badly (Panfilii, 2012). The research into the causes of failure of Lehman Brothers shows that it was failure of the governance system that laid the corporation to go into the fatal situation. The lack of good corporate governance and stringent accounting rules and regulations enabled the management to manipulate the financial statements. In the greed of jumping high in a quick time, the management overburdened the company with high debt. The financial statements were manipulated to so show the assets at values which did appear to be realizable in the normal course. The company was running its business with a very high leverage which gave rise to the risk of bankruptcy and ultimately in the year 2008 it went into liquidation (Panfilii, 2012).

It is crucial to understand that whenever the big corporations like Lehman Brother fails, the entire economy of the country is affected (Panfilii, 2012). This happens because these corporations control the resources at the large scale. All the other entities linked vertically or horizontally with the failing company also get affected. Thus, the impact of failure of a large corporation is perceived on the entire economy. The failure of Lehman Brothers in the year 2008 contributed to the financial crisis in the United Stated. Further, failure of banking and financial sector in the United States took this crisis to the larger scale and it spread to other parts of the world resulting into a global financial crisis (Panfilii, 2012).

Auditor’s Duty and Role

After getting an insight into the common reasons of corporate failures and global financial crisis, it is important to understand the role of the auditor. It is really important to understand the work of auditor, his scope, and the responsibility areas before fixing any liability on them for corporate failures, scandals and the global financial crisis. In respect of a corporation, the auditor’s duty is to issue report on the correctness or otherwise of its financial statements. In this regard, the auditor is duty bound to adhere to the legal provisions of the statue governing audit of the corporations and the requirements of the auditing standards (Knapp, 2016). As far as there is no contravention of the legal provisions and the requirements imposed by the auditing standards, the auditor is not liable to any kind of corporate failure. However, if there is clear departure on the part of the auditor from the legal provisions and or the accounting standards, the auditor would be liable for proceedings. The liability of the auditor could civil or criminal. Further, the auditor may also be liable for the damages caused to the third parties due his breach of duties (Knapp, 2016).

The cases of departing from the legal provisions of the statue and the provisions of auditing standards fall under the category of professional negligence. However, it is quite subjective to establish the fact that the auditor committed breach of duty (Plessis, McConvill, and Bagaric, 2005). This is because the auditor’s work involves subjective judgments and application of the concept of materiality. The concept of materiality entails that the auditor can restrict his examination in relation to material items only. Further, the auditor is also not liable to proceed with the predetermined mind frame to find out some fraud or scandals. The auditor is liable to proceed with due and reasonable care. Now what does this due and reasonable care implies depends upon the study of circumstances in which the auditor performed his duties. However, in most of the cases, where it is apparently clear that the auditor would have found the fraud or irregularity had he performed normal procedures, liability would arise. The auditor is in no way liable to perform like a bloodhound but it is expected that he performs like a watch dog. In the cases when the auditor fails to perform like even a watch dog, it raises questions on his competence, integrity, objectivity, and independence (Plessis, McConvill, and Bagaric, 2005).

Auditor’s Liability in Global Financial Crisis

As has been discussed in the above sections that the global financial crisis does not happen due to the failure of any one corporation, rather it is the impact of overall failure of the sector or industry (Friedman, 2011). However, the size of the corporation that has failed does matter. If the corporation is as big as Lehman Brothers, it could really hamper the sector or industry and contribute greatly to the emergence of the financial crisis like situation. However, in these situations, if the governance system and regulatory environment is good, the financial crisis could be avoided. Thus, the financial could emerge only if the governance system and regulatory environment of the country is weak. It is essential to note that the auditors play a crucial role in building and maintaining the governance system and the regulatory environment. The auditor’s owe duty to seek compliance with the rules and regulations and report the instances of non compliance to the regulatory bodies (Knapp, 2016). The failure on the part of the auditor in discharging their duties properly could lead to serious damage to the governance system and which in turn becomes the reason for financial crisis (Friedman, 2011).

Thus, it could be inferred that though the auditors may not be liable for global financial crisis directly, but their liability could be linked indirectly through corporate scandals. In this regard, it is important to analyze the cases of corporate scandals to find out the circumstances in which the auditor could be held liable for breach of duties and charged for being negligent in performing his duties. The three big corporate scandals namely Enron, WorldCom, and Lehman and Brothers are worthy to analyze in this context. In the case of Enron, three auditors from Arthur Anderson were found guilty and charged for professional negligence. The CPA licenses of these three auditors were revoked by the authorities (Edelman and Nicholson, 2008). Further, one of the auditors was also prosecuted for civil liabilities where he was found guilty and the court imposed heavy fine on him. Further, the court also found Arthur Andersen, the firm as a whole, guilty of professional misconduct. The auditors of the firm were found to be reckless in preparing audit plan and assessing the risk of fraud and misstatement appropriately while preparing audit program (Edelman and Nicholson, 2008).

The auditing standards require that the auditor consider the risk of fraud and misstatement while drawing out the audit program. In the case of Enron, the auditors did not consider the circumstances which were clearly indicating the risk of fraud or misstatement in the financial statements. Thus, it was a clear departure from the duties and the auditors were held liable for that (Edelman and Nicholson, 2008). Further, Arthur Andersen was also held liable for breach of due and professional care principles in the case of WorldCom. The auditors of WorldCom were also from Arthur and Andersen who were charged for being negligent in discharge of their duties (Lessambo, 2016). The auditors were debarred from practicing as professional accountant by the authorities. In the case of WorldCom, the company overstated its profits by capitalizing the revenue expenses. This breach of accounting principles and standards would have been caught by the auditors had they performed their duties carefully (Lessambo, 2016).

Another recent case of corporate scandal is Lehman Brothers. In this case, the company materially misrepresented the financial performance by manipulating the financial statements for several years and ultimately collapsed in the year 2008 (Futures, 2015). The auditors were brought into question later on and in the year 2015 they were held liable for breaching the principle of professional skepticism. This principle requires that the auditor should remain always alert to the events and the circumstances which provide any indication of the fraud or irregularity in financial reporting (Johnstone, Gramling, and Rittenberg, 2015). In the case of Lehman Brother, it was held that the auditors did not follow professional skepticism. The court held that had the auditors been alert, they would have encountered the mess at very early stage which might have saved the company from failing. The auditors were fined for $10 million in this case (Futures, 2015).

Therefore, it could be analyzed that the auditors can not be held liable for the global financial crisis directly and no penalty or persecution can be launched against them. However, the auditors owe duty to the individual corporations which they audit and they are responsible for any kind of default on their part in discharging audit function with reasonable and due care (Gray and Manson, 2007). The type of liabilities that the auditor can face could be civil, criminal, or third party liability. As can be observed from the discussion carried out in the above paragraphs, the auditor’s license to practice can be revoked, fine and penalty may be levied, and even prosecution can be launched for serious damages. Further, the auditors may also be liable to the third parties in certain cases if the third party has suffered due to the breach of duties by the auditor (Gray and Manson, 2007).

Conclusion

The discussion in this paper revolves around the issue of auditor’s liability in the case of global financial crisis. From the overall discussion, it could be articulated that the auditors are not directly liable for the global financial crisis because the global financial crisis is the result of many events. A single event that the auditors failed in discharging their functions appropriately could be not be the sole reason for the global financial crisis. However, the role of auditors is wide enough to help the economy and the society to build and develop, therefore, the auditors should have a sense of responsibility. They should work in the right direction to prevent accumulation of the events which could culminate into the global financial crisis.

Recommendations

The auditors owe duty to the entity and the owners of the entity, thus, they should be diligent in discharging their duties. The work performed by the auditors should help in building the nation from both economic as well social perspectives. The auditor should take responsibility to maintain and promote the integrity and objectivity. They should work independently and in an unbiased manner (Gray and Manson, 2007).

References

Clarke, F., Dean, G., and Oliver, K. 2003. Corporate Collapse: Accounting, Regulatory and Ethical Failure. Cambridge University Press.

Edelman, D. and Nicholson, A. 2008. Arthur Anderson Auditors and Enron: What happened to their Texas CPA licenses? Journal of Finance and Accountancy, pp. 1-9.

Friedman, J. 2011. What Caused the Financial Crisis. University of Pennsylvania Press.

Futures. 2015. Auditor found liable for Lehman fraud.[Online]. Available at: [Accessed on: 05 January 2017].

Gray, I. and Manson, S. 2007. The Audit Process: Principles, Practice and Cases. Cengage Learning EMEA.

Johnstone, K., Gramling, A., and Rittenberg, L.E. 2015. Auditing: A Risk Based-Approach to Conducting a Quality Audit. Cengage Learning.

Knapp, M.C. 2016. Contemporary Auditing. Cengage Learning.

Lessambo, F. 2016. The International Corporate Governance System: Audit Roles and Board Oversight. Springer.

Panfilii, A. 2012. Failure of corporate governance – intention or negligence. [Online]. Available at:

Plessis, J.D., McConvill, J., and Bagaric, M. 2005. Principles of Contemporary Corporate Governance. Cambridge University Press.

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