Reforms of auditor standards

Independence of Auditors

The objective of this study is to consider the statement as follows: "Unquestionably, the HIH story is also one of auditor failure" and to research into the background of the HIH collapse in Australia insofar as it relates to the role of auditors and their liability. A report will be prepared with summaries of the most important documents concerning this issue of auditor independence after the HIH collapse, the regulatory/legislative response and the review of the legislative response.

Ray Williams founded HIH in 1968. A British company, CE Health PLC acquired HIH in 1971. Prior to the collapse, HIH was the second largest Australian insurance company covering several segments of insurance. HIH had expanded globally into both the UK and U.S. markets. On the 15th day of March 2001 HIH entered into provisional liquidation with the liquidator estimating that HIH's total loss equaled approximately $A5.3 billion resulting from valuations of assets that were over-optimistic and liability being greatly under-estimated. HIH's failure is representative of the largest Australian corporate collapse in history. It was reported that the failure of HIH could be attributed to: (1) rapid expansion; (2) business strategy; (3) unsupervised delegation of authority; (4) underpricing; (5) reserve problems; (5) false reports; (6) reckless management; (7) fraud; (8) greed; and (9) self-dealing. (Causal Actuarial Society, nd, p. 2)

PART I

I. Auditor Negligence Prior to HIH

AWA is reported to be a company in Australia that had been established for a long time and that was in the import and export of electronic equipment business. The company made a decision that is would "hedge against currency fluctuations by engaging in forward purchased of foreign currency against contracts for imported goods." (Flynt, 1997) It is reported that the dealings of Koval has resulted in the company incurring losses that were approximately $50 million and these losses were kept concealed by Koval. There were two audits conducted by Deloitte Haskins & Sells during the employment of Koval and while the defects in the internal control system of the company was noted by the auditor the failure of AWA to put adequate internal controls in place and record and account keeping controls has resulted in the losses going unnoticed. AWA is reported to have sued the auditor for negligence due to its failure to draw attention to the deficiencies and failure to qualify the audit reports. The auditor denied a breach of duty to AWA and filed a cross-claim against AWA and "inter alia, the non-executive directors for contributory negligence." (Flynt, 1997, ) The court found that the non-executive directors were "expected: to take reasonable steps to place themselves in the position to guide and monitor the management of the company; to obtain a general understanding of the business of that company and the effect that a changing economy may have on that business; and to bring an informed and independent judgment to bear on the various matters that come to the board for decision." (Flynt, 1997) The case was appealed and the joint judgment of Clarke and Sheller JJA is one that is reported to have been heavily reliant on the opinion of the Supreme Court of New Jersey in the case Francis v. United Jersey Bank as it was held that the judgment "exposed what is generally expected of directors not only in the United States but in Australia." (Flynt, 1997) The court specifically stated that the director, as a general rule "should acquire at least a rudimentary understanding of the business of the corporation. Accordingly, should become familiar with the fundamentals of the business in which the corporation is engaged ... Directors are under a continuing obligation to keep informed about the activities of the corporation ... Directorial management does not require a detailed inspection of day-to-day activities, but rather a general monitoring of corporate affairs and policies... While directors are not required to audit corporate books, they should maintain familiarity with the financial status of the corporation by a regular review of the financial statements ..." (Flynt, 1997)

II. State of Regulation of Auditors and Their Understanding of Auditor Independence Prior to HIH Collapse

The working party on the state of regulation of auditors recommends that there should be adoption of competency standards as the primary basis for the determination of whether the individual has enough practical experience in company auditing techniques for them to be registered as a company auditor. The working party is reported to have additionally come to the conclusion that "an hours-based regime should continue to be used pending the introduction of competency standards by the authorized accounting bodies." (Report of a Working Party of the Ministerial Council for Corporations, 1997) In addition, the following recommendations were made concerning the level of practice needed by the auditor for registration: (1) Where an authorized accounting body has in place a competency standard in auditing that has been approved by the ASC, an applicant must satisfy the audit component of the competency standard in order to be registered; (2) The ASC must be satisfied about the appropriateness and workability of the audit component of an authorized accounting body's competency standard before that standard may be approved for use by the authorized accounting body as a basis for deciding whether an applicant meets the practical experience requirements for registration as a company auditor; (3) Where an authorized accounting body does not have an approved competency standard in auditing the level of practical experience required for registration as a company auditor should be: (a) at least 2,000 hours work in auditing over five years under the supervision of an RCA; and (b) a minimum of 500 hours of this time should be spent on work that involves a senior level of responsibility for audit." (Report of a Working Party of the Ministerial Council for Corporations, 1997) The 1993 report of the MINCO Working Party recommended a review be conducted based on the needs of institutional arrangements that "ensure that only adequately qualified and experienced accountants are registered as company auditors; and auditors are genuinely independent of the companies they audit." (Report of a Working Party of the Ministerial Council for Corporations, 1997)

III. Recommendations of the MINCO Working Party

The Working Party made recommendations that include the following:

(1) The work of all RCAs should be subject to periodic quality reviews conducted by authorized accounting bodies;

(2) Subject to privacy considerations, the Law should provide that all files in respect of audits that have been undertaken by an RCA must be available for inspection as part of a quality review. (Report of a Working Party of the Ministerial Council for Corporations, 1997, p. 17)

The Working Party is also reported to have made identification of the procedures of appointment of auditors by companies and measures to ensure the independence of auditors as important issues that required consideration. (1997, paraphrased) It was noted by the Working Party that auditor independence cannot be clearly defined as it is a "state of mind and that no specific restrictions or requirements can achieve independence." (Report of a Working Party of the Ministerial Council for Corporations, 1997, p. 18) However, there are some specifications noted that contribute toward this independence and as well toward the appearance of independence. There should be a level of indebtedness of an auditor to a client and prohibition should be placed on the company's debt to its auditor. The Working Party also recommended a mandatory rotation of the audit partner responsible fro the audit of listed companies according to the principles stated in the Statement of Auditing Practice AUP 32 -- on Audit Independence. The Working Party additionally recommends "the Law should not place any restrictions on an auditor or his or her firm performing non-auditing services for an audit client. However in the current review of ethical requirements by the accounting bodies, it is recommended that attention be directed toward the provision of additional procedures (including allocation of responsibility for the additional services to a partner other than the external audit partner) for application in the more contentious areas of accounting services, internal audit and specific and separate internal control reviews to strengthen independence in these areas" (Report of a Working Party of the Ministerial Council for Corporations, 1997, p. 18-19) Current disclosure requirements are stated to be needing expansion and to require a breakdown of the nature of those services and to include services that are entities and whose beneficial ownership is the same substantially as the firm of the auditor. There should be a review on an annual basis of non-audit services by the audit committee for the company. The method of auditor selection should not be restricted and the company's auditor should be given notice of the meeting where issues of relevance to the audit will be discussed. The Working Party additionally recommends that a Financial Reporting Review Board be established. (Report of a Working Party of the Ministerial Council for Corporations, 1997, p. 19)

PART TWO

I. The Role of Auditors in the HIH Collapse & Other Business Collapses

Allen (1997) states that the "most striking testament to bad management at HIH was, without doubt, its chronic under-reserving" because as noted by the Royal Commission Report "the largest single item on the balance sheet of the general insurer is the provision that sets aside payment for future claims." Allen states that the HIH board depended on independent actuary reports and its auditor assessments of those reports but that the reports were never tabled at the audit committee or board meetings and there was never an actuary who was asked to be at the meetings to provide explanations for those reports or to answer any questions that might be posed. Therefore, Allen reports that "the inefficacy of the HIH board is a theme that permeates the entire Royal Commission report" which states that there was a lack in "clearly defined limits on the authority of the chief executive" resulting in "some areas of the system being out of control." (1997) In addition, the board lacked a policy that was understood well in terms of policy matters and that these only came forward "at the discretion of the chief executive" with the agenda used for the board being one that was management controlled. The CLERP Proposals for Reform states that when investors do not possess enough information concerning conflicts of interest the result can be market failure. This is because investors are not in a position to make decisions of how much weight should be given to recommendations arising from research on investing decisions. Disclosure obligations have the purpose of correct market failures resulting from information that is "incomplete or asymmetric" as well as ensuring that information that investors need to make informed decisions has been received by those investors. Ramsey (2001) eports that the Corporations Act presently contains several provisions that relate to the independence of auditors including employment relationships that are prohibited and financial relationships that are prohibited but fails to include a general statement that requires the auditor to be independent therefore the Corporations Act makes provisions that are auditor is not considered to be independent if "the auditor is not independent with respect to an audit client, if the auditor is not, or a reasonable investor with full knowledge of all relevant facts and circumstances would conclude that the auditor is not, capable of exercising objective and impartial judgment on all issues encompassed within the auditor's engagement. In determining whether an auditor is independent, all relevant circumstances should be considered, including all relationships between the auditor and the audit client." (Ramsay, 2001) reports that the auditor also needs to make a declaration on an annual basis that is addressed to the board of directors that the auditor has "maintained its independence in accordance with the Corporations Act and the rules of the professional accounting bodies'. (Ramsay, 2001, p. 7) The parameters for auditor independence in various areas including the auditor's relationship with the employer or if the employer employs relatives of the auditor. Loans, business relationships and non-audit services are noted to affect the independence of auditors. It is reported that professional ethical rules be utilized to reflect the IFAC proposals. The independent supervisory board is held as an instrument that is critical in addressing the challenge of the implementation of new auditor independence requirements in Australia. The Auditor Independence Supervisory Boiardo (AISB) will assist in ensuring confidence in the public in the independence of auditors. Included and represented in the AISB include: (1) two representatives from the professional accounting bodies including one CPA from Australia; and (2) one form the Institute of Chartered Accountants in Australia (ICAA); and (3) one representative from the Institute of Chartered Accountants in Australia; (4) one representative from the Investment and Financial Services Association; (5) one representative from the securities institute of Australia; (6) one representative from the Institute of Internal Auditors; (7) One representative from the Australian Securities and Investments Commission; (8) one representative from the Australian Stock Exchange Limited; (9) One representative from the Australian Shareholders' Association (ASA); (10) One representative from the Australian Institute of Company Directors (AICD); and (11) Three representatives of the public interest. (Ramsay, 2001) The AISB must operate an as independent body.

II. The Regulatory Legislative Response

It was reported by the Parliament of the Commonwealth of Australia (2002-2003-2004) that amendments had been made for financial reporting including the following stated amendments:

(1) A modification of the information gathering powers to be used by the Financial Reporting Council (FRC) when overseeing auditor independence requirements to allow the FRC Chairman to issue notices on behalf of the FRC;

(2) Modifications to the forms to be used by registered company auditors and authorized audit companies, including a change to the timing for lodgment of an annual statement;

(3) Refinements to auditor appointment and independence provisions to clarify the legislative intent, and operation of, those provisions;

(4) Changes to the Financial Reporting Panel's administrative and operating procedures;

(5) Changes to Chapter 2M of the Corporations Act to facilitate the introduction of international accounting standards;

(6) Modifications to the whistle blowing provisions to expand the range of people who may make protected disclosures and to provide that certain disclosures are to be treated as confidential;

(7) The inclusion of a due diligence defense for persons involved in a contravention of the continuous disclosure provisions; and (8) The introduction of a requirement for a register of information about relevant interests in listed entities.( Parliament of the Commonwealth of Australia, 2002, 2003, 2004)