Litigation Risk and financial

Reporting Credibility of Auditors

By Godfrey Ngonyani

Managing Partner, Lilac Associates[CPA – PP, CISA, MBA]

ELIA Complex, M04, Junction of Zanaki/Bibi Titi, DSM

Zanzibar Beach Hotel, 27th September 2016 1

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The Enron scandal, revealed in October

2001, eventually led to the bankruptcy of

the Enron Corporation ($63.4 billion), an

American energy company based in

Houston, Texas, and the de

facto dissolution of Arthur Andersen, which

was one of the five largest audit and

accountancy partnerships in the world.

In addition to being the largest

bankruptcy reorganization in

American history at that time, Enron was

cited as the biggest audit failure!!!

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Agenda

Introduction

Type of liabilities and litigation system

facing auditors

Drivers of Auditors Litigation Risk

Financial reporting credibility

Sample Auditors’ litigation Cases

Consequences of Auditors Litigation

Managing exposure to liability

Conclusion4

Introduction An independent audit is expected to lend

credibility to financial statements.

The users of financial statements expect that

auditors will detect the material

misstatement or omissions. If the auditors fail

to do so, they will suffer from litigation and/or

(Reputation) activities when investors have

losses.

When stakeholders face financial damage

there is a probability that they will litigate the

auditor of the firm that caused the financial

damage. 5

Types of Liability

Auditors are potentially liable for both criminal and civil

offences:

The Criminal offence occur when individuals or

organisation auditors breach a government imposed law

in the countries in which they operate; in other words

criminal law governs relationships between entities and

the state;

Auditors could be prosecuted for acts such as fraud

and insider trading;

So, auditors could be prosecuted in a criminal court for

either knowingly or recklessly issuing an inappropriate

audit opinion.

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Types of liability…

CIVIL offence, in contrast, deals with disputes

between individuals and/or organisations.

CONTRACT law (breach of contractual obligations)

and the

Law of TORT. These establish the principles for

auditor liability to clients and to third parties,

respectively.

Under tort auditors can be sued for negligence if they

breach a duty of care towards a third party who consequently

suffers some form of loss [Auditors owed potential investors a

duty of care].

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Litigation Systems facing Auditors

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Litigation Systems facing Auditors

There are distinctly 2 Legal systemsaffecting the audit Profession:

liability regimes

Damage apportionment rules

Liability regime: Determine whether anauditor is held liable for damage lossesincurred by investors.

Damage apportionment rules: Determinethe share of the entire damages paid byeach of the co-defendants, given they aresolvent.

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Litigation Systems facing Auditors

Damage apportionment rules: Extent of

auditor’s legal liabilities based on 3 rules.

The joint-and-several rule: (which is still in use by the

United Kingdom, several European countries and others)

provides full insurance to the investors where the liable

auditors are responsible for the full amount of unpaid

damage losses.

Pure proportionate rule: (which is now used in Canada

and New Zealand), on the other hand, the liable auditors are

responsible for only the share of damages that the court

holds them responsible for causing..

Hybrid proportionate rule: In which the auditors are

responsible for paying up to 50% in damages over their

initially assessed share of claims.10

Drivers of Auditors’ Litigation Risk

Financial statement users face losses due to “audit

failure” and “no audit failure” in the form of decline in

share value;

The audit profession wants legal protection that

can protect the profession against litigation losses.

While financial statement users want the

possibility to recover (a part of) their losses by

litigating the audit firms and receive financial

compensation;

Litigation risk is higher when auditors provide low

quality services and when plaintiffs expect to receive

enough compensation to cover their litigation costs.11

Drivers of Auditors Litigation Risk…

Main Drivers are therefore:

Audit failure: Is the failure to discover and report

material negative facts, and the failure of financial

statements to serve as an adequate early-warning

device for the protection of investors and creditors.

When auditors provide low audit quality due to lack of

competence, independence, due care auditor fatigue,

laxity, the chance of audit failure becomes higher.

In the case of material misstatements or stakeholders

face financial losses due to audit failure, they will most

likely sue the auditor to receive a compensation…

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Drivers of Auditors Litigation Risk …

The outcome of the lawsuit will most likely be

“auditor payments” or “as out-of-court

settlements”, court imposed judgments, and

payments to avoid litigation.

In a very rare case of “audit failure” is that the

auditor won’t be involved in a lawsuit.

Plaintiffs (Shareholders) also litigate auditors to

be compensated for loss that is only business

failure driven even if there was no matter of

audit failure Because the auditors’ “deep pockets”

(Excessive fees) and fear for reputation damage.Chances that auditors will pay is very small…●

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Financial Reporting Credibility

One of the primary purposes of financial

statements is to facilitate the exchange of

capital between investors and companies.

The extent to which stakeholders and

shareholders rely on the information reported

in financial statements depends on the

credibility of those financial statements derived

from credible and independent auditor.

The ability to detect material error in the

financial statements is a function of auditor

competence.14

Financial Reporting Credibility…

Audit failure impacts reporting credibility

in the following manners:

The auditor can blunder by

misapplying or misinterpreting

accounting standards.

The auditor can commit fraud by

knowingly issuing a more favorable

audit report than is warranted.

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Financial Reporting Credibility…

The auditor can be unduly influenced

by :

Having a direct or indirect financial

interest in the client.

Having some personal relationship

with the client beyond what is

expected in a normal audit

between independent parties.

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Financial Reporting Credibility…

As a practical matter, audit quality generally

becomes an issue only for auditees facing

financial difficulties. In the litigious

environment such as in the U.S., investors

usually attempt to recover at least some of

their losses by suing the Auditor.

The higher the perceived audit quality, the

higher the credibility of the auditee's financial

statements. However, "credibility is judged by

users”.

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Financial Reporting Credibility…Example: Questions raised about Enron's

accounting during 2001-02 and the resulting

damage to the auditor's (Arthur Andersen's)

reputation resulted in a statistically significant

market decline in the stock price of

Andersen's audit clients.

The decline was more significant for clients

audited by Andersen's Houston office, i.e., the

office in charge of the failed Enron audit. The

stock price decline reflected investors'

downgrading of the perceived quality of the audits

performed by Andersen. 18

Sample Auditors’ litigation Cases

19Deci

De

Sample Auditors’ litigation Cases

Imperial Bank failure in Kenya

The Institute of Certified Public Accountants of

Kenya (ICPAK) and the Central Bank of Kenya

recently open enquiry seeking to establish what

PKF — as the external auditors at the mid-tier

bank — knew about the alleged fraud that led to

closure of the bank.

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Sample Auditors’ litigation Cases

BEAR STEARNS – Bruce Sherman, chief executive

of Private Capital Management LP and once one of

Bear Stearns’ largest investors, in September 2009

sued two Bear Stearns executives and auditor

Deloitte to recover losses from an alleged valuation

fraud. Sherman accused the company and its

auditors of overstating the value of mortgage,

asset-backed and derivative securities. The case is

Sherman v. Bear Stearns Companies Inc. et al, U.S.

District Court, Southern District of New York 2009-

cv-08161…

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Sample Auditors’ litigation Cases

LEHMAN – Then-New York Attorney General Andrew

Cuomo in December sued Ernst & Young over allegations

it helped hide Lehman Brothers’ financial problems before its

September 2008 bankruptcy. The civil fraud case accuses

Ernst of standing by while Lehman used accounting

gimmickry to mask its shaky finances. Ernst & Young

said the claims have no factual or legal basis and it intended

to defend itself in court. The case - New York v. Ernst &

Young LLP, New York County Supreme Court, No

451586/2010. Ernst filed to move the case to federal court,

[New York v. Ernst & Young LLP, U.S. District Court,

Southern District of New York, No. 11-00384].

Ernst & Young LLP paid $99 million to investors and $10

million to the New York attorney general’s office..22

Sample Auditors’ litigation Cases

13th August 2016: The largest-ever lawsuit against an

auditing firm was been filed in a Miami state court on behalf

of a trustee of Taylor, Bean & Whitaker, a defunct mortgage

underwriter, and sued PwC for a record $5.5 bn of failing to

catch a multibillion-dollar conspiracy.

According to the lawsuit, the fraud went undetected by PwC,

the independent public auditor in charge of auditing Colonial,

as a result of “gross negligence”. (PwC audited and issued

clean audit report from 2002 to 2008).

Colonial collapsed in 2009, becoming the sixth-largest US

bank failure in history.

The case has been settled out of the court●

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Consequences of Auditors’ Litigation

The increasing cost to the industry:

Higher audit fees:

More audit effort incorporates both the

use of more time, expensive staff and

an increase in audit services;

Cost for defending and settling

claims and also from spiralling

insurance premiums.

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Consequences of Auditors’ Litigation

Improved Audit Quality:

Audit Quality: From the stakeholders perspective

it is the probability that financial statements serve

as an adequate early-warning device for the

protection of investors and creditors.

Because auditors want to lower their litigation risk

they will increase the audit quality when they face

litigation risks, Improving the audit quality will result

in a decrease of litigation risk.

Auditors will stay away from clients who increase

litigation risk or that clients stay away from auditors

when they can’t afford the audit fee.

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Consequences of Auditors’ Litigation

The lack of competition in the audit market

for large (listed) entities.

Currently only the Big Four firms have

adequate insurance and asset cover to be able

to audit an extensive range of listed clients.

It may simply be too risky for smaller firms to

take on such clients. Given that settlements

against the Big Four have topped $300m, one

large negligence case could easily bankrupt a

mid-tier firm.26

Consequences of Auditors’ LitigationTightening of Rules and Regulations:

Governments, Sarbanes-Oxley Act (Sox 2002), Stock Exchange

Authorities and Professional Regulatory Bodies are enhanced rules.

Sox 2002(Corporate and Auditing Accountability and Responsibility Act“)

Top management must individually certify the accuracy of

financial information. In addition, penalties for fraudulent

financial activity are much more severe.

SOX increased the oversight role of boards of directors

and the independence of the auditors (Consulting jobs)

who review the accuracy of corporate financial

statements.

Section 404: Requires management and the

external auditor to report on the adequacy of a

internal control on financial reporting. 27

Consequences of Auditors’ Litigation

Tightening of Rules and Regulations:

NBAA

Have increase QAR to all audit firms;

Encouraging charging of “appropriate” fees;

Professional Indemnity;

Introduced severe punitive measure for those firms

who fail to conduct their work properly:

• Fines: Audit Fees or TZS 10m whichever is higher;

• Deregistering of the particular audit firm.

Only CPA should prepare org. financial statements.

DFA/CFO should individually signed the financials

statements.28

Consequences of Auditors’ LitigationTightening of Standards: IIA

CAE-CIA must develop and maintain a quality

assurance and improvement program that

covers all aspects of the internal audit (IA) activity;

The quality assurance and improvement program

must include both internal and external

assessments;Internal: Ongoing monitoring of the performance of the IA

activity and Periodic reviews performed through self-

assessment or by other persons within the organization with

sufficient knowledge of IA practices

External assessments must be conducted at least once every

five years by a qualified, external independent reviewer/ team.29

Consequences of Auditors’ Litigation

Audit firm demise:

Firms may not use audit services provided by

some auditors.

Regulators/ Court may ban audit firms, hence audit

firms demise.

Internal Auditors

Loss of Reputation – can’t deliver.

Loss of jobs

Sentenced to jails.

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Managing exposure to liability

Audit quality

The most obvious is not being negligent in the

first place - Improving audit works.

In practical terms this means rigorously applying

International Standards on Auditing and the Code

of Ethics for Professional Accountants and paying

close attention to the terms and conditions

agreed upon in the engagement letter.

With pressure to reduce audit fees, it is unlikely

that improvements in quality controls in

comparison to current levels would not happen

without investment from the audit firms…31

Managing exposure to liability

Liability Limitation Agreements

Since 2008 auditors have been permitted, under the

terms of the Companies Act (US), to use Liability

Limitation Agreements (LLAs) to reduce the threat of

litigation from clients.

LLAs are clauses built into the terms of an

engagement that impose a cap on the amount of

compensation that can be sought from the auditor.

These must be approved by shareholders annually

and be upheld by judges as ‘fair and reasonable’

when cases arise.

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Managing exposure to liability

Disclaimers of liability

Inclusion of a disclaimer of liability to third

parties in the wording of the audit report.

Disclaimers may not entirely eliminate

liability to third parties but they do reduce the

scope for courts to assume liability to them.

It is plausible that this reduces the

credibility of the audit report in the eyes of

the reader.

Strictly laws and Good corporate citizenship

Enhance laws of the land, educate and encourage

people to act ethically and with high integrity● 33

Conclusion

Litigation risk results in lower information

risk (Stakeholders are more appropriately

and timely informed). Because of this

positive effect of litigation risk, the auditors’

exposure to litigation risk drives audit quality

and improves Financial reporting credibility

of Auditors.

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Asanteni Sana

Godfrey Ngonyani – Managing Partner

www.lilac.co.tz+255 784 536 536

Elia Complex, Junction of Zanaki and Bibi

Titi Road – DSM