DUE CARE AND NEGLIGENCE IN AUDITING: A CASE STUDY
DUE CARE AND NEGLIGENCE IN AUDITING: A CASE STUDY
The paper is an analysis of my auditing case in one of our clients which is Kiwi Tours Ltd and my eventual litigation initiated by its parent company. Several areas to consider in reasoning why I was sued is presented such as major indicators of due care, major indicators of negligence, major issues of contributory negligence and the stance of when the New Zealand parent company is acting as third party. These aspects are important to discuss to guarantee my innocence of the incident, at worst, insignificant role or merely saving face of the managers of the parent company. Australian auditing rules from auditing institutions, auditing cases and the facts of my auditing case are used for the analysis.
Major Indicators of Due Care
In auditing, due care is the measure of diligence of an auditor where the benchmark for comparison is the diligence of a prudent and competent auditor within specific circumstances. Thus, application of due care and consequently judgment do not necessarily mean that the audit will arrive at correct conclusion. Certain circumstances may interfere in the process. In such cases, due care will not be easily undermined (e.g. degraded to negligence) due to uncontrollable factors out of the auditor's perception of due care. To resolve the complexity of due care, Aus Standards of Auditing and Assurance Standards Board (AUASB) will be used as basis of conceptualizing due care.
As I face litigation from the New Zealand parent company, there are several indicators of due care. Aus 10-206 is performed when I asked an independent expert regarding the effectiveness of the new database system as well as I underwent seminars and followed the work program of my firm. Due care is protected when I did not settle for the third party expert opinion rather also tried to evaluate the system myself. If due care is absent, I would bypass the work program because of the unwillingness to learn the new system. The testing framework is useless when I cannot understand the system.
The judgment in Esanda also supports the fact that I have no liability of due care to the third part expert in disclosing relevant facts about Kiwi because there is no real relationship. According to the decision, liability does not arise when the relationship is merely created by just knowledge of the expert's existence and support from theory (i.e. that he/ she can determine the system's effectiveness). Under Aus 206-24 or evaluating the client, I showed due care as the three-year consecutive losses of Kiwi was researched and as a result I have found information about pending loans and other financing information.
With regards to the litigation against me, my accountability is not guaranteed in Aus 202-5. This standard states that my findings and conclusion in the audit does not assure the efficiency and effectiveness of the management. Therefore, the loss of $0.40 per share accruing to the New Zealand parent company is not merited by the standard. The error in the system which was pinpointed as major source of the loss is a matter of management efficiency such as managing the database. In addition, the issue of misstated inventory at duty free stores is operational areas. On the other hand, the objective of my audit is on material respects of the financial statements. Duty free operations are only a tiny aspect of Kiwi rather it is known as touring company.
Due care is evident from the fact that I have exercised several researches, expert inquiry and diligent pursuit of the work program. These I have initiated even if I have no assistant or supervisor at my side. Giving me the opportunity to resolve the auditing work in Kiwi by myself implicitly conveyed the trust of my company to my skills and professional behavior. I can argue that I have followed the processes that I undergone since I have handled Kiwi ten years ago. The sudden understatement of its asset backing is a one-time and abrupt condition which I did not expect. Without sufficient guidance from available supervisors, I can also argue that I was all by myself that the particular matter is out of question in my head. This is true even if our parent company announced its interest of acquiring Kiwi through a generous bid. I was also not aware if the parent company had done initial assessments with the performance of the company and they are also aware my audit for the current period was not yet finished prior to their announcement of the bid.
Major Indicators of Negligence
Citing Aus 11-206, I may have not sufficiently disclosed to the third party expert that his assistance in appraising the system can impact my entire audit. In Case 3-4, only at the end of each quarter that depreciation and bonuses against inventories of Lakeside are deducted. If this is the case in Kiwi, the opinion of the expert of how effective the system is did not include the accounting or financial impact rather only organizational and management aspects. In addition, I did not disclose to the expert that it had been three years since Kiwi is experiencing short-term financial difficulties. The financial issue may have changed the evaluation of the expert toward the performance of the new system.
Although financing areas were considered under Aus 206-24, I fell short of evaluating the integrity of the Kiwi management. The three-year consecutive losses can have indication that auditing the firm can have high risks when managerial behaviors are not studied. Citing Aus 202-6, the essential suspicion against Kiwi is not used. Perhaps, my 10-year experience in auditing the firm provided room for complacency as I familiarized myself to its management and affected my awareness of such principle. Questioning about honesty is undermined. There is also eminent negligence on my part when I failed to disclose the possibility of affecting the share price of Kiwi due to its unique database system. When I was completing the audit report, I should have mentioned this issue to the New Zealand parent company as it may affect the parent's offer. Such move is required by Aus 202-7 regarding my responsibility in identifying risks in financial report.
In the Case 3-17, three risks components are required to be covered and analyze to become part of the entire audit program. I covered inherent risk detected in the financing aspect of Kiwi and control risk in the efforts against the database system. However, planned detection risk is seemingly not available. This is because, on verifying the effectiveness of the database, I only relied on the work program of my company. As a result, without updating it to the new processes of our clients or the industry, there is no chance of detecting material misstatements that penetrated the clients and our audit procedures.
Lastly, the Kingston Cotton Mill Case showed that merchandising firms have the potential to misstate the level of inventory. There is lack of due care in establishing the probable use of the new database system as a tool to overstate inventories. This is especially vital when the operational position of the client-company in Case 3-19 is not the same as in Kiwi. In addition, I was aware our client is at loss for three consecutive years that its target position in the perspective of our parent company became a lucrative parachute. It is negligent on my part not to inform the parent company when it is on the verge of constructing the plan of acquiring Kiwi.
Major Issues of Contributory Negligence
In case 3-16, it was evident that the predecessor auditing firm is in close communication with the new one. This is to assure that the new firm will have guide in assessing the client. However, such relationship is absent to the auditing company where I am employed and the New Zealand parent company. There was a BOD meeting when I was doing the audit and which I attended also but the parent company do not bother to solicit my view in their decision. They could have known that the understated share price of Kiwi is unpredictable due to adoption of new system. As inventory, operational and other financial records are being updated; the lack of knowledge of the parent about this issue established the platform to result a bidding loss.
In the case of AWA Ltd v. Daniels (1992), the auditor was held negligent from failure to audit a correct profit-loss statement misleading the company to issue dividends. However, the court decided to include the negligence of the company to implement internal control system. As in my case, our company (i.e. where the parent company owns 40%), did not also give appropriate internal control like provision for supervisor or assistants. It is evident in the case that it is subjective to my perception about the client's disposition on what to do and how to assure quality audit. I concluded that expert opinion and attending seminars are necessary to familiarize myself to the new system. I also followed the work program but doing the two main actions above proved that it was insufficient to reflect due care.
In case 3-19, contributory negligence can arise when the engagement team questioned several financial aspects and operations with the controller of the client-company. Since the controller disclosed vital information that can affect financial position and performance of its company, the engagement team can be liable for negligence without applying additional effort and due care. On the other hand, I initiated to personally attend seminars about database systems to appraise the new system with the combination of technical and financial dimensions. As the parent company did not have the same initiative especially to inquire auditors on the field, I did not expect that it would sue me for being fair. The parent company did not only have problems in internal control but did not provide individual recognition of handwork, resourcefulness and initiative.
There is this case in Queensland where an accountant falsely advised the investor to invest her money to a growing firm which subsequently went bankrupt. It is eminent in this case that the accountant misled (i.e. leading to negligence) the investor who had no prior experience to investing. But the accountant also sued the investor for contributory negligence where the court found to be invalid. In my case, the situation has indication that the parent company is not in the same position as the investor. The parent company is an entity that which operation includes investing. In addition, I did not initiate the investment climate in favor of Kiwi nor mentioned the idea to the parent company. There is also no contact between us. With comparison to the ruling of the preceding case, I have not misled the parent company as I am silent and do not have jurisdiction about its investment plans. My sole responsibility is to audit Kiwi and not determine its investment attractiveness or advice my company for that matter.
New Zealand Parent Company as Third Party
According to the decision of Caparo Industries PLC v. Dickman and Others (1990), my duty to audit Kiwi includes all the body of shareholders regardless if they are current or potential. As a result, there is duty of care for the parent company arising from my audit work not only because it plans to acquire Kiwi but also has a current 40% stake in the firm. However, the extent of duty is limited to the ongoing preparation and completion of the audited financial statements. At the time when decisions of bidding for the remaining stocks of Kiwi were promulgated, the audit is in progress. This admonition barred the existence of duty of care because the audit has yet been completed and where developments of the latter stages can significantly affect the current audit stage. Therefore, the mere knowledge of the auditor without the formal audit report cannot be applied with reliance by the parent company. Conclusion should follow after all findings have been considered. This condition will not come prior to the completion of the audit report.
There is also lack of merit to establish duty of care against me because the Esanda decision highlighted the issue real rather than theoretical relationship between me and the parent company. The ownership of Esanda as a publicly traded firm is unpredictable which is the reason why the standards apply to third party as neither potential nor current shareholders. With the new position of the parent company, the real relationship between me and the parent company has yet to be established. There is also no privity letter from the parent company that could set the relationship with the auditor. Without knowing the intention of the parent company to acquire Kiwi, the auditor cannot speak for himself. As a result, I have no chance to determine if the requests and needs of the parent company prior to the decision to purchase Kiwi’s shares require separate effort or coverable with my current standing.
I have been handing the Kiwi account for 10 years and so I was complacent that my previous performance and outputs are at an acceptable level. However, the expectation of the parent company to do an action in its favor at my cost would not constitute duty of care. This is a practical scenario with consequences that even if the privity letter is out of question can be easily observed. Informing me of the developments of the position of the third party with regards to the client is necessary due to several points. First, I am only responsible for duty of care to the date of the immediate audit report that I have been made. Therefore, financial transactions of Kiwi in the current setting that have yet to incorporate on a completed and readable report is only available. The extent of duty of care, thus, only extends on limited time horizon which is last audited financial year. Second, the strategy of the parent company is very substantial that it can reach the warranty of my audit. According to AGS 1014, auditors have only reasonable and not absolute assurance that the financial report is free of material misstatement. As a result, even if they actually ask me if there is something wrong with the offer price, I cannot address the issue on absolute terms.
In my position as auditor, I also did not get legal advice regarding the intention of the parent company. Without protection that should have been addressed from privity letter, I cannot measure how the request can be responded by me or my company. Further, I did not constraint or limit the extent of my responsibility regarding the purposes of the offer price. As auditing the financial reports are not absolutely accurate, there is a room for mistake on my part where such constraints are useful. Like any other entities either company or individual, I have the right to be protected from absolute liability against clients or my company. However, how can I measure the risk if information regarding the audit aspects that are vital to the parent company is not initially submitted?
I believe that the litigation against me is surmountable with the review of relevant auditing standards, past cases and analyzing my position in the Kiwi audit. It is found that misstatements that trigger the litigation is caused by a lot of actors in the auditing process which includes me, my auditing company, management/ directors of Kiwi and the same of the parent company. We have all contributed to the failure of the parent company to obtain its targeted gains. However, at second look, I have established the necessary evidence for due care in auditing Kiwi while the negligent issues are triggered by other actors or is far-fetched. I have been working for the same account for 10 years and I did not thought such abrupt decision from the parent company. As a result, contributory negligence should be shouldered by the parent company in its failure to initially submit a privity letter. Finally, duty of care is not attributable to parent company because its resulted to my ignorance about its intention and caused my lack of participation at the time when the offer price is established.
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