Key audit matters – liability of auditors and directors
View(s):By Ruwani Dharmawardana,Attorney-at-Law
The new International Standard of Auditing (ISA 701), pertaining to communicating key audit matters (KAMs) in the auditor’s report, to be effective for audits of financial statements for the period ending on or after December, 15, 2016, has brought changes to the traditional audit report written in boiler-plate language limiting to a binary pass/fail audit opinion. As per the standard, key audit matters are those matters that, in the auditor’s professional judgement, were of most significance in the audit of financial statements of the current period, selected from matters communicated with those charged with governance.
From a governance perspective the said new development is welcome though the informative value of the new standard by reducing the information asymmetry between the management and the investors will basically depend on many factors, namely, legal liability of auditors, legal rights of shareholders, existing knowledge on KAMs by other means, and the effectiveness of the audit committee, etc as otherwise the value will only be symbolic. In addition, if the majority investors consists of those who buy into businesses and not stocks they will benefit from the new standard as they monitor the company’s finances, including the balance sheet, cash flows, dividend yields and growth as opposed to merely the flavour of the season.
However, one significant message to be conveyed to the stakeholders, basically to the shareholders is that KAMs are not audit qualifications. Though the investors receive already such information as disclosures in the financial statements, separate disclosures in the auditor’s report, by way of KAMs, may more likely to change the decisions of the investors.
Responsibilities
The new standard will not impose additional significant responsibilities on directors as already such responsibilities are stipulated in the Companies Act, No. 07 of 2007, except under section 189. For example, the Companies Act imposes penalty for false statements under section 511, on “any person” who willfully makes a false or untrue statement through any document like balance sheet, profit and loss account, return, prospectus, intentionally, thereby causing a loss to the people who rely on such documents. Further, ‘any person’ who with intent to defraud or deceive a person falsifies records shall be liable under section 512 of the Companies Act (CA) 2007. In addition, section 526 of the CA empowers the court to grant relief in certain circumstances to officers and auditors act honestly and reasonably. However, there will be an additional liability on accountants serving in boards in terms of section 189, according to which a director of a company shall not act in a manner which reckless or grossly negligent and shall exercise the degree of skill and care that may reasonably be expected of a person of his knowledge and experience. Accordingly, an accountant on a board cannot be heard to say that he did not know the accounting standards and key audit matters. Under the said provision liability may extend to the other directors as well, for the adverse repercussions for not taking corrective or preventive actions, pertaining to key audit matters.
Legal liability
Another interesting area to discuss is the potential effects on auditor’s legal liability pertaining to enhanced disclosures. Liability of auditors is governed by the CA, case law, auditing standards and professional conducts and ethics. As per section 163, the auditors are liable to the shareholders. Ethical principles governing the auditor’s professional responsibilities are independence, integrity, objectivity, professional competence and due care, confidentiality, professional behaviour and technical standards. However, as Finch J.A. of the British Columbia Court of Appeal stated obiter in Kripps v. Touche Ross (1997) “While professionalstandards would normally be a persuasive guide as to what constitutes reasonable care,those standards cannot be taken to supplant or to replace the degree of care called forby law. A professional body cannot bind the rest of the community by the standard itsets for its members. Otherwise, all professionals could immunize their members from claims of negligence”. Therefore, obligations in professional handbooks are expressed not as a duty of auditors to third parties but as a duty of auditors to the profession. In Sri Lanka, the governing law of the liability of auditors is debatable: one school of thought believes in Roman Dutch Law whereas the other school of thought believes in English Law. In Sri Lanka, if the law governing the liability of an auditor in delict, is the Roman-Dutch Law, an auditor is not liable under the Roman-Dutch Law in delict for a report made negligently. Negligent statement does not cause physical injury so as to fall within the ambit of Aquilian action. However, in Prof. Priyani Soyza’a case, while the Supreme Court considered the evidence of the medical profession led to show whether Prof. Soyza had, in her conduct, conformed to the normal standards of the profession, the Court said it must make up its own mind in deciding on negligence and cannot abdicate that task to the profession. According to this case, even if negligence is established, yet auditors can escape liability if it can be shown that the loss claimed is not directly attributable to the incorrect report (causation).
Negligence
In South African Law, the determination of negligence depends on the test of the “reasonable person” whereas in English Law, the doctrine of the “duty of care” (owing a duty of care and breach of duty of care) is applied in respect of negligence. However, this is not particularly true with respect to reported South African cases that deal with auditor negligence because there is always a remark that auditors must exercise reasonable care and skill in the performance of their duties. Therefore, duty of care has found some acceptance in South African Law at least in relation to auditor negligence. David L. Carey Miller, in his article titled, “Three of a Kind? Positive Prescription in Sri Lanka, South Africa and Scotland”, discusses the special affinity exists between the laws of Scotland, Sri Lanka and South Africa. There is a long established practice of reference to South African sources based on Sri Lankan recognition of affinity with the southern hemisphere development of the Roman-Dutch law.
In the law of negligence, Lord Denning was bold and innovative, in his dissenting judgment in Candler v. Crane, Christmas & Co. in 1951 which set the ball rolling for changes. He held that the accountants owed a duty of care not only to their clients but to any third person to whom they showed the accounts and who acted on them to his detriment. Twelve years later in the great case of Hedley Byrne & Co v. Hellar & Partners Ltd, Lord Denning’s reasoning was adopted by the House of Lords and the earlier cases were overruled.
On the other hand, under the English Law of Tort, auditors are liable for negligence. There are three types of cases where an auditor undoubtedly can be liable: (i) claims in respect of specific transactions, (ii) claims in respect of failure to report internal fraud, and (iii) claims in respect of overpaid dividends. In New Zealand Court of Appeal decision in Scott Group Ltd v. McFarlane the defendant auditor was liable to third party investors who had invested in the audited client in reliance on the audited accounts prepared by the defendant, because it was “reasonably foreseeable” that investors would do so.
Rights of auditors
The writer is of the view that as the rights and duties of auditors are clearly stipulated in the CA, which is basically based on the New Zealand Companies Act, English Law should be applicable with regard to the responsibilities of auditors. Alternatively the Roman Dutch Law should be applied in a flexible manner with regard to the liabilities of auditors as in South Africa. In addition, key audit matters should not act as a warning to the financial statement users and accordingly, not as a disclaimer of the liability of auditors for identified high-risk areas.
Due to the omnipresent gaps between the liability of auditors as stipulated in the CA and accounting standards, especially new standard on key audit matters, and the traditional view of applicability of the Roman Dutch Law, according to which, auditors are not liable for negligent, the new requirement will impose additional liability only on directors.
Empirical evidence pertaining to the benefits of disclosure of KAMs is mixed. Potential benefits include enhanced transparency, reduction of information asymmetry and better navigation of financial statements. On the other hand, pertinent challenges and issues associated with the increased disclosures include weakening the overall effectiveness of the audit disclosures, over-reliance on the audit report and the perception of individual shareholders over KAMs etc. Further, the applicability of KAMs to Government owned entities (banks and insurance companies) and unlisted holding companies with listed subsidiaries is yet to be seen.