Sunday Times (Sri Lanka)

Key audit matters - liability of auditors and directors

- 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.

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.

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.

Newspapers in English

Newspapers from Sri Lanka