MUNHUMUTAPA SCHOOL OF COMMERCE

DEPARTMENT OF ACCOUNTING AND INFORMATION SYSTEMS

MASTER OF COMMERCE DEGREE IN PROFESSIONAL ACCOUNTING AND

CORPORATE GOVERNANCE/ICSA AND APPLIED ACCOUNTING

COURSE CODE : APPLIED AUDIT & ASSURANCE SERVICES

COURSE CODE : MPACC 525

GROUP ASSIGNMENT : GROUP 7

SUBMISSION DATE : 31 OCTOBER 2021

GROUP 7 MEMBERS
NUMBER NAME REG NUMBER
1 NETSAYI GWEME M210490
2 RAYMOND NZUMA M190851
3 GREGORY DIPURA M206770
4 MAFUWU NYASHADZAMWARI M210212
5 TINASHE TSVANGIRAYI M210844
6 EMMANUEL KAGOMA M200661
7 DAVID MASHINGAIDZE KAMKOYO M211219
8 IGNATIOUS NGONJE M201100
9 TAONA ZHOU M172714
10 BENJAMIN KASENGA M210713
11 VALENTINE CHIKUKWA M210235
12 NICODEMUS MUZVIDZIWA M154833
13 WEBSTER NZARA M132486
14 CHIPO MAUPA M206042
Assignment 1

Evaluate the implications of COVID-19 on external auditing. (40 marks)

The arrival of the global pandemic Coronavirus in 2019 brought a high level of risk due to
uncertainty in business. The World Heathy Organisation reported first an unknown virus in late
December 2019, and there have been developments throughout 2020 which have created great
uncertainty for the global economy (AASB-AUASB, 2020). Covid 19 has affected the role and
duties of the external audit greatly in the following ways.

The problems that risk and uncertainty (ISA 570) pose are very serious and not easily overcome
especially when the risk and uncertainty involve things that people are deeply concerned about.
This is where risk management helps choose among alternative causes of actions to reduce the
effects of risks. Risk management is “a process of understanding and managing the risks that the
entity is inevitably subject to in attempting to achieve its corporate objectives.

For management purposes, risks are usually divided into categories such as operational,
financial, legal compliance, information and personnel. One example of an integrated solution to
risk management is enterprise risk management” (CIMA, 2005). Effective risk management
involves risk assessment, risk evaluation, risk treatment and risk reporting. The focus of good
risk management is the identification and treatment of these risks in accordance with the
organization’s risk appetite. These risks need to be managed and controlled in order to prevent
vibrant organizations from catastrophic losses and help them achieve their goals and objectives

Most audit boards have highlighted areas for concern starting with IAS315 where the external
auditor has to consider the business environment in relation to risk. During audit the roles of the
external auditor have shifted considerably with areas stated to look out namely the going on
concern, accounting estimates ,subsequent events ,adjusting and non-adjusting, government
grants and other matters which are qualitative in nature of material effect to users of the financial
statements IAS520(AASB-AUASB, 2020: CA,2020: CEAOB. 2020).

According to CEAOB (2020) the nature of the audit report is modified and should contain an
emphasis of matter paragraph in compliance with ISA706. The report should comply with
IAS570 which requires having a separate section in the auditors report with a heading that
include specific reference to the uncertainty (Accountancy Europe,2020).

The implications of COVID-19 on external Auditing

Corona virus has led to global health crisis which affect the operations of economies and
corporates. Many countries introduced lockdown measures in order to reduce or to curb the
spread of virus and this have directly affected the normal company operations including
production, human resources and also the reporting of financial statements.
Implications of covid 19 on client acceptance.

One way that the pandemic has affected this phase of the audit process is by restricting the in-
person recruiting strategy that firms would usually incorporate when trying to acquire a new
client. Due to the pandemic, recruiting of clients has shifted to a more intentional strategy
compared to the old way of being able to casually meet potential clients via relationships and in-
person events.

Although this strategy has changed, it has been beneficial in maintaining relationships and
building trust between the audit team members and clients. The availability of clients has
increased slightly compared to pre-covid. There is more access to people, and more ability to
build those relationships. In regards to the evaluation process used to assess whether clients
should be accepted or current clients should be retained. New client acceptance, checks and
balances are done to make sure no management integrity issues are found. These evaluations
already happen remotely, so there has been no change in that area. There have been clients with
financial difficulties due to the pandemic but nothing that would affect increased risks in the
client acceptance process or decisions to continue serving clients.

Another impact of COVID-19 on this phase of the audit is the level of understanding needed.
One of the important general considerations when making the decision to accept or retain a new
or existing client is to have a solid understanding of the auditee’s business environment. With
COVID-19, the business environment of several companies have been unpredictable, negatively
impacted, and different from previous years.

The auditor’s understanding of the entity and its environment has likely changed from previous
periods due to the implications of COVID-19. There may be changes to the entity’s objectives,
strategy, organizational structure, governance arrangements and business model and it is
important that the auditor considers how these changes impact the audit. Management
commitment to GAAP and other relevant rules and regulations is another important
consideration for the client acceptance/retention decision process. With the COVID-19 pandemic
it is important to understand how any relevant changes in laws or regulations impact the entity
and how it operates, including extension of reporting periods in some jurisdictions. There may
also be changes to the applicable financial reporting standards in different jurisdictions that may
need to be considered.

Impact of covid 19 on preliminary engagement activities.

Risk assessment and understanding clients which are a part of the preliminary audit engagement
are two key audit takeaways that audit researchers discusses that Audit practitioners should keep
in mind as they work toward performing high quality audits as a result of COVID-19.

Performing robust risk assessment procedures and understanding the client’s business is as
important as ever ISA315. This includes understanding the impact of known and/or potential
changes due to COVID-19 and other economic challenges. Auditors should revisit their initial
assessment of risk and modify planned procedures as circumstances evolve.

Staffing level-A factor that is accounted for during the Preliminary Audit Phase is the staffing
needed for each audit engagement. Due to the pandemic, the workload for most audit
engagements may have increased and in turn affecting the number of team members needed for
an audit enguagement.

Impact of covid 19 on planning the audit.

In planning, the audit team had to take a step back and consider the risks that have been newly
introduced to the process now that both the auditors and clients are remote. For example, the
auditor should consider the changes that have occurred in their controls. When dealing with
accounts payable for instance, if prior to COVID-19 clients were cutting checks three days a
week and there were certain reviews and approvals that happened, now that fewer staff are in the
office on a regular basis, these functions might be reduced to one day a week. That being
considered, the auditor must now consider the additional risks this introduces into the process,
and how it will affect the scope and planning.

Scope, timing, nature and extent of the audits is very dependent on the type of client and the
industry in which they operate. If the client was heavily impacted by covid (e.g., a massive
restaurant chain or mask manufacturer whose revenues would be heavily impacted), then the
audit and its scoping are going to be altered. Reassessments would have had to be made to the
scope, timing and risks associated with the engagement.
One of the most important parts of developing an audit plan includes a thorough assessment of
planned risk procedures and planned responses to the risks of material misstatement. Audit
effectiveness is highly dependent upon the auditor’s ability to identify risks of material
misstatement, and to design and implement appropriate responses that adequately address those
risks. In connection with the risk assessment process conducted in every audit, circumstances
surrounding the COVID-19 pandemic need to be closely examined in almost all audit areas.

Risk assessments in the current environment are unlike any others, as clients are dealing with
significant changes to their businesses, the work environment, and the economy overall as a
result of COVID-19. Audit risk, risk of material misstatements, and detection risk are high and
practitioners need to reconsider risks throughout the audit cycle.

As a result of COVID-19, when planning the audit, communication is also very important more
than ever. Auditors should also have discussions with management and those charged with
governance about how they have assessed the impact of the pandemic on the business and
evaluate whether there are new or changed risks that could be material. Understanding how those
charged with governance are addressing the new or changed risks is essential for the auditor in
understanding where changes may be needed to the audit. Ongoing communication throughout
the audit is also essential as the entity’s circumstances may change.

Implications of covid 19 on company’s internal controls

An understanding of the entity’s system of internal controls is important to assist the auditors in
identifying possible misstatements. Internal controls may not have operated consistently
throughout the audit period because of the changed circumstances resulting from COVID-19.
(Arnold, 2020).

As mentioned in the planning phase, there have been new risks that have been introduced due to
the pandemic (e.g., fraud risk). These risks may not have been assessed as significant risks in
prior audits. If the auditor has determined that a significant risk exists, they are required to obtain
an understanding of the entity’s controls, including control activities, relevant to that risk. One of
the components of internal control that has been affected by the pandemic is the control
environment. Many organizations have had to change the way they operate and so would have
had to change their oversight processes and how controls operate. For the most part in terms of
the high level controls relating to the control environment, assessments have had to be more
deliberate. As it relates to signing of documents, there has been an increase in electronic
signatures by using an electronic signing softwares. There have been changes in the types of
approvals or the way reviews are conducted due to the new virtual environment, but overall
clients have adjusted well to working from home from a control perspective.

In relation to reliance, if the auditor intends to rely on the operating effectiveness of controls,
further insight as to the control and how it operates, as well as the auditor’s intended reliance,
may be required due to COVID-19. Further insights can be found when obtaining audit evidence
about the design and implementation of identified controls, including IT controls. However,
although this may be difficult because of a lack of access to certain information (e.g., documents
or reports) or company personnel (e.g., ability to inquire or observe the application of specific
controls), the relevant work still needs to be undertaken in an alternative way or the risk
identification or assessment should be changed accordingly. Auditors will need to consider what
evidence can be obtained remotely to determine if effectively designed controls have been placed
in operation to mitigate the applicable risks.

Overall, in terms of internal controls, being aware and having an understanding of many control
changes, as well as new and additional controls now relevant to the audit will be more important
than ever before in helping to understand whether controls are still operating as they previously
performed, whether any new risks have arisen because of the change, and how impactful these
risks are.

Other implications of covid 19 on carrying out the audit

The impact of covid 19 on external auditing has been varied between the mechanisms, practice
methods and duties of auditing in light of these adverse circumstances. On the level of
performance, technology has played an important role in preventing serious harms associated
with auditing tasks which shall be performed. For example the use of technology has contributed
to the continuation of works, jobs and tasks although various precautionary measures such as
direct contact have to be considered (Hussein, 2021).

As the covid pandemic continues, Auditors are facing new and unique challenges in performing
the audits. In response, they need to be more creative in performing audits and complying with
the International Auditing Standards as to obtain reasonable assurance that financial statements
are free from material misstatements (AICPA, 2020).

Obtaining of sufficient appropriate audit evidence – Most professional accountancy

institutions underscores that it is the auditor’s responsibility to obtain sufficient and appropriate
evidence before issuing their audit report. It is acknowledged that access and travel restrictions
as well as the limited availability of personnel due to health considerations may impair the
auditor’s ability to obtain sufficient appropriate audit evidence. For group audits, both the group
engagement partner and component auditors should adapt their audit approach to the current
circumstances.

Auditors are advised to explore alternative means, including technology, to the extent possible.
The completion of high quality audits under the current circumstances may require additional
time, which may impact reporting deadlines. As a consequence, auditors may need to postpone
the issuance of their audit report, and where this is not possible or not likely to resolve the issue,
auditors may need to modify their audit report to reflect that they have not been able to obtain the
necessary audit evidence.

Going concern – Auditors must pay close attention to the entity’s assessment regarding its
ability to continue as a going concern. Given the current circumstances, uncertainty around the
forecasts for economies worldwide as well as increased uncertainty around the outlook for many
entities may pose a challenge to the auditors’ assessment. Auditors should also consider the
impact of their evaluation of management’s assessment of the entity’s ability to continue as
going concern on the audit report and the communication with those charged with governance.
There also may be cases where an entity might need to apply liquidation based accounting.

Going concern is probably the most challenging area for both management and auditors because
of the uncertainty caused by Covid-19. It is management’s responsibility to assess whether the
going concern basis for accounting is appropriate, and for auditors to obtain sufficient
appropriate audit evidence and conclude on the appropriateness of management’s use of the
going concern basis of accounting in the preparation of the financial statements.
However, this does not necessarily mean that a material uncertainty automatically exists the
increased risk of significant doubt on an entity’s ability to continue as a going concern will rather
depend on the nature and circumstances of the entity, including the industry in which it operates.

Paragraph 18 of ISA 570 (Revised) states that based on the audit evidence obtained, the auditor
should conclude whether, in the auditor’s judgment, a material uncertainty exists related to
events or conditions that, individually or collectively, may cast significant doubt on the entity’s
ability to continue as a going concern. A material uncertainty exists when the magnitude of its
potential impact and likelihood of occurrence is such that, in the auditor’s judgment, appropriate
disclosure of the nature and implications of the uncertainty is necessary for:

(a) In the case of a fair presentation financial reporting framework, the fair presentation of the
financial statements, or

(b) In the case of a compliance framework, the financial statements not to be misleading.

In the UK as noted by the FRC’s Covid-19 Bulletin March 2020 publication12, it is expected
that given the current uncertainty and volatility that more companies and auditors may need to
consider reporting on material uncertainties. The FRC also stresses the importance that auditors
report on the available facts and circumstances and not generically report on material
uncertainties.

Some considerations for both companies and their auditors include:

• The company’s liquidity over the duration of Covid-19 and after

• Any breach of financing terms

• Deferral of financing repayments and

• The use of available government subsidies and other support

• The impact of Covid-19 in the overall operations of the company

Additionally, the IAASB’s Staff Audit Practice Alert on Going Concern in the Current Evolving
Environment – Audit Considerations for the impact of COVID-19, noted the following examples
of events and conditions that may exist as result of Covid-19:
• Loss of major market, key customer(s), revenue, labour shortages

• Significant deterioration in value of assets used to generate cash flows

• Significant deterioration in the value of current assets – inventory

• Delay in the launch of new products or services

• Foreign exchange fluctuations

• Measurements affected by increased uncertainty

• Counterparty credit risk

• The entity’s solvency

Furthermore, auditors need to take into consideration the impact of support packages, such as
grants and loans, offered by governments when evaluating management’s assessment of going
concern of an entity. Depending on the circumstances, the following are some considerations for
auditors:

• For how long the entity is likely to receive the support

• The extent of reliance on support

• The government transition plan for support packages and that impact on business

• Whether the entity has revised business plans

Auditors are also reminded that if based on their judgement, management’s use of going concern
basis of accounting in the preparation of the financial statements is inappropriate, they should
consider the implications on the auditor’s report and/or the audit opinion.

Subsequent events – For most entities the crisis emerged after the end of their financial year.
Auditors will need to assess whether the disclosures provided by the entity on the impact, both
qualitatively and quantitatively, of the Covid-19 outbreak on its activities, financial situation and
future economic performance is appropriate in view of the applicable financial reporting
framework, and may need to include a related emphasis of matter paragraph in their audit report.
Where this is not the case, auditors may need to modify their audit reports accordingly.

The Covid-19 outbreak was treated as a non-adjusting post balance sheet event by most entities
with December 2019 year-ends. ACCA’s article on the impact of Covid-19 on corporate
reporting10 states there is more doubt about whether for January or February reporting dates the
consequences of the COVID19 are adjusting or non-adjusting events. The outcome will depend
upon the particular circumstances impacting the entity, and when the major impacts occurred in
different parts of the world. For reporting dates of March and later then they generally will be
adjusting.

In countries where audits of financial statements with year-ends in 2019, auditors will need to
obtain sufficient appropriate audit evidence regarding the disclosures made by management in
accordance with the applicable financial reporting framework assuming that COVID-19 was
treated as a non-adjusting post balance sheet event. In the case of audits of financial statements
with year-ends in 2020, auditors will need to obtain sufficient appropriate audit evidence
regarding the necessary adjustments made by management in accordance with the applicable
financial reporting framework.

Whilst there is no obligation to perform any audit procedures regarding the financial report after
the date of the auditor’s report, if matters associated with the COVID-19 event became known
after the date of the auditor’s report but before the financial report is issued, there are specific
requirements auditors must perform to ensure the auditor’s report remains appropriate. If the
impact of the COVID-19 event became known after the financial report has been issued and, had
it been known at the date of the auditor’s report may have caused an amendment to the auditor’s
report, additional consideration by the auditor is required.

Reporting and Communication – Auditors are reminded to pay appropriate attention to

assessing whether the description of the entity’s financial position, the principal risks and
uncertainties that it faces and its likely future development is consistent with the knowledge they
have obtained as part of their audit work. Auditors are reminded that it is important that they
communicate timely and appropriately with the entity’s management and those charged with
governance about the impact of the Covid-19 outbreak on their audit work as well as on the
entity and its financial statements. Where appropriate, auditors may decide to include a key audit
matter in their audit report.

As per paragraph 9 of ISA 570 (Revised), the auditor should disclaim an opinion when the
auditor is unable to obtain sufficient appropriate audit evidence on which to base the opinion,
and the auditor concludes that the possible effects on the financial statements of undetected
misstatements, if any, could be both material and pervasive.

If for example, auditors are not able to obtain sufficient appropriate audit evidence regarding the
existence and condition of inventory due to the current restrictions imposed by Covid-19, then
depending on the materiality and pervasiveness of this to the financial statements as a whole,
auditors will need to decide which modification in the their opinion is more appropriate.

Conclusively the role of the external auditor has been made difficult because it’s difficult to find
sufficient audit evidence, risk has increased with restrictions where working from home poses
uncontrollable risk to business. As per advise of many boards, highlighted in the essay are the
matters which have arisen which auditors should consider to come up with expressive audit
reports. The high use of technology makes audit procedure easy as transactions easy to trace and
check during audits. The professional sceptism of the auditor is also of paramount importance
with covid 19 impacts to financial statements
Assignment 2

Auditors should accept some of the blame when a company on which they have expressed an
unmodified audit opinion subsequently fails, and they should also do more to highlight going
concern problems being faced by a company.

Required

Comment on the above assertion in view of different stakeholders who use audited financial
statements. (40 marks)

The auditor opinion is very important to many stakeholders and should clearly articulate the
matters at the heart of any financial statements audited. Over the last two decades, the auditing
profession has suffered from various scandals such as Enron and other high-profile audit scam
settlements. The involvement of PwC in the Satyam scandal has brought it to its knees in an
operational environment in India. Such is the scenario that once the auditor or firm is engaged in
the scandal, their career is literally over. Audit liability has increased many folds since the scam
of Enron.
In a South African case “Thoroughbred Breeders Association of SA vs Price Waterhouse
(1999)”, the auditors failed to detect the long outstanding cash deposits and promissory
note that had been stolen by the financial manager. The audit clerk who examined
the bank reconciliation failed to query the long outstanding cash deposit and promissory
note that was listed as an asset was not inspected. When the management detected the
fraud they sued t h e a u d i t o r s f o r b r e a c h o f c o n t r a c t . T h e c o u r t r u l e d t h a t t h e
auditors acted negligently and they had to pay damages to the company. This is an
example of a case in which the auditors would be liable for the failure of the company after the audit
work.
Responsibility for Assessment of the Entity’s Ability to Continue as a Going Concern

Management responsibility

According to ISA 570 some financial reporting frameworks contain an explicit requirement for
management to make a specific assessment of the entity’s ability to continue as a going concern,
and standards regarding matters to be considered and disclosures to be made in connection with
going concern. For example, International Accounting Standard (IAS) 1 requires management to
make an assessment of an entity’s ability to continue as a going concern. The detailed
requirements regarding management’s responsibility to assess the entity’s ability to continue as a
going concern and related financial statement disclosures may also be set out in law or
regulation.

Responsibilities of the Auditor

The auditor’s responsibilities are to obtain sufficient appropriate audit evidence regarding, and
conclude on, the appropriateness of management’s use of the going concern basis of accounting
in the preparation of the financial statements, and to conclude, based on the audit evidence
obtained, whether a material uncertainty exists about the entity’s ability to continue as a going
concern. These responsibilities exist even if the financial reporting framework used in the
preparation of the financial statements does not include an explicit requirement for management
to make a specific assessment of the entity’s ability to continue as a going concern.

However, as described in ISA 200,2 the potential effects of inherent limitations on the auditor’s
ability to detect material misstatements are greater for future events or conditions that may cause
an entity to cease to continue as a going concern. The auditor cannot predict such future events
or conditions. Accordingly, the absence of any reference to a material uncertainty about the
entity’s ability to continue as a going concern in an auditor’s report cannot be viewed as a
guarantee as to the entity’s ability to continue as a going concern. Auditors should have the
required skills to carry out their job with due care and fairly. An auditor is also expected to
complete tasks in good faith and integrity. An accountant who is negligible in their examination
of a company can face legal charges from either the company, investors, or creditors that rely on
the accountant's work. The accountant could also be responsible for the financial losses incurred
from any incorrect representation of a company's books. This possible negative scenario often
leads to accountants taking out professional liability insurance.

This forces auditors to be professionally competent and employ all the auditing and accounting
standards carefully. The auditor who performs his duties negligibly can face suit from the
company, its shareholders, or even creditors who rely on auditors’ work. The auditor can be held
responsible for financial disadvantage to the firm caused by incorrect representation of the
company’s books. This leads the auditors to take out professional liability insurance.

Stakeholders on Going Concern

While auditors are required to inquire of management, they are not explicitly required to perform
any other audit procedures to identify events or conditions beyond the required period of
assessment that may cast significant doubt on the entity’s ability to continue as a going concern,
although all evidence otherwise gathered throughout the audit must be considered. Some
stakeholders have questioned whether the auditor’s assessment should be extended to cover a
longer period, while others have highlighted that auditors are not able to predict events too far
into the future, in particular if management has no such requirement.

Implications of wrong going concern opinion to stakeholders

Auditors can be exposed to litigation from third-person parties for whom they have not
disclaimed liability. Hence, it is necessary to include a disclaimer of liability in the workings of
the audit reports. Disclaimers cannot be entirely reduced. Further, the laws do not protect from
threats from litigations under contract law

If a bank decides to lend money to a company based on the positive review of a company's
financial statements audited by an accountant and then down the line the company cannot pay
back its debt, resulting in a loss for the bank, the accountant could be held responsible. Similarly,
if investors purchase a company's stock based on the financial statements and the company
performs poorly and the stock goes down, the accountant can be held responsible for the losses.
Of course, in these scenarios, the injured party would have to prove that their decision was based
on reviewing the company's financial statements.

Auditors typically purchase professional liability insurance to protect themselves from any
monetary damage arising from such situations. This is often referred to as errors and omissions
insurance. This additional cost for the accountant can often raise the cost of the audit.

For ordinary negligence, an auditor owes a duty only to their client. An auditor’s liability for
general negligence in the conduct of an audit of its client's financial statements is confined to the
client. That being the person or business entity who contracts for or engages the audit services.
Other persons may not recover on a pure negligence theory.

There are two pieces of civil law of particular significance to the audit profession; contract law
and the law of tort. These establish the principles for auditor liability to clients and to third
parties, respectively.

Under contract law parties can seek remedy for a breach of contractual obligations. Therefore
shareholders can seek remedy from an auditor if they fail to comply with the terms of an
engagement letter. For example; an auditor could be sued by the shareholders, which was the
case in the PwC settlement to Tyco shareholders referred to above. Under the law of 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.

Case history

The application of the law of tort in the auditing profession, and the way in which auditors seek
to limit their exposure to the ensuing liabilities, has been shaped by a number of recent landmark
cases. The most notable of these are Caparo Industries Plc (Caparo) v Dickman (1990) and Royal
Bank of Scotland (RBS) vs Bannerman Johnstone MacLay (Bannerman) (2002).

In the first case Caparo pursued the firm Touche Ross (who later merged to form Deloitte &
Touche) following a series of share purchases of a company called Fidelity plc. Caparo alleges
that the purchase decisions were based upon inaccurate accounts that overvalued the company.
They also claimed that, as auditors of Fidelity, Touche Ross owed potential investors a duty of
care. The claim was unsuccessful; the House of Lords concluded that the accounts were prepared
for the existing shareholders as a class for the purposes of exercising their class rights and that
the auditor had no reasonable knowledge of the purpose that the accounts would be put to by
Caparo.

It was this case that provided the current guidance for when duty of care between an auditor and
a third party exists. Under the ruling this occurs when:

the loss suffered is a reasonably foreseeable consequence of the defendant’s conduct

there is sufficient ‘proximity’ of relationship between the defendant and the pursuer, and

it is 'fair, just and reasonable' to impose a liability on the defendant.

In the second case RBS alleged to have lost over £13m in unpaid overdraft facilities to insolvent
client APC Ltd. They claimed that Bannerman had been negligent in failing to detect a
fraudulent and material misstatement in the accounts of APC. The banking facility was provided
on the basis of receiving audited financial statements each year.

In contrast to Touche Ross, who had no knowledge of Caparo’s intention to rely upon the
audited financial statements, Bannerman, through their audit of the banking facility letter of
APC, would have been aware of RBS’s intention to use the audited accounts as a basis for
lending decisions. For this reason it was upheld that they owed RBS a duty of care. The judge in
the Bannerman case also, and crucially, concluded that the absence of any disclaimer of liability
to third parties was a significant contributing factor to the duty of care owed to them.

The main criticism of the current system is that the penalties incurred by the audit profession are
unfairly high. This arises from the civil law principle of ‘joint and several liability’ enforced in
the UK (as well as the US). This means that even if there are multiple culpable parties in a
negligence case the plaintiff may pursue any one of those parties individually for the entire
damages sought.

So for example, if a director fraudulently misstates the financial statements, the company’s
management fail to detect this because of poor controls and the auditor performs an inadequate
audit leading to the wrong audit opinion, it would be fair to say all three parties are at fault.
Shareholders seeking compensation for any consequent losses, however, could try and recover
the full loss from only one of those three parties.

Given that many of the cases arise when companies are facing financial difficulties, as with the
examples cited above, and that any individuals involved are unlikely to possess sufficient assets
to settle the liabilities, the audit firm, who may be asset rich and possess professional indemnity
insurance, is often the sole target for financial compensation.

Disclaimers of liability

One of the outcomes of the Bannerman case was the potential exposure of auditors to litigation
from third parties to whom they have not disclaimed liability. As a result it became common to
include 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 should be noted that whilst this should reduce the threat of
litigation in the UK, this protection may not extend overseas because the disclaimer is based on a
ruling from a UK court case. It also provides no protection from the threat of litigation from
clients under contract law.

There are also critics of the ‘Bannerman Paragraph,’ who believe that its presence devalues the
audit report. They argue that the disclaimer acts as a barrier to litigation, which reduces the
pressure to perform good quality audits in the first place. It is plausible that this reduces the
credibility of the audit report in the eyes of the reader.

Evaluation

Looking at the first part of the statement, this asks whether auditors should accept some of the
blame when their client firm fails. This suggests that the auditor is in some way at fault, and has
helped to contribute in some way to the failure of a business. It is the responsibility of
management to ensure proper risk assessment and risk management is conducted in a business.
Although in some jurisdictions the auditor performs an assessment of risk management
procedures, this is not the fault of the auditor if such procedures are inadequate and contribute to
the collapse of a company.
However, it is fair to say that auditors have a responsibility to gain an in-depth understanding of
their client’s business, including the environment in which it is operating. This means that the
auditor should at the very least be aware of going concern problems, and are in a position to alert
management to problems that they may have overlooked. But it remains the responsibility of
management to deal with such problems.

The second part of the statement asks whether the auditor should do more to warn stakeholders
about going concern issues. It could be argued that it is the responsibility of management to
make such warnings, and in fact, financial reporting standards require a lot of disclosure about
concentrations of risk. In particular IFRS 7 Financial Instruments Disclosures requires detailed
notes to the accounts describing and providing details on concentrations of certain risks. So, a
lack of disclosure may not be the critical issue. The problem is more likely to be that readers of
financial statements do not have the financial awareness to understand these disclosures. The
auditors cannot be blamed if users of financial statements are not sufficiently financially literate
to be able to understand such disclosures.

Auditors highlight significant going concern problems using an emphasis of matter paragraph
within the audit report. This means that problems should be clearly highlighted for users of the
accounts. Perhaps more could be done to make any such disclosures as transparent as possible,
which would aid users’ understanding of going concern problems. In addition, shareholders’
meetings could be used more often as a vehicle for the auditor to raise concerns with
shareholders. Auditors, however, may be reluctant to voice concerns in such a forum, and may
be put under pressure from management not to speak out.

The issue may be one of misunderstanding the expectation gap. The general public perceive the
role of the auditor to be much wider than just providing an opinion on the financial statements.
The expectation is that auditors provide advice on business strategy, and so should take some of
the responsibility when the business fails. This indicates that the public do not understand the
importance of the independent status of the auditor, and that the auditor must not take on the role
of management.

To conclude, it would seem unfair to make auditors take some of the blame for the failure of a
company, when it is explicitly the role of management to safeguard the company and manage its
risk exposure. However, auditors could be more proactive in highlighting going concern
problems through the various channels available to them, that is. Through highlighting matters
within the audit report, and through contact with shareholders at general meetings of the
company.

Reference

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Arel, B. 2012. The influence of judges' attitudes on liability assessments related to failed audit
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CEAOB. 2020 . CEAOB emphasises the following areas that are of high importance in view of
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Kumar R. & Sharma V, 2001. Fundamentals of Practical Auditing, Prentice Hall of India, New
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