The Hindu Business Line : Cautionary statements

There is a debate going on in the UK about the possible inclusion of cautionary statements in audit reports this year. The reason could be the un-quantified effects of the sub-prime crisis and a general slowdown in all aspects of business. Although the present format of audit reports is cautionary enough, one could expect specific mention of some disclaimers.

If one goes by the recent report of the Public Company Accounting Oversight Board (PCAOB) in the US against a major accounting firm (the firm) and its partner, it would be a foregone conclusion that auditors would be extra-cautious. The report is about audit of a pharma company.

A firm and its partner

The firm assigned the partner the task of serving as the engagement partner for its audit of the company’s 2003 financial statements. The Board also found that the firm assessed the engagement risk of the 2003 audit as greater than normal.

The Board found that during the audit, the partner failed to perform appropriate and adequate audit procedures related to the company’s reported revenue from sales of products for which a right of return existed, and failed to supervise others adequately to ensure the performance of such procedures.

Errors of judgment

Moreover, in evaluating the reasonableness of the company’s estimates of future returns, the partner neither performed nor ensured the performance of procedures that adequately took into account the extent to which the company had consistently and substantially underestimated its product returns.

In auditing the company’s reported revenue, the partner failed to evaluate these factors with the due care and professional scepticism required under the circumstances. He also failed to identify and appropriately address issues concerning the company’s policy of excluding certain types of returns from its estimates of future returns and the adequacy of the company’s disclosure of this accounting policy.

Certain members of the firm’s management concluded first that the partner should be removed from public company audits and ultimately that he should be asked to resign from the firm. Yet the firm continued with the partner and did not take meaningful steps to assure the quality of the audit work before issuing its audit report.

A penalty was imposed on the audit firm and the partner concerned was barred for a period of two years.

Liability?

The above decision brings back into light the discussion surrounding liability of auditors. Although the case seems to be a clear violation of recognition of accounting standards, what would happen in case the line between a prescribed accounting standard and what has been followed is very thin?

This could happen particularly with complicated accounting standards such as the one on financial instruments. In case the auditor has mentioned the treatment in the notes on accounts — which need not be what accounting legislation has prescribed — but has not qualified his report, would he still be penalised?

The profession has certainly become more riskier. Apart from attempting insurance against such claims, firms could also expect to do what the firm in question did: Implement changes to its quality control policies and procedures for identifying and addressing potential audit quality concerns regarding the performance and deployment of its audit teams and undertake certain documentation practices relating to these additional quality control policies and procedures.

(The author is a Hyderabad-based chartered accountant.)

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