Quiz 6 :
Legal, Regulatory, and Professional Obligations of Auditors
Securities Exchange Act of 1934 (SEA): This act was created to oversee security transactions in secondary market, it make sure that there is transparency and accuracy. It also ensures that there is less fraud and manipulation in security transactions. This act approves the formation of securities exchange commission (SEC), which is the regulatory body of SEA. It helps in monitoring the financial reports that companies which are trading publicly are required to disclose Company AB and its auditors were accused of negligence and fraud. Plaintiffs file complaint against the auditors for auditing the accounts of country 'C' reverse merger companies. The case was dismissed by the court as the plaintiff was not able to adequately plead scienter under the provisions of Private Securities Litigation Reform Act (PSLRA). 1. Section 10 b and Rule 10-5 of Security Exchange Act: The section 10b when read with Rule 10-5 prohibits use of any scheme, device or article to defraud and create liability for any misstatement or omission of material fact in any public statement of a company. Any investor who takes decision on the basis of such statement and suffer loss can claim for damages from the company. Auditors cannot be always found guilty of the action taken by them. The ruling under the given case provides the plaintiffs to prove scienter against an auditor or an audit firm to make him liable under the provisions of section 10b and rule 10(b)(5) of securities exchange act. The plaintiff has to prove that the auditor's practices were so poor that it amount to 'no audit at all' and the firm ignored the signs that were very obvious that the audit firm should have known them. It can be said that the legal standards of alligations cited under this case are not lenient but also not very strict with respect to the legal liablity of the auditors. The standard requires a specific condition which can prove auditors legaly liable in this case. 2. Gross negligence is committed when the auditor voluntarily and consciously disregards the need of using reasonable care while conducting an audit. In the given case it was alleged that auditors failed to prepare the accounts of the company in accordance with professional and accounting standards. It was alleged that auditors failed in identifying the purported 'red flags' that shows that something was wrong in the business. It can be said that failure in identifying the red flags in the business are sufficient to prove that gross negligence on the part of auditor. There should be sufficient evidence to prove that auditors failed to apply due diligence in conducting a audit. Generally accepted accounting standards (GAAS) provides an auditor to perform an audit with high professional standards. It is important for auditors to identify or detect the red flags of the business to protect the business from the future loss and also protect the interest of various stake holders who rely on the financial statements audited by an auditor. 3. It can be accurately said that the auditors should be held legally liable for filing an optimistic reports of the company with securities exchange commission and at the same time filing pessimistic report with country 'C' regulating agencies. This is because a company reports cannot be overly optimistic and pessimistic at the same time. It is against the ethical code of conduct of an auditor to file different reports for the same company to different regulating authorities. This would led to misunderstanding and will jeopardize the interest of the investors and other stakeholders.
Professional who is appointed as an auditor is responsible for performing his duties by using his skills and persistence. If he fails in performing his responsibilities, then he may be held liable for it. There are several liabilities which an auditor faces which are as follows: Liability of negligence : It arises when the auditor fails to examine the book of accounts properly. Criminal liability of auditor: It arises when an auditor commit any wrongdoings during the course of audit. Liable liability of an auditor: It arises when an auditor in his audit report defame any personnel of the company. Hence, he is responsible in the ground of defamation. Company M filed a complaint against its audit firm for giving an advice that leads to loss to company M. Company M contended that it was the advice of the audit firm that makes M invest in a project which in turn was not profitable. The auditor should not be held liable for the advices given by him to corporates in the course of his profession. When the advice is given in his professional capacity and that advice causes damages to the corporate, then the auditor cannot be held liable. The auditor is not responsible for the advice given by him to his clients in professional qualification. He is only responsible for the audit function he has performed for the company. An auditor who works ethically and fulfills his legal obligation is not liable for the decisions taken by him on professional basis but if it is found that the wrong decisions are taken with deceitful intensions, then the auditor can be held legally liable. The legal and professional standards of the auditor determine code of conduct that is to be followed by an auditor. Various statute and authorities form rules and standards that are to be followed by an auditor. Whenever an auditor fails to adhere to the standards, then, he can be held liable.
Whistleblower: It refers to a person (employee) who blows a whistle regarding the unethical and illegal activities that are going on in his company in his presence. When an employee discovers any illegal or unethical activity of any officer or other employee of the company and decides to disclose these activities to public or appropriate authority, this action is termed as whistle blowing. Person H discovers few confidential information about the tax avoidance strategies of his company. He went to his supervisor and found that she too was involved in the whole arrangement. At last he decided to blow the whistle regarding these actions and with the help of a reporter who called H regarding the information that was received by him related to unethical tax transactions of company in which H was working. 1. If H's actions are evaluated on ethical perspective it can be said that H is the person of high morals and ethical conduct. The facts of the case state that H was an ethical person and professional too. As soon as he discovered the matters related to tax avoidance he made an attempt to report it. However later he discovered that his supervisor were also involved in the whole arrangement of tax avoidance. Even then he was determined to make sure that the arrangement was exposed by one way or another. Thus it can be concluded that H was an ethical person and professional. 2. If a person discovers the conventional information in place of person H and is given following three alternative: a. Meet the reporter before discussing with the firm. b. Meet the reporter after first discussing it with the firm c. Skipping a Follow up meeting He should choose the alternative number second. This is because before going directly to the reporter the person should discuss the matter with his firm he should try to find a solution out with his company. If he is unable to find any solution or way out after the discussion with the company then he should take help of the third person that is the reporter. Thus it can be said that the alterative number second is an appropriate alternative for any individual who sees himself in place of H. 3. As an individual takes the second alternative and decides to meet with the firm first then the following game plan will be developed: a. The key factors that determine the actions of an individual are honesty, morals and professional code of conduct. b. Some of the arguments that are to be countered by the individual are, that the acts of tax avoidance should not be done within the organization as the organization is not only for a single or a group of person but for the whole community, that the actions of the executives are criminal offence and can leads to severe consequences, that the fraud will not only affect the people involved but the organization as a whole and other members of the organizations. c. The parties involved and their stakes in this argument are: (i) The company: The Company's part which is at stake is its reputation, goodwill, profit and long term survival. (ii) The person H : H's code of conduct, morals and ethical values are at stake. (iii) The executive: all the executive's personal benefit, his job and reputation in the company are at stake. d. If an individual faces any such situation of dilemma he should uses following levers to convince the people who are against him: (i) Positive persuasion - the person can persuade the people against him in a positive way, like he can make them realize that the act done by them is not ethical and legal and the consequences of this will adversely affect the lives of many people. (ii) Negative persuasion- the person can persuade the people against him in a negative way, like he can threaten them of disclosing their name to the higher authorities and media if the refuse to stop such illegal action. e. It is the basic human nature that most of the people respond to negative persuasion. Thus in this case the most powerful response an individual can give to pursue the other party is negative persuasion. The person should make such response to the executives that are involved in such engagement while the meeting with such executives. 4. In the practical world there can be two outcomes of the given situation that are given below: a. The executives of the firm would realize their mistake and stop doing such acts. b. The executive of the firm would refuse to stop such acts and they would be disclosed by employees like H.