HA3032: Holmes Institute- Auditing Case Study Assignment

Company History

In 1968, Ray Williams and Michael Payne formed CE Health International. As a result of a merger in 1995 between CE Heath and the Swiss based insurer Winterthur Insurance Company, the company HIH Winterthur was established. In 1998 the name of the company was changed again, this time to HIH Insurance Limited. This last name change had been brought about by the withdrawal of Winterthur from the operations. Winterthur had become increasingly nervous about the operations of the company and consequently had sold its shares. HIH continued to expand its insurance ventures with the purchase of FAI Insurance, World Marine and General Insurance and Cotesworth, which had direct links with Lloyd's Insurance. However, FAI had been purchased in 1998 at a premium from Rodney Adler (Non-Executive Director of HIH) and without either board consultation or the completion of a due diligence report. Accordingly, in September 2000, HIH was forced to write off its investment in FAI for $400 million.

The insurance arenas entered into by HIH included the high-risk areas of marine, aviation, natural disasters and film financing insurance, in addition to the highly competitive workers' compensation insurance market in California. HIH experienced considerable losses due to its exposure to these high-risk areas. Such losses included:

• $100 million from film losses
• Considerable damages claims from the major hailstorm in Sydney (from the takeover of FAI)
• Large losses from the 1999 Florida typhoon
• Extensive workers' compensation claims as a result of the industry deregulation
in California. The Californian courts had altered the award scale for benefits, which resulted in a dramatic increase in the cost of claims to insurance companies such as HIH.

Board of Directors

Details regarding notable members of the Board of Directors of HIH and changes to the Board are outlined in the table below.

Background to the Company Failure

In September 1999, Rodney Adler wrote to the Chief Executive Officer, Ray Williams, criticising the direction of the company and raising concerns about the company’s financial position. More than a year later, on Tuesday, 27 February 2001, trading in HIH Insurance Limited shares was halted and ASIC commenced a formal investigation into market disclosure by HIH. Provisional liquidators were appointed to the company on March 15, after the company had flagged a provisional loss of $800 million. In May the assets of the company directors, Adler, Fedora and Williams were frozen, pending further investigation. On 21 May, the Prime Minister, Mr John Howard, announced a Royal Commission into the collapse. ASIC began its investigation into the accounting for reinsurance agreements between HIH and Hannover Re and Swiss Re, and between FAI and National Indemnity and General and Cologne Reinsurance Australasia. The investigation by ASIC has raised many questions as to the role of directors, senior management and auditors.

In the two years preceding the cessation of trading, HIH’s share price had fallen sharply. This was due to a combination of poor financial results and significant asset sales, which were intended to improve the balance sheet position, as well as fund insurance claims. It is interesting to note that during 2000 HIH had paid an amount of

$1.7 million to the auditors for auditing services, together with $1.631 million for the provision of consulting and other services.

The difficulties experienced by HIH were due in part to its policy in regard to prudential margins. The premiums received by insurance companies are invested for long periods of time in anticipation of future claims, and companies (including HIH until 1997) traditionally maintain a prudential margin out of these funds. A prudential

margin means that a proportion of funds received by the company is maintained as a buffer in the event of unpredictable claims, such as those arising out of natural disasters such as earthquakes or floods. Some companies have margins such that there is an 80–90 per cent chance of covering claims. HIH discontinued this practice in

1997, choosing instead to adopt a reinsurance process.

The Aftermath of the Collapse

In September 2001 the independent Royal Commission commenced investigations into the collapse of HIH. The results were published in April 2003. The Commissioner concluded that “the primary reason for the collapse of HIH was the failure to provide properly for future claims. This failure was essentially due to mismanagement and an inadequate response to pressures emerging in insurance markets internationally.” The Commissioner also concluded that “the Australian Prudential Regulation Authority (APRA) did not cause the collapse of HIH.” However, new legislation for general insurers was enacted in September 2001 and new prudential standards were issued in February 2002 (applicable from 1 July 2002).

In addition to the Royal Commission, was the preparation of the Ramsay Report whose purpose was to review existing requirements for the independence of auditors and to make appropriate recommendations for changes to those requirements. The Ramsay Report was released in September 2002, prior to the findings of the Royal Commission. The Corporate Law and Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 (CLERP 9 ACT) was passed in June 2004. The recommendations of the Ramsay Report and the Royal Commission are generally consistent with the CLERP 9 proposals with respect to audit reform. (See Text Pages 105-109)

For Arthur Andersen the situation deteriorated with the subsequent collapse of Enron in January 2002. In June the firm was found guilty of obstructing justice for the destruction of work papers. In May 2003 Andersen Australia was integrated into the partners and staff of Ernst and Young.

The result has been a major review of the auditing profession.

Appendix:

Australian Securities and Investments Commission (ASIC)

Media and information releases

05-94 Ray Williams sentenced to four-and-a-half years' jail

Friday 15 April 2005

Mr Jeffrey Lucy, Chairman of the Australian Securities and Investments Commission (ASIC), today announced that Mr Ray Williams, the former Chief Executive Officer of HIH Insurance Limited (HIH), has been sentenced to four-and-a-half years' jail with a non-parole period of two years and nine months.

Mr Williams was today convicted and sentenced on three criminal charges arising from his management of the HIH group of companies in the three-year period 1998 to 2000.

'ASIC welcomes the strong message that today's sentencing sends to corporate Australia', Mr Lucy said.

'ASIC, the courts and the community will not tolerate company directors who do not act honestly and in the best interests of shareholders', he said.

Mr Williams was sentenced in relation to offences concerning three substantial transactions, which significantly distorted the true financial position of HIH. These matters involved hundreds of millions of dollars and Mr Williams' criminal conduct occurred over an extensive period.

Mr William's sentencing today on the three criminal charges follows ASIC's successful civil penalty proceedings (commenced in 2001) that resulted in him being:

• banned from acting as a director of any company for 10 years
• ordered to pay compensation jointly with Mr Rodney Adler and Adler
Corporation Pty Limited of approximately $7 million, and
• ordered to pay a pecuniary penalty of $250,000.

'Today's sentencing brings to a close ASIC's proceedings against Mr Williams concerning the collapse of HIH', Mr Lucy said.

ASIC's investigation into the matters surrounding the collapse of the HIH Insurance group of companies is continuing.

Background:

Mr Williams was sentenced after pleading guilty on 15 December 2004 to three criminal charges:

• that he was reckless and failed to properly exercise his powers and discharge his duties for a proper purpose as a director of HIH Insurance Limited when, on 19 October 2000, he signed a letter that was misleading
• that he authorised the issue of a prospectus by HIH on 26 October 1998 that contained a material omission
• that he made or authorised a statement in the 1998-99 Annual Report, which he knew to be misleading, that overstated the operating profit before abnormal items and income tax by $92.4 million.

ASIC's HIH investigation has already led to criminal prosecutions of 9 former senior executives, including directors, of FAI, HIH and associated entities on 31 Corporations and Crimes Act charges. These criminal prosecutions include:

• On 23 December 2003, Mr William Howard, a former General Manager of HIH Insurance Limited, was sentenced to three years’ imprisonment, fully suspended on the basis of on-going assistance to the HIH investigation. Mr

  Howard had pleaded guilty to two counts of criminal misconduct, namely that he dishonestly received from Mr Brad Cooper approximately $124,000 in return for facilitating payments by HIH directly or indirectly in favour of Mr

  Cooper. Mr Howard also admitted facilitating a payment of $737,000 to a company associated with Mr Cooper knowing that the payment obligation had already been discharged.

• On 22 October 2004, Mr Bradley Cooper was committed for trial on six charges of corruptly giving a cash benefit to influence an agent of HIH Insurance Limited, namely Mr Howard, and seven charges of publishing a false or misleading statement with intent to obtain financial advantage. The trial is set down to commence on 1 August 2005.
• On 20 April 2004, Mr Charles Abbott, the former Deputy Chairman of HIH Insurance Limited, was charged with dishonestly using his position as a company director. The committal hearing is set down to commence on 30 May

  2005.

• On 19 July 2004, Mr Timothy Maxwell Mainprize was committed for trial on charges of failing to act honestly in the exercise of his powers and discharge of his duties as an officer of FAI General Insurance Company Limited. He was also committed on one count of providing false and misleading information. His trial is set down to commence on 5 September 2005.
• On 19 July 2004, Mr Daniel Wilkie was committed for trial on charges of failing to act honestly in the exercise of his powers and discharge of his duties as an officer of FAI General Insurance Company Limited. He was also

  committed on one count of providing false and misleading information. His trial is set down to commence on 5 September 2005.

• On 19 July 2004, Mr Stephen Burroughs was committed for trial on charges of failing to act honestly in the exercise of his powers and discharge of his duties as an officer of FAI General Insurance Company Limited.
• On 16 February 2005, Mr Rodney Adler pleaded guilty to four charges, two of disseminating false information that was likely to induce people to buy HIH shares, one of making and publishing false statements and one of being

  intentionally dishonest and failing to discharge his duties in good faith. Mr Adler was sentenced on 14 April 2005 to four-and-half years' jail with a non-parole period of two-and-a-half years.

• On 24 March 2005 Mr Terry Cassidy pleaded guilty to two charges of recklessly making false statements and one charge of recklessly failing to discharge his duties as a director for a proper purpose. There will be a

  sentencing hearing commencing on 19 April 2005.

Question 1— Legal Liability

Sydney solicitor Bruce Dennis will be coordinating a class action for some 600 HIH shareholders against the auditors — Andersen’s (as the firm is now known). In addition, HIH's liquidator, Tony McGrath of KPMG is also likely to seek to recover funds for HIH creditors.

1. Identify and discuss in detail THREE (3) relevant legal concepts which are related to the collapse of HIH. In your answer, explain why these principles are relevant.
2. What conditions need to exist for a negligence action to be upheld?
.

Question 2 — Ethics

The HIH board of directors includes three former partners of the audit firm Arthur Andersen. In the past decade, Andersen’s has earned more than $8 million from auditing HIH books and $7 million for other services.

1. Why would HIH have wanted to hire prior members of its external audit team? –(2 marks).
2. What are the advantages of having the same firm provide both the auditing and consulting services? – (3 marks).
3. Indicate whether these circumstances represent a violation of ethical standards and give reasons for your answer – (5 marks).
4. Outline the primary recommendations for audit reform proposed by the introduction of CLERP 9. What impacts do you feel these changes will have on the practice of auditing? – (5 marks).

Question 1

1. Legal concepts

2. • Fraud Risk

   Fraud refers to the different ways through which human shrewdness can come up with, and which is applied by one to take advantage over another person by erroneous suggestions and suppression of the reality. It entails all the tricks, dissembling or cunning, and any unfair means through which another is deceived (Ghandar, 2014). For one to prove fraud, few elements are put into consideration, they include; a material bogus statement that has been made up with the intent to cheat. Another element that should be considered is the victim reliance that includes the shareholders’ testimony that they would not spend their money on that particular company if they had known its real financial situation. The final element that should be thought-out is the damages that are usually in terms of cash.

   Under the governorship of MR Ray Williams as the CEO and other senior executives, HIH insurance had allowed the provision of information that presented false statements about the financial position of the subject company. As a result, various investors made decisions to part with their money due to the prior knowledge that the subject company was doing well financially. The directors’ intent was to fraud the investors circumstantially by authorizing a statement in the Annual Report that had overstated the misleading working profit. HIH Insurance was experiencing high losses due to the workers’ compensation and other damages claims that had been caused by natural disasters, and this resulted in the drastic falling of its share price.

   From these findings, it is the auditor’s obligation to ensure that various fraud risks are identified, audit procedures and appropriate evidence are performed to address the liabilities and that action is taken in situations where actual fraud is detected. HIH insurance lacked professional skepticism that is necessary for addressing fraud risks. It employed a risk assessment mechanism that was concerned with the internal operations. However, Andersen had policies that ensured that any reports are subjected to rigorous review and also relied on other monthly reports that provided scant details as to the subject company’s assumptions and methodology.

   • Aggressive Accounting Practices

   The Royal Commission found that HIH Insurance did not deal with some accounting anomalies deferred acquisition costs, accounting for the future income-tax benefits, deferred information technology goodwill and costs. The accounting standard demands that any company that incurs a tax loss is subject to doubts about its ability to gain future income-tax benefits in the following periods. Some of Andersen’s partners believed that HIH would be profitable in the future and, therefore, decided to invest in it (Allan, 2006). However, the auditor had failed to

   acquire proper evidence and therefore did not issue a qualified opinion.

   Similarly, Andersen did not try to recover the deferred acquisition costs and relied on the historical profitability of HIH and therefore, the evidence was inefficient. It is important to ensure the acquisition costs incurred are capable regarding reliable measurement rather than just giving rise to premium revenues or before being recognized as assets. Also, Andersen lacked efficient, appropriate evidence regarding the specific accounting standards that are concerned with the deferred IT costs. As a result, the economic benefits of HIH were neither reliably measurable nor probable.

   In addition, the accounting for goodwill done by Andersen was highly questionable. As a result, as from 2000, goodwill kept on staggering a huge percent of the company’s shareholders funds. From these findings, it is important to ensure that financial reports entail the assessment of an item’s capability to continue operating; fairness and the truth of the assessment plays a significant role in the audit function.

   • Independence

   Andersen’s independence was highly questionable because he had appointed former partners of the company to be on the HIH board. These close personal relationships made it possible for him to pressure the appointed individuals and ensure that profits are maximized through non-audit services (Allan, 2006). Also, an audit engagement partner was once replaced after meeting with the non-executive directors without the consent of the senior management. From these findings, it is evident that it is important to ensure completeness to ensure that the risk of leaving something out of financial statement has been addressed (Ghandar, 2014). It is also essential to ensure documentation of audit procedures, and this will be of benefit if a new auditor with no knowledge of the firm will have information on what has been previously done.

3. Negligence

Negligence refers to the act of failing to perform an act that any other prudent individual would exercise in similar circumstances. It is any harm that is caused by a person due to carelessness. For one to prove that an individual was negligent, one has to present the damages, for example, loss, to hold the defendant liable. Another element that should be considered while dealing with negligence is the breach of duty.

In this instance, the CEO and the senior managers of HIH insurance did breach their duty in that they failed to exercise their powers and discharge of their duties as the employees of the subject companies and the associate firms.

Question 2

1. Companies mostly use the same auditing firms for a long time. This leads to cozy and friendly relationships between auditor and auditee. The auditor due to being used to the client charge huge amounts of fees and the work done is not worth the charges. The auditor maintains his quality of work each and every time they offer the services. The auditing firm can easily be biased if their ethics is not well governed. Bias is common where information can be interpreted in different ways. Auditors know that they are hired and fired by the companies they audit especially if they deliver unfavorable audits. Many firms also seek approval from the auditing firm and like it when their biased judgment is approved by the auditing firm. Due to being familiar, auditors unconsciously lean

   towards approving dubious accounting, and their ties deepen as their biases grow stronger towards their client.

2. Auditors understand the business of their client. When they offer consultancy, they help the business overcome intractable internal issues in areas on human resource, tax, and management.

   The auditing firm provides a holistic view of the business. They focus on particular issues such as organizational change or transactions like acquisitions and mergers as the audit firm is aware of the company financial situation.

   The cost of auditing and consulting is usually cheaper when handled by the same company. The auditing firm has considerable knowledge about the client being audited, the industry in which it operates and its personnel and systems. The auditing firm does not need to spend time and cost for familiarization effort. The service provider has sufficient experience in dealing with problems unique to the client’s industry and can come up with the industry’s best practices to benefit the clients systems and operations.

3. These circumstances represent a violation of the ethical standards. There is a limitation on what services an auditing firm can offer especially where the potential for conflict of interest arises.

The quality of audit is normally questioned when a company fails. The auditors are accused of allowing inappropriate accounting treatment due to their independence being compromised. The compromise rises from the familiarity threat or over-reliance on the income generated from the client.

The Institute of ethical code forbids auditors from providing non-audit service to the audit clients if it may result in the threat to independence that is not well safeguarded. In such conditions, the auditor may not provide non- audits services or resign as the auditor. Under the arrangement of Combined Code of corporate governance, the Audit committee which represents the stakeholders oversees the relationship with the auditors and keeps the structure and extent of the consultations under review. The objectivity and independence of the auditors should not be compromised as per the audit committee. The auditors must approve that in their professional judgment, the organization is independent, and the objectivity of the auditors and audit staff is not compromised. The auditors should put it in writing to the audit committee all relationship that may be viewed to breach the independence and objectivity of the auditing firm. The distinction between the values of income from various sources is artificial. The ethical code specifies that audit appointment not to be accepted if the client gives an unduly large proportion of firms gross practice income. This means that auditors of particular companies are within this limit.

The stakeholders can assess the extent of consultations provided by the auditors

4. The objective of the reform incorporated measures to improve the credibility and reliability of financial statements through auditor’s independence. The reforms would also improve enforcement arrangement, allocate and manage risks (Houghton, Kend & Jubb, 2013). The reforms would be also better enforcement mechanism for continuous disclosure and provide particular duty on experts to manage conflicts of interest