Professional skepticism vital to independence of jury belief
"There are no accounting issues, no trading issues, no reserve issues, no previously unknown problem issues." - Kenneth Lay, Aug. 20, 2001 (Note: Enron filed for bankruptcy on Dec. 2, 2001.)
Remember the scene in the 1996 movie “A Time to Kill” where Matthew McConaughey makes his closing jury argument?
Close your eyes for a moment, and imagine Ken Lay's quote on a big white poster board, prominently displayed before a jury. Imagine it placed adjacent to large blowups of audit work papers addressing accounting, trading and reserve verifications.
Imagine a deep, booming voice incredulously asking the defendant, “And just what exactly did you do to verify that what Mr. Lay told you was true?”
Now put yourself in the scene. Imagine that the blow ups are taken from your audit work papers, that you are on trial, and that your defense counsel is trying to convince a jury that you are not responsible for damages caused by the CFO of a now-bankrupt former audit client that overstated assets or understated liabilities.
Now imagine that you audited the company for in question for 20 years and never had cause to question management's integrity or representations.
Except of course you did. That’s the problem.
Every year, for 20 years, you had an obligation to obtain sufficient, competent evidential matter to provide reasonable assurance that management’s financial statement assertions were free of material misstatement. You also had an obligation to remain independent.
While regulatory bodies evaluate the technical nuances of independence of fact and appearance, at trial, independence of jury belief is what matters.
While conceptually similar to independence of appearance, independence of jury belief is the jury perception of your professional skepticism that ultimately arises from the clash of witnesses, documents and attorneys in the crucible of litigation.
Convincing a jury that you failed to exercise sufficient professional skepticism is an important first step in convincing them that you should be held responsible for damages arising from the fraud. Once your professional skepticism is successfully placed in question, it becomes much easier to convince the jury to resolve complicated, conflicting facts and professional standards issues against you.
As discovered by Andy Accountant in the battle for independence of jury belief, factors you may have thought mitigated the risk of the engagement, such as your extensive knowledge of the client and how well you knew senior management, can be used by an experienced attorney to convincingly question your professional skepticism.
Andy audited the financial statements of XYZ Company. While XYZ had modest profit margins and substantial credit facilities which it fully utilized, the company had been in operation for over 30 years, and Andy had worked with its senior management for 20 of them. He was, therefore, quite surprised when XYZ unexpectedly sought bankruptcy protection and the company’s lender (Lender) filed a lawsuit against him, seeking damages arising from his failure to detect an alleged fraudulent overstatement of XYZ’s assets.
Because there were no glaring audit deficiencies, Lender’s counsel built his case on the theory that Andy had become complacent and overly trusting of management.
He argued that Andy’s extensive knowledge of XYZ’s financial operations should have made him suspicious of changes in the company’s historical performance and that the fraud would have been detected if he had performed additional testing in these areas instead of accepting management’s explanations for the variations. Lender’s counsel pointed out that Andy’s audit approach and procedures showed little, if any, change over the years, and that the fraud had exploited this fact.
He also pointed to the fact that Andy’s work papers referenced management representations without including any supporting evidential matter and included factual errors, missing signoffs and incorrectly completed check lists.
Finally, Lender’s counsel pointed to the long, profitable relationship between Andy and XYZ and his close relationship with XYZ’s management and argued that the audit defects were evidence that Andy had become complacent and overly reliant and accepting of management representations.
So, does this mean that long-term audit engagements give rise to valid independence concerns? No.
Does it mean that minor defects in audit work papers prove that the audit as a whole did not comply with professional standards? No.
Does it mean that auditors have an obligation to verify all management representations or materially change their audit approach and procedures every year? Absolutely not.
Although this case was resolved for a nominal amount as a result of strong legal defenses, and there were compelling and likely meritorious responses to the alleged professional standards violations, it still illustrates how a few small changes can substantially mitigate the litigation risk of an audit claim.
While there is much to be said for long-term audit engagements, why not take a look at few of them this year and ask yourself what you could do to improve your prospects of winning the battle for independence of jury belief if a claim were asserted.
Why not make a few changes to your audit approach or procedures or have another partner perform a cold review this year?
Why not do something that improves your prospects for detecting management fraud and demonstrates your professional skepticism even if it is not mandated by professional standards
The additional time it would have taken Andy to address all the alleged audit errors and defects is nominal compared with the total time invested in the audit, but it would have paid huge dividends if it had been necessary to defend the audit at trial.
Claims arising out of long-term audit engagements are not uncommon, and professional standards often represent minimum requirements, not best practices.
With the continuing financial turmoil and the ongoing discussion of a possible recession, why not raise the bar a little this year?
By Kent Keeling, J.D.
Vice president, Claims
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