HA3032 AUDITING AND ASSURANCE SERVICES TRIMESTER 2, 2016 INDIVIDUAL ASSIGNMENT Assessment Value: 20% Instructions: HIH Insurance Limited: Business risk and Inherent Risk Assessment, Legal Liability, Ethics This Case is based on Chapters 1, 3-7 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. Name Position Resigned Comments Ray Williams (Founder CE Health in 1968) Deputy Chairman and Chief Executive Officer Dec, 2000 Randolf Wein (replaced Ray Williams) Deputy Chairman and Chief Executive Officer Geoffrey Cohen Chairman Former partner Arthur Andersen Rodney Adler Director Feb 26, 2001 Sold FAI to HIH in 1998 Justin Gardener Director 12 Oct, 2000 Former partner Arthur Andersen, and auditor of FAI in 1980s Dominic Fedora Finance Director 12 Oct, 2000 Former partner Arthur Andersen 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 nonparole 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 —Business Risk and Inherent Risk Assessments "It is difficult for an insurance company to go broke in the space of a year, let alone a few months" Sydney Morning Herald, May 19–20, 2001. Required: a) How would you assess the business risk of HIH Insurance Limited? The business risk of HIH are related to the global, local and the control environment factors. This could be based on the terms to understand about the insrance industry as well as how the HIH is able to fit under the SWOT analysis. The best approach is the profitability and the structure of the industry which will help in handling the insurance industry which is competitive with the increase in the compeitie price range. This results in handling the insrance in Australian industry which are relatively new dpending upon the regulation levels. The Insruance and the Superannuation commission has been the Australian body which holds the part of Australian Prudential Regulator Authority. When the company is seen close to insolvency, then there have been risks which are associated to the auditing. There have been methods to determine the insolvency where the roles are based on the auditing risks. The general agreements have been made to hold the capacity to meet the debts under which the companies fall. With the profitability and the structure, there is a need to focus on the buseinss which will have few customers to lauch the industry. This can lower the profitability of the industry. Hence, the concept of solvency is related to the capacity which meets the debt. There is a need to determine about the solvence which is based on the financial and the non financial considtions where the company is able to pay or unable to pay all the debts. b) List several inherent risk factors effecting HIH at the financial report level and whether they would have contributed to an increase or decrease in the inherent risk assessment. The risks where the company is able to handle the aduting risks factors helps in issuing an unqualified audit based on certain financial statements. These are based on holding the procedures and planning as per the risks which are: inherent risk, control risk and the detection risk. The inherent risks is the risk for the financial statement where the HIH insurance company includes the maitnance of the solvency margins, charing of the suffiencet premiums and the liquidity factor. These include the reinsuring of the different policies along with providing the file with marine insurance practices which differ greately with the profession related to insrunace. The control risks includes the material error which has not been detected by the internal control system. In HIH, there have been completeness and accuracy of the general ledger which does not perform the recoincilatins of the ledger and the bank accounts. The performance is based on the different substantive procedures which are able to place a greater reliance for the documentation process externally. The inclusion of the ledger accounts and the different bank accounts help in the valuation of the intangibles. The detection risks are mainly for the different auditing procedures based on the performance that do not easily detect the material errors or the assertions. There is a need to work on timely planning and effectively minimize the chance for not identifying the material misstatement. In HIH, the internal audit documents are not able to perform appropriate substantive procedures which will help in better performance with insuffieicnt planning and relating to the goodwill, future income tax benefits. Question 2— Legal Liability Sydney solicitor Bruce Dennis will be coordinating a class action for some 600 HIH shareholders against the auditors — Andersens (as the firm is now known). In addition, HIH's liquidator, Tony McGrath of KPMG Peat Marwick is also likely to seek to recover funds for HIH creditors. Required: a) Discuss the facts and findings of relevant court cases that Andersens should refer to in determining the likelihood of the partnership being held liable to: 1) clients 2) creditors. This related to the issuing of the unqualified auditing opinion which relates to the auditing risks which has not been managed. The auditors have a limited knowledge which does not recognize through the inherent risks with the change from the previous year. The major empaisis is based on the auditing report that indicates about the auditing with concerns over the HIH practices. They do not investigate about fully notifying for the different parties. The issues are related to the inadequate audtiro independence with the performance of the non-auditing work and the international HIH operations for the increased risks. The cases are related to the adequate auditing procedures with the planned managed auditing risks. a. For the clients, the focus has been on performance to show up the insuffieicent planning that relates to the goodwill along with the deferred acquisition costs and the income tax benefits. If the clients have been hiring the former auditors, then this will have a major impact on the indpeendece of the external auditing. The former auditors have been holding a higher partnership on the auditing team. This is holding a higher influence to the current auditors due to the authority they are in. there have been close relationship in the former and the exsiting auditors as they are able to handle the problmes with the parties and the influence they hold. b. The creditors need to focus on the minimum solvency requirement which believes that the entity can be solvent at the time of the declaration of the director. The reports are related to determine the management wwith the going concern basis. The HIH needs to focus on the cash position where the extended analysis is absed on the operational and the financial activiites. The risks were related to thepricing ability and the other positions with outstanding claims and the reserving policy to handle and work on the investment decisions. These are important for the insrance to use the risks with the risk pricing ability. The representation is based on handling the provisions where there is a need for the prudential margin. b) What conditions need to exist for a negligence action to be upheld? The negligence action of the HIH insrance related to the acceleration of the changes in the legislation. There hhave been crisis in the prices and the insrance availability. These are largely to relate to the law of negligence. The major issue related to the charges which are politicaly reinforced with the direct liability pattern of the government and re-insurere. The commence of the legislative changes are following the related escalations with the public liabilities and the medical negligence. The inadequate risks management plays important role for the operations where the investments are based on the risks investments and their guidelines. The major fact is based on the failures which provide the evidences related to the risks management that have not been shaped and performed. The directors are negligent to analyses the strategy for the investments along with appreciation of the risks which are related to the different information sources. The risk management failure has been the management style to handle the HIH down the work. The collapsing of the HIH is based on the increased compensation payment with the litigious community which has been able to extend the liability for the negligent impacts. The system has been divided under the different jurisdictions with the establishment of the liability and including the contributory negligence with the proportionate liability factors. Question 3 — Ethics The HIH board of directors includes three former partners of the audit firm Arthur Andersen. In the past decade, Andersens has earned more than $8 million from auditing HIH books and $7 million for other services. Required: a) Why would HIH have wanted to hire prior members of its external audit team? The focus has been on the insuffieicnt evidence before the releasing of the auditing erports with the adjustments that have been made in the different accounts. The close relationship with the non-auditing services are important for the refusal to the increase in the paid auditing fees. The company wants to work on the hiring of the members for the auditing team where there have been different resaons: a. The auditors are accustomed for the company. b. The auditors are seen to have the effective experience with the different financial matters. c. The management is based on holding the chance for working with the proper auditing and development along with holding a stronger relationship with them. the auditors should be able to trust the client exeuctives to the extent that it is not affecting the independence of the external auditors. The auditors need to maitnan the professional skepticism which carries the management of the company. This is not able to handel the financial statements where the management and company executives work under the auditing with the consistent communication. b) What are the advantages of having the same firm provide both the auditing and consulting services? The auditing companies need to provide the non-auditning services with the management consultancy, advicing of the tax and the human resource. This will provide the auditing and the non auditing services to the client. The objectivity is baased on handling the dependency where the information of the client is depending upon the source of income. Conflict of interest are set to provide the auditing and the consulting services where the discrepancy is set between the responsibilities and the interests. The audtiors hold the reports about the financial situation wite maximization of the company profits. The biased audits are based on handling the business till the time they are able to get a particular audit. The profitability is based on holding the change for the different impaired reports. The reports of the error for the auditors and the consultant are mainly to analyse the information as per the management of the client. This will cover up the mistakes and provide the inadvertently compiling the reports of error. The regulatory dilemma is the best soluton for the accuracy of the finncail reports where the services are able to benefit for the different accounting firms. c) Indicate whether these circumstances represent a violation of ethical standards and give reasons for your answer. It is not possible for the auditors to trust the client executives. The auditors need to maintain a healthy profession which is based on the quetitioning of the minds and the auditing evidence. The auditor will not be able to handle the dishonest management or the undisputed honesty. HIH focus on the different figures to monitor the oeprations with the incredible extended that will regard to handle the account focus on the quantity. The Austrlain post conducts the busiensss with the integrity and honesty through the relevant rules and the regulations. The employees are set to commit for the highest ethical standards of behavior in the customer deals. The statement is based on conducting the laws and regualtions with the appropriate codes and the corporate standards. The employees and the contractors need to meet the highest ethical stnadards of behavior which related to the disclosure of information in the accounting practices, conflicts of interests and the dealings in the Foster's share. d) Outline the primary recommendations for audit reform proposed by the Ramsay Report and CLERP 9. What impacts do you feel these changes will have on the practice of auditing? The report policy recommends about the governance and the financial repsoting with the finanlisation under the CLERP 9 amendments. The CLERP 9 has been set to include the bills in the leading up to the expected enactments. This will deal with the personal liabilities for the breach and the other auditor independence and accounting standards. The focus is bmainly on handling the dueties which bind the directories, secretaries and the other officers. The recommendation is based on the officer class which is by being concerned in the management. This is held under the performance with the relevant functions for attracting the legal duty. The functions involve the duty which not only use the position to gain the advantage rather work on the information to gain a proper advantage. The financial reesporting is based in ASX to seek the disclosure and the executive renumeration in the market by announcing about the employment contracts along with the different significant responsibilities and practices.