HIH Insurance Collapse: Auditing - Case Study Example

HIH Insurance Collapse: Auditing Name Institution Name Course Name and Code Date Executive Summary HIH insurance was among the largest companies in Australia and the company collapsed in 2001 after financial and managerial deficiency. The company was established in 1968 and became a public company was listed on Australian Stock Exchange in 1992. The poor governance, ineptitude and deceit contributed to the collapse. The management hid some information while the senior managers manipulated some of the information to fulfill their intended goals and objectives. Numerous auditing and accounting were highlighted after the collapse. Lack of professional skepticism was a major issue because the auditing firms did not critique or look for evidence or information during auditing processes. The auditing practices and independence on the auditing firms were also questionable. Professionalism and independence are some of the important components that determine the success of any auditing requirement but HIH insurance including the Andersen auditing firm did not adhere to such principles. Most of the directors of HIH insurance were charged while for the chairman the charges were dropped. Alder and William were sentenced and served jail terms because of their contributions to collapse of the company. Business individual was judged and sentenced because of their respective role in the collapse, such as bribing and corrupting directors of HIH. The auditing firm, Arthur Andersen, surrendered its license and stopped operating as a auditing firm. Due to the ineffective of policies and standards in auditing process as indicated in the collapse of HIH insurance, reforms were instituted. Some of the reforms were aimed at improving independence, whistle blowing and levels of liabilities. Moreover, some legislation were updated and additional clauses were introduced to prevent occurrence of auditing problems. The professional bodies such as ASCI, and Financial Reporting Panel roles and responsibilities were reviewed to ensure monitoring, surveillance, carrying out frequent analysis and instituting charges were tightened. Table of Contents Introduction 4 Trigger for the Collapse and Causes 5 Ineptitude 5 Deceit 6 Major Accounting Issues Involved 6 Professional Skepticism 6 Accounting Practices 7 Independence 10 HIH Insurance Executives 11 Director Rodney Adler 11 Chief Executive Ray Williams 11 Businessperson Brand Cooper 11 HIH Chairman Geoffrey Cohen 12 Auditing Firm: Arthur Andersen 12 Impact on Auditing Profession in Australia 12 Corporate Governance 12 The Independence Requirements 13 Standard Setters and the Watchdogs 15 Conclusion 16 References 18 Introduction HIH Insurance was established in 1968, was known as MW Payne Underwriting Agency Pty. Ltd, and was started by Williams and Michael Payne in Australia. In 1971, a British insurer acquired the company and the name was changed to HIH and began trading on the Australian Stock Exchange in 1992. Through numerous name changes, mergers and acquisitions, HIH Insurance diversified in numerous insurance sectors and was able to operate in numerous countries. As of 2001, the HIH Insurance had 217 subsidiaries and the largest licensed insurance companies were FAI General Insurance Company Limited, HIH Casualty and General Insurance Limited and CIC Insurance Limited. Before the collapse of the company, some of its activities include property and financial services, investment funds management and insurance underwriting. HIH insurance also managed employees; compensation schemes in South Australia, Victoria, and New South Wales. The collapse of the company is estimated to have resulted in approximately AUD$ 53. Billion. Even though the paper discusses the collapse of HIH Insurance, the paper concentrates on auditing components and factors. Trigger for the Collapse and Causes Ineptitude In most corporate failures, poor accounting and bad management are attributed to the challenges. The common management problem at HIH Insurance was the chronic under reserving approach of accomplishing activities (Mirshekary, Yaftian & Cross 2005). For example and according to Royal Commission Report, in the balance sheet of the company, the company had set aside payments for future claims (ASIC 2015). In estimating this provision, the company relied on independent assessments and actuaries including advice from Arthur Andersen who was the auditor. However, the documents of actuarial or assessments were not included in any meeting or even the actuaries called to explain the reports or address any questions that may arise (Royal Commission Report 2003). Inefficiency was a major problem at HIH since the chief executive office had no defined limits while the board did not have defined control system to manage its operations. The management controlled all the operations rather than a policy (Mak, Deo & Cooper 2005). The HIH after its listing on the ASX was managed as an entrepreneurial organization rather than a publically listed company. The directors who were independent non-executive directors were many, which is against numerous policy requirements (Clarke, Dean & Oliver 2003). The company also lacked long-term strategy and some of the decisions did not reflect the requirements of the market or did extensive market research to understand the dynamics of acquisitions and mergers and other components, which informs in management of business and general operations. Deceit The corporate culture and structure of the company contributes to catalytic transactions, which are attributed to individual decisions (ASIC 2015). The decision of the company relied on auditors and management, without considering other independent perspectives (Haines, Sutton & Platania-Phung 2008). The information systems within the company were inaccurate meaning the management based decision making on the wrong information. The information was also filtered depending on the requirements of the board and most of the negative news were hidden unless otherwise (Royal Commission Report 2003). The ‘lying’ was evident in the accounting practices since the HIH management had understood and recognized the company was underperforming. The management also relied and used questionable transactions resulting in doubtful accounting entries, which hid serious situation (Mak, Deo & Cooper 2005). The entire process of entries and transactions was fatally flawed. Some of the questionable entries include extensive one-off entries that were associated with recoveries under reinsurance contracts and goodwill (Financial Reporting Council 2015). The accounting practices were ineffective to an extent on whether there were really auditors. Major Accounting Issues Involved Professional Skepticism The auditors contributed to the failure of HIH (ASIC 2015). The auditor, Andersen, had categorized the company as a maximum-risk client based on the client-risk assessment mechanism. Since the auditors knew the position and circumstances of the HIH insurance, the auditors should have employed a formal risk management plan and also expanded its risk management procedures. The high materiality attributed to misstatement for future claims, the Andersen’s policies required rigorous review of any information obtained from the actuaries (Mak, Deo & Cooper 2005). The management of the company relied on biannually information from the Slee, which was the principal consulting actuary, and the information was prepared before finalization of yearend accounts. The Slee’s assumptions and methodology were questionable because of inconclusive use of available data and information. Furthermore, HIH insurance did not seek additional expertise assistance in understanding the extracts from the actuary and other stakeholders (Haines, Sutton & Platania-Phung 2008). Andersen’s approach of not questioning the actuary reports was one of the components that contributed to HIH’s principal failure and it also formed a basis of ineffective inquisitive rigor (Royal Commission Report 2003). Moreover, in doing its auditing requirements, Andersen relied on internal business audit processes of HIH insurance. Andersen relied on the HIH processes without testing of the operations or conducting any evaluation, or reviewing the procedures and policies of internal audit function (Mak, Deo & Cooper 2005). The audit team had recognized deficiencies in the auditing practices within the internal audit department; Andersen’s should have employed their policies in manually evaluating and testing the financial records and any other auditing requirements. Accounting Practices HIH Insurance also failed to address numerous accounting anomalies. The Royal Commission categorized the anomalies as goodwill, deferred information technology costs, deferred acquisition costs and income tax benefits. Future income tax benefits based on the accounting standard practices states that when an organization incurs a tax loss, doubts should exist on the organization’s ability to realize income tax benefits in future (Royal Commission Report 2003). A ‘virtual certainty’ test is required and the auditor’s engagement partner stated that, he applied a less exacting test in determining whether HIH would continue operating in a profitable manner in the future. According to the view of the Commission, Andersen failed to collect enough evidence based on the AUS 502 and qualified opinion was required to analyze the information. In the deferred acquisition costs, the same approach and story suffices (Mak, Deo & Cooper 2005). In accounting standards, before transferring the acquisition costs and recognizing the costs assets, it is prudent to be measured and may contribute towards raising premium revenue in the following financial years (Mardjono 2005). Therefore, obtaining and recoding policies of insurance should understand the component of acquisition and subsequent recording of the transaction and to determine the impact of the entire processes to the success of the business (Royal Commission Report 2003). Andersen did not employ any measurement test and rather employed professional judgment based on the HIH’s historical profitability. Furthermore, Andersen did not employ the requirements and principles as indicated under AUS 502 (Haines, Sutton & Platania-Phung 2008). Even though during the period, the accounting standards that were applicable to deferred information technology costs did not exist, the Statement of Accounting Concepts 4 (SAC 4) defined its standardization. SAC 4 states that a test that is similar or comparable to the deferred acquisition cost should be employed based on the assumptions that future economic benefits be both reliable and probable measurable (Financial Reporting Council 2015). The Commission questioned if Andersen had sought enough and appropriate information regarding the requirements and expectations of deferred information technology costs (ASIC 2015). The accounting for goodwill is another component that raised concerns and contributed towards the financial and auditing challenges in the HIH (Royal Commission Report 2003). The future benefits and the manager of calculations, which include tests, were ineffective in determining whether the future is viable or not. The data and statistics of June 2000 illustrate the anomalies of goodwill representation. For example, the balance sheet of HIH showed 50% as shareholder funds, which is comparatively different to other insurance firms such as QBE insurance, which represent 4.9% and NTMA 0.4% of shareholder funds. Therefore, the HIH accounting for goodwill was inappropriate and did not reflect the requirements at the ground (ASIC 2015). The Allianz transaction is another auditing failure that raised numerous controversies. The auditor was given minimal information of the transaction. Moreover, it is crucial to note that an auditor is not responsible in determining or analyzing the commercial prudence of an organization including its strategic decisions (Buchanan, Arnold & Nail 2003). However, Andersen was required to analyze the financial report through effective assessment to determining the going concern of HIH; in addition, Andersen was supposed to analyze the information in a truthful and fair method since it is the responsibility of the auditor. Since Andersen did not accomplish the started requirement effectively, it means that Andersen lacked professional skepticism (Haines, Sutton & Platania-Phung 2008). Andersen accepted the Allianz transaction without considering and seeking additional evidence and analytically analyzing the information to determine the potential financial consequences. Therefore, HIH lacked credible and effective professional skepticism. Independence Andersen’s independence is highly questionable. For example, three former employees at Andersen sat on the HIH insurance board (du Plessis 2003). One of the partners continued to receive benefits from Andersen and was appointed within seventeen months after retirement into becoming the board chairman. The second partner was made the chief financial officer within the same day the partner resigned from Andersen. The third partner was employed after five months after he retired and having playing an integral role in HIH auditing for 25 years (Royal Commission Report 2003). The Andersen’s engagement audit partner was replaced without consideration of the views of the senior management (ASIC 2015). It means decisions on managerial and independence were not considered in assigning duties to different individuals without considering the impartiality and influence of decisions made. Andersen’s, as indicated, had personal relationship to HIH and the approach of acceptance of HOH’s internal audit processes without questioning and analyzing the work of consulting actuarial indicates that Andersen was independent for the period 1999 to 2000; the audits also within the period were questionable. The Andersen was also required to indicate maximum profits through introducing non-audit techniques (Royal Commission Report 2003). The evidence provided during the commission of inquiry by one of the Andersen partners stated that if he had employed professional skepticism and independent judgment through avoiding management proposals, so of the transactions would not have been promoted with non-audit services (Allan 2006). Even though minimal information on fact did not exist, the appearance was enough to show lack of independence of the auditing firm. HIH Insurance Executives Director Rodney Adler Director Rodney Alder was jailed for four and half years on 14 April 2005 after pleading guilty on 16 February 2005 to four charges. The four changes are obtaining money by misleading or false statements, two counts of disseminating false information, and failing to discharge his duties and roles according to the requirements of directorship. Alder was charged of stock market manipulation by the Australian Scurrilities & Investment Commission. Alder used the Pacific Eagle Equities Pty Ltd to acquire HIH shares in June 2000 and most of the funds were shifted from HIH (Royal Commission Report 2003). Therefore, Alder aimed to manipulate the market so that investors continued purchasing the stocks. In October 2000, Alder persuaded HIH to invest in Business Thinking Systems even though he had interests with the purpose of gaining financial support. HIH Board approved $2 million amount to support the operations of Business Thinking Systems. Chief Executive Ray Williams The sentence of Ray Williams was between two years and nine months, and an optimum of four years and six months. Ray Williams was released on January 14, 2008 for his role in contributing towards Australia largest corporate collapse. Businessperson Brand Cooper Cooper was sentenced on 23 June 2006 by the Supreme Court after he was found guilty of 13 charges. Cooper had bribed a senior HIH official to push some false claims immediately before the collapse of the insurer. Cooper was sentenced to eight-year jail term and during the imprisonment periods; he reported to prison officials that he was addicted to cocaine, valium, dex-amphetamines and painkillers. Cooper was released in late 2010. HIH Chairman Geoffrey Cohen The case was dropped before it was heard by Sydney Downing Centre Local Court and similar decision was undertaken by the Commonwealth Director of Public Prosecutions. The Prosecutor wanted to institute two charges relating to a December 2000 address to shareholders in the first charge while the second charge was lack of passage of information to shareholders based on the requirements of Australian Securities and Investment Commission. Therefore, the chairman did not face any criminal investigators on his role in HIH collapse. Auditing Firm: Arthur Andersen In 2001/2 Arthur Andersen audit firm surrendered its license and stopped operating. It coincided with other scandals that the auditing firm is associated with, such as the Enron scandal. Therefore, the partners and employees were taken by other companies while other partners started their own firms. Impact on Auditing Profession in Australia Corporate Governance Due to the auditing challenges and management problems that surfaced after the HIH insurance scandal, some changes were made. The chief financial officers and chief executive officers of listed companies are required to declare their annual reports indicating the financial records are maintained effectively (Royal Commission Report 2003). The financial records show be based on and have to comply with accounting standards including the requirement of provide a true and fair nature of financial position of the company. The requirements also should indicate the director’s performance targets and the directors’ remuneration. The stakeholders are then given opportunity to analyze the targets and other information during the annual stockholders meeting. The investors will then be able to determine whether the directors met their respective targets and whether the compensation was appropriate (Mak, Deo & Cooper 2005). Management analysis and discussions are important in ensuring the business strategies, assessment of information and other information that would enable the stockholders to determine prospects for future financial years (Royal Commission Report 2003). The liability based on the Corporations Act was changed to determine the liability of an individual on function rather than on position (Haines 2007). A Financial Reporting Panel was also established, which is required to summon witness and to gather any information in addressing disputes that may arise between the corporate regulator and a company (Financial Reporting Council 2015). The CLERP 9 also allowed and protected whistle blower were the employees suspected instances of Corporations Act breach. Apart from the approaches, the unique and most important is the independence of the auditor (Haines, Sutton & Platania-Phung 2008). The Independence Requirements The original requirement of the Corporations Act before reforms focused on auditor independence through focusing on specific objectivity such as employment relationships and indebtedness between the auditor and the company (Hill 2006). However, the Act as introduced another important clause termed ‘Professional Statement F1 that was developed and adopted by the accounting professional associations (ASIC 2015). The auditing firms are required to disclosure any information that threatens independence and employ safeguards that may contribute towards managing the problem. Therefore, it is an offence to hide conflict of interest or not take appropriate steps in addressing the conflict of interest problems (Westfield 2003). The auditors are also required to operate a quality mechanism, which is able to identify conflicting situations and enabling the auditor to acknowledge the existence of the situation (Financial Reporting Council 2015). The same liability is also on audited companies’ directors. Any employee of any audit firm is required to notify the corporation authority within seven days after noticing any conflicting problem. The auditors are required to provide written declarations that indicate that the independence requirements of the Corporations Act have not been contravened or any other professional conduct code has not been broken (Mak, Deo & Cooper 2005). Without such documentation and a problem arise, the individuals concerned are liable of an offence (Monem 2011). Non-auditing services should be declared in the annual reports and explanations accompanied including the fees paid and for the audit committee to determine why the services provided do not compromise independence. The purpose of the approach is to reduce the chances in which auditing firms and companies can depart from F1 requirements. The composition of the audit team also faced additional independence requirements (Haines, Sutton & Platania-Phung 2008). The audit partner and the critical members within the audit team should be rotated within five years. After rolled off, the employee is not allowed to return to an engagement until two years passes. Additional restrictions exist that continues to support the requirements of independence (McCarthy 2001). The restrictions state that no more than one ex-partner can be allowed to be appointed to the senior management or directorship of a company, which was a client to the ex-partner firm (Parker 2005). Moreover, review partners and audit partners are not allowed to accept such appointments after resignation and the partners will have to wait for two years before been appointed into any managerial position (Financial Reporting Council 2015). Standard Setters and the Watchdogs Within the Financial Reporting Council, the CLERP 9 Act has introduced additional institutional changes. The traditional role of Financial Reporting Council is to advice the government on accounting standards, overseeing the standards-setting processes, determine the stander setter strategic direction, act as an advisory and to oversee the operations of the Australian Accounting Standards Board (Financial Reporting Council 2015). The Financial Reporting Council role was revised and additional roles were included including preeminent public oversight board for accounting and auditing. Therefore, Financial Reporting Council managed the Auditing & Assurance Standards Board (AuASB). The laws that AuASB passes received additional legislative backing under the s307A and strictly, states that the liability is determined based on adherence to the Board’s auditing standards. The compliance role has also been introduced as another function of the Financial Reporting Council (ASIC 2015). With the support of other institutions or professional bodies, Financial Reporting Council is required to monitor audit quality and auditor independence (Financial Reporting Council 2015). Financial Reporting Council is also required to collected information from accounting firms and professional accounting bodies and required to store these documents for a minimum of seven years. The powers of Financial Reporting Council override any claims of confidentiality and privacy (Mak, Deo & Cooper 2005). The Australian Securities and Investments Commission (ASIC), which is the primary corporate regulator, is supposed, to monitor complicate with independence requirements and auditing standards requirements (ASIC 2015). ASCI oversee the auditing processes and frequent carries studies to determine components that are classified as risk criteria. ASIC continues to administer surveillance and quality assurance of the firms. The quality assurances include educational requirements before registration and registrant specialist courses before becoming auditors. ASIC is also allowed to issue infringement notices in allegiance of market-disclosure breaches (Haines, Sutton & Platania-Phung 2008). Therefore, the numerous institutions and professional bodies required to oversee the auditing processes ensure conflicts does not exist, the auditing firms adheres to the policy requirements, mechanism for advice exist and means for instituting disciplinary actions clearly identified. Conclusion In conclusion, auditing is an important requirement in ensuring an organization manages financials and determining the future of the organization. Auditing is crucial for both private and public organizations; for example, public organizations have shareholders who want to know how their respective resources are utilized. HIH is an example of an organization who employed an auditor who was impartial and the auditor with the support of HIH introduced numerous malpractices, which contributed to the collapse of HIH. Lack of independence, poor auditing standards, complacency, misinformation, deceit and poor governance strategies are some of the reasons resulting in collapse of the HIH. The Arthur Andersen, which was the auditing firm, surrendered its license during the period while the some of the directors of HIH insurance were jailed. Due to the challenges and weaknesses witnessed during and subsequent investigations into HIH collapse, numerous reforms were introduced. It included allowing different institutions and professional bodies to monitor the auditing requirements and the management of companies. It improved on transparency, governance and liability measures. In any instances of criminal activity, the individuals are liable based on the updated offences. Moreover, independence of the companies was improved in which the employees and other partners had specific instructions and policies in fulfilling their respective duties and sitting on the boards. Even though conflicts may exist in the way the legislations and directives are between implemented, it has played an important role in deterring misappropriate, falsifying information and lack of independence. References Allan, G (2006) HIH Collapse: A Costly Catalyst for Reform, The Deakin L. Rev., vol. 11, no. 137. ASIC. (2015). HIH Insurance Investigation. Retrieved from http://asic.gov.au/ Buchanan, B., Arnold, T., & Nail, L. (2003). Beware of the ides of March: The demise of HIH Insurance. Clarke, F, Dean, G, & Oliver, K (2003) Corporate collapse: accounting, regulatory and ethical failure, Cambridge University Press. du Plessis, JJ (2003) Reverberations after the HIH and other recent Australian corporate collapses: the role of ASIC. Australian Journal of Corporate Law, vol. 15, pp. 225-245. Financial Reporting Council. 2015. Financial Reporting Review Panel. Retrieved from https://www.frc.org.uk/About-the-FRC/FRC-structure/Former-FRC-structure/Financial-Reporting-Review-Panel.aspx Haines, F (2007) Crime? What Crime? Tales of the Collapse of HIH. In International Handbook of White-Collar and Corporate Crime (pp. 523-539), Springer US. Haines, F, Sutton, A, & Platania-Phung, C (2008) It's all about risk, isn't it? Science, politics, public opinion and regulatory reform, Retrieved from http://dspace2.flinders.edu.au/xmlui/handle/2328/1837 Hill, JG (2006) Regulating executive remuneration: International developments in the post-scandal era, ICFAI Journal of Corporate & Securities Law, 06-15. Mak, K, Deo, HN, & Cooper, KA (2005). Australia's major corporate collapse: Health International Holdings (HIH) Insurance" May the force be with you". Mardjono, A (2005) A tale of corporate governance: lessons why firms fail, Managerial Auditing Journal, vol. 20, no. 3, pp. 272-283. McCarthy, G (2001) The HIH Royal Commission and the tangled web of truth, Australian Journal of Public Administration, vol. 60, no. 3, pp. 110-112. Mirshekary, S, Yaftian, AM, & Cross, D (2005) Australian corporate collapse: The case of HIH Insurance. Journal of Financial Services Marketing, vol. 9, no. 3, pp. 249-258. Monem, R (2011) The One. Tel collapse: lessons for corporate governance, Australian Accounting Review, vol. 21, no. 4, pp. 340-351. Parker, LD (2005) Corporate governance crisis down under: post-Enron accounting education and research inertia. European Accounting Review, vol. 14, no. 2, pp. 383-394. Royal Commission Report (2003) HIH Royal Commission Final Report dated 4 April 2003. Retrieved from http://www.hihroyalcom.gov.au/finalreport/index.htm Westfield, M (2003) HIH: Inside the Story of Australia's Biggest Corporate Collapse, Wiley. Read More