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The Professional Accountants Ordinance (PAO) provides the legal and regulatory framework for Hong Kong's accountancy profession. It statutorily empowers the Hong Kong Society of Accountants (HKSA) to (a) institute admission requirements for the accounting and auditing profession (b) stipulate professional standards for its members (c) undertake regular reviews of members' practices (d) carry out investigations and (e) mandate disciplinary actions (FSB 1).
Existing regulations stipulate that the initial auditors for a company can be appointed at any time by the directors, prior to the first Annual General Meeting, (FSB 1), even as succeeding auditors need to be appointed at its Annual General Meeting (AGM) (FSB 1).
This study aims to assess the appropriateness of the mandatory audit requirements in Hong Kong. The assessment also focuses on the ways and means, whereby the rights and obligations of auditors can be further improved to enhance the current mandatory audit regime, taking account of the accounting environment, in terms of conformance and implementation of Hong Kong Standards on Auditing (HKSA).
Auditors are duty bound to report to company shareholders, in their Audit Reports, on the accounts examined by them, as also on all profit and loss accounts, balance sheets and group accounts put up by companies in their AGMs (FSB 1). Auditors must act diligently, honestly and with reasonable proficiency and concern (FSB 1). They are liable to companies for losses caused due to negligence from the conduct of the audit (FSB 1). In exceptional circumstances, they can also be liable to other persons who suffered financial losses on account of relying on the contents of the report (FSB 1). It is also necessary for auditors to adhere to a meticulous code of auditing and ethical principles in order to ensure compliance with qualitative standards. Non-conformance to the observance of such standards in Hong Kong attracts disciplinary action by the HKSA (FSB 1).
Hong Kong auditors, under section 141 of the Companies Ordinance (CO), are required to state in their audit report whether accounts of companies have been prepared according to the CO's provisions and also whether, in their view, the annual reports represent true and fair views of the accounting and financial positions of audited companies. They are however not responsible for the preparation of accounts of companies or for managing companies (FSB 1).
Whilst auditors can offer "reasonable assurances" on the state of the books of accounts, they cannot warrant the financial health of audited companies (FSB 1). Their obligations are restricted to the furnishing of opinions on the accounts of companies after examining the accounting records and information offered to them by company managements (FSB 1). The genuineness of the transactions presented to them is however not required to be investigated (FSB 1). It is also accepted that auditors will not always be able to discover the perpetration of well-planned frauds or conspiracies by managements to conceal information from the auditors (FSB 1).
The primary objective of an audit of financial statements is to allow the auditor to "express an opinion whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework" (PN 820 1-8). The HKICPA Code of Ethics for Professional Accountants avers that practicing accountants must essentially not accept or perform work that they are not capable of undertaking (PN 820 1-8). Such a code infers that auditors should not accept audits of licensed companies unless they are satisfied that they can, or are in a position to obtain the required competency level (PN 820 1-8).
Protection of Investors
An audit primarily aims to benefit and protect company shareholders, facilitating them in checking on the operational performance and financial management of their invested companies (FSB 1). It is an impartial, independent and external check on the financial statements and books of account prepared by a company, which in turn reflect the performance and financial health of the company (FSB 1). Auditors are obliged to maintain their professional standards and code of conduct (FSB 1). The HKSA can investigate an auditor's compliance with the requisite code of conduct and statutory standards and resort to appropriate disciplinary action wherever necessary (FSB 1).
Auditor's Rights and Obligations
The underlying approach of an auditor, throughout the conduct of a company audit, should be that of professional scepticism, understanding and appreciating that the probability of a material misstatement in the books of accounts due to fraud could exist, despite positive past experience with the integrity and honesty of the company's management (PN 820 1-8). The resources of the client, in terms of moneys, securities and other assets are perpetual fraud and risk areas that require the attention of the auditor (PN 820 1-8). Auditors are as such encouraged to obtain external confirmations of client account balances, as also of assets held in custody, in order to obtain third-party verification for the support of regulatory reporting (PN 820 1-8).
Auditors are also required to enquire from managements on the conditions, events and related business risks that have occurred beyond the audit period and which may cast doubt on the capability of licensed companies to continue functioning as going concerns (PN 820 1-8). In this context, it is an important audit principle that management representations cannot substitute the audit evidence that is expected to be available to the auditors (PN 820 1-8).
The particular competencies expected of the entire audit engagement team include (a) a comprehension of the audit engagements, along with the practical exposure, of similar complexity and nature through suitable training and participation, (b) knowledge of professional standards and lawful and regulatory requirements, (c) suitable technical and IT (information technology) knowledge, (d) awareness of the relevant industry to which the client belongs (e) ability to exercise professional judgement, and (f) a comprehension of the firm's QC procedures and policies (Hksa 220 1-11).
It is laid down, vide HKSA 220, that the engagement partner of the audit firm needs to form an opinion regarding the "independence requirements" that are applicable to the audit assignment. The partner, in so doing, must obtain and evaluate all the relevant information, and, must also, wherever required, network with other firms to identify and examine the relationships and circumstances that produce threats to the independence of such audit assignments (Hksa 220 1-11).
The partner, by doing so, might identify threats to audit independence that available safeguards might not be able to remove or decrease to an acceptable level (Hksa 220 1-11). In such case, appropriate action (with appropriate documentation) should be determined after intra-firm consultations, which could include the possibility of elimination of the interest or activity creating the threat or, even withdrawal from the assignment (Hksa 220 1-11).
The rationale behind this Hong Kong Standard on Auditing (HKSA) is the institution of standards and the provisioning of guidance on the responsibility of auditors to consider the rules and regulations for audit of financial statements (Hksa 250 1-9). Auditors, whilst designing and conducting audit procedures, or analysing and reporting results, must recognise that the noncompliance of companies with rules and regulations might significantly affect their financial statements (Hksa 250 1-9). The detection of noncompliance, regardless of its materiality, entails the association of such non-compliance with the integrity of the employees/management and its probable impact on other auditing issues (Hksa 250 1-9).
'Noncompliance' as used in HKSA 250 represents "acts of omission or commission, either intentional or unintentional, by the entity being audited, which is contrary to the prevailing rules and regulations" (Hksa 250 1-9). These would include acts entered into by or in the name of the company, employees or the management. Such noncompliance however excludes personal misconduct that is unconnected to organisational business activities (Hksa 250 1-9).
The determination of an act as noncompliant is however a statutory process that is normally outside the professional competence of an auditor (Hksa 250 1-9). The determination of an act being, or likely to be, noncompliant is normally supported by the advice of an informed and practicing legal expert, even though it can finally be determined only by a court of law (Hksa 250 1-9). It is also obvious that the further removed a particular noncompliance is from the transactions/events shown in the financial statements, the lesser is the likelihood of an auditor being alerted of the noncompliance or of identifying its possibility (Hksa 250 1-9).
Audit planning is a continuously iterative process that is implemented throughout the audit assignment. Changes in conditions, unanticipated events or audit evidence obtained from conduct of audit procedures can require the auditor to alter the overall audit plan and strategy, consequently modifying the planned timing, extent and nature of subsequent audit procedures (Hksa 300 1-10).
The information that is actually obtained by an auditor can be considerably different from the information available when audit procedures were initially planned. The audit evidence obtained through conducting substantive procedures might for example contradict the audit results obtained from testing the operating usefulness of the controls (Hksa 300, 2004, p1-10). In such situations, the auditor re-assesses the planned audit procedures based on amended considerations of evaluated risks for some or all categories of account balances, transactions or disclosures (Hksa 300, 2004, p1-10).
An auditor, in setting the audit direction at the planning stage, considers a number of issues that relate to materiality. These include (a) focusing on materiality for planning purposes (b) categorising account balances and material components (c) reviewing materiality during audit implementation at the time of performance of audit procedures, and (d) detailing and communicating the materiality of particular components (Hksa 300 1-10). The auditor also needs to focus on areas with greater risks of material misstatement, the impact of the evaluated risk of material misstatements on the overall financial statements, the selection of the engagement team, including the quality control reviewer, and, inter alia, budgeting and allocating adequate time for possible spheres with greater risks of material misstatements (Hksa 300 1-10).
"Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement." (Hksa 320, 2005, p1-5).
The auditor, whilst assessing whether the financial statements are prepared in accordance, in all material respects, with the applicable reporting framework, needs to examine whether the cumulative uncorrected misstatements identified during the audit are material. (Hksa 320 1-5).
Professional Compliance and Disciplinary Action
The HKSA constantly oversees the functioning of auditors not just with reviews of the financial statements of listed companies, but also by watching over the practice of licensed accountants (FSB: 1). The body, which strengthened its investigative powers during the 1994 PAO amendment exercise, commences investigation into the affairs of its members if it has reason to suspect major noncompliance, professional misconduct or lack of adherence to standards (FSB 1).
The society also acts on public grievances and recommendations from other regulatory bodies like the Securities and Futures Commission (SFC) and the Stock Exchange of Hong Kong Ltd. (SEHK). It is authorised to conduct penal hearings and enforce sanctions, including reprimand orders, on its members, fines of up to $500,000 and debarring members from its rolls of professional accountants (FSB 1).
The HKSA conducts regular reviews of the annual reports of listed companies through the PSMC (Professional Standards Monitoring Committee, a non-statutory committee established HKSA Council) (FSB 1). The PSMC annually chooses a sample of the annual reports for its review (FSB 1). The rationale of a regular review of financial statements of listed companies is to ensure that the preparation of these statements has been in conformity with the necessary professional standards (FSB 1).
The PSMC informs the HKSA Council about major non-compliance cases for contemplation of formal investigation, in case of reasonable doubts of compliances with professional standards. Such investigation can lead to disciplinary action, where prima facie cases are established (FSB, 1999). The PSMC, during the last three years has conducted more than 400 reviews, of which four cases were referred to the Council (FSB, 1999).
South-east Asian State of affairs
Paul Pacter, Head, IASB's project on SME (small to medium-sized) businesses, Director of the IFRS (International Financial Reporting Standards) global office, and MD, Deloitte TT, Hong Kong states that the accounting fraternity in emerging economies, by and large have few members, and stress more on training and education rather than enforcement. He adds "But that's the nature of emerging economies: they have bigger fish to fry than the enforcement of accounting standards" (Quinn 30).
None of the countries across almost all of Asia, including Japan, Hong Kong and Thailand, truly comply with global standards. While each country avers its conformance, actual financial details reveal many differences, even within individual countries (Quinn 30). Whilst countries like Singapore, Hong Kong, Thailand and the Philippines confirm that they have implemented IAS in its entirety, Pacter states "My point is that no matter which country in Asia says it is modelling itself after IAS, there's not one country that can say honestly its national standards are identical to IAS," (Quinn 30).
Although the accountancy profession's regulatory system, put in place by the PAO, has satisfactorily catered to the community's needs during the last 26 years, this should not breed complacence (FSB 1). The Government is closely interacting with the HKSA on likely spheres of improvement that can assist in developing the regulatory mechanism for auditors (FSB 1).
Nevertheless, there is awareness of the necessity to fulfil the growing expectations of the business sector and the investing public, and also to assure a transparent and fair market (FSB 1). The improvement drive is a constant process as proved by the earlier legislative amendment exercises (FSB 1). The HKSA as well as the government are committed to continuously endeavouring to enhance the effectiveness of the auditors' regulatory system, to enable the improvement in the protection of the audit services' beneficiaries and improvement in the qualitative standards of the audits (FSB 1).
The Hong Kong Stock Exchange has issued the Code on Corporate Governing Practices and the Corporate Governance Report, which requires the maintenance of effective and sound internal control systems be maintained. The code also necessitates that Directors should review, at least once a year, the usefulness of such systems. Such reviews should include all material controls and functions, including those of operational, financial, compliance and risk management (IFAC 10).
It can be concluded in light of this analysis that whilst statutes mandate minimum compliances in terms of adherence to auditing standards by company managements, much ground remains to be covered in terms of compliances that satisfy the requirements of all stakeholders. Whilst there has been marked improvement in compliances over the last three decades in the Hong Kong region, the working of numerous areas of corporate governance and internal controls can be facilitated with more transparency of information, better accounting policies and auditing practices.
The rights, obligations and responsibilities of auditors can be further enhanced in the prevailing audit regime by adhering to better standards of accounting policies and practices that are in line with global accounting and auditing standards. Increased employee, management and auditor participation is necessary for furthering the cause of self-improvement in norms regarding disclosure, internal controls and transparency norms, which can benefit companies, industries and the economy as a whole.