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Petitioner: KPMG TASEER HADI AND CHARTERED ACCOUNTANTS and another VS Respondent: SECURITIES AND EXCHANGE COMMISSION OF PAKISTAN
Court Name: Securities and Exchange Commission of Pakistan Judge(s): Tahir Mahmood, Zafar Abdullah Title:KPMG TASEER HADI AND CHARTERED ACCOUNTANTS and another vs
SECURITIES AND EXCHANGE COMMISSION OF PAKISTAN Case No.: Appeal No, 90 of 2016 Date of Judgment:2017-02-09 Reported As: 2018 CLD 952 Result: Appeal allowed Judgment ORDER This Order is passed in Appeal No, 90 of 2016 filed under section 33 of the Securities and Exchange Commission of Pakistan (Commission) Act, 1997 (SECP Act) against the order (Impugned Order) dated 23/09/16 passed by the Respondent. 2. The Insurance Division of the Commission during the review of the Audited Accounts of Pak Kuwait Takaful Company Limited (Company) observed restatement of comparatives. It was disclosed in the Audited Accounts for year 31/12/14 that management identified various instances in the current year and previous years where liability for the claims were deliberately understated and endorsements were issued without documents to delay the provisioning requirements against outstanding contributions, policies being issued without adequate documentation. Resultantly, contributions, receivables, and related heads were overstated and claim liabilities and related accounts were understated. It transpired that the Audited Financial Statements and the Regulatory Returns of the Company along with Statements of Assets and Liabilities of the Company for the years ended 31/12/12 and 31/12/13 filed with the Commission under section 51 of the Insurance Ordinance, 2000 (Insurance Ordinance) were materially misstated. M/s. KPMG (Appellant No,1) acted as Statutory Auditors of the Company for the years 2012, 2013 and 2014. The brief facts leading to this case are that the Board of Directors of the Company in their meeting held on 01/12/14 decided to appoint M/s. Ernst and Young (EY) to carry out assessment of reserves against claims, examination of paid claims, identification of potential phantom agents and assessm ent of adequacy of bad debts and EY submitted their report on 06/03/15 with the following significant findings:
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a. The Reserve against Claims was understated and understatement as at 30/11/14 amounted to Rs,40,817 million. b. Out of selected sample of 122 claims, supporting documents including the final surveyors reports and invoices of 32 claims amounting to Rs,1,914,694 were not made available to them and review of the remaining 90 claims disclosed that: Alteration and/or removal of dates and amounts, by hand, on the surveyor reports and its underlying document; Claim number and date generated before the accident, i,e, claim lodged in February 2014 and date of accident is June 2014; Supporting bills of workshop are dated before the date of accident; Incorrect details of policies in the surveyor report; Claim approved on a Sunday (6 July 2014). c. The comparison of the aging report and revised aging report identified that an additional provision of Rs,51.740 million was required for doubtful debts, as at 30/11/14. d. It was observed that Sales Development Executive (SDE) Scheme Policies and Procedure Manual were not complied with in relation to recruitment of SDE. Furthermore, there was no policy at the Company for recruitment of cash and carry agents. e. Agencies may be created in the name of family members of existing Company agents and/or employees. It was recommended that relationships, if any, should be disclosed in writing at the time of creation of an agency and should be approved. Furthermore, the disclosure and approval documents should be made part of agents' files. The management of the Company subsequently carried out an analysis of the EY report, to identify full impact of irregularities and identified the following: f. Contribution due but unpaid as at 31/12/14 before adjustments amounted to Rs, 363.6 million and subsequent receipts there amounted to Rs, 83.042 million. g. There were no recoveries of contributions aggregating to Rs,31.1 million (2012: Rs 105 million, 2013: Rs 1.89 million and 2014: Rs, 28.16 million) nor were they supported by adequately documented policies. h. There were no recoveries of contributions aggregating to Rs,249.5 million (2012: Rs 20.17 million, 2013: Rs, 52.2 million and 2014: Rs,177.1 million), however, according to management they are supported by adequately documented policies. The specific reason for non-recovery have not been identified. According to the Company's policy, a provision of Rs,8.06 million has been made against the policies issued during 2014. i. Claims at 31/12/12 were understated by Rs,30.8 million and at 31/12/13, they were understated by Rs,23.099 million. The reversal of endorsements which were made without any adequate supports effected the provision for doubtful debts in the respective year. 3. The Appellant No,1 vide their Board Letter dated 24/04/15 forwarded the draft accounts of the Company to the Respondent for the year ended 31/12/14 together with draft audit report thereon. Among other things, Board concurrence and approval was sought in respect of restatement of comparatives and their confirmation that all material adjustments have been identified and recorded accordingly. In view of the above circumstances, the Respondent considered it necessary to obtain clarification on the said matters, especially whether Appellant No,1 as Statutory Auditors have discharged their responsibilities and performed work in accordance with the International Standards on Auditing (ISA) including ISA 240 (The Auditors Responsibilities Relating to the Fraud in an Audit of Financial Statements). 4. Show Cause Notice (SCN) was issued under sections 48(2), 48(4) of the Insurance Ordinance read with sections 255 and 260 of the Companies Ordinance, 1984 (Companies Ordinance) to the
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Appellants as to why necessary penal action may not be taken against them in terms of section 260 of the Companies Ordinance. The request of Appellant No,1 for extension in time was agreed by the Respondent and was extended to 23/05/16. The Appellant No,1 vide letter dated 23/05/16 submitted their written reply to the Notice, stating that they have fulfilled their responsibilities and audit reports for the respective years are appropriate and are in conformity with the requirements of the law. 5. The Appellant No,1 was found to have committed a breach of fiduciary duty cast upon them by the policyholders as well as shareholders. After careful consideration of the conduct of the Appellant No,1 and the circumstances of this case, Mr. Muhammad Nadeem, FCA, (Appellant No,2) was found to have signed audit reports for the years 2012, 2013 and 2014 otherwise than in conformity with the requirements of sections 48(2), 48(4) of the Insurance Ordinance read with section 255 of the Companies Ordinance. In exercise of the powers conferred under section 260(1) read with section 476 of the Companies Ordinance, instead of imposing penalty for violation each year, an aggregate fine of Rs,100,000/- was imposed on Appellant No,2. 6. The Appellants preferred the instant appeal on the following grounds: a) The Impugned Order has failed to appreciate that the Appellants carried out the audit in accordance with the requirements of ISA. The Impugned Order does not explain why the Reply filed by the Appellants was not cogent. The Impugned Order fails to appreciate that the audit procedures carried out need to be looked at with the background where there was no information about the fraud and consider whether the procedures carried out without the knowledge of fraud were adequate or not. The holistic view of the facts and circumstances, in particular finding of fraud and collusion on part of senior management, read with the statutory protection conferred upon the Appellants as auditors vindicates the Appellants from any breach of law in the instant case, as elaborated hereunder: (i) The Respondent has failed to recognize the inherent limitations of audit, due to which there is an unavoidable risk that some material misstatements of the financial statements may not be detected, even though the audit is properly planned and performed in accordance with ISA (ISA 240, Para 5). The Appellants contend that even as acknowledged by ISA 200 (particularly A45), the auditor is not expected to and cannot reduce audit risk to zero. Therefore, this renders the auditor's opinion to be only persuasive rather than conclusive. (ii)The Appellants submit that in Note 2.8 to the Financial Statements for the year ended 31/12/14 the 'Restatement of Comparatives' has been referred to and details such as inter alia deliberate understatement of liabilities have been disclosed rendering the true and fair status of the Company. This shows that the intent of the Appellants was neither to deceive nor conceal anything from the stakeholders of the Company nor could it be attributed to a "failure to bring out material facts about the affairs" of the Company which has also not been relied as basis in the SCN. Furthermore, with respect to Paragraph 15 of the Impugned Order, the ISA 560 'Subsequent Events' is not relevant as the Appellants were not required to revise their audit report. Based on identification of irregularities in the year 2014, the full impact of irregularities in the year 2014 was determined and recorded in the financial statements 2014. As the matter was already fully disclosed in the financial statements, therefore an "Emphasis of Matter" paragraph was not considered necessary. More importantly, the ISA particularly recognizes that where there are misstatements resulting from fraud, the risk of not detecting such a misstatement is significantly higher as compared to a misstatement resulting from error (ISA 240 Para 6). Furthermore, the risk of the auditor not detecting a material misstatement resulting from management fraud is greater than the employee fraud, for the plain reason that management is in a position to directly or indirectly manipulate accounting records, present fraudulent financial information or override control procedures designed to prevent similar frauds by other employees (ISA 240 Para 6).
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Therefore, in the case of collision, fabricated, sophisticated and carefully organized schemes to conceal may cause the auditor to believe that the audit evidence is persuasive, when it is in fact false (ISA 240 Para 6). Nevertheless, the primary responsibility for the prevention and detection of fraud rests with those charged with governance of the entity and management (ISA 240 Para 4). (iii) The Appellants carried out client and management evaluation prior to commencement of work and they assigned appropriately qualified and trained personnel to the engagement. Risk assessm ent was performed at both entity and account level and planned audit approach was developed based on the risk assessment. According to risk assessment conducted at the beginning of each audit, the Appellants' assessment was that the Company had a well-qualified board, qualified and trained management with no integrity issues and reasonably designed and controlled processes. The tests performed included test of controls for all significant processes and substantive procedures for all significant account balances. The work papers were appropriately reviewed by partner and manager and appropriate representations were obtained from management. b) In terms of section 260(1) of the Companies Ordinance, the Commission is empowered to impose a penalty if it is satisfied that the "default is willful". In this regard, the Commission in its own order in the case of Sherman Securities (Pvt.) Ltd v. Joint Director (SMD) Securities and Exchange Commission of Pakistan cited at 2012 CLD 612 defined the term 'willful' while placing reliance on the definition of 'willful' as reproduced in Black's Law Dictionary "as an act done with stubborn purpose, but not with malice, as done intentionally, knowingly and purposely as distinct from an act done carelessly, thoughtlessly, heedlessly or inadvertently." The Impugned Order, however, has attempted to make it an offence of strict liability, which is not the intent of the statute i,e, provision of section 260(1) of the Companies Ordinance. The Impugned Order has further failed to establish or even refer to the intention of the Appellants. The Appellants submit that the audit was planned and performed in accordance with ISA, the default, if any, cannot be termed as c willful default. The view taken in the Impugned Order is diametrically opposed to the view expressed and adopted earlier by the Commission and consistently followed by the Courts. Reliance is placed on the judgments of Sherman Securities cited at 2012 CLD 612; Kora Khan v Director-General Agriculture Department, Government of Balochistan cited at 2011 PLC (C. S.) 842; Muhammad Nawaz Sheikh v. Manzar Hassan and others cited at PLD 2011 Lahore 531; Mirza Shaukat Baig and others v. Shahid Jamil and others cited at PLD 2005 SC 530; Nasrullah and another v. Haji Usman Ghani and 5 others cited at 2002 CLC 1925) c) The Impugned Order fails to appreciate that even in the EY Report at Page 40, it has been expressly stated while pointing out the limitations of the audit that "it follows that if the information provided to us by PKTCL was inaccurate, wrong, incomplete or unclear or if further information comes to light, this may likewise have affected the completeness and accuracy of any analysis in this report. In substance, the findings are based on the information provided by the management and specific enquiries undertaken; this was also the case when the Appellants undertook the audit. However, as acknowledged the possibility of the findings being further revised cannot be ruled out. Hence, appreciating the above position, any absolute obligation or breach thereof cannot be alleged against the Appellants." d) Finding of breach of fiduciary duty as well as the imposition of penalty on the Appellants was wrong and mistaken. In this regard attention is drawn to section 255(7) of the Companies Ordinance which is to be read with the order of the Commissioner, Insurance Division dated 24/08/16 passed against the Chairman, Chief Executive, Directors of the Company and the Company itself. The Commissioner's Order was passed under sections 11(1)(f) and 12(1) read with section 158 of the Insurance Ordinance, holding the Chief Executive and Directors liable for not managing the business in a second and prudent manner. This may be read together with section
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255(7) of the Companies Ordinance, which makes provision for a penalty to be imposed on officers of a company for not providing an auditor with access to books or any information possessed by him. The provisions of section 260(1) of the Companies Ordinance become inapplicable since the Commissioner's Order has already found the management guilty. The information provided was deliberately distorted by the management itself and was not shared with the auditor. Furthermore, the primary responsibility for preparation of the financial statements which present true and fair view rests with the Board of Directors. Therefore, as the management has been found guilty in the Commissioner's Order for misrepresenting facts and figures, the Appellants should be relieved of any liabilities in relation thereto. With respect to policy holders, no loss has been suffered by them as all the claims are acknowledged by the Company and only recording of claims has been delayed. The Appellants while relying on ISA 200 submit that an audit is conducted on the premise that management and those charged with governance acknowledge and understand that they have responsibility for the preparation of the financial statements in accordance with the applicable financial reporting framework to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error. The management is also responsible to provide the auditor with access to all relevant information for preparation of the financial statements; as well as additional information that the auditor may request; and unrestricted access to persons within the entity, from whom the auditor determines it necessary to obtain audit evidence (ISA 200-A2). The Respondent has failed to take into account that the EY Report was in fact subsequent to the issue of fraudulent reporting surfacing and the investigation was specifically carried out for the purpose of ascertaining whether or not fraud had been committed. Therefore, drawing such distinction is crucial as once the knowledge that fraud has been committed is present, all analysis and management reports and statements of claims analysis are performed with that bearing in mind. Reliance is placed in the matter of Treasure India Ltd v. A.F. Ferguson and Co. and others cited at 1987 61 Comp cases 548 Born, wherein, it was held that, "In judging whether an auditor exercises reasonable care and skill, it would not (Sic) appropriate to proceed on matters which have subsequently transpired, but one must place oneself in the position of the auditor as when the accounts were audited and find out how the matters appeared [Sic.] for ought to have appeared to a man of reasonable care and skill." Therefore, as also recognized by the ISA 200 (particularly A47) an audit is not an official investigation into alleged wrongdoing and the auditor is not given specific legal powers, such as the power of search, which may be necessary for such an investigation and an auditor merely has to employ reasonable care and skill depending on the circumstances of each case. f) The Respondent has incorrectly concluded that the understatements were apparent from the data/information available in the Audited Statement of Claim Analysis. The ' Commission performed off sight monitoring on a quarterly basis and on site monitoring on annual basis of insurance companies, however, no observations relating to misstatements were made by the Commission until a year after such misstatements were fully disclosed and restated in the audited financial statements for the year ended 31/12/14. An inspection of the Company was also conducted in 2013 covering period up to 31/12/12 and no unusual observation was made. Attention is also drawn to another order of the Commission dated 03/08/15 under section 36 and section 46(6) read with section 11(1) of the Insurance Ordinance in relation to Statement of Compliance filed for the year ended 31/12/13 (Solvency Order). Under the Solvency Order, the Commission while reviewing the financial statements for the year ended 31/12/13 observed that the Company was insolvent. Such observation was made from Note 7 of the financial statements for the year 2013; wherein it was specifically disclosed that the Company has been unable to meet solvency related requirements. The Appellants submit that the figures as reported by the Company were not
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challenged by the Commission at the time of the Solvency Order despite the fact that the EY Report as well as restatements for the year ended 31/12/12 and 2013 were on record. g) The Impugned Order omits to consider that the Appellants disclosed issues, which appeared to be only weaknesses and departures from policies and procedures. However, since adequate reasons were provided by the management for such departures negating the likelihood of commission of fraud, the explanations were accepted. The management letters were reviewed by the audit committee and the Board of Directors, none of whom highlighted any concerns that there may be an indication of misstatements or fraud. The principles of natural justice deem it necessary for an opportunity of hearing to be given to a party to address and respond to all allegations made against it. The Respondent in Paragraphs 16 and 19 of the Impugned Order has respectively referred to contents of the Management Reports submitted by the Appellants during the hearing of 21/07/16 as well as a Claims Development Table. The Appellants, however, were never apprised of or. given the opportunity of responding to such evidence either in SCN or during the hearings held. The principles of natural justice also envisage that the material being relied upon as evidence against a person must be confronted to him for his comments and rebuttal. The Claims Development Table produced in the Impugned Order has been prepared by the Respondent based on statutory returns submitted from 2011 to 2015. The Appellants, however, while doing the audits of statutory returns for the year 2012 and 2013 did not have such table and subsequent returns. The Table comprises of gross claims expense for respective claim year and does not take into account reinsurance recoveries. On a net claims expense basis, the overall shortfall in 2012 would stand greatly reduced. Therefore, through review of each year of statement of claims analysis, the misreporting is not apparent unless you are aware that the misreporting has been done. At the time of the audit for years 2012 and 2013, the Appellants by using statutory returns could only compare provisions made in 2011 and 2012 respectively with claim expense recorded in 2012 and 2013. On a net basis, shortfall in respect of prior years (earlier than 2013) was approximately Rs,11 million. Furthermore, estimation of claims liability involves judgment based on information available when the financial statements were prepared and for many accounting estimates, these include making assumptions about matters that are uncertain at the time of estimation. The auditor is not responsible for predicting future conditions, transactions or events that, if known at the time of the audit, might have significantly affected management's actions or the assumptions used by management. The EY Report states that the assessm ent of reserves maintained against the outstanding claims based was on surveyor's estimates and other information provided. In case of the Appellants, at the time of conclusion of audits for 2012 and 2013, surveyors' estimates were not provided in many cases, therefore, understatement of reserves could not be identified. i) Paragraph 13 of the Impugned Order fails to appreciate that the average claims of Rs,27,500/- cited are claims during the period January 2014 to 30/11/14 and reserves at 30/11/14 at Rs,10,000 per claim. The audit of 2014 financial statements was finalized after December 2014 and Appellants had no responsibility to review the position at 30/11/14 which the Appellants did not look at. The Appellants only had the responsibility to report on the financial statements as at 31/12/14. The response as to why tests performed on sample basis could not identify the payments made on Sundays was that the Appellants carry out a small sample, size of which is determined on a statistical basis as opposed to the size of sample in a fraud investigation. Furthermore, when sample is selected as per ISA 530 there is an equal possibility for a transaction to be selected or not selected for the purpose of said sample. Therefore, it is not necessary that the sample would identify all irregularities. EY was appointed to carry out an exercise which is distinct from the audit of financial statements. EY work was targeted towards known areas and they were guided by persons who had full knowledge of the fraud and their sample was a judgmental sample i,e, only
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those claims were selected which had irregularities. The management explained the instances noted of endorsements without adequate supports as valid endorsements which are not uncommon in insurance. The endorsements are made to record any changes to the policies and these changes can be of several nature e.g. change of asset, change of agent etc. The tests carried out by the Appellants in 2012 and 2013 did not identify any fake endorsements. The EY Report in its assessm ent of adequacy of bad debts discovered that the outstanding delays in the 'Outstanding Contribution Register Client and Policy' were being computed from the posting date of the last endorsement passed against the policy instead of the effective date of the policy, i,e, when the balance actually became due. The incorrect dates were incorporated in the Register by the management and this was done deliberately to distort the overdue balances. The Appellants had unknowingly placed reliance on the misstated figures as provided in the Register, resulting in the overdue balances being understated. The Respondent's reference to IFRS-4 in Paragraph 18, and specifically the 'Liability Adequacy Test' and disclosure of information, appears to be of no relevance. The Liability Adequacy Test is carried out to determine whether there is any deficiency in premiums. In general, for the type of business carried out by the Company, this estimation is not significant. This is not directly linked or has…
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