As the second largest insurance company in Australia, HIH Group was constituted by more than 240 subsidiaries at one time. It operated within 16 countries, covering the business over five continents. However, HIH went into liquidation in March 2001, with an estimated shortfall of $5.3 billion. The unexpected collapse was due to various reasons and we will focus on four aspects in our analysis:
1. Reinsurance problem
2. True and fair view & compliance with accounting standards
3. Insolvency assessment for director and auditor
4. Auditor independence
Implications of HIHRC Report
In the HIHRC Report, Justice Owen noted that fraud was not a major contributing factor to the collapse. We will identify the implications of this assessment from both accounting and auditing perspectives.
In terms of accounting, HIH provisioning policy did not provide for an adequate prudential reserve margin in respect of its future claim obligations, but rather it sought reinsurance to cover the risk. The reinsurance arrangement would actually be loans, and would possibly reduce the reported profit and increase the liability, which would accordingly result in increased D/A ratio. Moreover, there is a doubt that whether the Accounting Standards fully reflect the true and fair view of the financial statement. The reported assets of HIH, such as good will, deferred acquisition costs and future tax benefit were not serviceable for assessing the real financial position. They exist only in accounting, and do not represent anything that necessarily can be converted into cash. Whereas, these capitalisations of expenses and ‘bookkeeping debits’ all complied with Accounting Standards. As a result, auditors are on a near impossible mission to satisfy the joint criteria of complying with the accounting standards and attesting to the truth and fairness of financial statements. Hence, someone suggest that the true and fair criterion should override the Accounting Standards.
In respect of auditing, the main issue is auditor independence. Firstly, three former partners of Andersen sat on the board of HIH. Secondly, HIH dealt with the audit committee and non-executive directors. Thirdly, Andersen received a high proportion of non-audit fees from HIH. So it can be concluded that auditor independence was compromised. Besides, auditors were lack of the knowledge of the specific insurance industry, and negligently ignored the contingent liability which may become future claims, thus increasing D/A ratio.
Issue of Insolvency: Director’s Duty
A company is insolvent if it is unable to pay all its debts as they fall due. According to the Corporations Act, directors have to assess whether their company is solvent and to make a declaration of solvency in its annual report. Moreover, directors also have the duty to prevent insolvent trading. In principle, there are two major tests which are cash flow test and balance sheet test generally used to determine solvency. Under cash flow test, the entity is regarded as insolvent when it is unable to pay its debts as they become due. The cash on hand, and the level of debts incurred are some important elements to consider when cash flow test is employed. While the balance sheet test requires comparing entity’s asset to its liability. If the book value of the assets is less than its liabilities, the company is insolvent. In HIH case, there was an under estimation of liabilities, the large amount of investment and transactions reduced the cash flow within the company. Moreover, the assets of HIH were recorded at historical cost, and some were not serviceable for assessing solvency. Although there were several indicators suggesting the possibility of insolvency, the director of HIH ignored them and consequently failed to detect the company’s possible insolvent status.
Issue of Insolvency: Auditor’s Duty
As part of the audit planning, auditor is responsible for tracking the client’s solvency. Auditor is responsible to express a true and fair view on a going concern basis of a company’s financial statements. ASA 570 Going Concern requires the auditor to assess the risk of going concern problems at the planning stage and again during the final review when forming an opinion. AUS 708.02 also specifies the auditors’ responsibilities to consider the appropriateness of going concern principle as a basis for preparing financial reports.
Since 1992, HIH started to implement the deed of cross guarantee to reduce group financial and reporting costs. Under a cross guarantee, only the ultimate holding company’s directors of the group are required to prepare consolidated financial statements and provide an annual solvency declaration. This increases the difficulties for auditor to assess the solvency of an individual company within a group setting due to the absence of subsidiaries’ financial statements and non-disclosure of market-sensitive information, especially when they cross guarantee each other’s debts. HIHRC observed, with a deed of cross guarantee in place, HIH had netted-off related company assets and liabilities in several APRA annual returns, thus treating its insurance subsidiaries as if they were part of a singular corporate group enterprise.
Justice Owen commented on the first step in determining the state of insolvency of HIH would be to identify the corporate entity that has incurred the debt or debts in question. It would also be necessary for auditor to make a more detailed audit planning procedure and assess each insurance company within the HIH group continually to determine its solvency status. Moreover, separate legal entity perspective should be adopted in assessing solvency rather than group enterprise perspective.
There was a close relationship between HIH executives and its auditors, which may give cause for concern for the auditing profession in independence aspect. An auditor must be independent both in fact and in appearance is fundamental to an effective audit. However, an auditor cannot be truly independent when they are being remunerated by the client.
In HIH case, three former partners of Andersen, Cohen, Fodera and Gardener had been present on HIH board since December 1998. In addition, Andersen’s presentations to the audit committee were discussed with HIH management prior to audit committee meetings. The closed business relationship involves a commercial interest and may create self-interest and intimidation threats, which is a specific threat to independence. Moreover, the pressure on Andersen partners to maximise non-audit fees was to the potential detriment of their professional obligations. Therefore, the close relationship between HIH and Andersen would primarily contribute to a perception that Andersen was not independent of HIH.
In order to improve auditor’s independence, Sarbanes Oxley Act (2002) was created to enforce auditing independence for public companies and to inspect auditing operations while CLERP 9 (2002) was issued to oversight the auditing profession, auditor liability and independence etc. thus promoting auditor independence. It has been proposed that the appointment of the auditor should be made through a regulatory agency, not by the company receiving the audit.
As analysis above, the failure of HIH raises both accounting and auditing issues which alarms the directors and auditors to meet their duties and fulfill their responsibilities. This case also gives an insight view of the integral nature of accounting and auditing, and how the profession and regulators could facilitate the reforms to improve auditor’s independence as well.
1. Australia’s Corporations Act 2001 (Cth)
2. Deeds of cross guarantee, ASIC Class Order 98/1481: Wholly Owned Entities, retrieved 18th May, 2009 from
3. F. Clarke and G. Dean, “Corporate Officers’ Views on Cross Guarantees and other Proposals to Lift the Corporate Veil” Companies & Securities Law Journal, August, 2005, pp, 299-320.
4. F. Clarke and G. Dean (2007), Indecent Disclosure: Gilding the Corporate Lily, Cambridge University Press, pp, 94-180
5. F. Clarke, G. Dean and K. Oliver (2003) Corporate Collapse, Cambridge University Press, Chapter 15
6. Financial reporting relief for wholly-owned entities under Class Order 98/1418, retrieved 18th May, 2009 from http://www.asic.gov.au/asic/asic.nsf/byheadline/Relief+for+wholly-owned+entities+under+Class+Order+98-1418?openDocument
7. HIHRC Report, 2003, HIH Royal Commission, April 2003, Volume1 & Volume3
8. Leung, Coram and Cooper (2009) Modern Auditing & Assurance Services, 4th Edition, Wiley, pp79-661
9. Worrells, 2003, Determining solvency and insolvent trading, 26th April, 2009 from http://www.worrells.net.au/library/insolvency/Determining%20Solvency%20and%20IT.pdf