technical release Management representation letters Explanatory Note (this guidance issued November 2002) AUDIT 4/02 This guidance does not constitute an auditing standard. Professional judgement should be used in applying it. No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this guidance can be accepted by the Institute. 1 Management representation letters The purpose of this Technical Release is to help auditors to increase the usefulness of management representations as audit evidence. This guidance draws attention to specific explanatory paragraphs in Statement of Auditing Standards 440, ‘Management Representations’ (SAS 440), in order to underline the importance of ensuring that such representations are reliable. The guidance is not intended to be comprehensive and is not a substitute for the procedures or related material contained in SAS 440, or for specific measures that may be appropriate to particular matters or engagements. Background Barings Futures Singapore v Deloitte & Touche Singapore1 A recent High Court decision in a preliminary hearing concerning the audit by Deloitte & Touche (D&T) of Barings Futures (Singapore) Pte Ltd. (BFS) has identified some key points in relation to management representations, and the protection they afford to auditors. It was noted in the course of the Barings hearing that the BFS director who signed the representation letters in question had little knowledge or understanding of Nick Leeson’s activities, despite being nominally his boss. However, the director made written statements to the effect that there had been no irregularities involving management or having a material effect on the financial systems, and that the financial statements were free of material errors and omissions. On this basis, D&T claimed that the representations by the BFS director were recklessly fraudulent, and therefore gave them an absolute defence of circuity against the claim in damages which they faced. D&T’s claim failed, however, because they did not establish to the judge’s satisfaction that the BFS director signed the representation letters: i. knowing that the statements in the letters were untrue, without an honest belief in their truth, or indifferent as to whether or not they were true; ii. knowing that he had no reasonable grounds for making the statements, without an honest belief that he had such grounds, or indifferent as to whether he had or not. The judge did, however, address the issue of the result if D&T had proved that, in signing the representation letters, the director was reckless of their truth or falsity. He concluded that, had such a case for fraudulent misrepresentation been established, he would have held that BFS was vicariously liable for the director’s action, and thus D&T would have succeeded in their claim. SAS 440 ‘Management Representations’ SAS 440 requires auditors to obtain written confirmation of appropriate representations from management before their report is issued. In particular, auditors should obtain evidence that the directors acknowledge their collective responsibility for the preparation of the financial statements and that they have approved them. The SAS also requires that auditors should obtain written confirmation of representations from management on matters material to the financial statements, when those representations are critical to gathering sufficient audit evidence. Paragraph 10 of SAS 440 states that, “In addition to obtaining representations from the directors as to their responsibility for the financial statements, auditors often rely on representations by management as part of their audit evidence.” However, as paragraph 15 points out, “Representations by management cannot be a substitute for other evidence that auditors expect to be available.” Unsupported representations by management do not normally constitute sufficient audit evidence. The only situations where corroborative evidence may not be available are those where the subject of the representations are management judgment or intentions. Whatever their function in the body of evidence collected by an auditor to support the audit opinion, management representation letters are not a mere formality. This is why the final part of SAS 440 states that, “If management refuses to provide written confirmation of a representation that the auditors consider necessary, the auditors should consider the implications of this scope limitation for their report” (SAS 440.5). 1 Barings Futures Singapore v Deloitte & Touche Singapore [2002] All ER (D) Mar 1 Increasing the usefulness of management representations as audit evidence The Barings judgment does not contradict the basic procedures or principles contained in SAS 440. What it does do, however, is emphasise the need for auditors to have regard to the ‘grey lettering’ material in the SAS in relation to obtaining comfort from representation letters. Paragraph 12 suggests that auditors discuss such matters with those responsible for giving the written confirmation before they sign it to ensure that they understand what it is they are being asked to confirm. Paragraph 14 invites auditors to “....consider whether the individuals making the representations can be expected to be well-informed on the particular matters”. In order to assist this process, and in particular to focus directors’ attention on whether proper enquiries have been made, auditors may find it helpful to request management to add a sentence to the representation letter along the following lines: We confirm that the above/following representations are made on the basis of enquiries of management and staff with relevant knowledge and experience (and, where appropriate, of inspection of supporting documentation) sufficient to satisfy ourselves that we can properly make each of the above/following representations to you. This wording is suggested for illustration only, and is not mandatory. It could help to reduce the impression given to directors that phrases such as “to the best of our knowledge and belief” may enable them not to make proper enquiries. Auditors would further be well advised to ask the signatory(ies) what steps they took to obtain comfort that such an assertion had substance. In circumstances where the representations are being made by those distanced from the activities involved, for example the use of complex financial instruments, auditors could suggest that the relevant member of management responsible provide specialised representations to the board. In this case it may be useful for the directors’ own letter of representation to attach and refer to the specialist memorandum, to ensure that they retained overall responsibility. It is already a criminal offence, under section 389A of the 1985 Companies Act, for an officer of a company knowingly or recklessly to make a misleading or false statement to the company’s auditors. Auditors may, therefore, take the opportunity when discussing representations with the directors (and other staff, if applicable), to remind them of the statutory provisions relating to false or misleading statements. Future developments It is generally considered that section 389A of the 1985 Companies Act has not had much impact to date. The importance of written representations by management, and their reliability as audit evidence, may be increased if draft clauses 107 and 108 in Part 6 of the recently published Companies Bill are enacted. These clauses require directors of companies and certain subsidiaries, and people connected with a company and its subsidiaries in Great Britain, to provide information or explanations in answer to the company auditor’s questions. Failure to answer the questions, or the knowing or reckless provision of a misleading, false or materially deceptive statement, is a criminal offence, punishable by a fine of up to £5,000 and/or imprisonment. 2 TECPLM1089