TOPIC : LEGAL LIABILITY

REVIEW QUESTION ANSWERS

1. Describe the legal environment for auditors.
Legal environment for auditors are auditors liability under common law
to clients and third parties and the auditors duties to report breaches of
laws under various statutes in Malaysia. Besides that it also explain
about the measures that auditors can undertake to minimize their
exposure to legal liability and the quality control standards that auditors
are required to comply with when providing auditing and other
assurances services. Auditors can be held liable for a number of types
of lawsuits. The types of plaintiffs that typically sue auditors, what must
be proved to sue the auditors successfully, and the defences available
to the auditor.
2. Explain what is meant by deep pocket syndrome.
Deep pocket syndrome is the tendency of the injured party to sue the
auditors regardless whether they are at fault or not. This is because
auditor is often time perceived as the only one left with financial
resources to compensate the users of financial statements (plaintiff) in
cases of business failure.
3. What is meant by proportionate liability? Contrast this legal
doctrine with the doctrine of joint and several liability.
Proportionate liability is holding each defendant liable solely for the
portion of the damages that corresponds to the percentage of
responsibilities of that dependant.
While Joint and several liability is holding defendant fully liable for all
assessed damages suffered by plaintiff regardless of the extent to which
the defendant contributed to the injury.
4. What types of actions may an auditor be liable to a client under
common law? Why would client prefer to sue the auditor for a
tort action rather than for a breach of contract?
An auditor can be liable to a client under common law for breach of
contract, negligence, gross negligence or constructive fraud, and fraud.
Any of the previously stated actions can create a situation where a
client may sue the auditor. A client may prefer to sue the auditor for a
tort action than a breach of contract because tort actions typically pay
larger sums than for a breach of contract case.

5. Liability for negligence represents a deviation from a standard

of behaviour that is consistence with that of a reasonable
person. What behaviours constitute a reasonable person in
this context?
Negligence represents a deviation from standard of behavior that is
consistence with that of a reasonable person. With respect to audit
engagements, two classic statement have often been referred to in
defining the auditors responsibility in relation to auditing of an entitys
account.
6. What elements must a plaintiff prove to be successful in an
action against an auditor for negligence?
Plaintiff should prove :
i.

The auditor owed a duty of care to the plaintiff to conform to a

required standard of care.

ii.

There is a failure to act in accordance with that duty of care that

is a breach of duty of care to the plaintiff on the part of the
auditor.

iii.

There is a causal relationship or connection between the

auditors negligence and the plaintiff damage.

iv.

The plaintiff suffered actual loss or damage.

7. How does the decision in Re Kingston Cotton Mills Case define

the standard of care in the performance of an auditors duty?
In that case, duty of an auditor to bring to bear on the work he has to
perform that skill, care and caution which a reasonable competent,
careful and cautions auditor would use depend on the particular
circumstances of each case. An auditor is not bound to be a detective or
to approach his work with suspicion or with a foregone conclusion that
there is something wrong. He is watchdog, but not a bloodhound. He is
justified in believing tried servants of the company in whom confidence
is placed by the company. He is entitled to assume that they are honest
and to rely upon their representations, provided he takes reasonable
care. If there is anything of that kind, he is only bound to be reasonably
cautious and careful.
Auditors must not be made responsible for not tracking out ingenious
and carefully laid schemes of fraud, when there is nothing to arouse
their suspicion and when those frauds are perpetrated by tried servants
of the company and are undetected for years by the directors. So to
hold would make the position of an auditor intolerable.

8. What is the famous statement made by Judge Cardozo in the

Ultramare case?
If a liability for negligence exists, a thoughtless slip or blunder, the
failure to detect a theft or forgery beneath the cover of deceptive
entries, may expose accountants to a liability in an indeterminate
amount for an indeterminate time to an indeterminate class. The
hazards of a business on these terms are so extreme as to enkindle
doubt whether a flaw may not exist in the implication of a duty that
exposes to these circumstances.
9. What is the significance of the Hedley Byrne case with relation
to auditors liability to third parties?
The significance are :
i.

The auditor must be aware that the financial statements are to

be used for a particular purpose.

ii.

A known party was intended to rely on the financial statements

for that purpose.

iii.

There must have been some conduct on the part of the auditor
linking him to that party, which indicates the auditors
understanding of that partys reliance.

10. What is the significance of the Caparo case with respect

relation to auditors liability to third parties?
In this case that the auditor should have foreseen the loss or damage
resulted from the misleading audited account. The court found that it
was was unreasonable to establish a relationship of proximity between
the auditors and the third party who was not the intended recipient of
the audit report. A most significant element in the Caparo decision is
that the auditors were found not to owe a duty of a care to potential
investors or to individual shareholders rather the duty is owed to
shareholders as a body. Lord Oliver in the Caparo case maintained that
the purpose of statutory audit and audited accounts was for the
company and the shareholders.
11. What are the statutes that impose on the auditor a duty to
report breaches of laws?
The duty primarily require the auditors to the relevant authority
violation of laws or regulations they encounter in the course of
performing their duties, for example when performing the annual
statutory audit of company accounts.

12. Identify steps that can be taken at the professional and

individual firm level to minimise legal liability against auditors.
The steps that can be taken at the professional level are :
i.

Establishing stringer auditing and assurance standards.

ii.

Continually updating the code on professional ethics and

sanctioning members who do not comply with.

iii.

Educating users.

The steps that can be taken at the firm level are :

i.

Instituting sound quality control and review procedures.

ii.

Ensuring that members of the firm are independent.

iii.

Following sound client acceptance and retention procedures.

iv.

Being alert to risk factors that may result in lawsuits.

v.

Performing and documenting work diligently.

13. What is the purpose of an audit firm establishing a system

of quality control?
The firm should establish a system of quality control designed to
provide it with reasonable assurance that the firm and its personnel
comply with professional standards and regulatory and legal
requirements, and that reports issued by the firm or engagement
partners are appropriate in the circumstances.
14. List the six elements of quality control set out in ISQC 1.
Provide one example of a policy or procedure that can be used
to fulfil each element.
Elements of quality control are :
i.
ii.
iii.
iv.
v.
vi.

Leadership responsibilities for quality on audits.

Ethical requirements
Acceptance and continuance of clients and audit engagements
Assignment of engagement team
Engagement performance
Engagement quality control review
One example of a policy or procedure that can be used to fulfil each
element is the revised ISA 220 provides guidance for quality control at the
engagement partners. The areas where quality control policies and

procedures are required for the provision of audit service.