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Auditors Liabilities to Third Parties: An International Perspective

An auditor can be held liable to third parties for negligence, gross negligence, and fraud. The main difficulty faced by third parties in proving negligence against an auditor is showing or proving that an auditor owes them a duty of care. Concept of duty of care: The due diligence and competency as reasonably expected from a qualified professional. It is the duty of an auditor to bring to bear the work he has to perform that skill, care and caution which a reasonably competent, careful and cautious auditor would use. What is reasonable skill, care and caution must depend on the particular circumstances of each case. An auditor is not bound to be a detective, or, as was said, to approach his work with suspicion or with a foregone conclusion that there is something wrong. He is a watch-dog, but not a bloodhoundhe is entitled to assume that they (tried the servants of the company) are honest, and to rely on their representations. If there is anything calculated to excite suspicion, he should probe it to the bottom but, in the absence of anything of that kind, he is only bound to be reasonably cautions and careful. (Kingston Cotton Mill Co., 1896; English) The spectrum of common-law standards that have evolved internationallly for determining the types of third parties that can successfully sue auditors for ordinary negligence can be illustrated as follows:

Narrowest definition of of eligible third parties Privity Near privity Foreseen Reasonably foreseeable

Broadest definition eligible third parties Any users of financial statements

At the narrowest end of definition of third parties, third parties must have a privity relationship with the auditor to prove the latter's duty of care owing to them. Privity means a contract or specific agreement exists between two parties. At the end of broadest definition, an auditor owes any user of financial statements a duty of care, a parallel concept in the case of Donoghue v Stevenson (1932; English), where a woman drank a bottle of ginger ale (bought by her sister), which appeared to have the remains of a snail at the bottom. She was taken ill and later sued Stevenson, the soft-drink manufacturer. Limit of duty of care is defined as that

negligence was redressable despite the lack of a contractual relationship. Reasonable care must be taken in all circumstances where it can be it can be foreseen that a failure to do so would result in damage. However, the Donoghue case is applicable to physical injuries only; not one jurisdiction has applied the doctrine of Donoghue case to auditors. The concept of eligible third parties does not apply to cases of gross negligence or fraud. Concept of proximity: A person suffers injury physically or financially that could reasonably be considered as being affected by the act. (Hedley Byrne & Co Ltd. V Heller and Partners Ltd (1963; English)) Australia Mutual Life and Citizens Assurance Co. Ltd v Evatt (1971) causal The principle put forward by the Privy Council is this: A special relationship exists where a person holding a position of skill and care or expertise, professes or offers advice to another person, at the direct request of the person receiving the advice. The adviser knows, or ought to know, the other person will rely on the advice. The principle of this case would apply to auditors only if they hold themselves out to be experts and are in the business of giving advice. 2R. Lowe Lippmann Figdor & Frank v AGC (Advances) Ltd (1992) The Appeal Division of the Supreme Court of Victoria maintained that the auditors, in issuing their audit report, were merely discharging their statutory obligations. Issuing an audit report did not amount to issuing a statement to induce a particular person, or members of a class which include that person, to act or refrain from acting in a particular way in reliance on the statement. Mere belief that a person would rely on that statement or report did not constitute making a statement to that person with the intention of inducing that person to act in a particular way. 1Columbia Coffee and Tea Pty Limited v Churchill & Ors t/a Nelson Parkhill and Saunders v Donyoke Pty Ltd & Ors (1992) Supreme Court of NSW held that the auditor in the case had assumed a greater level of responsibility than just to the company and its existing shareholders. Taking into account expert evidence in relation to the extent of reliance that may be placed on audited accounts, Rolfe J indicated he relied on a commonsense approach, the prevailing community standards, and perception in relation to audited accounts. As the damages involved were nominal, the decision was never appealed. The decision was rejected by the Full High Court of Australia in Esandas case.

Esanda Finance Corp v Peat Marwick Hungerfords (1997) due care Supreme Court of South Australia held that the relationship of proximity was needed to give rise to a duty of care. Brennan CJ of High Court of Australia held that, for an auditor to be liable to a third party, the following would have to be established: 1. The audit report was prepared on the basis that it would be conveyed to a third party; 2. The report would be conveyed for a purpose which was likely to be relied on by that third party; and 3. The third party would be likely to act in reliance on that report, thus running the risk of suffering loss if the statement was negligently prepared. Summary The High Court of Australia rejected the contention that liability could be based on foreseeability of reliance alone. There had to be circumstances establishing a relationship of proximity between the auditor and the third party before of duty of care could be said to exist. It appears that the industry has remained relatively stable in both its provision of doubtful debts and account receivable and days or account receivable outstanding while the client has significantly increased the days account receivable outstanding over the period. Assuming no significant change in customer base or credit policies, the client should increase the allowances in 20X3 since days AR outstanding has increased. Inventory has significantly increased, especially when compared to the industry average. At the same time, inventory turnover is decreasing and is significantly below the industry average in 20X2. The auditor should be concern about obsolescent of excess inventory and should do additional testing to ensure the inventory is being valued properly by the client.

New Zealand Scott Group Ltd v McFarlane (1978) New Zealand Court of Appeal supported the concept of reasonable foreseeability. They found auditors did owe a duty of care to a specific third party of whom they were not aware but who was part of a class of persons of whom the auditors should have been aware would rely on their audit opinion.

United Kingdom Candler v Crane Christmas & C0. (1951; English) The Court of Appeal in England held that, provided there was no contractual or fiduciary relationship between the parties, the auditors did not owe a duty of care to the party who suffered financial damages. Cardozo CJ stated that auditors liability does not extend to a liability in an indeterminate amount for an indeterminate time to an indeterminate class. Hedley Byrne & Co Ltd. V Heller and Partners Ltd (1963; English) The case involved a bank, but the principles established had implications for accountants and auditors. The judgment indicated that a reasonable banker ought to have realised that some third party was going to rely on the information, and therefore the banker owe a duty of care to the third party. However, the duty of care was confined to a special relationship, where a person holding a position of skill and care or expertise, professes or offers advice to another person, at the direct request of the person receiving the advice. The adviser knows, or ought to know, the other person will rely on the advice. This case is an example of the concept of proximity. 1JEB Fasteners Ltd v Marks, Bloom & Co. (1981; English) The court held that the defendants (auditors) were negligent in preparing the financial report. They ought reasonably to have foreseen that anyone examined the accounts with a takeover in mind would rely on the financial report prepared by them. Therefore, the auditors were in breach of their duty to act with care and skill. The case reaffirmed the basic principle of third party liability and confirmed the notion of reasonable foreseeability. Twomax Ltd v Dickson, McFarlane & Robinson (1983; Scottish) The principle set in the JEB Fasteners case (viz. the principle of foreseeability) was upheld. Auditors did owe potential investors a duty of care. 2Caparo Industries Pty Ltd v Dickman (1990; English) The case held that three conditions were necessary for the imposition of a duty of care to a third party:

1. Foreseeability of damage; 2. Proximity of relationship; and 3. The reasonableness or otherwise of imposing a duty. The Law Lords held that the auditor did not owe a duty of care to potential investors or to individual shareholders. The duty is owed to shareholders as a body and not to individual shareholders. The Law Lords also held that the auditors liability for financial loss suffered should be limited by reference to specific situations and/or transactions and relationships, rather than by reference solely to the broad concept of reasonable foreseeability. Lord Oliver pointed out foreseeability is not synonymous with proximity. The Caparo decision reverses the principles set by Hedley Byrne & Co Ltd. V Heller and Partners ltd (1963; English); JEB Fasteners Ltd v Marks, Bloom & Co. (1981; English); and Twomax Ltd v Dickson, McFarlane & Robinson (1983; Scottish) to the narrow test of liability espoused by Candler v Crane Christmas & C0. (1951; English) and Ultramares. Auditors liabilities to third parties are parallel between United Kingdom and Australia. The main difference between persuasive and convincing evidence is persuasive is done within limited amount of time and for a reasonable cost taking only certain sample size of clients rather than all clients which we have to look in the case of convincing evidence. So auditors prefer to conduct persuasive audit evidence than convincing. For example, current accounts receivable balance of $50,000. To accomplish this, you send confirmation letters to the clients 20 largest customers. The sum of these customers accounts receivable balances is $37,500, which is 75 percent of the total the percentage your senior associate told you to check. If all the customers reply with positive responses (meaning they confirm that they owe your client the amounts shown in accounts receivable), you have enough persuasive evidence to issue an opinion on the accuracy of the overall accounts receivable balance No convincing evidence is not always pefecrt evidence. Lets take an example of convincing evidence: Your job is to verify the current accounts receivable balance of $50,000. To accomplish this, you send confirmation letters to the all clients customers. But when we take all clients customer records, its not always 100%

Dr Geokjan is major shareholder of ABC and its CEO.No impact Reason : The fact that Dr Geokjan is both a major shareholder and CEO of ABC does not increase the risk of material misstatement and therefore there is no inherent risk. The fact that he also holds shares in the company does not give him an incetive to misstate the financial records. Your firm has audited ABC for the last four years.Increase Reason: The longer a firm spends in a working relationship with a client , the more chances there is that independence will become impaired. After a greater length of time it becomes more likely that the auditor will lose objectivity when dealing with

this particular client the limit is 5 years. There has been high turnover of key personnel during the last two years.increase Reasonjob dissatisfaction and expenses increases due to training and employ benefit. The internal audit function report to the audit committee: Increase Reason: report The fact that the internal auditor has prepared a report internally means that it may not be as objective as a report that has been prepared and circulated externally ABC has been the subject of lawsuits by users of the health supplement Liveraid;the users claim that the drug affects their liver functions .ABC is confident that there are no such side effects from the use of Liver-Aid. increase Reason: In the pharmaceutical industry where ABC operates , there is a high degree of inherent risk. This results from the uncertainty associated with products such as experimental drugs. Becuase of the uncertainty that is inherent in the pharmaceutical industry, there is susceptibility for ABC to misstate the effects of their products once released into society.Because it decreases the public image and reputation of the company which may decrease the sales ratio of the company. USA Ultramares Corporation v. Touche Niven & Co. (1931) The Ultramares doctrine, or the privity requirement, as found by the New York Court of Appeals, is summarised by Benjamin Cardozo J: If a liability for negligence exists, a thoughtless slip or blunder, the failure to detect a theft of forgery beneath the cover of deceptive entries, may expose accountants to a liability in an indeterminate amount for an indeterminate class. The hazards of a business on these terms are so extreme as to rekindle doubt whether a flaw may not exist in the implication of a duty that exposes to these circumstances. Rusch Factors, Inc. v. Levin (1968) A federal district court applied Section 552 of the Restatement (Second) of the Law of Torts to define an accountant's third party liability. Section 552 of the Restatement broadens the auditor's liability beyond privity requirement and near privity requirement (even though the Rush Factors case is an earlier case than both Credit Alliance case (1985) and Security Pacific Business Credit, Inc. (1992) which established the near privity requirement and is explained in the next paragraph) to a small group of persons and class who are or should be foreseen by the auditors as relying on the financial interpretations. The doctrine can be illustrated as follows. Company ABC approaches Audit Firm Smith & Associates for an audit report as a document to apply for credit from Bank XYZ. Smith & Associates is aware of this purpose, and therefore owes a duty of care to Bank XYZ. However, if Company ABC uses the same audit report and

applies for a loan from a bank other than Bank XYZ without informing Smith & Associates, Smith & Associates is not liable to any banks other than Bank XYZ as all other banks are not foreseen third parties by Smith & Associates. Essentially, the Rusch Factors case substituted the concept of caveat emptor ("buyer beware") with the concept of public duty or responsibility. A number of state and federal cases have followed the Rusch Factors doctrine (e.g. Tocchet v. Cater (2003); Loop Corp. v. McIlory (2004)). However, courts thus far have ruled that Section 552 of Restatement does not impose a public duty. There also have been subsequent cases that narrow this concept of foreseen third parties to near privity requirement, as explained in subsequent sections. It is worthwhile to point out that the Restatement is a compendium of common law prepared by legal scholars and presents an alternative view to the traditional privity doctrine. Its language is general, and is subject to different interpretations. Credit Alliance v. Arthur Andersen & Co (1985) and Security Pacific Business Credit, Inc. v. Peat Marwick Main & Co. (1992) In these cases, the New York Court of Appeal expanded the privity requirement to the near privity requirement: the requirement that the third party be known to the auditor, and the auditor has directly conveyed the audit report to the third party, or acted to induce the third party reliance on the audit report. Since an auditor would usually not communicate with any third parties other than those with privity relationships, many users of financial statements would not meet the demandng near privity standard. Rather than further expanding the definition of eligible third parties established by the Rusch case, the New York Court of Appeal narrows the definition instead. 1H. Rosenblum, Inc. v. Adler (1983) Citizens State Bank v. Timm, Schmidt & Company (1983) Murphy v. BDO Seidman, LLP (2003) The courts of three jurisdictions (Mississippi, New Jersey, and Wisconsin) have used a more expansive view of auditors' liability to third parties: reasonably forseenable third parties. In the precedent-setting Rosenblum case, the New Jersey Supreme Court ruled that Touche Ross & Co. was responsible for damages incurred by all reasonably foreseeable third parties who had relied on the financial statements. In the Citizen State Bank case, the Wisconsin court extended the scope of third parties to include all reasonably foreseeably users: If relying third parties, such as creditors, are not allowed to recover, the cost of credit to the general public will increase because creditors will either have to absorb the cost of bad loans made in reliance on faulty information or hire

independent accountants to verify the information received. Accountants may spread the risk through the use of liability insurance. In Murphy case, the California Court of Appeal ruled that "grapevine plaintiffs," who alleged indirect reliance based on what others (e.g. stockholders and stockbrokers) told them about the financial statement, had legal claims for ordinary negligence against the auditors so long as the auditor would have reasonably foreseen that stockholders or stockbrokers would tell other people of the content of the financial statements, and that the other people would rely upon the mispresentations in purchasing the corporate stock.

Rosenblum case probably represents the high-water mark of expansive auditors liabilities where auditors could be liable to any users of financial statements for reasonably foreseeable negligence. Since 1987, no state high court has adopted the foreseeability approach to accountant liability, while a large number have approved or adopted one of the narrower standards. For example, in 2Bily v. Arthur Young & Co. (1992), the California Supreme Court expressly rejected the Rosenblum foreseeability standard, stating that it subjected auditors to unreasonable exposure. Rather, the court concluded that an auditor owes no general duty of care regarding the conduct of an audit to persons other than the client. The court held that an auditor could be liable to those who act in reliance of those misrepresentations in a transaction which the auditor intends to influence, which is consistent with the Rusch Factors or Restatement (Second) of Torts. In 1995, New Jersey legislation overturned Rosenblum and restricts auditor liability to the near privity standard, as illustrated by court cases (e.g. E. Dickerson & Sons, Inc. v. Ernst & Young, 2003)).

Third-party claims of ordinary negligence against auditors is a complicated matter in the US in the sense that, while all four concepts of privity, near privity, foreseen and reasonably foreseen have been demonstrated by corresponding state and federal courts, and legislation, these doctrines of third party eligibility from narrowest to broadest definitions have not been applied consistently across states and overtime.