AUD 610

LEGAL LIABILITY

LEGAL LIABILITY
Auditors are accountable for their
professional conduct.
Responsibility arises under:

Common law
Statute

The vulnerability of the auditing profession to

negligence lawsuits has been brought to
notice in recent years by:

The litigation crisis

Debate over the limitation of company auditors
exposure to liability.

LEGAL ENVIRONMENT
Increased in volume and cost of litigation
related to alleged audit failures in recent
years.
Possible reasons:

People equating business failures with audit

failures Expectation gap.
Deep pocket theory
Auditors carry professional indemnity insurance
The only one left standing with sufficient financial

resources to indemnify the plaintiffs losses.

Auditors have unlimited liability.

LEGAL ENVIRONMENTcontinued

Increasing internationalization of the profession.

Litigation crisis in US

Enron
Worldcom
Xerox

Litigation crisis in Australia

Tricontinental
State Bank of Australia

LEGAL ENVIRONMENTcontinued
Effects of litigation against auditors:

Firms retreating from serving high risk clients.

Smaller firms shying away from audits.

Most litigations are settled out of court

because:

To avoid adverse publicity.

Defending against litigation is costly.
Litigation takes a long time to settle.
Defending against litigation is burdensome.

LEGAL ENVIRONMENTcontinued

The compensation is covered by their professional

indemnity insurance.
Audit firms are exposed to unlimited liability.
They may attempt to negotiate out of court
settlement in order to limit their liability should
they be found to be guilty.
To prevent their working papers from being
subpoenaed and discuss in the courts of law.

LEGAL ENVIRONMENTcontinued
However the tendency to settle out of court
bring about other problems such as:

The lack of confidence in the auditing profession is

not rectified.
There are difficulties in assessing the firms
abilities to adapt to a changing business
environment.
There is difficulty in identifying the changes
needed in audit standards and techniques.
Devising ways to improve the expectation gap is
limited.
The success of legally backed standards cannot be
assessed.

LIABILITY UNDER STATUTE

(ORDINARY NEGLIGENCE)
The major laws that govern the auditors
in Malaysia are:

Companies Act 1965

Section 172 Appointment of Auditors
Section 174 Duties and Responsibilities of

Auditor

Capital Market & Securities Act 2007

LIABILITY UNDER COMMON

LAW
Arises under:

Contracts with clients.

Express terms

Implied terms

Duty to exercise reasonable care not negligent &

professionally competent.
Carry out work with reasonable expediency.

With third parties to whom a legal duty of

care is owed.

LIABILITY TO SHAREHOLDERS
AND AUDITEES
For audits conducted under the
Companies Act 1965, the auditors are
liable under statute and common law to
the shareholders for any negligent
performance of statutory duties.
Auditors are also liable in the same
manner as any other citizen for cases of
fraud or defamation.

LIABILITY TO SHAREHOLDERS
AND AUDITEES - continued
In respect of the provision of auditing
services, an auditor is liable to compensate a
plaintiff if:

A duty of care is owed to the plaintiff.

The audit is negligently performed or the
opinion is negligently given.
The plaintiff has suffered a loss as a result of
the auditors negligence (where the causal
relationship is reasonably foreseeable)
The loss the is quantifiable.

DUE CARE
It is the duty of the auditor to perform their
work with skill, care and caution which a
reasonably competent, careful and cautious
auditor would use. They must pay particular
attention to:

Auditing standards in determining the adequate

performance of audit work.
Accounting standards in determining the basis for
expressing an opinion on fairness of presentation.

Auditor is a watchdog not a bloodhound.

Auditor is not an insurer, he does not
guarantee that the books do correctly show
the true position of the companys affairs.

NEGLIGENCE
Defined as any conduct that is careless or
unintentional in nature and entails a breach
of any contractual duty or duty of care in tort
owed to another person or persons.
The case of negligence depends on the
courts judgment under the circumstances of
the case.
Auditors must exercise judgment in forming
opinion on financial statements, particularly:

In applying standards to specific circumstances of the entity

they are reporting.
In the rare circumstances where compliance with Accounting
standards would not give a true or fair view and where
additional information and explanations must be added.

PRIVITY OF CONTRACT
Refers to the contractual relationship
between two or more parties.
Contract between auditors and their clients
are found in the engagement letter.
However, responsibility stated under
statute cannot be reduced.
Parties to the contract members
collectively.

CAUSAL RELATIONSHIP
A relationship where one matter causes
another to happen e.g. breach of duty by
auditor causes loss or harm to another
party.
This relationship must have been
reasonably foreseeable and it must be
proven that the loss suffered is
attributable to the negligent conduct of
the auditor in a negligent case.

CONTRIBUTORY NEGLIGENCE
Relates to the failure of the plaintiff to
meet certain required standards of care.
Together with the defendants negligence,
it contributes to bringing about the loss in
question.
The court tends to examine all relevant
circumstances to judge the likely
proportion of liability attributable to
respective parties.

THIRD PARTY LIABILITY

(GROSS NEGLIGENCE)
Auditor may be liable to third parties if
a loss was incurred because of reliance
on misleading financial statements.

Third parties shareholders (present &

potential)
Bankers, creditors
Employees, customers
Example bank is unable to collect loan.

THIRD PARTY LIABILITY

UNDER COMMON LAW
The decisions in the legal cases relating
to third party liability have not been
consistent.
Case Laws:

Candler v. Crane Christmas & Co

Hedley Byrne v. Heller & Partners
Jeb Fasteners v. Marks Bloom & Co
Caparo Industries plc v. Dickman

CANDLER V. CRANE
CHRISTMAS & CO
It was held that the auditor did not owe
a duty of care in the absence of a
contractual or fiduciary relationship
although Candler was induced to invest
in a company on the strength of a set
of accounts negligently prepared by the
companys auditors.
Denning LJ dissented.

HEDLEY BYRNE V. HELLER &

PARTNERS
A certificate of creditworthiness was negligently issued by
a firm of merchant bankers on request by a third party.
The certificate related to the financial standing of one of
the banks customers.
The House of Lords upheld the minority judgment of
Denning LJ. It was decided that the certificate was issued
in the ordinary course of business of the bank and would
have been relied upon by the third party and the absence
of a contract did not constitute a valid defense.
The case established the concepts of forseeability and due
care. Also introduced the issue of proximity. Proximity is
generally meant to be interpreted as the person injured
physically or financially being within that class that could
reasonably be considered as being affected by the act.
However, the defendants escaped liability because of a
disclaimer clause included in the reference issued.

JEB FASTENERS V. MARKS

BLOOM & CO
Marks Bloom & Co was the auditor of BG
Fasteners. Marks Bloom & Co was aware that
BG Fasteners was in financial difficulty. A
company JEB Fasteners, previously unknown
to the auditor, took over BG Fasteners.
Subsequently JEB Fasteners sued the auditor
for negligence on the grounds that
inventories of the company were overstated.
It was alleged that JEB Fasteners paid more
for the acquisition than it would have, had it
known the true facts.

JEB FASTENERS V. MARKS

BLOOM & CO - continued
It was held that there was sufficient degree
of proximity or neighbourhood thus a duty of
care was owed to the plaintiff.
However, no damages were awarded because
the plaintiffs purpose for taking over the
company was to obtain the services of two
directors of BG Fasteners. The causal
relationship between auditors negligence and
economic loss was not established.

CAPARO INDUSTRIES V.
DICKMAN
Caparo, a shareholder of Fidelity plc
purchased additional shares and made a
successful takeover bid based on the audited
accounts. The accounts showed a profit of
1.3 million instead of a loss of .46 million.
Caparo said he would not have purchased
Fidelity if he had known of the
misrepresentation in the financial position.
The issue here was whether the auditors
owed a duty of care to the plaintiff.

CAPARO INDUSTRIES V.
DICKMAN - continued
The House of Lords held that auditors did not
owe a duty of care to members of the
investing public/potential shareholders, who
relied on the accounts to buy shares.
The purpose of the audit was to fulfill a
statutory requirement on which auditors
express an opinion to assist the shareholders
in their collective function of scrutinizing the
companys affairs.

CAPARO INDUSTRIES V.
DICKMAN - continued
Auditors were only liable to existing
shareholders as a class who had
elected the auditor.
The case narrowed the liability to third
parties.

Kingston Cotton Mill

For several yrs the mgr of the Kingston
Cotton Mill had been exaggerating the
qty and values of the cos stocks so as
to fraudulently overstate the cos
profits.
The auditor relied on a certificate
signed by the mgr and did not
physically observe stock take.

Kingston Cotton Mill-continued

Judgement It is the duty of auditor to bring
to bear on the work he has to performed that
skill, care and caution which a reasonably
competent, careful and cautious auditor
would use. An auditor is a watchdog not a
bloodhound. He is justified in believing tried
servants of the company in whom confidence
is placed by the company. Auditors must not
be made responsible for not tracking out
ingenious and carefully laid out schemes of
fraud, when there is nothing to arouse their
suspicion.

London & General Bank

The bank made loans to customers for which it held
inadequate security. Interest due on the loans was
accrued but not received, yet dividends were paid out
of profits arising from such interest. The auditor
made a full report to the directors in respect of the
valuation of these loans and the need for a provn for
bad debts against both the loan and the accrued
interest.
However, in his report to the shareholders, the
auditor merely qualified his opinion with the following
sentence: The value of the assets shown on the B/S
is dependent upon realisation.

London & General Bankcontinued

Judgment Auditor is not an insurer;
he does not guarantee that the books
do correctly show the true position of
the cos affairs; he does not guarantee
that the b/s is accurate. However, he
must not certify what he does not
believe to be true, and he must take
reasonable care and skill before he
believes that what he certifies is true.

Essential Elements in Negligence

Action
Bases:
Proximity
Reasonable forseeability
Reliance

Candler v. Crane Christmas

No

Duty of care
Hedley Byrne v. Heller & Partners
Jeb Fasteners v. Mark Bloom & Co

Yes

No liability

Kingston Cotton Mill

London & Gen Bank

Negligence

No

Pacific Acceptance Corp v. Forsyth

Yes

Loss due to reliance

On negligently
prepared report

Jeb Fasteners

Segenhoe Ltd

No
Scott v. Mc Farlane

Yes

Loss
quantifiable

No

Twomax v. Dickson, McFarlane, & Robinson

Yes

Liability

AUDITORS LIABILITY DEFENSE

No negligence
Duty of care not owed
If under tort, no financial loss was
suffered
Contributory negligence

AVOIDANCE OF LITIGATION
Use of engagement letters for all professional
services.
Investigate prospective clients thoroughly.
Comply fully with professional pronouncements.
Recognise the limitation of professional
pronouncements.
Establish and maintain high standards of quality
control.
Maintain adequate professional indemnity cover.
Be prepared to issue a privity letter on request.