Chp 4: The legal liability of auditors

Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs t/a Auditing and Assurance Services in Australia 5e
by Grant Gay and Roger Simnett

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Learning objectives
4.1 Explain the concepts of reasonable care and skill,
and negligence.
4.2 Explain the auditors legal liability to clients.
4.3 Describe the concept of contributory negligence.
4.4 Indicate to what extent a duty of care may be
owed to third parties.
4.5 Describe alternative methods used to limit the
auditors liability.
4.6 Explain the auditors duties in regard to the
prevention, detection and reporting of fraud.
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Establishing the auditors duty

Society imposes a duty to exercise

reasonable care and skill in two ways:

1. Contractual (including statutory) relationship
2. Special relationship between two parties.

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LO 4.1: Reasonable care and skill

Anand
auditor
must exercise the reasonable care
negligence
and skill expected of a professional.
Requires adherence to regulatory & professional

standards in all aspects of an audit.

The professional man owes a duty to exercise

that standard of skill and care appropriate to his

professional status (Caparo, 1990).

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LO 4.3: Contributory negligence

Exists where the plaintiff fails to exercise

the required standard of care, thus
contributing to its own loss.

Prior to AWA (1995), such a defence by

auditors was unsuccessful. Refer to
Pacific Acceptance (1970).

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Negligence

Negligence can be 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.

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Claims for Negligence

To be successful in a claim for negligence, a
plaintiff must prove that:
1)A duty was owed to the plaintiff by the
defendant (duty of care),
2)A breach of the duty of care (negligent
conduct) occurred,
3)The plaintiff suffered a loss or damage,
4)The breach of duty by the defendant caused
the harm suffered by the plaintiff, and
5)The loss is quantifiable.
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LO 4.2: Liability to clients

Liability to clients arises both in contract

and in the tort of negligence. Early cases
include:
London & General Bank Ltd (1895)
Kingston Cotton Mill (1896)
Thomas Gerrard & Son (1967)

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Liability to clients (cont.): Pacific

Acceptance (1970)
Auditors duties and responsibilities are to:
Use reasonable care and skill
Check and see for themselves (professional scepticism)
Audit the whole year
Appropriately supervise and review work of inexperienced staff
Properly document procedures
Rely on satisfactory internal controls
Warn and inform the appropriate level of management
Take further action where suspicion is aroused
Structure plans and procedures so that discovery of material error

or fraud is reasonably expected (no wilful blindness)

Be guided by professional standards (but not determinative).
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Liability to clients (cont.): significant cases

Cambridge Credit (1985)

Segenhoe (1990)
Galoo (1994)

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Liability to third parties (cont.)

Next test: reasonable foresight:
A duty is owed to a specific third party of whom the auditor was not aware,

but who was part of a class of persons of whom they should have been
aware would rely on their audit opinion:
Scott Group (1978)
Shaddock & Associates (1979)
JEB Fasteners (1981)
Twomax (1983).
Current test: proximity:
Was there a sufficient degree of proximity between the auditor and third
party? To answer this question, courts examine whether the report by the
auditor was meant to induce the third party to undertake specific actions:
Caparo (1990)
AGC (1992)
Columbia Coffee (1992) (very wide interpretation,

later overturned in Esanda)

Esanda (1997).

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Contributory negligence: AWA (1995)

AWA: the company suffered losses due to

internal control weaknesses over foreign

exchange.

Auditor

liable for failure to report to board of

directors.

Company

found to contribute to loss by

officers failing to report to board of directors
and failing to put in place adequate internal
control system.

Defence

upheld.

of contributory negligence therefore

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LO 4.4: Liability to third parties

A number of cases have considered the auditors liability

in relation to persons other than the immediate client.

It was believed from early cases (e.g. Donoghue
v Stevenson (1932)) that the recovery of losses by third
parties from auditors for negligence (in the absence of
fraud) was not possible.

Early test: special relationships:

A duty is owed to any third party to whom the auditor

shows accounts or to whom the auditor knows the client is

going to show accounts, so as to induce some action.

Candler (1951) (per dissenting judgement of Lord Denning)

Hedley Byrne (1963)
MLC v Evatt (1971).
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Current situation: liability to third parties

A general conclusion is that it would be

hard to show that audits on general

purpose financial reports (GPFR) were
ever intended to induce third parties to
undertake a specific course of action.
(Auditors would strongly argue that this
was never the intention.)

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Privity letters

A privity letter is a letter from the auditor

acknowledging a third partys reliance on
an audited report. The third party requests
the privity letter from auditor.
Purpose: to establish a relationship with
the requisite foreseeability and proximity
and thereby establish a duty of care by the
auditor to the third party.
AGS 1014 provides guidance.
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Liability to third parties: Competition &

Consumer Act 2010

Consideration needs to be given to the

provisions of the Commonwealth

Competition and Consumer Act and
relevant State Fair Trading Acts:
Acts

prohibit misleading and deceptive

conduct.
It is possible that, in issuing an inappropriate
auditors report, an auditor might be guilty of
conduct that is misleading or deceptive.
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ASIC Act
Under section 50 of the ASIC Act proceedings

for damages to the public interest can be

initiated by ASIC.
In 2008, ASIC utilised this power by
commencing action against KPMG for $200
million over the collapse of the Westpoint
Group. (In 2011 ASIC entered into a
confidential settlement with KPMG and four of
the directors of Westpoint being sued).

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Criminal liability of auditors

Auditors can be subject to criminal prosecution.

It is an offence under section 1308(2) of the

Corporations Act 2001 to knowingly make or

authorise false and misleading statements. A
penalty of $22 000 and/or 5 years imprisonment
exists.

Criminal actions against auditors are rare.

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LO 4.5: Limitation of liability

Prior to CLERP 9, audit firms were required to

operate as sole traders or in partnershipsstill the

dominant form of organisation for audit firms.
Therefore, auditors are personally liable for
damages arising from failure by either themselves
or their partners to exercise reasonable skill and
care.
Spiralling litigation costs and court-awarded
damages.
Professional indemnity insurance is difficult to
obtain and prohibitively expensive (claimed to be
about 14 % of audit revenues).
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Arguments for limiting auditors liability

Inability of auditors to restrict the scope of their

operations and/or resign.

Inequitable position of the auditing profession

compared with other professions and service

providers.

Inability of auditors to rely on representations

of management.

Auditors carry a heavier burden than other

professionals with respect to the amount of

damages assessed.
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Arguments against limiting auditors liability

Auditors should accept full responsibility for

their work.

Auditors are only successfully sued when not

performing their duties competently.

If there is a limit, the auditors share of liability

passes on to the public.

A precedent for other professions.

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Methods of limiting auditors liability

Imposition of a statutory cap on auditors

liability.
Incorporation of auditors.
Removal of joint and several liability and

replacement with proportionate liability.

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Changes to auditor liability

Changes to Corporations Act 2001 as a result of

CLERP 9 allow:
Auditors to incorporate and form authorised audit companies

with adequate and appropriate professional indemnity

insurance.
Apportionment between the plaintiff and defendant

according to blame, and proportionate liability

if there are two or more defendants. (Note: Centro lawsuit
was settled May 2012 for $200 million, with PwCs share
being $67 million, but no admission of liability.)
Introduction of Professional Standards legislation to provide

a statutory cap to auditor's liability.

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LO 4.6: Responsibility for prevention &

detection of fraud
Guidance: ASA 240 (ISA 240) for fraud & error
Prevention and deterrence of fraud remains managements

responsibility.

ASA 240 outlines auditor's responsibility, which has

significantly increased in recent years.

Auditors objectives in relation to fraud are :

identify and assess risks of material misstatements due to

fraud
obtain sufficient appropriate evidence about assessed risks
of material misstatement through designing and
implementing appropriate responses
responding appropriately to identified or suspected fraud.
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Auditors responsibility for prevention &

detection of fraud
ASA 240 indicates that the auditor's responsibility is

to:

Focus on areas where there is a risk of material misstatement

owing to fraud, including management fraud

Maintain an attitude of professional scepticism
The engagement team is required to discuss how the financial
report may be susceptible to material misstatement from fraud
and identify what audit procedures would be effective for its
detection
Design and perform these audit procedures.

These requirements result in a much more proactive

approach toward fraud than required under previous

auditing standards.
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Auditors responsibility for reporting of fraud

An auditor has a duty of care to report fraud,

irrespective of materiality, to an appropriate level

of management when suspicions are aroused.
An auditor may have a mandatory responsibility

to report fraud under the Corporations Act 2001

or the Crimes Act 1914.
In most cases an auditor is protected by qualified

privilege when reporting matters in good faith.

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Summary
A review of the legal cases reveals marked differences in the

judgments illustrating that the extent of the auditors liability is

unclear.
In order to avoid litigation it is vital that the auditor exercise
reasonable care and skill.
The extent to which auditors duty to exercise reasonable care and
skill includes fraud detection is unclear.
Auditors no longer have unlimited liability. Regulatory changes
include:
a statutory cap on auditors liability
allowing the incorporation of auditors
the removal of joint and several liability and replacement with
proportionate liability.
There has been some reversal of these provisions in recent years.

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