AF304

Auditing
Tutorial 4 Answers
Chapter 5
5.12 Name the elements necessar y to be successful in a case of negligence and show how
these wer e applied in the case of Twomax Ltd v. Dickson, McFarlane & Robinson
(1983).

The elements necessary to be successful are:

• The auditors must have owed a duty of care to the plaintiffs
• The auditors must have breached that duty of care by being negligent
in their audit
• The plaintiff must have suffered a loss due to reliance on the
negligently audited accounts
• The loss must be quantifiable
• In the case of Twomax, the financial position of Kintyre Knitware
made it reasonably foreseeable that they would probably be a
takeover target. The potential investors were therefore owed a duty
of care by the auditors on the basis of reasonable foreseeability.
• The auditors breached the duty of care by negligently performing the
audit.
• The plaintiff lost their entire investment when Kintyre Knitware went
into liquidation.
• The loss was quantifiable as the amount of the plaintiff’s investment.
5.13 How did the key pr inciples of ‘due car e’ develop thr ough the Kingston Cotton Mill
Co. case, the London and Gener al Bank case and the Pacific Acceptance case?

In the Kingston Cotton Mill Co. case the auditors were judged to have exercised their
reasonable care under the circumstances, where management representation was acceptable
and that an auditor is not bound to be a detective to seek out fraudulent activities. The auditor
was said to be a watchdog and not a bloodhound. What is reasonable skill, care and caution
must depend on the particular circumstances of the case.

In London and General Bank, it was no part of the auditors’ duty to give advice either to the
directors or shareholders as to what they ought to do. He is not an insurer and he does not
guarantee that the books do correctly show the true and fair position of the company. The
auditor must be honest, and 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.

In summary
(6) The auditor does not guarantee the financial report is fairly presented.
(7) The auditor is only expected to exercise the skill and care of a reasonably competent and
well-informed member of the profession.
(8) The auditor is not liable for the detection of fraud where his or her suspicion has not been
aroused.

It has been suggested that there has been a too literal interpretation of these cases, which
has retarded the development of the profession of auditing. Such a narrow view was laid to
rest by the Pacific Acceptance case in 1970, which comprehensively evaluated auditing
practices at the time and led to the development of a number of auditing standards.

The Pacific Acceptance case (1970) is probably the most significant, as it was the first major
case to review auditing under modern concepts with respect to what is reasonable due care
and diligence. The auditor was found to be liable to exercise care to competently carry out
his audit. The judgement has been wide ranging and requires several matters to be attended
to by the auditor.

These include:
• Paying due regard to the possibility of material fraud or error in
framing the audit procedures;
• Promptly report fraud or warn of possibility of fraud;
• Closely supervise and review the work of inexperienced staff;
• Carry out proper objective auditing procedures; and
• Recommendations regarding the standards of auditing to be
performed.

The Pacific Acceptance case calls for a changed standard to be met where the conditions or
understanding of dangers is changed. The audit profession has accepted a change in
emphasis in procedures and acknowledged a different approach to the exercise of due skill
and care.
5.14 The Esanda case established the elements that would be necessar y for a thir d par ty
to succeed in an action of negligence against the auditor due to r eliance on the
audited accounts. Identify what these elements ar e.

In order for a third party to succeed they would have to establish:
• The report was prepared on the basis that it would be conveyed to a
third party
• The report would be conveyed for a purpose that was likely to be
relied on by that party
• The third party would be likely to act in reliance on that report, thus
running the risk of suffering the loss if the statement was negligently
prepared.

5.20 What is a pr ivity letter ? How should an auditor r espond to a r equest for a pr ivity
letter ?

A privity letter is one issued by an auditor, acknowledging a third party’s reliance on an audited
financial report. The purpose of the letter is to establish a relationship with required
foreseeability and proximity and thus a duty of care by the auditor to the third party. A decision
to issue such a letter is an individual business risk and management decision. Auditors should
be cautious when such a letter is requested. AGS1014 provides some guidance for auditors if
requested to produce a privity letter.

5.22 Due car e

As the audit senior for Lockerparts Hardware Ltd, you are happy with the smoothness
of the audit for the year ended 30 June 2015. Today, your audit partner tells you that
Lockerparts has just gone into liquidation. The financial controller was diverting
company funds into a Swiss bank account and has left the country to live in Majorca.
The lawyers for the creditors of Lockerparts are taking action against the partner for
not performing an appropriate audit. They believe that a properly conducted audit
should have detected such a fraud.
The fraud was substantial; however, it was not material from the company’s point of
view. You explain to the partner that the audit was performed in accordance with all
auditing standards and nothing was found to arouse suspicion during the audit. The
audit took the same amount of time as last year’s, and all appropriate work steps were
performed. Your work was reviewed by a manager and the entire file was reviewed by
the audit partner.
The audit partner is still concerned. He rings an audit partner in an associated office of
your accounting firm and asks her to review the audit file. She agrees and spends a day
reviewing the file. After completing her review, she is satisfied that the audit was
performed properly.

Required
(a) Explain whether your accounting fir m has acted with due car e. What do you think
will be the cour t's decision if the case goes to tr ial?
(b) Even if the par tner is convinced he acted with due car e, explain why he may offer
Locker par ts a substantial settlement amount.

(a) The key issue in determining whether an auditor has acted with ‘due care’ or not is done
by looking at decided cases and the relevant professional standards. Cases such as Kingston
Cotton Mill and London and General Bank have suggested that the auditor will have exercised
due care if he or she exercises the skill and care of a reasonably competent member of the
profession. The case of Pacific Acceptance stated that the courts would consider whether the
auditor had followed the appropriate professional standards in determining whether he or
she had acted with due care.

In this case it appears as though the audit firm has acted with due care. They have followed
all the appropriate work steps and have ensured that the audit was performed in accordance
with Auditing Standards. There has even been a subsequent review by another audit partner
in an associated firm who cleared the audit file.

The key auditing standard in this case that the audit firm should be concerned about is
compliance with ASA 240. That standard requires that the auditor should plan the audit with
an awareness of the possibility of fraud. It also requires that further work should be performed
when there is a suspicion of fraud.

The court’s decision would probably be in favour of the auditor in this case. (Note: This would
be unless the court decided to extend the duties of auditors with respect to the detection of
fraud.)

(b) A large number of cases are settled before their ultimate conclusion. The high rate of
settlement before verdicts has encouraged a large number of frivolous claims to be made
against auditors. The reasons for settling include the following:
(1) litigation tends to be a lengthy and expensive process;
(2) bad publicity and reputation damage that will arise out of a court decision that goes
against the auditor;
(3) bad publicity and reputation damage that will arise out of a lengthy legal dispute.
It may make more economic sense to settle with Lockerparts Hardware Ltd.

5.24 Negligence, liability to thir d par ties

Sonny Manufacturing Ltd sought a $2 million loan from Bank of Australia. The bank
insisted that audited financial statements be submitted before it would extend the credit.
Sonny agreed to do this and also agreed to pay the audit fee. An audit was performed by
an independent qualified accountant who submitted his report to Sonny to be used
solely for the purpose of the loan negotiation with the bank. The bank, after reviewing
the audited financial statements, decided not to extend the loan to Sonny. The bank had
been using some ratios from the financial statements and decided they were too low.
Sonny used the financial statements to obtain a loan from another financial institution.
However, it was subsequently discovered that the auditor had failed to detect a
significant embezzlement by a senior manager at Sonny.

Required
(a) What ar e the liabilities, if any, of the auditor ? To whom is the auditor liable?
(b) If the auditor did uncover the embezzlement, and noted it in the notes to the financial
statement, is he still liable and to whom?
(c) What factor s should appr opr iately be consider ed befor e the auditor ’s liability is
confir med?

(a) The auditor is only liable when there is a duty of care proven towards the injured party. In
this case, the auditor has knowledge that the financial statements will be used for the purpose
of loan negotiation with the Bank of Australia. It is important to examine the terms of the
engagement and whether the Bank of Australia was named as the only bank in the negotiations.
For the other financial institution which subsequently lent money to Sonny to establish a cause
of action for negligence against the auditors, it must prove that:

• The auditors owed a legal duty of care to the Financial Institution
• The auditors breached the legal duty by failing to perform the audit with the due care and
competence expected of members.
• The auditor’s failure to detect the embezzlement is directly caused by a failure of due care
proximately caused the damages suffered by the Financial Institution;
• The Financial Institution suffered actual losses or damages.

The facts of this case does not establish that the auditors were negligent by not detecting the
embezzlement, because of its nature. However the auditors will not be liable to the Financial
Institution for negligence because they owed no duty to them. This is the case because the
auditor was not in privity of contract with them, and the financial statements were neither
audited for the primary benefit of the Financial Institution, nor was it within a known and
intended class of third parties who were to receive the audited financial statements. Although
in the Columbia Coffee & Tea Case (1992), the New South Wales Supreme Court held that it
was not necessary to prove that the audited financial statements were prepared for the
purpose of the plaintiff or the class of persons intended to rely upon the audit, the Lowe
Lippman Figdor & Frank v. AGC (1992), and Esanda Finance Corp Ltd v. Peat Marwick
Hungerfords (1994) endorsed the decision in the Caparo case that the defendant did not owe
the plaintiff a duty of care.

(b) It may however be stated that the auditor is likely to be liable to the Financial Institution
if it is proven that the audit has been done negligently, or that proper auditing standards have
not been followed. The auditors would have lacked reasonable ground for the belief that the
financial report was fairly presented if they recklessly departed from standards of due care in
that it failed to investigate embezzlements, having the knowledge. The mere noting in the
financial statements does not necessarily mean the proper discharge of due care. The
auditors intended that others rely on the audited financial report. The Financial Institution
justifiably relied on the audited financial report in deciding to loan Sonny and, if damages
resulted from a negligently prepared financial report, the auditors will be liable.

(c) Factors to be considered before the auditor’s liability is confirmed:

Establishment of due care to exist between the lender and the auditor, proximity
The audit has been negligently performed
The causal relationship between the auditor’s negligence and the financial
injury.

5.29 Negligence, contr ibutor y negligence

You are the external auditor of Kiwi Tours Ltd, a company which promotes New
Zealand tours to Australia and owns a chain of duty-free shops. You have been auditing
the company since it was listed on the Australian Securities Exchange 10 years ago.
Although the accounts have never been qualified, you are aware that the company has
been making losses for the past 3 years as a result of short-term cash flow difficulties.
The company has no long-term loans and the bank overdraft is near its limit at the end
of the financial year.
During the financial year, the company upgraded its accounting system to a computer
database. A consultant was hired to aid in the correct changeover of files for this
system. At year-end, this new system had been in place for 6 months, and the directors
report they are happy with the way it is operating. You do not have the expertise to
review and evaluate the database management system, so you ask an independent
expert to undertake this role. This person concludes that the system appears reliable
and that the changeover was correctly carried out. You have never before audited this
type of system, so you attend some courses to familiarise yourself with its features. Your
firm has a standard work program that you use to test the controls operating within the
system.
In your review of the minutes of the board of directors’ meetings, you become aware
that the New Zealand parent company (which owns 40 per cent of the shares of the
company) is considering making an offer for the remaining shares. This is because the
company’s share price is trading well below its net asset backing.
After your audited 30 June 2009 financial statements are published, the takeover offer
from the New Zealand parent company proceeds on the basis of an offer price
equivalent to the net asset backing of $1.10 per share (as determined from the financial
statements). The takeover results in acceptances of 96 per cent of the issued capital, and
compulsory acquisition proceedings have been instituted for the other 4 per cent.
While these compulsory acquisition proceedings are being instituted, it is discovered
that there were errors in the changeover of the computer system, which resulted in
inventory at the duty free stores being materially misstated. After the subsequent write-
down of inventory, a new asset backing of $0.70 per share is established. The New
Zealand parent company is suing you for alleged negligence for its loss of $0.40 per
share.

Required
· Decide what major questions must be answer ed to deter mine whether you have
been negligent. You should suppor t your answer by r efer ence to case law and the
auditing standar ds.
· Outline the major issues to be deter mined to decide whether the company is guilty
of contr ibutor y negligence.
· Assuming you wer e negligent, explain whether you owe a duty of car e to the New
Zealand par ent company.

(a) The key issue in determining whether an auditor has acted with ‘due care’ or not is by
looking at decided cases and the relevant professional standards. Cases such as Kingston
Cotton Mill and London and General Bank have suggested that the auditor will have exercised
due care if he or she exercises the skill and care of a reasonably competent member of the
profession. The case of Pacific Acceptance did say that the courts would consider whether
the auditor had followed the appropriate professional standards in determining whether he
or she had acted with due care. Not complying with the professional standards would
probably mean that the auditor had not acted with due care. Complying with the standards
may or may not mean that the auditor had acted with due care.

The professional standards to consider in this case are as follows:
ASA 570 Going Concern states that the auditor should obtain sufficient appropriate audit
evidence that it is appropriate, based on all reasonably foreseeable circumstances for the
financial report to be prepared on a going concern basis.
In this case the onus will be on you to prove that you had reasonable grounds to believe that
the company would continue as a going concern. Based on the facts that the company had
been making losses for the last three years, had short term cash flow difficulties, and the bank
overdraft was nearing its limit it looks as though some reference to going concern problems
should have been disclosed.

ASA 315 and ASA 330 require an auditor to obtain an understanding of the control procedures
sufficient to assess its effectiveness. This includes the use of information technology.
Although you went to a training course, it does not appear that you had a particularly good
knowledge of the controls over the new computer system.
ASA 620 Using the Work of an Expert states that the auditor should assess the
appropriateness of the expert’s work as audit evidence.
It does not appear that you have done anything to assess the work performed by the expert.
It appears that there may be a reasonable case of negligence against you for your work on
this audit client.

(b) The principle of contributory negligence was introduced to the Australian legal
environment by the AWA case (1992). Contributory negligence relates to the failure of the
plaintiff to meet certain required standards of care that contribute to bring about the loss in
question. In the AWA case the court accepted that the directors have a duty to establish a
sound system of internal control to safeguard the company’s assets. Their failure to do so
was held to be contributory negligence.
In this case the failure of the Kiwi Tours to implement proper controls over the changeover
to its new computer system would be grounds for a claim of contributory negligence.

(c) The key case that is most relevant to the facts of this case is the Caparo case (1990). On
appeal to the House of Lords it was found that a duty of care was owed only to third parties
that were existing shareholders to whom the auditor knew their report would be sent and
relied upon. This approach was recently endorsed by the High Court of Australia in 1997 in
the Esanda case.

To owe a duty of care the following would have to be established according to Brennan, CJ,
in Esanda Finance (on the appeal to the High Court in 1997):
• The report was prepared on the basis that it would be conveyed to a third party.
• The report would be conveyed for a purpose that was likely to be relied upon by that third
party.
• The third party would be likely to act in reliance on that report, thus running the risk of
suffering the loss if the statement was negligently prepared.