TOPIC 2 Legal Liability

By: Aida Hazlin Ismail & Kamaruzzaman Muhammad Shah Alam

AUD 610

Topics to discuss

Areas to be cover Liability under statutory law Liability to clients (Directors of the company) Under companies Act 1965 Duties to report breaches of laws under different acts

Liability under Common Law Liability to clients. Due to breach of contract, negligence and fraud Liability to third parties (Shareholders, bankers, government and investor). Due to negligence and fraud

Introduction

Lawsuits against auditors relatively uncommon before the 1970s, but not now auditors profession face greater exposure to legal action, especially in US, Canada, U.K. and Australia.
In U.S., approximately 4,000 each year (in 1960s, only a few hundred a year) claims against auditors. Example, as table below:Auditors EY Andersen Andersen PWC EY Company Audited Cendant Waste Management Sunbean Microstrategy Saving & Loan Settlement Amt (USD) 335 million 75 million 110 million 51 million 400 million
Source: text book

Introduction Key Legal Terms

Privity A contractual/trust relationship, lack of privity means the accountants may not owe a duty of care to an injured third party. Breach of contract Occurs when the contracting parties fails to meet the terms and obligation established in the contract. Example: Failure of a CA to deliver a tax return on the agreed-upon date. Parties who have relationship that is established by a contract are said to have privity of contract. Tort A wrongful act other than a breach of contract but not criminal action and can held liable under the civil court. Example: Negligence and Fraud. Negligence means some act or omission which occurs because the person concerned has failed to exercise that degree of professional care and skill, appropriate to the circumstances of the case, which is expected of accountants and auditors (ICAEW). Ordinary negligence An absence of due care in the conduct of an assignment. For auditors, in terms of what other auditors would have done in the same situation.

Introduction Key Legal Terms

Due care - is evaluated in terms of what other professional accountants would have done in similar circumstances. Gross negligence An extreme departure from professional standards of due care. Lack of even slight care, totally reckless that can be expected of a person.

Fraud Actions taken with the knowledge and intent to deceive (make someone believe on something not true) Example: auditors has made false representation and the auditor has the knowledge that the representation is false.
Third-party beneficiary A third party who does not have privity of contract but is known to the contracting parties and intended to have certain rights and benefits under the contract. E.g. Bank. The company has a large outstanding loan and the bank requires audited financial statement as parts of its loan agreement.

Introduction

Statutory Law: Written law enacted by the legislative arm of the government that establish certain course of conduct that must be adhered to by covered parties. Example: Under the Companies Act 1965, the auditors are liable to express their opinion on the financial statements of the clients. Auditors also has reporting duties under various other statues such as under BAFIA, SCA and AMLA. These duties require the auditor to report to the relevant authorities violation of laws or regulations they encounter in the course of performing their duties.

Introduction

Auditors can be sue by clients, shareholders, bankers investors, creditors and government for failure to perform professional services adequately. Auditors can be held liable under two classes of law; i.e. common law and statutory law.

Common law: Case law developed over time by judges who issues legal opinion when deciding a case. The legal principle announced then become precedent for judges deciding similar case in future. Under the common law: Auditor held liable to client: for breach of contract, negligence and fraud. Auditor held liable to third party: for negligence and fraud.

The outcome of application the common law for the third party is subjective, inconsistent and sometimes depend on the location where the case is tried.

Introduction Why??

Increase legal action against auditors, why?? Many accounting and legal professional believe that a major cause of lawsuit against auditors is because lack of understanding by financial statements user of the difference between a business failure and an audit failure and between an audit failure and audit risk.

Business failure occur when business fail financially and as a result, will be unable to pay its financial obligations and unable to meet the expectations of its investors due to poor management, economic conditions etc..
Audit failure occur when the auditor issues an erroneous audit opinion as the result of failure to comply with the requirement of auditing standards. E.g. Assigned unqualified staff to perform audit, he unable to detect material misstatement that qualified auditors would discover. Audit risk is the risk that the auditor will conclude that the financial statements are fairly stated and an unqualified opinion can therefore be issued when in act they are materially misstated. This because the auditors gather information on test basis

Introduction Why??

Increase legal action against auditors, why??

When there is a business failure due to unable to pay its debt, it is common for the user of the financial statement to claim that there was an audit failure, even if the audited financial statements in actual fact is fairly stated and it was correctly reported by the auditors. The user argue, if the auditor perform their job with due care the auditor should be able to detect misstatement and advise their client accordingly. In other word, the auditors can prevent the business to fail by implementing proper audit job.

This conflict we called Audit Expectation Gap.

Introduction Why??

Audit of Expectation Gap: Is the difference that exists between what the public expects of auditors and what the auditors believe their responsibilities should be.

The users believe, unqualified audit opinion provides an assurance that an entity is well managed, financially sound and there is no fraud.

On the other hand, auditors argue that the user is lack an understanding of the limitations of the financial reporting or the auditors examination of the financial statements, i.e. base on sample and materiality.

Introduction Why??

Audit of Expectation Gap: Thus, the public has unreasonable expectations on the auditors and financial statements.

However, the gap is also due to auditors inadequate performance. This is due to either the auditor not performing up to the standard OR the standards itself are not drawn up to the required benchmark. An understanding of the gap enables the profession to address the relevant issues and maintain confidence of the users of the financial statements in providing the services.

So, Component of audit expectation gap: Unrealistic expectations on the part of users Performance gap By auditor to comply the standards By standard to meet the need of users

Introduction Why??

Implications of Audit Expectation Gap:

Loss confidence on auditors Audit report less reliable Bad reputation of auditors Increase of lawsuits

Action to be taken to narrow the gap Expanded audit report (more explanation or disclaimer clause) Increase public awareness and education in respect of the nature of audit work and its inherent limitations Educate client and audit committees Educate client and public on the word reasonable assurance. Due to inherent limitation, auditor unable to give absolute assurance.

Introduction Why??

Action to be taken to narrow the gap

Influence public opinion and changing professional standards to ensure an audit is designed to provide reasonable assurance that materials errors, irregularities and misstatement in the financial statement will be detected (Example: developed good audit program to enable to detect fraud). Auditors strictly adhere to auditing standards. Auditors should be more sensitive to possible existence of fraud in every audit they conduct.

Introduction Why??/

In U.S., factors that contribute to the high incidence to lawsuit: Evolution of the legal system: Professional Indemnity is mandatory to auditor. The client who facing the business failure or injured parties tend to get compensation from the auditor as the auditor is covered with the large insurance coverage. This so-called deep pocket syndrome.

The practice of contingency legal fees: no legal fee when the case is lost and the fee will charged on the percentage of damages awarded when the case is successful. Plaintiffs have no risk of paying legal fee from their own pocket. Jury system: members of public as a jury will apply laymans standard in judging professional negligence and most in cases the decision is favour to the injured parties.

Measures to reduce exposure to lawsuits

At the profession level:

Research in auditing Establish stronger auditing and assurance standards Set requirement to protect auditor. E.g. developed a sample of engagement letter and letter of representation to be followed by all auditors Establish peer review (auditing the auditors) requirement Lobby for changes in the law to protect the auditors Education of users to the meaning of auditors opinion and scope of audit work Continually updating the code on professional ethic and sanction (official order to stopping trade) members for improper conduct and performance

Measures to reduce exposure to lawsuits

At the individual firm level Deal only with clients possessing integrity and investigate prospective clients thoroughly Hire qualified personnel and train them properly Follow the standards of the profession Understand the clients business Maintain independence Perform high standard of quality audits Documented the work properly Obtain clear engagement letter and representation letter Maintain confidential relations Carry adequate insurance coverage Alert to risk factors that may result in lawsuit Exercise professional scepticism..

TOPIC 2 Legal Liability

LIABILITY OF AUDITORS: UNDER THE STATUTORY LAW

AUD 610

Liability Under the Statue

Statutes in Malaysia: Company Act 1965 (CA), SCA 1993, BAFIA 1989 are intend to safeguard the interest of shareholders, depositor, investor and public. Companies Act 1965 govern the auditors in Malaysia of which auditor has specific duties and responsibilities under the following sections: Sec 9 Qualification as auditors Sec 172 Appointment and remuneration of auditors Sec 174 Power and duties of auditor
Besides the above provision, the liability of the auditor also came from the legal reporting liabilities imposed under the various statutes. The auditor has the duty to report but not to detect any violation of law that came to the auditors attention during the course of the audit. Example Companies Act 1965: Duty to report companys financial statement (CA 1965) and become whistle blower, i.e. to report a breach or non-compliance with any provision of the CA.

Liability Under the Statue

Example Securities Industries Act 1983: (Governed the trading of securities on the stock exchange). The auditors need to report breach of securities law to authorities such as SC.

BAFIA 1989: (licensing and regulation of banking institution). Any violation of BAFIA by the bankers, the auditor need to report to the central bank (Bank Negara) immediately. AMLA 2001: (dealing with law and penalties of money laundering and measure for preventing such activities). AMLA imposes a legal duty on a reporting institution including auditor to report unlawful transaction to the Financial Intelligent Unit of Bank Negara. SCA 1993: (Establish SC as approving and registering body for prospectus issued in connection with public securities offering). The auditor is responsible to report non-compliance of the Act by the company or borrower in the case of issuing debenture.

TOPIC 2 Legal Liability

LIABILITY OF AUDITORS: UNDER THE COMMON LAW

AUD 610

Liability Under Common Law

Auditors has liability to clients and third parties under the common law. Liability to clients due to Breach of contract, Negligent and Fraud Liability to third party due to Negligent and Fraud
Under the both liability, plaintiff must prove the following in order to bring any legal action against the auditors: Duty of care: The auditor owed a duty of due care to the plaintiff. Extensively discussed with cases

Breach of duty of care: The auditor has failure to act in accordance with due care. The standard of care is that of the reasonable skill and care of another person carry in the same assignment. Casual relationship: There is casual relationship or connection between the auditors negligence and the plaintiff damage. Damage: The plaintiff suffered actual loss or damage.

Liability Under Common Law

Liability to clients (Due to Breach of contract, Negligent and Fraud): When the auditors accepts appointment, he actually enters into a contract with client which then indirectly impose certain obligation on him. These obligations may clearly stated (express term) or unstated (implied terms) in the contract:

Express terms: Provision stated in the contract (e.g.: engagement letter) and these terms shall NOT override the statutory law but they may be go beyond the statutory law. Example: Clearly stated auditors responsibilities and client responsibilities which are not stated in the Companies Act 1965 and also the deadlines.

Liability Under Common Law - Liability to Clients

Implied terms: The terms which parties in concert have left unstated because they consider too obvious to express. Example: Auditors have a duty to exercise reasonable care, work with reasonable expediency (with normally in the engagement letter) and auditors have the right to reasonable remuneration. Under the common law, the auditor may liable to clients for breach of contract, negligence and fraud.
Breach of contract for example, the auditors failure to complete the job as stated in the engagement letter (the duties, the fee and time line should be clearly stated in the letter). The auditor also is required to perform the professional service with due care (same degree of skill, knowledge and judgment with the other members of the profession).

TOPIC 2 Legal Liability

LIABILITY OF AUDITORS: UNDER THE COMMON LAW TO THIRD PARTY

AUD 610

Liability Under Common Law

Liability to Third Party (due to Negligence and Fraud)

As discussed above, plaintiff must prove the following: Duty of care: The auditor owed a duty of due care to the plaintiff. Extensively discussed with cases

Breach of duty of care: The auditor has failure to act in accordance with due care. The standard of care is that of the reasonable skill and care of another person carry in the same assignment. Casual relationship: There is casual relationship or connection between the auditors negligence and the plaintiff damage. Damage: The plaintiff suffered actual loss or damage.

Liability Under Common Law

Duty of Care to the third party: The auditor under the law has responsibility to perform his duty with skill and care required under the circumstances.

Legal action by third party often involve allegation of misrepresented financial statements and inaccurate audit reporting. However, this area of liability is complex and court ruling are always inconsistent. The main difficulty faced by the plaintiff is to prove negligence of the auditors. Until the 1960s, view under U.K. common law was that accountant would not be held liable to a third party outside the contractual relationship which is based on the doctrine of privity of contract. Privity of contract means the obligation exist under the contract are between the original parties to the contract and failure to perform with due care results in a breach of contract only to those parties.

The evolution of liability under common law based on case (Duty of care)
First landmark case: Ultramares v Touche. Et. Al (1931) Fact of the case: The plaintiff (Ultramares Corporation) was approached for a loan. The plaintiff asked the borrower to provide the audited financial statement of which audited by the defendant (Touche). The borrower were bankrupt after obtained the loan from the plaintiff. The plaintiff alleged that the auditor has been negligent in their report for failing to detect or report deceptive accounting entries that hide the borrowing companys problem.

Judgment: The auditors did not owe a duty of care to the plaintiff due to not in contractual privity.

Explanation: In this case the court held that although the auditor (Touche) was negligent, they were not liable to third party (Ultramares) because Ultramares was not deemed to be primary beneficiaries (i.e. a known third party was informed before the audit)

The evolution of liability under common law based on case (Duty of care)
Case 1 : Chandler v Crane, Christmas and Co. (1951) Fact of the case: The plaintiff (Mr Chandler) in this case was invest in a company based on audited accounts of the company, which is negligently prepared by the auditor. The company subsequently became insolvent. Mr. Chandler sue the auditor and the auditors did not deny their negligence in performing the audit and they also aware that the account would be used by the plaintiff in investment decision.

Judgment: It was held by the majority of the Court of Appeal in England that in absence of a contractual relationship between the parties, the auditor did not owe a duty of care to the plaintiff (Mr. Chandler). Why: view under the U.K. common law was that a professional accountant would not be held liable to a party outside the contractual or fiduciary relationship based on doctrine of privity of contract. Referring case: Ultramares V. Touche, et. Al (US 1931)

The evolution of liability under common law based on case (Duty of care)
Auditor-Crane Christmas

Prepare account negligently

Chandler Shareholder

Company

Purchase share based on the Accounts and suffer losses

Judgment: The auditor did not owe duty of care in the absence of a contractual relationship.

The evolution of liability under common law based on case (Duty of care)

The privity doctrine was again tested in another important English case: Hedley Byrne v. Heller and Partner (U.K. 1963).
Case 2: Hedley Byrne vs Heller & Partners (1963) Fact of the case: The case did not involve auditor but a merchant bank, Heller & Partners, was approached by Hedley Byrne, an advertising company for credit reference on a potential client, Easipower Ltd., who was also a customer to the bank. The reference was supplied by the bank without making a careful check of the records. Based on this reference, Hedley Byrne provided a credit to Easipower Ltd., which subsequently went into liquidation before the debt were recovered by Hedley Bryne.

Hedley Bryne sue the bank and the bank denied responsibility on the ground that it owed no duty of care to the plaintiff in absence of contractual relationship. According to privity doctrine, Chandler case and Ultramares case.

The evolution of liability under common law based on case (Duty of care)

Case 2: Hedley Byrne vs Heller & Partners (1963) Judgment: House of Lord held that the bank owed a duty of care to the plaintiff on the ground that the bank is responsible to give information with due care once he knew or ought to have known that Hedley will rely on its information to make credit decision.

This judgment eroded the precedent ruled in the Ultramares and the Chandler case and the privity standard is no longer strictly used as a defense measure. However, Heller & Partners escaped liability because it had inserted a disclaimer of responsibility in the certificate of credit references. On the strength of the disclaimer, the bank did not have to pay any compensation to the plaintiff. Example of disclaimer: We must emphasize that this report has

been prepared solely for your own records/information and no responsibility nor warranty will be accepted by our firm to any third party who may use this report for any purpose.

Hedley Byrne & Co v Heller and partner (1963) -- Duty of care

Hedley ByrneAdvertising Agent
Asked about companys credit worthiness from banker

Provide information without proper checking

Company
Banker - Heller
Want to be advertised in media

Judgment: bank owed a duty of care to the plaintiff on the ground that

the bank is responsible to give information with due care once he knew or ought to have known that Hedley will rely on its information to make credit decision.

The evolution of liability under common law based on case (Duty of care)

Since the Hedley case, a number of court decision have demonstrated the extension of auditors liability to third party base on the Hedley principle. As long as the auditor knew the identity of third party which would rely on the audited account to make a decision, the courts are more ready to establish the existence of a duty of care.

The evolution of liability under common law based on case (Duty of care)

Case 3: JEB Fasterners Ltd v. Marks, Bloom & Co (1981) Fact of the case: JEB Fasteners Ltd was acquired the entire shares of BG Fasterners which was facing liquidity problems. Marks, Bloom & Co were the auditors of BG Fasterners Ltd.

In performing the audit of BG, the auditor did not verify the net realizable value (NRV) of the inventory but accepted the companys own figure of NRV. The accounting policies is Inventory will be valued at lower of cost and NRV. In actual fact that the cost of the inventory is far less than NRV and to comply with an accounting standards, the amount of the inventory is should be based on cost not based on NRV.
If inventory carried at cost, the company would shown substantial loss instead a small profit as reported. The plaintiff brought an action against auditors claiming that the account negligently audited and they had rely on the audited account when acquiring the companys shares.

The evolution of liability under common law based on case (Duty of care)

Case 3: JEB Fasterners Ltd v. Marks, Bloom & Co (1981) Fact of the case (Continued): The auditor contended that they did not owe a duty of care to plaintiff and if a duty of care existed, it was only to persons who made a specific request for information. In this case, JEB Fasterners was not officially request for the information, they just use the information available for public at large, i.e. the audited accounts.

Judgment: The court held in favour of plaintiff on the ground that the auditors knew at the time the accounts were prepared, the company needed outside financial support and ought reasonably to have foreseen that a take over was a solution to financial problem faced by BG. The auditor owed the JEB Fasterners a duty of care in the preparation of audited accounts.

The evolution of liability under common law based on case (Duty of care)

Effect to profession: Make accounting profession more risky as the court had broadened the auditors liability to the extent that they could potentially owe a duty of care to almost anyone who relying on their audit opinion.

JEB Fasteners vs Marks Bloom Duty of care

Company BG Fasteners
Aware co having liquidity problems. Prepare Account so that co get financial support from outside
I

By shares in the company based on audited account.

Auditor

JEB Fasteners

Judgment: The auditors could have been liable to the third party because he knew or ought to have reasonably foreseen that the accounts, which he audited were to be relied on upon for the purpose of making investment decision.

Liability under Common Law Duty of care

From the cases so far, a few terms that need further explanation. Example ought reasonably to have foreseen in the JEB case. Basically this is a type of relationship between plaintiff and the auditor to be established by the court before enter the judgment for the case. There 1. 2. 3. 4. are 4 types of relationship between plaintiffs and the auditor: Privity relationship as discussed above. Primary Beneficiary relationships Foreseen Party relationships Foreseeable party relationship

Privity relationship refers to the contractual relationship that exists between two or more contracting parties. (i.e. the auditor and the client)

Liability under Common Law Duty of care

Primary Beneficiary relationships Non-client could have this relationship. A known third party. Auditor knows that the audit is specially for the identified third party. Example: Carried out due diligence review for a specific third party to take over a company. Hedley Bryne is a known third party to Heller & Partner
Foreseen Party relationships Non client relationship. (In the case of JEB Fasterner) Known to or reasonably expected to be known and rely on auditors work in making decisions. Foreseen party is a member of limited class of user whom auditor is aware that they will rely on the financial statement and to be treated the same as a known third party. Example: a bank that has loans outstanding to a client may be a foreseen user.

Liability under Common Law Duty of care

Foreseeable party relationship Users who are not specifically known to or identified to the auditor. Often called an unlimited class of third party. Reasonably be expected to see the auditors report and financial statements. Example: Public or market who make investment decision based audited accounts. Explanation: Many courts allowed third parties whom having Primary Beneficiary relationships and Foreseen Party relationships the right to bring legal action against auditors, BUT not for the parties which considered under foreseeable party relationship. In other word, third party such like potential buyer of the company (who asked the auditor to perform due d), bankers and creditors as at balance sheet date are the parties who have right to take action. Potential shareholders, creditors and bankers is foreseeable party of which does not have legal right to take action against auditors. This called Test of Proximity. i.e. testing to identify the primary and foreseen relationship.

The evolution of liability under common law based on case Duty of care

Case 4: Caparo Industries Pty Ltd v. Dickman & Others (1990)

The fact of the case: In 1984, relying on the audited account, Caparo purchased Fidelity plc shares in the open market on staged basis until finally acquired control of the Fidelity. The audited accounts of Fidelity showed a profit of 1.2m. After take over, Caparo discovered that the result would have been a loss of 400,000. Caparo alleged that the auditor had been negligent in auditing the account. The main issue here whether the auditor owed a duty of care to the plaintiff.

The evolution of liability under common law based on case Duty of care

Case 4: Caparo Industries Pty Ltd v. Dickman & Others (1990) Judgment: House of Lord (reversing the Court of Appeal). The decision gave substantial comfort to the auditing profession as it held that:1. the auditor owed no duty of care to the potential investors making

investment decision on the strength of audited accounts.

2. Duty of care should only to the intended recipient of the auditors

report, i.e. primary beneficial third party and foreseen third party (Proximity relationship) where the account were prepared specifically for a third party for a particular purpose and the intention was made clear to the auditor at the time of the audit engagement.

The Caparo decision seems to reaffirm the privity rule in the earlier Ultramares and Candler case where individual shareholders, prospective investors, lenders or other third parties who suffer financial loss by relying on negligently audited account would have no claims against the auditor.

The evolution of liability under common law based on case Duty of care

Case 5: Royal Bank of Scotland v. Bannerman Johnston Mc Clay and

Others (2002) Fact of the case: This case has an impact on the auditors report in

Malaysia. The plaintiff (Royal Bank) claimed on misleading audited account in disburse loans and investing in equity of a company that had to go into receivership. As a result, the plaintiff suffered loss and sue the auditors. Judgment: The Scottish Court, in reference to the Caparo case, held that when the auditors did not stated the disclaimer statement in the auditor report and did not disclaim their responsibility, they could be held owing a duty of care to a third party if they knew (or ought to have known) that the third party would rely on the audited account for lending or investment decision.

The evolution of liability under common law based on case Duty of care

Case 5: Royal Bank of Scotland v. Bannerman Johnston Mc Clay and

Others (2002) Effect to profession: Modification on the audit report to include the

following clause: It is our responsible to form an independent opinion, based on our

audit, on the financial statements and to report to you as a body in accordance with Section 174 of the Companies Act 1965 and for no other purpose. We do not assume responsibility to any other person for the content of this report.
This statement serve as disclaimer statement for the auditor, i.e. the responsible of the auditor is to report the accounts to the shareholders as a body as required by CA 1965 and the auditor do not accept any other responsible.

Summary of Cases for Duty of Care

Case Summary of the case Judgment Auditors Privity Doctrine Auditors Privity Doctrine Plaintiff but auditors escaped due to disclaimer sttmt Ultramares Plaintiff was approached for a loan by a company (1931) which went bankrupt after receiving loan. Chandler (1951) Hedley (1963) Plaintiff invest in a company which became insolvent. Investment made based on the audited account Plaintiff asking the bank (Heller & Partner) about the credit worthiness of a client which went into liquidation subsequently. Certificate given by bank without proper checking on the record.

JEB Fastener (1982)

Plaintiff take over a company which having a financial difficulties. The financial statement was negligently prepared (show small profit instead of substantial loss).

Plaintiff Auditor should know account to be used by 3rd party

Summary of Cases for Duty of Care

Case
Caparo (1990)

Summary of the case

Plaintiff take over a company shares on stages until having control in the company based on financial statement which shown profit Rm1.2 whereas in actual fact it should loss RM400k.

Judgment
Auditors no duty of care to unidentified party (Doctrine of proximity) Plaintiff Absent of disclaimer Statement

Royal Bank of Scotland (2005)

Plaintiff give a loan and invest in a company which go into receivership subsequently. Investment made based on the audited account

The evolution of liability under common law based on case

Significant to the profession: Based on example cases above, lawsuit exercise against auditors has give significant changes in the profession in particular:

Many find judgment in caparo case difficult to accept raises questions about the role of the auditor and the value of the auditors service. New audit standard were developed from time to time Auditors are encourage to obtain clear engagement letter Clarified the certain concept so that more clear. Example concept of contributory negligence: Relates to the failure of the plaintiff to meet certain required standards of care that also contributed to the negligence such as the directors fail to establish a sound internal control to safeguard the companys assets. Rise on litigation cost and the cost of professional liability insurance and become the second largest cost after the cost of human resources for the auditing profession.

Liability Under Common Law

The plaintiff also must prove the following: Breach of duty of care: Second condition in a tort negligence is to establish by the plaintiff that the auditor has failure to act in accordance with due care.

The standard of care is that of the reasonable skill and care of another person carrying the same assignment. Under common law, an auditor has the duty to perform an audit using the same degree of care that would be used by an ordinary, prudent member of the public accounting profession.

Liability Under Common Law (Breach of Duty of Care)

Two classic statement have often been referred to in defining the auditors responsibility to perform with due care:First statement by Lindley LJ in Re London and General Bank (1895): An auditor is not bound to do more than exercise reasonable care and skill in making inquiries and investigations. He is not an insurer, he does not guarantee that the books do correctly show the financial position BUT auditor must be honest, 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. Where suspicion is arose, more care is necessary. In absent of the above, auditor may be said as breach of duty of care.

Liability Under Common Law (Breach of duty of care)

Second statement is by Lopez LJ in Re Kingston Cotton Mill (1896): the auditor had relied on a managers certificate as the basis for ascertaining the amount of inventory stated in balance sheet. As a result the inventory is misstated and inflate the profit (at that time stock take is not normal auditing practice). The judge conceded that it was not the auditors duty to take stock and that he must rely on some skilled person to record the proper value of stock. However, to respond to the auditors responsibility relating to detecting fraud, the judge stated that it is auditors duty to perform with reasonable skill, care, competent, careful and caution of which depend on particular circumstances of each case but he is not bound to detect the fraud.

Conclusion: Reasonable skill and care is not static concept. The standard of reasonable care will go inline with current expectation.

Liability Under Common Law (Causal Relationship)

The plaintiff also must prove the following: Causal Relationship: Third condition in a tort negligence is the proof of connection between the plaintiff loss and the act of negligence.

The plaintiff must demonstrate that the loss is the consequence of the breach in the duty of care and at the time the breach was committed, the loss was reasonable foreseeable as a consequence. Example: To proof of connection between auditors failure to detect (not carry more care when suspicion arose) a fraud and the loss (damage) arising from the fraud. Plaintiff has to proof that if the audit had been carried out competently, the auditor can detect the weakness of internal control and able to prevent the fraud and accordingly the loss from the fraud can be avoided.

Liability Under Common Law (Causal Relationship)

The plaintiff also must prove the following: Causal Relationship: Example Legal Case: Galoo Ltd Vs Bright Graham (1994). The plaintiff claimed the auditor were liable for its trading losses for a number of years during the audited account materially misstated. Plaintiff alleged that if the financial position was known earlier, the entity may discontinued its business operations, thus avoiding the huge trading losses.

Court: Causal relationship not exist, because an entity operations decision and result depend on many factors such as management and market forces. Accordingly, the plaintiff claims against the auditor was denied. In the case of Haig Vs Bamford, the plaintiff was able to satisfy the court on the issue of relationship by showing that he had discussed the account with bankers and auditor regarding the intention of the investment.

Liability Under Common Law (Damages)

The plaintiff also must prove the following: Damages: The forth element in the tort of negligent is the proof the plaintiff suffered actual loss or damage.

Type of damages are loss of investment, overpayment for investment, loss due to defalcation by management or employee and overpayment of dividends. The measurement of damages is dependent on the circumstances and the courts typically attempt to approximate monetary equivalents that the plaintiff will get if the auditors discharged his duties properly. Award of damages would not be granted if the plaintiff had not suffered real or measurable loss.

TOPIC 2 Legal Liability

AUDITORS DEFENSE MEASURES AGAINST LEGAL ACTION : BY CLIENT BY THIRD PARTY

AUD 610

Auditors Defenses Against Legal Action

Legal Action by Client: Defenses Measures by Auditors:

Lack of duty to perform: Auditors would claims that there was no implied or express contract. E.g. The misstatement due to fraud was not uncovered because the obligation of prevent fraud is on the management, not on the auditors. Must clearly stated in the engagement letter. Non negligent performance: auditors would claims that the audit was performed in accordance with auditing standards. Absence of causal connection: The succeed client need to prove that the damaged suffered by them mainly due to auditors negligence. E.g. client alleges that the bank not granted the bank facilities to the company due to the auditor unable to complete the audit on the agreed-upon time, which cause damages to the company. The auditor may defence is that the bank refuse to give the loan for other reason such as weakening financial condition of the company. This defense is called an absence of causal connection.

Auditors Defenses Against Legal Action

Legal Action by Client: Defenses Measures by Auditors:

Contributory negligence: Auditors would claims that the clients own actions and interfering were resulted in the loss that is rge basis for damages. E.g. Client have to pay penalty for late filling of tax return due to auditor unable to complete the job on time. The auditors defense is that the audit job unable to complete within the time due to lack of corporation from the management in providing appropriate audit evidence and explanation.

Legal Action by Third Parties: Defenses Measures by Auditors The first three defenses measures above also available in third parties lawsuit. Contributory negligence is not available because the third parties are not contribute to misstated of financial statement. The most preferred defense measure could be Non Negligent Performance. The auditors had perform the job according to auditing standards. The other defenses measures: Lack of duty to perform (lack of privity of contract) and lack of causal connection

END OF TOPIC 2

EXAMPLE QUESTIONS
QUESTION 1
Range Bhd. went into receivership in 2004 after incurring a deficiency in shareholders funds over RM117 million. The deficit was mainly due to trading losses in the past 5 years and the writing off in 2000 of some non-existent investments and receivables. The liquidator of Range Bhd. is now suing the former auditor of the company for the breach of contract and negligence. The auditors conceded that they had not carried out adequate procedures to verify the investments and receivables and had relied mainly on the Chief Executives written representations and assurance. However, the auditors claimed that they are not liable for the loss because the loss was not caused by their negligence. Required: How can the liquidators of Range Bhd. establish that the auditors negligence has resulted in the loss of the company? (6 marks)

EXAMPLE QUESTIONS
QUESTION 2
Negligence on the part of the auditor could be so willful so as to constitute a conspiracy with management to defraud the company or other parties. The auditors could be brought to court on criminal fraud charges, (Gill, G.S. & Cosserat, G.W.,2000). Required: a) What elements must a plaintiff prove to be successful in action against an auditor for negligence? (4 marks) b) What is the significance of the Caparo case with respect to auditors liability to a third party? (4 marks) c) Identify steps that can be taken at the professional and individual level to minimise legal liability against the auditors. (6 marks)

EXAMPLE QUESTIONS
QUESTION 3 Halim & Co has been the auditor of Berkat Bhd., a public listed company for several years. Halim & Co issued an unqualified audit report on the financial statements for the year ended 30 June 2006. Halim & Co did not detect a material misstatement in the financial statements as a result of negligence in the conduct of the audit. Based on the audited financial statements, Fortune Bhd purchase substantial amount of shares in Berkat Bhd which subsequently has a drastic downturn. Berkat was place under receivership and Fortune Bhd began proceeding against Halim & Co for damages caused by his negligence. Required: a) Discuss the factors which might substantiate Halim & Cos liability towards Fortune Bhd. Support your answer with relevant cases. (9 marks) b) State, if any, Halim & Cos defences against the action. (3 marks)

SUGGESTED ANSWER
ANSWER 1 To establish that the auditors negligence has caused the loss of the company, liquidators of Range Bhd. can claim that if the auditor had performed their work with due care, the company would have caused a receiver to be appointed earlier, instead of carrying on the business until 2004. It can claim that the overstatement in investments and receivables had presented a very misleading picture of the true financial position of the company. If the company has appointed a receiver earlier, the company would have avoided the subsequent trading losses and the increase in the deficiency in the shareholders funds can also be avoided.

6 marks

SUGGESTED ANSWER
ANSWER 2a Element must a plaintiff prove to be successful in action against an auditor:-

1. Duty of care: The auditor owed a duty of due care to the plaintiff. 2. Breach of duty of care: The auditor has failure to act in accordance with due care. The standard of care is that of the reasonable skill and care of another person carry in the same assignment. 3. Casual relationship: There is casual relationship or connection between the auditors negligence and the plaintiff damage. 4. Damage: The plaintiff suffered actual loss or damage.
4 marks

SUGGESTED ANSWER
ANSWER 2b The Caparo case seems to be a reversal of the principle found in cases such as Hedley Byrne, Haig v. Bamford, and JEB Fasteners. In the case, it was stated that the purpose of statutory accounts was for the company and the shareholders and not to assist investors making investment decisions. Accordingly, the auditors do not owe a duty of care to investors making investment decisions on the strength of auditor accounts. It was held in the case that it was unreasonable to establish a relationship of proximity between the auditors and the third party who was not intended recipient of the auditors report. 4 marks

SUGGESTED ANSWER
ANSWER 2c The following steps can be taken to minimize legal liability against auditors: 1. Establishing stronger auditing and assurance standards 2. Continually updating the code of professional conduct on ethics and sanctioning members who do not comply with it 3. Educating users 4. Instituting sound quality control and review procedures 5. Ensuring that members of the firm are independent 6. Following sound client acceptance and retention procedures 7. Being alert for risk factors that may result in lawsuits 8. Performing and documenting work diligently 9. Pushing for tort reform

SUGGESTED ANSWER
ANSWER 3a Factors that might substantiate Halim & Cos liability to Fortune Bhd are:1. Duty of care: The auditor owed a duty of due care to the plaintiff. 2. Breach of duty of care: The auditor has failure to act in accordance with due care. The standard of care is that of the reasonable skill and care of another person carry in the same assignment. 3. Casual relationship: There is casual relationship or connection between the auditors negligence and the plaintiff damage. 4. Damage: The plaintiff suffered actual loss or damage. 4 marks

SUGGESTED ANSWER
ANSWER 3a Court held for the following cases are in favour of Plaintiff:Case Summary of the case Judgment

Hedley (1963)

Plaintiff asking the bank (Heller & Partner) about the credit worthiness of a client which went into liquidation subsequently. Certificate given by bank without proper checking on the record. Plaintiff take over a company which having a financial difficulties. The financial statement was negligently prepared (show small profit instead of substantial loss).

Plaintiff but auditors escaped due to disclaimer sttmt Plaintiff Auditor should know account to be used by 3rd party

JEB Fastener (1982)

SUGGESTED ANSWER
ANSWER 3a Whereas in the following cases, court held are in favour of auditor:-

Case Ultramares (1931) Chandler (1951)

Summary of the case Plaintiff was approached for a loan by a company which went bankrupt after receiving loan. Plaintiff invest in a company which became insolvent. Investment made based on the audited account

Judgment Auditors Privity Doctrine Auditors Privity Doctrine

SUGGESTED ANSWER
ANSWER 3b Halim & Co defenses measures include:-

1. That there is no duty of care to Fortune Bhd. Audited account is for shareholders NOT for investment decision making. 2. No proximity relationship as his liability towards Fortune Bhd would mean that the auditor is exposed to liability in an indeterminable amount for an indeterminate time to an indeterminate class of person, under Caparo case 3. Halim & Co has carried audit due care and diligence. Not breach duty of care.. 4. Contributory negligence by the Berkat Bhd.