auditing.Topic 4

Topic 4

Auditor’s Legal Liability

Powerpoints revised by Professor Barry J. Cooper,

Deakin University – full version based on Chapter 3

September 2009

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The legal environment

• Litigation related to alleged audit failures have caused some concern in the profession, especially in the context of the “deep pockets “ theory

• The requirement to hold a practising certificate imposes an obligation on auditors to carry professional indemnity insurance for possible liability to their clients and members of the public

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• This source of compensation (insurance) creates a perception that auditors have ‘deep pockets’ and, arguably, contributes to the extent of claims filed against them

• There have been major changes in the legal environment concerning auditor liability in the last few years

• We examine legal liability in the context of the litigation crisis, the professional standards legislation and the impact of the CLERP 9 Act

The legal environment

The legal environment

• KPMG paid $136 million in 1994 over its audit of the failed merchant bank Tricontinental

• KPMG and Price Waterhouse paid $120 million over the 1991 collapse of the State Bank of South Australia

• Litigation over the Adsteam collapse involved Deloitte Touche Tohmatsu in $20 million settlement

• Arthur Andersen settled a substantial claim over the Bond Corporation collapse

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The legal environment

• Table 3.1 in Chapter 3 provides a 6 year overview of claims defended by the Big 4 accounting firms

• However, it is difficult to come to conclusions because of the lack of public information for the out-of-court settlement cases – which is the norm

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Government concerns

• Government concern with lack of appropriate insurance is threefold: – Lack of insurance coverage– Less audit firms leads to reduced competition– Both these impact on public interest

• Because of these three points a number of changes occurred

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The professional standards legislation

• The Treasury Legislation Amendment (Professional Standards) Bill 2003 was passed by the Commonwealth Government on 24 June 2004

• The Bill adapts the Professional Standards Legislation (PSL) at the State and Territory level to limit civil liability for misleading and deceptive conduct under the Commonwealth’s Trade Practices Act 1974, the Australian Securities and Investments Commission Act 2001 and the Corporations Act 2001

• Replaces joint and several liability with a national model of proportionate liability

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• The following key points relate to subsequent state-based legislations to enact the Commonwealth based reforms:

– Limitation caps are calculated with reference to a multiple of fees charged

– The cap does not apply to liability arising from claims for death, personal injury or any conduct involving a breach of trust, fraud or dishonesty

– A minimum cap of $500 000 applies but can vary within and between occupational groups

The professional standards legislation

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The Impact of the CLERP 9 Act

• In 2004 CLERP 9 Act allowed (for the first time) companies to register as independent auditors provided they have adequate and appropriate professional indemnity insurance

• Provision for registration of companies is a major change in the law

• Previously had to operate in a partnership with full personal liability

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• To determine the required insured amount, ASIC proposes the following formula:

– If the maximum engagement fee is estimated to be less than $50 000, the insured amount will be $500 000, for any one claim and in the aggregate; or

– If the maximum engagement fee is estimated to be more than $50 000, the insured amount will be ten times the estimated maximum engagement fee up to a maximum figure of $20 million for any one claim and in the aggregate

The impact of the CLERP 9 Act

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Auditor’s responsibility for specific tasks

• Familiarisation with contractual, regulatory and professional provisions governing the audit;

• Maintain independence;

• Effectively plan (to gather audit evidence);

• Use audit practices known to be generally accepted by professional peers;

• Ensure audit opinion is compatible with evidence;

• Audit opinion clearly expressed;

• Properly supervise audit staff.

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Auditor’s responsibility for specific tasks

• Detecting and preventing fraud and error?

• Warning of business failure?

• Ensure all regulatory requirements complied with?

• Guaranteeing the accuracy of the accounting content of financial statements?

• Judging the efficiency and effectiveness of the entity’s operations and management?

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Auditor’s responsibility to report to Users

• Corporations Act, S’s 307 to 313.

• S 307: To form an opinion about:– whether company’s financial report is in

accordance with Corporations Law (inc. accounting standards, true and fair);

– whether auditor has been given all information, explanation and assistance necessary;

– whether company has kept sufficient financial records and other records and registers required by the Corporations Law.

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Auditor’s responsibility to report to Users

• S 308: (Audit report):– To report to members on the above (S 307)

matters;– Report any non-compliance with AASB accounting

standards (inc. financial effect);– Report any defect or irregularity in the company’s

financial report ;– Audit report date.

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Auditor’s responsibility to report to Users

• S 311: Auditor to notify ASIC in writing if they:– have reasonable grounds to suspect the company

has contravened the Corporations Act, and;– believe that the contravention has not been or will

not be adequately dealt with by commenting on it in the auditor’s report or bringing it to the attention of directors.

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Auditor’s Powers

• S 310: (Auditor’s have the power to obtain information):– Auditor has right of access at all reasonable times to

the books of the company;– Auditor may require any company officer to give

him/her information, explanations or other assistance.

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Auditor’s Liability

• Auditors can be held liable to either:

– Shareholders and auditees who can bring an action under contract law for breach of an actual or implied contract term, or they can bring an action under tort (common law); or

– Third parties who can bring an action under tort

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Liability to shareholders and auditees

• 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 and the audit is negligently performed

– the plaintiff has suffered a loss as a result of the auditor’s negligence (where the causal relationship is reasonably foreseeable)

– The loss must also be quantifiable

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The following issues, therefore, need to be considered and each is dealt with separately:

•Due care

•Negligence

•Privity of contract

•Causal relationship

•Contributory negligence

•Damages

Liability to shareholders and auditees

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Duty of care?

• The development of the concept of due care, as applied to the performance of an auditor’s duties, is considered by referring to cases decided in UK and Australian courts

• Consideration is also given to the relevance of the profession’s auditing and accounting standards that exist at the time of the case

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Kingston Cotton Mill Co. (1896)

Finding

• The Kingston Cotton Mill case laid down some fundamental auditing principles such as the ‘watchdog’ role and the notion of taking reasonable skill and care

• Auditors did no physically observe inventory but relied on a certificate from management

• As the judge observed - The auditor is a watchdog, not a blood hound

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London and General Bank (1895)

Finding

• The duty of an auditor is to convey information, not to arouse enquiry

• Although an auditor might infer from an unusual statement that something was seriously wrong, it by no means follows that ordinary people would have their suspicions aroused by a similar statement

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Implications of the Kingston Cotton Mill and the London and General Bank cases

• These two cases formed the basis for most subsequent decisions as to the determination of auditor negligence

• The narrow interpretation of the Kingston Cotton Mill Co. case concerning some audit practice was finally laid to rest by the Pacific Acceptance case

• The Pacific Acceptance case showed the changing expectations in respect of the auditor’s responsibility, with the standards of reasonable care also being raised

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Implications of the Kingston Cotton Mill and the London and General Bank cases

• The auditor is not necessarily answerable for an error of judgement, provided he or she exercises the skill and care of a reasonably competent and well-informed member of the profession

• Nevertheless, a too-literal interpretation of the Kingston Cotton Mill Co. case has been criticised as retarding the development of improved auditing practices

• The Pacific Acceptance case established some of the key features of professional due care now expected of an auditor

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Pacific Acceptance Corporation Ltd v. Forsyth (1970)

Findings

• ‘Reasonable skill and care’ calls for changed standards to meet changed conditions or changed understanding of dangers, and in this sense standards are more exacting today than in 1896 (Kingston Cotton Mill case)

• This case was the first to review a major audit failure under relatively modern standards

• Led to the first major review of auditing standards in Australia

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• The judgement was wide ranging and important points included:

– must pay due regard to the possibility of material fraud or error in carrying out audit procedures

– Closely supervise and review the work of inexperienced staff

– Properly document audit procedures in a written audit program which is to be amended as necessary as the audit progresses

– Carry out proper objective auditing procedures

Pacific Acceptance Corporation Ltd v. Forsyth (1970)

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Due care further emphasised in:

• The Royal Commission into HIH Insurance– ‘… auditors have an obligation to ensure that they

are, and are seen to be, maintaining high standards of honesty and probity, acting in the interests of the shareholders of the company … and exercising independence of mind …’

• Stanilite Pacific Ltd & Anor v. Seaton and Ors (2005) (trading as Price Waterhouse)– the judgement referred to ‘… an extension of the

duty to exercise reasonable skill and care in giving consent for their report to be included in a prospectus …’

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Negligence

• Negligence has been 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 (that is, to those who the auditor could reasonably foresee would rely on the auditor’s report), owed to another person or persons

• If the auditor has been negligent, then the client may sue the auditor for breach of an implicit term of the contract to exercise reasonable care and skill, so as to recover any consequential loss suffered

• The client may also sue the auditor in the tort of negligence to obtain damages sufficient to restore the client to its original position

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• The auditor’s duty of care to a client thus arises either in contract or in the tort of negligence

• Subsequent to the Pacific Acceptance case, the Australian accounting bodies issued more comprehensive and specific auditing standards and practice statements concerning the conduct of the audit

• Disputes may still arise as to whether, in a specific engagement, an auditor has complied with the standards and thus has a good defence against an action for damages on the if can show standards are being followed grounds of negligence

Negligence

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• Subsequent to the Pacific Acceptance case, the Australian accounting bodies issued more comprehensive and specific auditing standards and practice statements concerning the conduct of the audit

• Disputes may still arise as to whether, in a specific engagement, an auditor has complied with the standards and thus has a good defence against an action for damages on the if can show standards are being followed grounds of negligence

Negligence

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Privity of contract

• The term privity of contract refers to the contractual relationship that exists between two or more contracting parties

• An audit is assumed to be performed in accordance with professional standards unless the contract (engagement letter) contains specific wording to the contrary

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Privity of contract

• Under contract, only the directors (on behalf of the company) or, more commonly, the liquidator or receiver, may sue the auditor in respect of losses incurred by the company arising from the auditor’s negligence

• Individual shareholders, creditors, employees etc. have no claim against the auditor under contract

• Refer Figure 3.1

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Causal relationship

• A causal relationship exists between the breach of duty by the defendant and the loss or harm suffered by the plaintiff

• This relationship must have been reasonably foreseeable

• Also, it must be proven that the loss suffered is attributable to the negligent conduct of the auditor in a negligence case

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• Segenhoe Ltd v. Akins & Ors (1990) – court held that where an auditor has been negligent

and the company has been induced to pay a dividend out of capital — relying on an incorrectly audited profit and loss account — the auditor is liable for the loss incurred

• Galoo Ltd v. Bright Graham Murray (1994)– reaffirmed the causation relationship requirement to

establish the liability of the auditor

Causal relationship

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Contributory negligence

• Contributory negligence relates to the failure of the plaintiff to meet certain required standards of care and together with the defendant’s negligence, it contributes to bringing about the loss in question

• The judgement in the AWA case is the landmark decision on contributory negligence in an auditor–client relationship

• Court accepted that the directors have a duty to establish a sound system of internal control to safeguard the company’s assets and failure to do so was contributory negligence

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Damages

• Where auditors fail in their duty to act with reasonable care and skill, whether under contract or in tort, a plaintiff is entitled to recover any economic loss arising out of such a breach of duty

• Two issues need to be considered– Firstly, what is the purpose of statements that may

give rise to reliance reasonably being placed on them?

– Secondly, to what extent may responsibility for any loss be assigned on the one hand to the auditor’s negligence and, on the other, to other causes and other parties?

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Damages

• In the 1985 Cambridge Credit case, damages were determined on basis of the company trading 3 years after should have been placed in receivership

• Auditors successfully appealed on the grounds could not have foreseen the economic downturn that caused the losses to reach the level they did, due to a collapse in the property market

• Court agreed there was no causal connection between the auditor’s negligence and losses eventually sustained by the company

What legal liability do auditors owe to their clients and to third parties?

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Fiona Campbell Audit Partner

Ernst & Young Melbourne

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Third party liability

• As previously mention third parties can bring an action against the auditors under tort

• The extent of a duty of care to a third party… has been alternately narrowed and widened by the courts to the point where one cannot conclusively say to what group of third party a duty of care is owed, nor in what circumstances such a duty will be owed.

• As a result of the reluctance of professional indemnity insurers to allow cases to come to court, there are very few decided Australian (or overseas) cases of significance involving claims by third parties against auditors

• Most of these cases involve action being brought by companies relying on audited accounts in making a takeover bid for another company

Third party liability

• The English case of Hedley Byrne (1963, involving merchant bankers) opened up the potential liability of auditors to third parties.

• In the Jeb Fasteners case (1981) the judge held the view the auditor owed a duty of care , but the plaintiff’s loss had not arisen out reliance on the audited accounts

• In the Twomax (1983) case, a third party was successful in recovering losses suffered through reliance on negligently audited accounts.

• Refer Figure 3.2 for the essential elements in negligence actions

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Proximity and third party liability

• English case, Al Saudi Bank & Ors v Clark Pixley (1989): Found auditors did not owe a duty of care to a bank that had relied on publicly available audited financial statements in advancing loans.

• The above judgment rejected the reasonable forseeability test, and applied the more stringent test of reasonable proximity .

• Proximity is held to arise through the fact that where a company’s financial condition is such that it is a likely takeover target, auditors should be aware that potential suitors will rely on the accounts and that a duty of care thus arises

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• In Caparo Industries PLC v Dickman & Ors (1990) it was held that auditors do not owe a duty of care to members of the public considering an investment in shares or to individual shareholders or investors (as opposed to shareholders as a class).

• The judge in Caparo stated the purpose of an audit is fulfil a statutory function and audit reports are not to be used for any other purpose

Proximity and third party liability

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• This suggested that liability might be restricted to situations where the auditor has actual knowledge of the user’s identity and the use to which the accounts will be put

• Te general view of the legal profession is that the Caparo verdict appears to treat auditors more favourably than it treats other experts on whom third parties place reliance

Proximity and third party liability

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• In Australia, the common law concerning the nature and extent of an auditor’s duty of care to third parties remains complex because judgements contain differences of judicial opinion and interpretation

• However, the judgement in the Esanda case was a positive development for auditors because the Court rejected the contention that liability could be based on foreseeability of reliance alone

Proximity and third party liability

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• The High Court in the Esanda case found that there had to be circumstances establishing a relationship of proximity between the auditor and the third party before a duty of care could be said to exist

• … ‘an auditor is not under a duty of care to the plaintiff unless the auditor intended to induce the plaintiff to act in reliance on the audit certificate’.

• In respect of auditor liability for negligent misstatements, the current position and court expectations are changing as a result of a continual struggle to balance the respective rights and interests of auditors, investors and the wider community

Proximity and third party liability cont’

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• For a 3rd party to succeed, given Esanda, it would need to be established that:– The report was prepared on the basis that it would

be conveyed to a 3rd party;– That it was conveyed on the understanding that the

third party would be relying on the report, and that– In reliance on the report, the third party would be

running the risk of suffering loss if the report was negligently prepared.

Australian Situation

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Avoidance of litigation

The following precautions may be taken by auditors wishing to avoid or minimise the consequences of litigation:

• Use engagement letters and investigate prospective clients thoroughly

• Comply fully with professional pronouncements

• Establish and maintain high standards of quality control and insurance cover

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The Trade Practices Legislation

• Rights for individual investors

• Section 52 of the Trade Practices Act (1974) (TPC) covers use of misleading information

• Auditors are subject to the competition requirements of the TPC

• The Professional Standards Legislation allows for damages claims for misleading and deceptive conduct under S 52 of the TPC, so is another possible avenue to sue auditors.

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