ACC701

AUDITOR’S
LEGAL LIABILITY
 OVERVIEW
• LEGAL ENVIRONMENT ON PROFESSIONAL LIABILITY

• AUDITOR’S LIABILITIES TO SHAREHOLDERS , AUDITEES AND

THIRD PARTIES

• CONCEPT OF DUE CARE AND CIRCUMSTANCES GIVING RISE

TO NEGLIGENCE IN THE CONDUCT OF AN AUDIT AND
COMPLIANCE

• PRECAUTIONS AUDITOR SHOULD TAKE TO AVOID LITIGATION

 THE LEGAL ENVIRONMENT

• AUDITORS ARE ACCOUNTABLE FOR THEIR PROFESSIONAL CONDUCT

UNDER COMMON LAW AND STATUE LAW

• RESPONSIBILITY UNDER COMMON LAW MAY BE VIA CONTRACTS WITH

CLIENTS OR WITH THIRD PARTIES TO WHOM A LEGAL DUTY OF CARE IS
OWED.

• RESPONSIBILITY UNDER STATUE LAW ARISES AS A RESULT OF

REGULATIONS ENACTED FOR THE PROFESSION BY LAWMAKERS E.G.
FIJI COMPANIES ACT
 THE LEGAL ENVIRONMENT CNTD…

• LITIGATION RELATED TO ALLEGED AUDIT FAILURES HAVE CAUSED

SOME CONCERN IN THE PROFESSION

• 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

• THIS SOURCE OF COMPENSATION (INSURANCE) CREATES A

PERCEPTION THAT AUDITORS HAVE ‘DEEP POCKETS’ AND, ARGUABLY,
CONTRIBUTES TO THE EXTENT OF CLAIMS FILED AGAINST THEM
 THE LITIGATION CRISIS

• 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

• IT CAN BE SEEN FROM THE DATA THAT THE LITIGATION CRISIS MAY
HAVE REACHED ITS PEAK BETWEEN 2002 AND 2003. HOWEVER, IT IS
DIFFICULT TO COME TO CONCLUSIONS BECAUSE OF THE LACK OF
PUBLIC INFORMATION FOR THE OUT-OF-COURT SETTLEMENT CASES
 INDUSTRY RESPONSES

• INCREASE IN LITIGATION CASES AGAINST AUDITORS HAS RESULTED IN

MAJOR CHANGES TO THE LEVEL OF INSURANCE COVERAGE AUDIT
SERVICE PROVIDERS NEEDS TO ATTAIN WORLDWIDE.

• IN AUSTRALIA FOR INSTANCE, FOLLOWING IS THE REQUIREMENT;

– 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
 LIABILITY TO SHAREHOLDERS AND
AUDITEES
• AUDITOR IS LIABLE FOR ANY NEGLIGENT PERFORMANCE OF ITS
STATUTORY DUTIES.

• IN THE PROVISION OF AUDITING SERVICE, AN AUDITOR IS LIABLE TO

COMPENSATE A PLAINTIFF IF;

• A DUTY OF CARE IS OWED TO THE PLAINTIFF

• THE AUDIT IS NEGLIGENTLY PERFORMED OR
THE OPINION IS NEGLIGENTLY GIVEN
• THE PLAINTIFF HAS SUFFERED A LOSS AS A
RESULT OF THE AUDITORS NEGLIGENCE
• LOSS IS QUANTIFIABLE
 LIABILITY TO SHAREHOLDERS
AND AUDITEES CNTD

• 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
 DUE 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

• KINGSTON COTTON MILL CO (1896)

• FACTS: MANAGER HAS BEEN OVERSTATING INVENTORY VALUES FOR

YEARS TO SHOW INCREASED PROFIT. AUDITORS RELIED ON A
CERTIFICATE SIGNED BY MANAGER AS VALUATION FOR STOCK
FIGURES. COMPANY FAILED TO PAY DEBTS AND DISCREPANCIES WERE
NOTED IN STOCK VALUES. AUDITORS WERE SUBSEQUENTLY SUED.
 DUE CARE CNTD…

• JUDGMENT:
“IT IS THE DUTY OF THE AUDITOR TO PERFORM ITS WORK WITH SKILL,
CARE AND CAUTION WHICH A REASONABLY COMPETENT, CAREFUL
AND CAUTIOUS AUDITOR WOULD USE… AN AUDITOR IS NOT BOUND
TO BE A DETECTIVE NOR IS HE TO APPROACH HIS WORK WITH
SUSPICION OR WITH FOREGONE CONCLUSION THAT THERE IS
SOMETHING WRONG. HE IS A WATCHDOG NOT A BLOODHOUND”…

• 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
 DUE CARE CNTD…

• LONDON & GENERAL BANK (1895)

• FACTS: BANK MADE LOANS TO CUSTOMERS BUT KEPT
INADEQUATE SECURITIES. INTEREST DUE WERE ACCRUED
BUT NOT RECEIVED YET DIVIDEND WAS PAID OUT FROM
PROFITS CALCULATED FROM THESE ACCRUED INTEREST.
THE AUDITOR MADE A FULL REPORT TO DIRECTORS ON
THE NEED FOR PROVISION FOR BAD DEBTS AGAINST BOTH
(LOANS AND INTEREST) AND FOR VALUATION TO BE
CARRIED OUT FOR THE LOANS. HOWEVER, MERELY
QUALIFIED OPINION WITH THE FOLLOWING, “ THE VALUE
OF THE ASSETS AS SHOWN ON THE BALANCE SHEET IS
DEPENDANT UPON REALIZATION”.
 DUE CARE CNTD…

• LONDON & GENERAL BANK (1895)

• FINDINGS
• AUDITORS DUTY IS NOT TO GIVE ADVISE TO DIRECTORS
OR SHAREHOLDERS ON WHAT THEY OUGHT TO DO
• IT IS ONLY TO ASCERTAIN AND STATE THE TRUE
FINANCIAL POSITION OF THE COMPANY AT THE TIME OF
THE AUDIT AND HIS DUTY IS CONFINED TO THAT
• AN AUDITOR MUST BE HONEST, MUST NOT CERTIFY
WHAT HE DOES NOT BELIEVE TO BE TRUE AND MUST
TAKE REASONABLE CARE AND SKILL BEFORE HE
BELIEVES THAT WHAT HE CERTIFIES IS TRUE.
 DUE CARE CNTD…

• LONDON & GENERAL BANK (1895)

• FINDINGS
• AUDITORS DUTY IS NOT TO GIVE ADVISE TO DIRECTORS OR SHAREHOLDERS
ON WHAT THEY OUGHT TO DO
• IT IS ONLY TO ASCERTAIN AND STATE THE TRUE FINANCIAL POSITION OF THE
COMPANY AT THE TIME OF THE AUDIT AND HIS DUTY IS CONFINED TO THAT
• AN AUDITOR MUST BE HONEST, MUST NOT CERTIFY WHAT HE DOES NOT
BELIEVE TO BE TRUE AND MUST TAKE REASONABLE CARE AND SKILL
BEFORE HE BELIEVES THAT WHAT HE CERTIFIES IS TRUE.
• 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
 DUE CARE CNTD…

• IMPLICATIONS OF THESE CASES

• THESE TWO CASES HAVE FORMED THE BASIS FOR MOST SUBSEQUENT
DECISIONS AS TO THE DETERMINATION OF AUDITOR NEGLIGENCE

• 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

• THE NARROW INTERPRETATION OF THE KINGSTON COTTON MILL CO. CASE

CONCERNING SOME AUDIT PRACTICE WAS FINALLY LAID TO REST BY THE
PACIFIC ACCEPTANCE CASE
 DUE CARE CNTD…

• PACIFIC ACCEPTANCE CORPORATION LTD V

FORSYTH (1970)
• FACTS: BRANCH MANAGER MADE LOANS ON STRENGTH OF SECURITY
CONFIRMED BY SOLICITOR OF DEBTORS. SECURITIES WERE EITHER FORGED
OR IMPROPERLY DRAWN UP. AUDITORS SENT TO AUDIT WERE
INEXPERIENCED, WAS NOT ADEQUATELY SUPERVISED, RELIED ON
MANAGEMENT REPRESENTATION RATHER THAN RATHER THAN EXAMINE
DOCUMENTARY EVIDENCE AND FAILED TO EITHER IDENTIFY
IRREGULARITIES FOR FOLLOW UP WHEN DISCOVERED.

• FINDINGS

– AUDITORS 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
 NEGLIGENCE
• IS 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 AUDITORS ARE NEGLIGENT, CLIENTS CAN SUE THE AUDITOR SO AS

TO RECOVER ANY CONSEQUENTIAL LOSS SUFFERED OR TO OBTAIN
DAMAGES SUFFICIENT TO RESTORE THE CLIENT TO ITS ORIGINAL
POSITION

• COMPLIANCE WITH ACCOUNTING STANDARDS, AUDITING

STANDARDS AND GUIDELINES PROVIDES A CERTAIN DEGREE OF
ASSURANCE THAT THE AUDITOR HAS EXERCISED REASONABLE
CARE AND SKILL THEREFORE HAS NOT BEEN NEGLIGENT IN ITS
WORK.
 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

• UNDER A 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
 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 AND IT MUST
BE PROVEN THAT THE LOSS SUFFERED IS
ATTRIBUTABLE TO THE NEGLIGENT CONDUCT OF
THE AUDITOR IN A NEGLIGENCE CASE
 CONTRIBUTORY NEGLIGENCE

• CONTRIBUTORY NEGLIGENCE RELATES TO THE FAILURE OF

THE PLAINTIFF TO MEET CERTAIN REQUIRED STANDARDS OF
CARE

• TOGETHER WITH THE DEFENDANT’S NEGLIGENCE, IT

CONTRIBUTES TO BRINGING ABOUT THE LOSS IN QUESTION

• IN CONTRIBUTORY NEGLIGENCE CASES, ALL RELEVANT

CIRCUMSTANCES ARE CONSIDERED TO JUDGE THE
PROPORTION OF LIABILITY ATTRIBUTABLE TO RESPECTIVE
PARTIES
 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?
 LIABILITY TO THIRD PARTIES

• 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

• CAPARO (1990) AND ESANDA (1994) CASES ARE

LEADING LIABILITY TO THIRD PARTY CASES ON THE
MATTER
 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

• ESTABLISH ADEQUATE RISKS STRATEGIES

 SUMMARY

• KEYWORDS: AUDITORS LIABILITY TO CLIENTS AND 3RD

PARTIES
• NEGLIGENCE
• AUDIT CASES AND RULINGS