THE LEGAL LIABILITY OF AUDITORS - Muhariefeffendi's …...THE LEGAL LIABILITY OF AUDITORS CHAPTER 4 . ... 4 NEGLIGENCE Any conduct that is careless or unintentional in nature and entails

Copyright 2003 McGraw-Hill Australia Pty Ltd

PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett

Slides prepared by Roger Simnett 1

THE LEGAL

LIABILITY OF

AUDITORS

CHAPTER 4




ESTABLISHING THE

AUDITOR’S DUTY

Society imposes a duty to exercise reasonable care and skill in two ways:

• Contractual (including statutory) relationship

• Special relationship between two parties




REASONABLE CARE AND

SKILL

An auditor must exercise the reasonable care and skill expected of a professional.

Requires adherence to professional standards in all aspects of an audit.

‘The professional man owes a duty to exercise that standard of skill and care appropriate to his professional status’ (Caparo, 1990).




NEGLIGENCE

Any conduct that is careless or unintentional in nature and entails a breach of any contractual duty or duty of care in tort owed to another person or persons.




NEGLIGENCE CLAIMS To be successful in a claim for negligence,

plaintiff must prove:

• Duty was owed to plaintiff by defendant

• A breach of the duty of care (negligent conduct occurred)

• Loss or damage was suffered by plaintiff

• A causal relationship existed between breach of duty by defendant and harm suffered by plaintiff




LIABILITY TO CLIENTS

Arises both in contract and in tort of negligence. Early cases:

• London & General Bank (1895)

• Kingston Cotton Mill (1896)

• Thomas Gerrard & Son (1967)




LIABILITY TO CLIENTS —

PACIFIC ACCEPTANCE (1970)

Exposition of auditor’s duties and responsibilities:

• Duty to use reasonable care and skill • Duty to check and see for themselves • Audit the whole year • Appropriately supervise and review • Properly document procedures • Reliance may be placed on internal controls • Duty to warn and inform appropriate level of

management • Duty to take further action where suspicion is aroused • Expectation of discovering material error or fraud • Professional standards provide a guide




LIABILITY TO CLIENTS —

RECENT CASES

• Cambridge Credit (1985)

• Segenhoe (1990)

• Galoo (1994)




CONTRIBUTORY NEGLIGENCE

Exists where the plaintiff fails to exercise the required standard of care, thus contributing to its own loss.

• Prior to AWA, such a defence by auditors was unsuccessful. Refer:

Pacific Acceptance (1970)




CONTRIBUTORY NEGLIGENCE —

AWA (1995)

AWA — losses suffered by company due to internal control weaknesses over foreign exchange.

• Auditor liable for failure to report to board of directors.

• Company contributed to loss by officers failing to report to board of directors and failing to put in place adequate internal control system.




LIABILITY TO THIRD

PARTIES A number of cases have considered the auditor’s liability in relation to persons other than the immediate client.

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

Donoghue v Stevenson (1932)




LIABILITY TO THIRD PARTIES —

EARLY TEST — SPECIAL

RELATIONSHIP

A duty is owed to any third party to whom the auditor shows accounts, or to whom the

auditor knows the client is going to show accounts, so as to induce some action.

• Candler (1951) (per dissenting judgment of Lord Denning)

• Hedley Byrne (1963)

• MLC v Evatt (1971)

• Shaddock & Associates (1979)





NEXT TEST — REASONABLE

FORESIGHT

A duty is owed to a specific third party of whom auditor was not aware but who was part of a class of persons of whom they should have been aware:

• Scott Group (1978)

• JEB Fasteners (1981)

• Twomax (1983)





CURRENT TEST — REASONABLE

PROXIMITY

Was there a sufficient degree of proximity between the auditor and third party? To answer this question, examine whether the statement by the auditor was meant to induce the third party to undertake specific actions: • Caparo (1990) • AGC (1992) • Columbia Coffee (1992) (very wide interpretation, later

overturned in Esanda) • Esanda (1997) (Full High Court of Australia)




CURRENT SITUATION —

LIABILITY TO THIRD PARTIES

A general conclusion is that it would be hard to show that audits on general purpose financial reports were ever intended to induce third parties to undertake a specific course of action. (Auditors would argue strongly that this was never the intention.)




PRIVITY LETTERS

Third party requests privity letter from auditor. Privity letter is letter from auditor acknowledging third party’s reliance on audited report.

• Purpose — to establish a relationship with the required foreseeability and proximity and thereby establish a duty of care by the auditor to the third party.

• AGS 1014 provides guidance.





TRADE PRACTICES ACT

Trade Practices Act: Consideration needs to be given to the provisions of the Commonwealth Trade Practices Act and State Fair Trading Acts:

• Acts prohibit misleading and deceptive

conduct. • Possible that in issuing an inappropriate audit

report, auditor might be guilty of conduct that is misleading or deceptive.




CRIMINAL LIABILITY OF

AUDITORS

• Auditors can be subject to criminal prosecution.

• Offence under s. 1308(2) of Corporations Act for knowingly making or authorising false and misleading statements with penalty of $10,000 and/or two years’ imprisonment.

• Criminal actions against auditors are rare.




LIMITATION OF LIABILITY • Auditors currently jointly and severally liable

for damages arising from failure by either themselves or their partners to exercise reasonable skill and care. Liability is unlimited.

• Spiralling litigation costs and court-awarded damages.

• Professional indemnity insurance difficult to obtain and prohibitively expensive (claimed to be about 14% of audit revenues).




REASONS FOR LIMITING

AUDITORS’ LIABILITY

• Inability of auditors to restrict the scope of their operations and/or resign

• Inequitable position of the auditing profession compared with other professions and service providers

• Inability of auditors to rely on representations of management

• Auditors carry heavier burden than other professionals with respect to amount of damages assessed




REASONS FOR NOT LIMITING


• Should accept full responsibility for their work

• Only successfully sued when not performing their duties competently

• If there is a limit, auditor’s share of liability passed on to public

• A precedent for other professions




METHODS OF LIMITING


• Imposition of a statutory cap on auditors’ liability (recommended by JCPAA 2002)

• Incorporation of auditors (recommended by both JCPAA and CLERP 9, 2002)

• Replacement of joint and several liability with proportionate liability (recommended by both JCPAA and CLERP 9, 2002)




RESPONSIBILITY FOR THE

PREVENTION AND DETECTION

OF FRAUD

Guidance: AUS 210/ISA 240 for fraud and error

• Prevention of fraud is management’s responsibility.

Auditor has responsibility to:

• plan so they have reasonable expectation of detecting irregularities; and

• pursue further any suspicions.




RESPONSIBILITY FOR THE

REPORTING OF FRAUD

• Auditor has a duty of care to report fraud, irrespective of materiality, to an appropriate level of management when suspicions are aroused.

• Auditor may have a mandatory responsibility to report fraud under the Corporations Act or the Crimes Act.

• Auditor is protected by qualified privilege when reporting matters in good faith.

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THE LEGAL LIABILITY OF AUDITORS - Muhariefeffendi's …...THE LEGAL LIABILITY OF AUDITORS CHAPTER 4 . ... 4 NEGLIGENCE Any conduct that is careless or unintentional in nature and entails