Chapter 4

The legal liability of auditors

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Establishing the auditor’s duty

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

1. Contractual (including statutory) relationship

2. Special relationship between two parties.

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Learning objective 1: 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).

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Learning objective 2:Negligence

• Negligence can be 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 owed to another person or persons’.

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Claims for NegligenceTo be successful in a claim for negligence, a plaintiff

must prove that:

• Duty was owed to the plaintiff by the defendant (duty of care)

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

• Loss or damage was suffered by the plaintiff

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

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Learning objective 3: Liability to clients

Liability to clients arises both in contract and in the

tort of negligence. Early cases include:• London & General Bank Ltd (1895)• Kingston Cotton Mill (1896)• Thomas Gerrard & Son (1967)

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Liability to clients (cont.): Pacific Acceptance (1970)

• Auditors’ duties and responsibilities are to:– Use reasonable care and skill– Check and see for themselves– Audit the whole year– Appropriately supervise and review work of inexperienced staff– Properly document procedures– Rely on satisfactory internal controls– Warn and inform the appropriate level of management– Take further action where suspicion is aroused– Structure plans and procedures so that discovery

of material error or fraud is reasonably expected– Be guided by professional standards (but not determinative).

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Liability to clients (cont.): significant cases

• Cambridge Credit (1985)

• Segenhoe (1990)

• Galoo (1994)

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Learning objective 4: Contributory negligence

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

• Prior to AWA (1995), such a defence by auditors was unsuccessful. Refer to Pacific Acceptance (1970).

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Contributory negligence: AWA (1995)

• AWA: the company suffered losses due tointernal control weaknesses over foreignexchange.

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

– Company found to contribute to loss by officers failing to report to board of directors and failing to put in place adequate internal control system.

– Defence of contributory negligence therefore upheld.

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Learning objective 5: 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 from early cases (e.g. Donoghue v Stevenson (1932)) that the recovery of losses by third parties from auditors fornegligence (in the absence of fraud) wasnot possible.

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Liability to third parties (cont.)

Early test: special relationships

• 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 judgement of Lord Denning)

– Hedley Byrne (1963)– MLC v Evatt (1971).

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Liability to third parties (cont.)

Next test: reasonable foresight

• A duty is owed to a specific third party of whom the auditor was not aware, but who was part of a class of persons of whom they should have been aware would rely on their audit opinion:

– Scott Group (1978)– Shaddock & Associates (1979)– JEB Fasteners (1981)– Twomax (1983).

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Liability to third parties (cont.)

Current test: proximity

• Was there a sufficient degree of proximity between the auditor and third party? To answer this question, courts examine whether the report 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).

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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 strongly argue that this was never the intention.)

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Privity letters• A privity letter is a letter from the auditor

acknowledging a third party’s reliance on an audited report. The third party requests the privity letter from auditor.

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

• AGS 1014 provides guidance.

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Liability to third parties: 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. – It is possible that, in issuing an inappropriate

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

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ASIC Act

• Under Section 50 of the ASIC Act proceedings for damages to the public interest can be initiated by ASIC.

• In 2008 ASIC utilised this power by commencing action against KPMG for $200 million over the collapse of the Westpoint Group.

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Criminal liability of auditors

• Auditors can be subject to criminal prosecution.

• It is an offence under s 1308(2) of the Corporations Act 2001 to knowingly make or authorise false and misleading statements. A penalty of $22,000 and/or five years’ imprisonment exists.

• Criminal actions against auditors are rare.

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Learning objective 6: Limitation of liability

• Prior to CLERP 9, audit firms were required to operate as sole traders or in partnerships

— still the dominant form of organisation for audit firms.

• Therefore, auditors are personally liable for damages arising from failure by either themselves or their partners to exercise reasonable skill and care.

• Spiralling litigation costs and court-awarded damages.• Professional indemnity insurance is difficult to obtain

and prohibitively expensive (claimed to be about 14 per cent of audit revenues).

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Arguments 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 a heavier burden than other professionals with respect to the amount of damages assessed.

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Arguments against limiting auditors’ liability

• Auditors should accept full responsibility for their work.

• Auditors are only successfully sued when not performing their duties competently.

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

• A precedent for other professions

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Methods of limiting auditors’ liability

• Imposition of a statutory cap on auditors’ liability

• Incorporation of auditors

• Removal of joint and several liability and replacement with proportionate liability.

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Changes to auditor liability

• Recent changes to Corporations Act 2001 as a result of CLERP 9 allow:

– Auditors to incorporate and form authorised audit companies with adequate and appropriate professional indemnity insurance

– Apportionment between the plaintiff and defendant according to blame, and proportionate liability if there are two or more defendants.

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Learning objective 7: Responsibility for the prevention

and detection of fraud• Guidance: ASA 240 (ISA 240) for fraud and error

– Prevention and deterrence of fraud remains management’s responsibility.

• ASA 240 outlines auditor's responsibility, which has significantly increased.

• Auditor’s objectives in relation to fraud are:– Identify and assess risks of material misstatements due to

fraud– Obtain sufficient appropriate evidence about assessed risks

of material misstatement through designing and implementing appropriate responses

– Responding appropriately to identified or suspected fraud.

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Auditor’s responsibility for the prevention and detection of fraud

• ASA 240 indicates that the auditor's responsibility is to:

– Focus on areas where there is a risk of material misstatement owing to fraud, including management fraud

– Maintain an attitude of professional scepticism– The engagement team is required to discuss how the

financial report may be susceptible to material misstatement from fraud and identify what audit procedures would be effective for its detection

– Design and perform these audit procedures.

• These requirements result in a much more proactive approach toward fraud than required under previous auditing standards.

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Auditor’s responsibility for the reporting of fraud

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

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

• In most cases an auditor is protected by qualified privilege when reporting matters in good faith.

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