AUDITING & ASSURANCE SERVICES II-UBAF 2144/UKAF 2124

Tutorial 2: Auditors Legal Liabilities

MCQ

1. Auditors are accountable in law for their professional conduct. This accountability
arises under:
A. Common law.
B. Statute law.
C. Tort law.
D. All of the above.

2. The so-called 'deep-pockets' theory in relation to alleged audit failures, refers to:
A. The auditor being the only party left with sufficient funds to indemnify the
plaintiff's losses.
B. The requirement to hold a public practice certificate.
C. Several widely reported business failures that resulted in significant loss to
investors.
D. The coverage gap between the potential liability and available insurance
cover.

3. Which case laid down the fundamental auditing principles of the ‘watchdog’ role
and the notion of taking reasonable skill and care?
A. Kingston Cotton Mill.
B. London and General Bank.
C. Pacific Acceptance.
D. AWA.

4. What is the term used when a failure on the part of a plaintiff to meet certain
required standards of care is a factor leading to a loss by the plaintiff?
A. Negligence.
B. Reasonable foreseeability.
C. Contributory negligence.
D. Damages.

5. The decision in the Caparo case (1990) reduced the duty of care of auditors to:
A. all users known to the auditor.
B. all users that ought reasonably to have been known to the auditor.
C. the shareholders as a group.
D. all users of the financial statements, except for investors

6. Which of the following precautions taken by auditors would avoid or minimise the
consequences of litigation?
A. An engagement letter is used for all professional services offered by the firm.
B. All potential clients are thoroughly investigated before acceptance.
C. Professional pronouncements are fully complied with by the firm.
D. All the above

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7 Who is unable to sue the auditors under contract law?

A. the directors (on behalf of the company).
B. the liquidator.
C. individual shareholders.
D. the receiver.

Short Essay questions

Q1. Identify steps that can be taken at the professional and individual firm level to
minimize legal liability against auditors.

Q2 What elements must a plaintiff prove to be successful in an action against an

auditor for negligence?

Q3 What is the significance of the Caparo case with respect to auditor’s liability to
3rd party?

Q4 How the decision in Re Kingston Cotton Mills Case define the standard of care in
the performance of an auditor’s duty?

Scenario Questions

Question 1

You are the auditor of Best Quality Trading Sdn Bhd, a company principally involved in
trading of electronic consumer goods. As in previous years, a full inventory count was
conducted by the company at end of November 2001, one month prior to the company's
financial year end on 31 December, 2001.

In February 2002, while auditing the inventory balances at year end of RM4 million, you
noted that inventories at two locations amounted to about RM2 million. Your firm did not
send any audit staff to the two locations as there were minimal inventories at end of
November 2001. Your client explained that the inventories were to cater for an expected
increase in demand towards the end of the year. You proceeded to request for
confirmation of the balances of the inventories from the custodian, who is a third party
warehouse operator, and the confirmation were obtained without any exceptions. You
decided to accept the amount, at which the inventories were stated in the financial
statements as at 31 December, 2001 on the grounds that:

(1) no problems had been encountered in determining the physical stock quantities in
November 2001 and also in previous years; and

(2) confirmation was obtained from a third party warehouse operator.

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You issued an unqualified auditor’s report in March 2002. However, unknown to you,
one of the major shareholders used the financial statements to negotiate for the disposal
of his entire equity interest in the company to Mr Rich. The consideration for the disposal
was based on the audited net tangible asset value of the company as at 31 December,
2001. Upon taking over the company, Mr Rich discovered that the inventories at the said
two locations were overstated by about RM1.5 million. Apparently, the previous
management had sold the inventories without properly recording the sales in the books of
the company.

Required
Discuss the legal position of your firm in respect of the above matter, commenting
specifically on the following:

(i) the possibility of demonstrating that your firm was not negligent; and

(ii) the fact that you were not informed that the financial statements and your
auditor’s report were to be used to negotiate for the disposal of the company.

(Adapted from the Malaysian Association of Certified Public Accountants)

Question 2

Ken Teo & Associate is external auditor of Ben Cari Gali Sdn Bhd, which is involved in
the oil and gas exploration business. Ben Cari Gali has communicated to the external
auditors of its intention to furnish the said report to the bank to secure financing facilities
to finance the latest exploration project.

However the financial statements in question were misstated by RM 450,000. Instead of

having a net worth of RM 700,000, Ben Cari Gali was insolvent. The management of Ben
Cari Gali has falsified the financial records with such misstatement to avoid liquidation.
The external auditors, however failed to detect these discrepancies.

Placing reliance on the furnished audited financial statements the bank has extended a
loan of RM 900,000 to Ben Cari Gali and now the bank is taking steps to recover the loss
from Ben Cari gali.

Required:
Discuss whether the bank will be able to recover the loss from Ken Teo & associate
on the ground of negligence.

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Question 3

Wan & Co. is the auditor of Jung Sdn Bhd, a company that trades in cosmetic and health
care products. Upon completion of the audit, the auditors supplied Jung with twenty
copies of the audited financial statements. The audit firm knew in a general way that Jung
wanted that number of copies of the auditor's report to furnish to banks and other
potential lenders,

The financial statements in question were misstated by approximately RM500,000.

Instead of having a net worth of RM400, 000, the company was insolvent. The
management of Jung had falsified the books to avoid bankruptcy. The assets had been
overstated bv RM400,000 of fictitious investments and RM100,000 of non-existing
inventory. The audit failed to detect these fraudulent entries. Edison, a major supplier,
relied on the audited accounts and extended a loan of RM200, 000 to Jung Sdn Bhd. He
seeks to recover his loss from Wan & Co.

Required:
Will Edison be able to recover his loss from Wan & Co.? Discuss.

Question 4

“ The decision in the Caparo case has led many informed commentators to believe that
auditors have no liability to third parties for negligence, which has led to deterioration in
the quality of audit work” (Note: the Caparo case is Caparo Industries plc v Dickman and
others-UK house of Lords judgement)

You are required to discuss this statement and in particular:

(a) explain the decision in the Caparo case and state the parties who may successfully
sue the auditor for negligence
(b) discuss the reasons why the Caparo judgement may lead to deterioration in the
quality of auditors work
(c) describe the measures which have been introduced and the factors that have led to
an increase in the independence of auditors and an improvement in the quality of
their work.

Question 5

The public accounting firm of Alex and Co. was engaged to perform an audit of Roz Zen
Bhd, which had been incorporated within the last year. Alex & Co. was aware that the
financial statements accompanying the report would be used to support an application for

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a substantial loan from the Rational Bank. The financial statements, released six weeks
after year end, reflected tremendous sales growth during the last 2 months of the year.
Alex & Co. had confirmed the account receivable as of year end, selecting the accounts
on a random sampling basis.
The Rational bank refused to grant the desired loan, but another local bank, Hart Bank
approved the loan application. When the second instalment become due, Hart Bank
investigated and discovered that many of the sales transactions near year end were
fictitious and that confirmations have been returned to the auditors by employees of Roz
Zen Bhd, who have established fictitious companies using their own home addresses.

Hart Bank sued Alex & Co. for negligence in conducting the audit of Roz Zen Bhd and
claimed damages equal to the amount of the loan defaulted.

Required:
(a) Can the auditors be held liable for negligence under the circumstances
described? State your reasons clearly by citing relevant judicial decisions.
(b) What action do you think the auditors could have taken to prevent such legal
action(s) from arising?

Question 6

Johnson Mak & Co. has been engaged to examine the financial report of Mirror
Manufacturing Sdn Bhd for the year ended 30 September 2014. Mirror needed additional
cash to continue its operations.

To raise funds, it agreed to sell its interest in a subsidiary. The buyers insisted upon
having the proceeds placed in trust because of the possibility of a major contingent tax
liability. Lily Lam, president of Mirror, explained this to Johnson, the partner in-charge
of the Mirror audit. She indicated that she wished to show the proceeds from the sale of
the subsidiary as current accounts receivable. She stated that, in her opinion, the
government’s claim was groundless and that she needed an “uncluttered” statement of
financial position and a “clean” auditor’s report to obtain additional working capital.
Johnson acquiesced in this request.

The government’s claim proved to be valid and, pursuant to the agreement with the
buyers, the amount received from the sale of the subsidiary was reduced by RM 4.5
million. This, coupled with other adverse developments caused Mirror to become
insolvent, with assists available to cover only some of its liabilities, Johnson Mak & Co.,
is being sued by several of Mirror’s creditors, who lent money in reliance upon the
financial report which was “unqualified opinion”.

Required:
What is the liability if any, of Johnson Mak & Co., to the creditors of Mirror?
Justify your answers with relevant legal cases.

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Question 7

Chen is the auditor for Greenleaf Manufacturing Sdn Bhd, a privately owned company
that has a June 30 fiscal year. Greenleaf arranged for a substantial bank loan that was
dependent in the bank’s receiving, by September 30, audited financial statements that
showed a current ratio of at least 2 to 1. On September 25, just before the audit report was
to be issued, Chen received an anonymous letter on Greenleaf’s stationery indicating that
a 5-year lease by Greenleaf , as lessee, of a factory building accounted for in the financial
statements as an operating lease, was in fact, a capital lease. The letter stated that there
was a secret written agreement with the lessor modifying the lease and creating a capital
lease.

Chen confronted the Managing Director (MD) of Greenleaf, who admitted that a secret
agreement existed but said it was necessary to treat the lease as an operating lease to meet
the current ratio requirement of the pending loan and that nobody would ever discover the
secret agreement with the lessor. The MD said that if Chen did not issue his report by
September 30, Greenleaf would sue Chen for substantial damages that would result from
not getting the loan. Under the pressure and because the audit files contained a copy of a
5-year lease agreement that supported the operating lease treatment, Chen issued his
report with an unqualified opinion in September 29.

Despite the fact that the loan was received, Greenleaf went bankrupt within 2 years. The
bank is suing Chen to recover its losses on the loan, and the lessor is suing Chen to
recover uncollected rents. Answer the following questions, setting forth reasons for ny
conclusion stated:

Required
(a) Is Chen liable to the bank?
(b) Is Chen liable to the lessor?
(c) Is there potential for criminal action against Chen?

Question 8

Izzati Nasrun has been the auditor of Liong Sdn. Bhd. for several years. As she and her
staff prepared for the audit for the year ended December 31, 2010, Felix Liong told hear
that he needed a large bank loan to “tide him over” until sales picked up as expected in
late 2011.

In the course of the audit, Izzati discovered that the financial situation at Liong was worse
than Felix had revealed and that the company was technically bankrupt. She discussed
that situation with Felix, who pointed out that the bank loan will “be his solution” – he
was sure he will get it as long as the financial statements don’t look too bad.

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Izzati stated that she believed the statements will have to include a going concern
explanatory paragraph. Felix said that this wasn’t needed because the bank loan was so
certain and that inclusion of the going concern paragraph will certainly cause the
management of the bank to change its mind about the loan.

Izzati finally acquiesced and the audited statements were issued without a going concern
paragraph. The company received the loan, but things did not improve as Felix thought
they would and the company filed for bankruptcy in August 2011.

The bank sued Izzati Nasrun for fraud.

Required:
Indicate whether or not you think the bank will succeed. Support your answer.