Week 2: Auditor’s Legal Liability & Ethics, Independence

and Corporate Governance

Tutorial Solutions

A 2-4 Proportionate liability means that the various parties whose negligence contributed
to a loss are liable for an appropriate share of the damages. This means auditors should
not carry the full burden for losses resulting from a misstatement when other parties
contributed to the level of losses incurred by failing to take adequate precautions. This
was introduced by State legislation because there was a common perception that the
courts were placing insufficient weight on the reasonableness of taking precautions to
prevent or reduce the risks.

A 2-5 Vicarious liability means a person (or entity) is liable for the acts of a subordinate,
agent or employee. This means an audit partner or firm (or AAC) can be liable for acts or
omission by a person who is member, employee or agent of the firm. This requires the
person to have acted within the actual or apparent scope of his or her authority or
employment. (Also see question 2-8.)

A 2-6 The reasonable person concept states that a person is responsible for conducting a
job in good faith and with integrity, but is not infallible. Therefore, the auditor is expected
to conduct an audit using due care, but does not claim to be a guarantor or insurer of
financial statements.

A2-8 Contributory negligence means another person (usually the plaintiff) has
contributed to his or her own loss by failing to take sufficient reasonable care. An example
is the claim by the auditor that management knew of the potential for fraud because of
weaknesses of internal control but refused to correct them. The auditor thereby claims
that the client contributed to the losses caused by the fraud by not correcting material
weaknesses of internal control structure. This was employed successfully in Australia for
non-statutory audit work in AWA Ltd v. Daniels [1992]. Since then, various States have
legislated requirements for damages to be apportioned according to a ‘negligence
calculus’ that can recognise the duties of parties additional to the auditor. This is known
as proportionate liability.

A2-10 Liability to clients under common law has remained relatively unchanged for many
years. If an auditor breaches an implied or expressed contract with a client, there is a
legal responsibility to pay damages. Traditionally, the distinction between privity of
contract with clients and lack of privity of contract with third parties is essential in
common law. The lack of privity of contract with third parties means that third parties
have no rights with respect to auditors except in the case of gross negligence. Liability to
third parties under common law has been restrictively defined in the High Court’s decision
in Esanda to accord with these notions of privity by employing a combination of proximity
and foreseeability tests.
A2-11 The auditor should assess the risk that errors and irregularities may cause a
client’s financial statements to contain a misstatement. Based on this assessment, the
auditor should design the audit to provide reasonable assurance of detecting errors and
irregularities that are material to the financial statements. Because of the nature of
irregularities (including defalcations), properly designed and executed audit procedures
that are effective for detecting error may not be appropriate in the context of an identified
risk of material misstatement due to fraud. The decision in the Pacific Acceptance case
confirmed the auditor’s duty to audit with due care and skill, including a duty to design
the audit with due regard to the possibility of fraud. WA Chip and Pulp highlighted the
irrelevance of materiality in considering the need to further pursue indicators of fraud.
The Auditing Standards establish the minimum level of competency expected of the
auditor during the conduct of the audit.

2.25 The concept of ‘reasonable skill and care’ has been discussed in a number of cases
such as London and General Bank, Kingston Cotton Mills, Thomas Gerrard & Son
and Pacific Acceptance. These cases have indicated that ‘reasonable skill and care’ is
a dynamic concept that will be judged based on the skill and care that a ‘reasonable
auditor’ would employ under the circumstances. For example, at the time of the
Kingston Cotton Mills case in 1896, it was considered appropriate for an auditor to
rely on the representations of management. However, by the mid-nineteenth century
this was no longer considered adequate, as was indicated in Thomas Gerrard & Son.
Moffitt J in the Pacific Acceptance case, indicated that auditors have a duty to use
reasonable care and skill. Moffitt indicated that reasonable care and skill included
among other things that auditors:

• have a paramount duty to check and see for themselves—reliance on independent

sources or the client’s personnel is an aid to, and not a substitute for, the auditor’s
procedures
• should audit the whole year
• should closely supervise and review the work of inexperienced audit staff
• should properly document procedures in a written audit program which is
amended when conditions change
• have a duty to warn and inform
• should take further action if their suspicion is aroused by the discovery of a large
number of irregularities
• plan the audit such that if a material error or fraud exists the auditor has a
reasonable expectation of discovering it.

Professional standards also provide a guide as to reasonable care and skill and ASA
500 (ISA 500) indicates that evidence is more reliable when it is obtained directly by
the auditors themselves.

2.26 The following actions by Graham Young are likely to result in the court deciding that
he did not exercise reasonable care and skill, as they represent breaches of accepted
practice, as indicated in the auditing standards.
 • Hiring two accounting students who have inadequate training and experience and
not supervising or directing the work performed is a breach of quality control
requirements (ASA220/ISA 220).
• Failing to gain the required understanding of the accounting system and related
internal controls (ASA 315/ISA 315).
• Failing to ensure that the auditor obtained sufficient appropriate audit evidence—
just checking mathematical accuracy and relying on client representations does
not meet this requirement (ASA 500/ISA 500).

2.28 (a) Tran & Associates has a duty of care to its client, Easyrider, under both the law of
contract and the tort of negligence. Therefore, Tran & Associates would be liable to
Easyrider if the loss was caused by the negligent performance of the audit
engagement.
(b) In deciding whether the company was guilty of contributory negligence, the major
issue to be determined is whether Easyrider failed to meet the standard of care required
for its own protection—in this case, a sound internal control system—which
contributed to bringing about its loss. The AWA case established for the first time in
Australia that contributory negligence by the client is acceptable as a reason for
reducing the damages attributable to an auditor.

Week 2: Auditor’s Legal Liability & Ethics, Independence

and Corporate Governance
Tutorial Solutions

3.15 The three main categories of ethical theory are:

1. Teleological ethics, also called consequential ethics, deal with the consequences or
outcomes of actions. Generally, if the benefits of a proposed action outweigh the
costs, then the decision is considered morally correct. The most important
teleological ethical theory is utilitarianism. According to this theory, ethical
decision making should maximise the greatest good for the greatest number. This
involves an assessment of costs and benefits, not only in economic terms but also
in terms of human costs and benefits. Therefore, it involves a value judgment and
 needs to consider all the stakeholders who are affected by a decision. This theory
is relevant to auditors, as they need to consider the impact of their behaviour on
the public interest.

2. Deontological ethics are based on duties and rights. Duties are an obligation and
are actions that a person is expected to perform, while rights are an entitlement
and are actions that a person expects of others. These duties and rights are set
down in rules that must be followed regardless of the consequences. Hence, these
theories are also sometimes called non-consequential ethics.
Deontological ethics is particularly important to auditors in understanding their duties
based on the ethical rules of the accounting bodies. This rule leads to the principle of
beneficence, which advocates that we should do good to others rather than harm. Kant
suggested the categorical imperative as a universal ethical law.

3. Virtue ethics, which dates back to Aristotle, is concerned primarily with integrity,
which is an essential characteristic of an auditor. Virtue ethics focuses on the
person undertaking the action. Virtues are personal qualities that enable us to do
what is ethically desirable and generally include traits of character such as courage,
fairness, honesty, integrity, loyalty, courtesy and fidelity. Virtue ethics emphasises
what makes up a morally good person, but does not necessarily make it clear what
should be done to solve an ethical conflict. Virtue ethics is relevant to the auditor
when considering the fundamental ethical principles outlined in APES 110.

Week 2: Auditor’s Legal Liability & Ethics, Independence

and Corporate Governance
Tutorial Solutions

3.19 AAA Decision Model

Determine the facts
George’s future promotion to partner is likely to be largely dependent on the success
of the tender document he has just submitted for a potential client. He has been
offered some inside information about his submission by the flatmate of his wife’s
sister that could significantly improve his chances of success with the tender and
therefore, his chances of partnership promotion.
Identify the ethical issues
List all stakeholders:
• George
• George’s wife
• Other senior managers
 • The competitor firms
• The senior manager’s firm
• The potential client
• The managing director’s secretary
Define the ethical issues
Should the senior manager take advantage of the confidential information to try to win
the tender and enhance his career prospects or should he refuse the information to
maintain his integrity and the fairness of the bidding process?
Identify major principles, rules, values
Refer to APES 110 Sections 100 to 150.
• Integrity—should be straightforward, honest and sincere in their approach to
professional work.
• Objectivity—must be fair and not allow prejudice or bias to override their
objectivity.
• Professional behaviour—must not do anything that would bring discredit to
the profession.
Specify the alternatives
• Do nothing
• Reject the offer to see the memo and alert the potential client to the secretary’s
offer.
• Apprise a senior partner in the audit firm of the offer.
• Accept the offered memo and revise the proposal.

Weighing alternatives and assessing consequences

Do nothing (i.e. not accept the offer to see the memo and let the matter drop):
• a competitor firm is likely to get the engagement
• the senior manager’s chances for promotion will be damaged severely
• the secretary’s indiscretion will not be reported
• the senior manager’s integrity will be intact.
Report the offer to see the memo and alert potential clients to the secretary’s offer:
• a competitor firm might get the engagement
• the potential client might renew the entire bidding process to see if it is
compromised, so it could re-open bidding
• the potential client might appreciate the senior manager’s integrity and award
the engagement to his firm
• the potential client could thank the senior manager for his integrity, thus
enhancing his professional reputation
• the secretary might be dismissed or reprimanded
• the senior manager’s relationship with his sister-in-law may be strained as her
flatmate may suffer from trying to help him out
• the senior manager’s integrity will be intact.
Tell a senior partner in the audit firm of the offer:
• the firm might notify the potential client that the bidding process is
compromised
 • the firm might notify its competitors that the bidding process is compromised
• the senior manager’s standing at the firm might be enhanced, despite the
probable loss of the new client
• the firm might decide to use the offered memo to revise its proposal, thus
securing the new client. (In this event, the senior manager would have to
decide whether to go along with the decision—and enhance his chances for
promotion—or to notify the client, and probably resign.)
Accept the offered memo and revise the proposal:
 the firm might win the engagement
 neither the potential client nor competitors might learn of the tampering with the
bidding process
 the senior manager might be promoted
 the senior manager’s integrity may be compromised
 the revision might be questioned by the potential client, and the secretary and
senior manager might be exposed
 a partner of the firm might examine the revised proposal before it is submitted,
investigate and stop the process

Make your decision

Reject the offer and advise your senior partner and client.
Week 2: Auditor’s Legal Liability & Ethics, Independence
and Corporate Governance
Tutorial Solutions

3.22
Professional standards Regulatory Recommended possible
breached requirements course of action
breached

(i) Accounting Associates may have The outstanding fee The fee level needs to be
breached fee dependence requirements. is not a breach of the assessed and if above
APES 110.290.217 states that Corporations Act 15% of firm fees,
where the fees from one 2001, unless it has safeguards need to be
client constitute a large taken on the discussed with the
proportion of a firm’s total characteristics of a board.
fees, it may create a self- loan, in which case it Perhaps an instalment
interest threat. Further APES would be a breach of plan can be agreed to
110.290.219 requires the total s.324CH. pay outstanding fees
fees for a public interest Also, there may be a before the audit report is
client not to exceed 15% of breach of the general issued.
firm fees, unless there are independence Conflict of interest
adequate safeguards in place requirement of s. situation needs to be
to reduce the risk to an 324 CD in that a resolved within 7 days
acceptable level. conflict of interest or ASIC advised (s.324
APES 110.290.220 states that situation may be said CB).
where the fees for an audit to exist.
client remain unpaid for a
long time it creates a self-
interest threat that would
require adequate safeguards.
Further, the auditor needs to
consider whether the unpaid
fees have taken on the characteristic of a
loan, which, if material, would be
prohibited under section APES
110.290.121 due to self-interest threats.
Week 2: Auditor’s Legal Liability & Ethics, Independence
and Corporate Governance
Tutorial Solutions

(ii) Since the car-hire and receipt This situation does If the threat created is
of 10% discount from DHL not appear to be a other than clearly
for visiting clients is in the breach of the insignificant, safeguards
normal course of business Corporations Act should be applied to
and on an arm’s length basis, 2001 reduce the threat to an
as it is the same loyalty rate acceptable level, which
offered to other clients, there in this case could
is no breach of APES 110 and include eliminating or
no threat to independence. reducing the magnitude
of the transaction. For
However, acceptance of the
example, not allowing
10% loyalty discount by
partners or staff to
Rebecca for hiring the four-
utilise the business
wheel drive from DHL for
discount for personal
personal reasons for a holiday
with her family may create a hires.
self-interest threat. APES110
s. 260.1, states that a member
of public practice should not
accept a gift or hospitality
from a client unless the value
is clearly insignificant.
Week 2: Auditor’s Legal Liability & Ethics, Independence
and Corporate Governance
Tutorial Solutions

3.25

Issue Category of Explanation Safeguard

threat to
independence
1. LTH wants Intimidation Chris presents an The advocacy threat and
Geoff to threat intimidation threat by the intimidation threat in
promote its saying that LTH will relation to Geoff
Advocacy
business. find it difficult to promoting LTH are
threat
continue business significant, and no
engagements with CJ safeguards could reduce
should Geoff refuse to the threat to an acceptable
represent LTH (APES level. Geoff should
110.200.8). therefore refuse to accept
LTH wanting Geoff to this appointment.
present a speech to
promote its business
to attract more
investors will create
an advocacy threat
(APES 110.200.6).
2. LTH is Self-interest Chris made it clear, in The self-interest and
offering you threat giving the holiday familiarity threats of the
and Geoff voucher to you and complimentary gift
Familiarity
complimentary threat Geoff, that he is vouchers are significant,
holiday anticipating they will and no safeguards could
vouchers. reciprocate by way of reduce the threat to an
a ‘smooth audit’. This acceptable level.
gift is therefore Therefore, you and Geoff
neither trivial nor should refuse to accept
inconsequential, and these gifts.
thus creates self-
interest and familiarity
threats (APES
110.290.227).
Week 2: Auditor’s Legal Liability & Ethics, Independence
and Corporate Governance
Tutorial Solutions

3. Michael is Familiarity Michael’s father, who The self-interest,

related to threat is LTH’s financial familiarity and
LTH’s controller, has a intimidation threats in
Intimidation
financial significant influence relation to Michael’s
threat
controller. over the preparation of relationship with LTH’s
Self-interest LTH’s financial financial controller can be
threat statements. Having eliminated by removing
Michael in the audit Michael from the audit
team creates self- team. The threat could
interest, familiarity also be reduced to an
and intimidation acceptable level by
threats (APES structuring Michael’s
110.290.128). responsibilities to ensure
he does not deal with
matters that are within the
scope of his father’s
responsibilities.
4. Annette was Self-review Annette’s involvement The self-review threat of
involved in the threat with the audit team in Annette having worked
preparation of reviewing LTH’s tax on LTH’s tax calculations
LTH’s calculations, which can be eliminated by
financial she helped to prepare, removing her from the
report. creates a self-review audit engagement. The
threat (APES threat could also be
110.290.140). reduced to an acceptable
level by allocating
someone else in the team
to review Annette’s audit
work, or structuring her
responsibilities so that
she does not audit the
work she was involved
with preparing during her
assignment at LTH and
advising her of the need
to take a more sceptical
attitude when conducting
her audit work.