Week 2: Auditor’s Legal Liability & Ethics,

Independence and Corporate Governance

Tutorial Discussion Problems and Case Studies

A2.4 What is ‘proportionate liability’ and why was it introduced by legislation?

A2.5 What is ‘vicarious liability’ and how does it affect auditors?

A2.6 How does the ‘reasonable person’ concept affect the civil liability of the auditor?

A2.8 What is meant by the term ‘contributory negligence’ and under what conditions is
this most likely to be a successful defence for claims against an auditor?

A2.10 What are the main contemporary issues for auditors in Australia in relation to their
legal liability?

A2.11 Describe the auditor’s responsibility to detect a defalcation.

2.25 ‘Auditors need to check and see things for themselves. Reliance on the client’s
personnel is an aid to, and not a substitute for, the auditor’s procedures’

REQUIRED
With reference to the above statement and other relevant common-law rulings,
discuss the requirements for an auditor to discharge their duty to ‘exercise reasonable
skill and care’ in an audit engagement.

2.26 Elegance Pty Ltd (Elegance), a fashion house, requested Young & Associates to
conduct an audit of the company’s records. The audit needed to be completed in time
to submit an audited financial report to a bank as part of a loan application.

Audit partner, Graham Young, immediately accepted the engagement and agreed to
provide an auditor’s report within 3 weeks. As they were short of staff, Graham hired
two accounting students to conduct the audit and spent several hours telling them
exactly what to do. Graham told the students not to spend time reviewing the
controls, but instead to concentrate on proving the mathematical accuracy of the
ledger accounts, summarising the data in the accounting records that supported the
financial report and obtaining explanations from client’s staff for any variances. The
students followed Graham’s instructions and completed the audit within two weeks
and Graham young issued an unmodified audit report indicating that in his opinion
the financial report gave a true and fair view.

It was subsequently found that the inventory was significantly overvalued and the
auditors had relied on management’s representations about the value of the
inventory. A large amount of inventory consisted of unsold stock of the past two
years that was worthless due to changes in fashion trends. Also, one of the
warehouse managers had not written off defective garments worth thousands of
dollars. The bank withdrew their loan facility and Elegance was unable to fulfil a
large number of orders resulting in a significant loss to the company.

As a result, Elegance is suing Young & Associates for negligence.

REQUIRED
Explain whether you consider that Young & Associates was negligent. Justify your
answer.
Week 1: Auditor’s Legal Liability & Ethics, Independence
and Corporate Governance
Tutorial Discussion Problems and Case Studies

2.28 Your audit firm, Tran & Associates, has been the auditor of Easyrider Ltd
(Easyrider), a large motorcycle manufacturer, for the past 5 years. Easyrider is
Tran’s largest client, and senior partners at Tran’s have a good working relationship
with the directors and senior management of Easyrider.

Easyrider has been a leading motorcycle manufacturer for several years. In the past,
audits of Easyrider have run smoothly and its auditor’s reports have always been
unmodified, stating that in the auditor’s opinion the financial report gives a true and
fair view.

The company has a 30 June year end. Four months after Tran’s issues an unmodified
opinion on the financial reports of Easyrider for the year ended 30 June 2015, the
Chair of Easyrider announced that over the past two years the company had
recognised fictitious revenue of $20M and capitalised development expenditure in
excess of $25M that should have been expensed. These irregularities, which resulted
from poor internal controls, resulted in an overall loss for the financial year of 2015
equal to $30M. Easyrider is suing Tran & Associates for negligence.

REQUIRED
a) Explain whether Tran & Associates is liable to Easyrider.
b) Discuss whether Tran & Associates can reduce its liability by claiming
contributory negligence by Easyrider.
Week 2: Auditor’s Legal Liability & Ethics, Independence
and Corporate Governance
Tutorial Discussion Problems and Case Studies

3.15 You are the staff training manager at a major audit firm and a new graduate has asked
you about the relevance of ethical theory to the ethical rules that auditors are required
to follow:

REQUIRED
Explain the three main categories of ethical theory and their relevance to the auditor.
Week 2: Auditor’s Legal Liability & Ethics, Independence
and Corporate Governance
Tutorial Discussion Problems and Case Studies

3.19 AAA Decision Model

George Martin is a promising senior manager beginning his tenth year at his audit firm.
George has been a steady performer during his career and is known for his technical and
personal skills. However, not all of the firm’s partners are enthusiastic about George. His
track record for bringing in new clients has been marginal. This weakness has not stopped
George from moving up the ladder, but slow expansion in the client base has meant that the
firm has not made a new partner for 3 years. George is well aware that his ability to bring
in new clients is critical to his aspirations to become a partner.

BVA Manufacturing Ltd (BVA), a large stationery manufacturer, has decided to put its
audit and related accounting services out for tender. BVA’s current auditor performs
significant non-audit services. In fact, fees for non-audit services are well in excess of the
audit fee.

George has been given primary responsibility for developing and presenting the tender to
BVA’s board of directors. He has nearly completed preparations for the presentation and
has discussed all the specifics with two partners who will have a significant involvement in
servicing the audit and related service needs of BVA, should the firm be successful in its
tender. As required by the board of BVA, a detailed outline of the proposal presentation
and itemised preliminary budget were submitted four weeks in advance of the presentation.

On the Thursday evening before the presentation, George’s wife receives a call from her
sister, Rosemary. Rosemary’s flatmate, Fleur, is the secretary of BVA’s managing director.
Fleur had noticed that one of the proposal presentations was going to be done by someone
named George Martin and asked Rosemary whether it was the same George Martin who
was married to Rosemary’s sister. Rosemary had said that it was, and Fleur had begun to
tell her about some of the proposals.

Fleur had said that she had noticed several things about the managing director’s evaluation
of the proposal submitted by George’s firm. Firstly, the bid was significantly higher than
one of the other bids. Secondly, the managing director had mentioned two items of major
importance that had been left out of the proposal. Fleur could not remember what these two
items were off the top of her head, but she told Rosemary that she would be willing to run
off a copy of the memo if Rosemary wanted her to.

George’s wife tells him about the call from Rosemary at dinner that evening.

REQUIRED
Outline the ethical issues and your decision using the American Accounting Association
decision making model.
Week 2: Auditor’s Legal Liability & Ethics, Independence
and Corporate Governance
Tutorial Discussion Problems and Case Studies

3.22 Consider the following two independent situations in relation to Dream Holidays Ltd
(DHL), a major client of your audit firm, Accounting Associates.

a) DHL contributes around 10% of the total audit fees revenue and 20% of the non-
audit fee revenue of Accounting Associates. DHL has not paid any of its fees for
the past two years, citing cash flow problems. The partners at Accounting
Associates have been reluctant to put any pressure on DHL for outstanding fees, as
DHL is a high-profile client that they wish to retain.
b) The partners at Accounting Associates frequently hire cars from DHL to visit long-
distance clients. DHL gives a 10% discount to its loyal customers, including
Accounting Associates. Recently a tax partner at Accounting Associates, Rebecca
Holmes, hired a four-wheel-drive from DHL to go on a holiday with her family on
the same as those offered to Accounting Associates.

REQUIRED
For each of the above independent situations, identify any professional standards and
regulatory requirements that have been breached, and recommend possible courses of
action that Accounting Associates could take to rectify these breaches.

Tutorial Week 2 Page 5

Week 2: Auditor’s Legal Liability & Ethics, Independence
and Corporate Governance
Tutorial Discussion Problems and Case Studies

3.25 Threats to Independence

You are an audit manager with Clarke & Johnson (CJ). For the past three years CJ has been
the auditor of luxury Travel Holidays Ltd (LTH), a travel company. Geoff the audit partner has
asked you to contact Chris, LTH’s CEO, with a view to CJ being re-engaged as the auditor for
the upcoming audit of the 30 June 2019 financial report.

Geoff has also indicated that he intends to allocate Michael, a first year-accountant, and
Annette, an accountant in CJ’s tax advisory department, to the LTH audit for the first time.
Geoff suggested that you discuss the audit with each of these staff, with a view to identifying
any independence issues. You held talks with Chris, Michael and Annette and excerpts of
these conversations were as follows:

1. Conversation with Chris, excerpt 1:

Chris stated: ‘The Board of directors were impressed with last year’s audit and would
like to propose reappointing CJ as the auditor of the 30 June 2019 financial report
audit. The board would also like to invite Geoff to give a speech about LTH at the next
travel agency seminar, to assist in promoting LTH’s business to attract more investors.
I understand that this is outside CJ’s normal practice; however, the board expressed
the view that it will be very difficult for LTH to continue any business engagements with
CJ should Geoff refuse to provide such assistance.

2. Conversation with Chris, excerpt 2:

Chris stated: ‘To express our sincerity towards CJ and Geoff, and to maintain the good
relationship in anticipation of another smooth audit for 2019, LTH would like to present
a complimentary 14-day holiday package voucher for four people to the Greek isles for
both Geoff’s and your family. All expenses, including accommodation and travelling
costs, will be paid by LTH.’

3. Excerpt from discussion with Michael

Michael stated: ‘I am very excited to be part of the audit team. I believe that I will be a
valuable asset to the team, as my dad is LTH’s financial controller. He is responsible
for the preparation of LTH’s financial report’.

4. Excerpt from discussion with Annette

Annette stated: ‘I’m glad that I’ve been allocated to this year’s LTH’s audit team. It’s
going to be a very efficient audit this year! I was on temporary assignment at LTH just a
month ago, helping LTH with its tax calculations and preparing accounting entries that
will be reflected in the 30 June 2019 financial report, so I don’t think there will be much
audit work required around the tax accounts. It will be great to catch up with everybody
at LTH again, as they are so easy to work with.’

REQUIRED
a) For each excerpt, identify and evaluate any threats in relation to auditor
independence.
b) Identify any safeguards to those threats identified above.