Auditing Tutorial Two – Lecture 2

Tutorial Two Solutions

TQ 2.1: Describe the circumstances that are necessary for a negligence
claim against auditors to be Successful?
The matters that must be proved to the satisfaction of a court before a claim of negligence can
succeed are that:
 a duty of care was owed to the plaintiff (that is, that there was reasonable foreseeability
and proximity)
 the auditor was negligent (that is, that reasonable care and skill were not exercised by
the auditor)
 the plaintiff relied on the auditor
 the plaintiff suffered a quantifiable loss as a result of the auditor’s negligence
 the loss was suffered as a result of relying on the auditor (that is, causation).

TQ 2.2: Outline the legislative actions that have been taken to reduce the extent of an auditor’s
liability and explain why these actions were undertaken.

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The changes to limit the auditor’s liability that were implemented through CLERP 9 and the

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professional standards legislation include the following:

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 A statutory cap: This is where a statutory limit is placed on auditors’ liability. This has

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been introduced by the professional standards legislation with a cap of 10 times the

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audit fee, up to a maximum of $75 million.
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 Incorporation: This involves letting audit firms incorporate and operate as authorised
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audit companies. This allows members of the audit firm, other than the auditor signing
the report, to have their liability limited to their capital invested in the firm.
 Proportionate liability. This means that the auditor is liable only for the proportion of the
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loss suffered by the plaintiff that was the responsibility of the auditor.
These reforms were introduced because it was argued that unlimited liability was unfair andmeant
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that auditors were reluctant to carry out audit-related engagements that were in the public
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interest, for fear of litigation. Also, unlimited liability and escalating claims had resultedin
public liability insurance for auditors becoming extremely expensive and sufficient cover im-
possible to obtain. Further, limited liability reforms such as incorporation and proportionate
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liability had already been introduced in the UK, the US and Canada
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TQ 2.3 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
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accepted the engagement and agreed to provide an auditor’s report within three weeks. As they
were short of staff, Graham hired two accounting students to conduct the audit and spent several
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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

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 Auditing Tutorial Two – Lecture 2

number of orders resulting in a significant loss to the company. As a result, Elegance is suing Young
& Associates for negligence.
Explain whether you consider that Young and associates was negligent. Justify your answer.

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).
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TQ 2.4: Quick Money Ltd (Quick Money) is taking legal action against Crew & Associates (Crew)over

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the audit of Poultry Pty Ltd (Poultry), which went into liquidation owing almost $10 million to
its creditors, including $5 million to Quick Money. Quick Money claimed that the profits recorded

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were vastly overstated and inventory levels inflated in the financial report of Poultry. Crew has
denied that they were negligent and has argued that they relied heavily on information provided

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by Poultry’s management.
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(a) Do you believe that Crew owes Quick Money a duty of care? Provide reasons for your
decision, citing relevant case law where appropriate.
(b) Discuss the validity of Crew’s defence.
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(a) Following the rulings in recent cases, such as AGC, Caparo and Esanda, the test of proximity needs
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to be satisfied to determine a special relationship.

To satisfy the test of proximity the following must be proved:
 it was foreseeable by the auditor that the third party would suffer an economic loss as a
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result of their lack of due care;

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 there was an intention to induce the third party to act in a certain way; and
 it would be fair, reasonable and just, given all the circumstances, to impose a liability on
the auditor for the economic loss.
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In this case, there is no indication that Crew induced Quick Money to rely on the audited
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financial report of Poultry. Therefore it does not appear that Crew owes Quick Money a duty
of care
(b) Crew’s defence was that they relied on information from Poultry’s management. Pacific
Acceptance (1970) confirmed the standards of reasonable care and skill, which includes that
auditors have a duty to check and see for themselves. To rely on client’s personnel and/or
management is an aid, but not a substitute for auditor’s procedures. Therefore, if a duty of
care did exist, this would not be a valid defence.

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