Tutorial Two – Lecture 2

Tutorial Two
Learning objectives
 Identify the attributes of professional status and describe to what extent they exist in public
accounting.
 Describe the regulation of auditing and its subject matter.
 Explain the impact of internationalisation on auditing.
 Outline the characteristics of the professional bodies and accounting firms engaged in the auditing
profession and describe the internal structure of an audit firm.
 Identify the elements of quality control within audit firms and explain practice-monitoring programs.
 Explain the concepts of reasonable care and skill, and negligence.
 Explain the auditor’s legal liability to clients.
 Explain the auditor’s liability to third parties
 Describe alternative methods used to limit the auditor’s liability.

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Major Lecture sections

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Professional status of the auditor

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Regulation of auditing and of the subject matter of audits
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Internationalisation of auditing
Profile of the auditing profession and of audit firms
Quality control
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Reasonable care and skill, and negligence

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Liability to clients
Liability to third parties
Limitation of liability
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TQ 2.1:
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Describe the circumstances that are necessary for a negligence claim against auditors to be
Successful?
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A)
The matters that must be proved to the satisfaction of a court before a claim of negligence can succeed are
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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).

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 Tutorial Two – Lecture 2

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.
A)
The changes to limit the auditor’s liability that were implemented through CLERP 9 and the professional
standards legislation include the following:
 A statutory cap: This is where a statutory limit is placed on auditors’ liability. This has been
introduced by the professional standards legislation with a cap of 10 times the audit fee, up to a
maximum of $75 million.
 Incorporation: This involves letting audit firms incorporate and operate as authorised 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 loss

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suffered by the plaintiff that was the responsibility of the auditor.

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These reforms were introduced because it was argued that unlimited liability was unfair and meant that

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auditors were reluctant to carry out audit-related engagements that were in the public interest, for

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fear of litigation. Also, unlimited liability and escalating claims had resulted in public liability insurance
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for auditors becoming extremely expensive and sufficient cover impossible to obtain. Further, limited
liability reforms such as incorporation and proportionate 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
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as part of a loan application. Audit partner, Graham Young, immediately accepted the engagement and agreed
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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 hours telling them exactly what to do. Graham told the
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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
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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.

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 Tutorial Two – Lecture 2

Explain whether you consider that Young and associates was negligent. Justify your answer.
A)
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 stan -
dards.
 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:

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Quick Money Ltd (Quick Money) is taking legal action against Crew & Associates (Crew) over the audit of

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Poultry Pty Ltd (Poultry), which went into liquidation owing almost $10 million to

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its creditors, including $5 million to Quick Money. Quick Money claimed that the profits recorded were vastly
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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 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
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decision, citing relevant case law where appropriate.

(b) Discuss the validity of Crew’s defence.
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A)
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(a) Following the rulings in recent cases, such as AGC, Caparo and Esanda, the test of proximity needs to be
satisfied to determine a special relationship.
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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 result of
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their lack of due care;

 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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