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    9.2- AUDITOR'S LIABILITY

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    14 views15 pages

    9.2 - Auditor's Liability

    Uploaded by

    Danita

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    © All Rights Reserved
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    of 15
    CHAPTER 29 ALCXTOR'S UAB - DDUCTION ould ale idy have appreciated ly reciated tha and its effect on auditors which also affect auditors, s perform audits and si 1 of financial sea tors certify that a set the law has relevance for auditors, in particular the Companies sich has been detailed in Chapters 2 and 3. However, other branches Particular what happens when things go wrong. sm audit reports which, as we knows, contain the auditor's opinion on the arements. Auditors are reputed to be independent, competent and honest 50, vill have faith in hen nancial statements show a true and fait view, eaders of those financial | 1em because they have faith in the auditors. This is why maintenance of the c oe of the audit profession is so impor their work i relied upon by others, auditors clearly have sea others, auditors clearly have a responsibility to do their work honestly Mls: The judge in the London & General Bank case (1895) summed it vp when he said, about an t be honest ~ that is, he mi le care and sl bone gl Mot certify wat he does not believe tobe true, and he must take 1 believes that what he certifies is true. st standard for the performance level of audit work ~ auditors are not meant to be all seeing and they must simply exercise ‘reasonable care and skill’ in careying out their work. This is known (of care” to the people to whom they report. casonable care and skill’ actually means depends on the circumstances of each case and ult 10 generalize. Where auditors fail to exercise sufficient care and skill in carrying out their fraud or a material error may go undiscovered at the time of the audit, so they certify the accounts fication having failed to discover that the financial statements do not show a true and fair view contain a material misstatement which the auditors have failed to detect. that somebody who claims to or actually does rely on the work of the auditor may lose money. joney flows directly from the failure of the auditors to do their job properly. ho have lost money are to somehow claim it back one question needs to be addressed and this 0 the Courts to decide in a series of landmark eases which have, so far, set the boundary on the ity to third parties and to their clients. The question is: ro whom does the auditor owe a duty t0 the shareholders or co the world a large? rn to that question later. ubject to a code of ethics and are generally held to be honest and trustworthy individuals, fare cases where professionally qualified individuals either become embroiled in, or worse, criminal acts so it is worthwhile having a working knowledge of the main aspects of the affects auditors and accountants. ne specific offences which are criminal offences under various statutes. It is not necessary to jslation but the nature of the offences is listed here. offences ander the Companies Act 2006) to: appointment as an auditor when disquatfed to do s0 or to continue as an auditor alter becoming ‘thers to carry on a company with intent to defraud. recklessly to cause an auct report to Include ‘any matter that is misleading, false or deceptive in any jor Knowingly or eck cx rer to eit saa thal eed UPR CT BUEN hy Knowing or eke couse an auc rpc 10 eee ot agree wth accounting records and returns 2 Sexo ner a congas cs 099 An Ay ‘© Section 498 (3) - statement that necessary Inrmation and €% Se ‘© Section 498(5) - statement that directors wrongty took advantage of @xer iption from obligation to prepare, coe eamnes + qsuing a false audit report, are new under CA, “The last rwo offences, concerning ‘knowingly or recklessly” issuing arora ims 2006 Sante gO) They cone eebanitred bya director, member, employee or agent ofan aut rm if such ern iam accountant who soul be eligible co be the 3 Sopuiabhs fy nie wi Fo a pretesion was concereed hat negigene or hott mistakes could come to Be penalize ag criminal offence The problem les nthe defnton of"eckesI"- The Bove vitor of the company and, on conviction, offences reasonable risks and consciously decide ; failure to act carried wm ‘the auditor would have to know that failure to act pena cals nd ole Oa 10 g0 ahead despite that. The real point is that it isa long way al inadvertently, a degree of consciousness has to be shown: This opens up several issues. IF negligence is proved because the auditor failed to carry out at the planning stage of the audit deliberately not to carry them out, but is it reckless? Courts may choose to look at the situation in this way: © the docision was taken as the result of a faut risk assessment, and the auditors honestly believed the procedures vrownt recount may begat fngipet aug, saan hey were bin aay mad ye directors, perhaps because they fale to cary out proper procedures under the relevant ISAS. ‘© However they decided not to carry out aut procedures simply to save money by reducing auc time, prhaos ‘based on some very superficial reasoring about the trustworthiness of thelr cient, they may not only be negigent but also reckoss. Clearly it will require some prosecutions before the attitude of the courts becomes clear. Consequent!, audit documentation will become even more significant, in terms of justifying decisions taken at the audit planning stage. In addition to these Companies Act offences we saw in Chapter 20, the auditor’ responsibilities concern- ing fraud and in Chapter 6 the ethical rules with respect ro money laundering and insider trading. Whilst these are of interest, of much more importance is the auditor's duties under what is known as common law concerning negligence. proper professional procedures, i. decided this will almost certainly be negligent CML LIABILITY UNDER THE COMMON LAW ‘The most complex area for auditors is the civil law and this brings us back to the earlier questions relating to duty of care and negligence. Common law is law made by cases or precedents as opposed to statute law ‘which is law set out in statutes passed by Parliament, Duty of care Duty of care is the obligation to exercise a level of care, as is reasonable in all the circumstances, in carrying cout professional work. In the case of an audit for example, auditors have a duty to use their training and professional expertise to minimize the risk of material errors or misstatements going undetected and so being included in the financial statements with the result that these are misleading, This would require auditors to exercise the level of skill care and competence expected ofa suitably qualified professional in the circumstances. 2 _—i Sueveue = The dt of cre is therefore, based upon ae sl te Posle consequences of actions eared Out the reasonable probability of foreseein (Only a neglige 1B any loss, ip of the parties, the negligent act or omission and act wil be regarded as having breached a duty of care What is negligence? The broad ee Principle was stated in 1932 inthe case of Donaghue v Stevenson by Lord ‘you must take reasonable care to av Pett mstmaen £0 avoid acts or omissions which you can reasonably foresee might This oahu Principal has caused no litle trouble in legal circles when considering the culpability of ae eee kal nel see later but asa statement of general principles itis a sound one ~ auditors a hr caes a ta nraaea £© avoid doing something, such as issuing an incorrect auditors report, sshich might cause loss co their client or someone reasonably close to them. We have put this last point in italic to highlight it as it i this question of what lawyers call proximity which has caused al the trouble. For an allegation of negligence to succeed the claimant must proves the defendant had a duty of care to the daimant ‘there was a breach ofthe duty of care which caused harm or damage that damage must have been foresesable there must be proximity between the parties its far, just and reasonable forthe court to impose afablty on the auditors ‘We will look at two situations under ci law where auditors can be sued for negligence: ‘© under contract law where a contractual relationship exists between two parties, in this case shareholders and auditors (© toa third party where @ duty of car exists but not contractual One of the key issues we will be looking at in this chapter is quite how far that duty to a third party extends. Clearly auditors owe a duty of care to the shareholders, but what about other readers of the accounts. such as lenders, suppliers or potential investors? DUTY OF CARE We have established (Chapter 8) thar the Letter of Engagement, duly signed by the auditors and the client, represents the basis of a contract between them. Because there is a contract the auditors can be sued for a breach of it if they provide a negligently prepared audit report which results in loss to the client. “The cease fer ehic i cht the existence of the contract creates a duty of cae between the auditors and the shareholders to whom they report. Although the Lerer of Engagement is signed by the directors they are signing iton behalf of che company, which is owned by the shareholders, so the duty of care is owed to the company, otto the directors. Ifthe anditors fail ro carcy out their duties to a reasonable standard, they can be liable, “As we have already scen the auditors are only bound to exercise ‘reasonable skill and car’ in carrying out their activities. Quite what this means has often been left to the courts ro decide. “This hes beer-reflecte in the ethical codes of various accounting bodies, For example, the ACCA requires their members to carry out their work with: “due sill, care diligence and expedition with proper regard tothe technical and professional standards expected of them as members.” 432 f al competence’ and their ethical The ICAEW expects their members to display what they call ‘professional coms 7 rules state: The principle of pre id due care imposes the following obligations on profes sional accountants: (a) To maintain professional knowledge and skill receive competent professional service: and (b) To act diligently i accordance with applicable technical and pre professional services. essional competence di atthe level required to ensure that clients or employers ssional standards when providing The courts have also given guidance as to what is considered to be ‘reasonable skill and care’ in various judgements Re London & General Bank (No 2) (1895) We have already nored, above, part of the wording of the judgment in the London here is another point the judge made: & General Bank case but “|The auditor's busines is to ascertain and state the true financial position of the company at the time of the audit and bis duty is confined to that. But then comes the question: How is he t0 ascertain such position? The answer is by examining the books of the company: But he does not discharge his duty by doing this without enguiry and without taking the trouble to see that the books and records of the company show the company’s true position. He must take reasonable care to ascertain that they do. Unless he does this his duty will be worse than an idle farce: Re Kingston Cotton Mill No 2 (1896) This is a classic case which the auditing profession has relied on implicitly almost since the judgment was given by Mr Justice Lopes in 1896. The judgment contained two significant phrases which students should be aware of. One of them, the reference to the auditor being a ‘watchdog not a bloodhound’ we have already met in Chapter 20: “Itis the duty of ar auditor to bring to bear on the work he has to perform that skill, care, and caution swhich a reasonably competent, careful, and cautious auditor would use. ‘An auditor is not bound to be a detective, or, as tas said, to approach his work with suspicion, or with a foregone conclusion that there is something wrong. He is a watchdog, but not a bloodhound. ‘Auditors must not be made lable for not tracking out ingenious and carefull aid schemes of fraud when there is nothing to arouse their suspicion ... So to hold would make the position of an auditor intolerable: ‘This judgment set the tone for the audit profession for over a century ~ auditors were to be passive checkers rather than be proactive detectives in searching out errors, misstatements and frauds. However, this statement may no longer have the force it once did in the light of ISA 240 “The auditor’ responsibilities relating to fraud in an audit of financial statements’. Auditors have now to recognize atleast the possibility that fraud may exist and, consequently, adopt an attitude of professional scepticism in their approach to audit work, They have to recognize that schemes of fraud may involve complex mistepresenta tions and carry out their work accordingly. ‘This ISA may well be interpreted by the courts as placing on auditors a rather greater element of awareness, if not actual sleuthing, than the previous decisions admitted. Auditors still do not have to actively seek out fraud, but they have to be alert watchdogs! Re Thomas Gerrard & Son (1968) For many years the managing director of the company falsified the inventory figures in the accounts in ordet to conceal losses and to enable dividends to be paid. To do this he included non-existent inventory and he also altered invoices, which were discovered by the auditors but not followed up or investigated. HAPTER 29 ALTO APTER 29 ALOSTOR'S UABLITY 433 T : siven to the We apy contended that it was nt part them by the managing director, a person who they cose Matthey were emied wo sah is auditor's role to count imentory, mevely wo verify the fees nunported by the decison inthe Kington Coen Mats ficial of he company te ed ain ed eran of he company oa Mill case where the judge stated that an auditor: weve in eis case the court held that the Scones sof io is poeed by fhe Comber playa they should have invested the mane TY of the altered invoices had put the auditors on ‘Frey were no longer able to trust the assurances gi inces given to them and should have made enquiries, if neces~ can irom supplier, £0 verify the assurances given, D fly. I they had dee enc Othe auditor’ suspicions were aroused they had to reeligen® auditing ‘so the fraud would have been revealed. They were thus guilty This is particularly rele where auditors are obtaini Se are obtaining information from officials of the company with- exacancmitant am ck at checking work I he have reson to doubt or ae suspicious of snytansactions they mus follow it up, This supported by the content of IA 240 which requires auditors tofollow upon qu anomalies and goes tothe heart ofthe attitude of professional scepticism required. UABILITY FOR NEGLIGENCE his is the most contentious area of auditor's liability and has given the courts and the audit profession, no and of trouble over the years. 2 header ‘The problem is as follows. Clearly as we have seen above, auditors can be liable to the shareholders for filing to carry out their audit with reasonable skill and care should they suffer loss as a result. However, partes other than shareholders use audited financial statements ~ for exam lenders employees regulators tax authorities suppliers customers Potential investors Indeed, a whole range of third parties some of whom ofwhich they have no specific knowledge at all. Are they liable co everyone? To be liable in negligence there ae five condition be fulfilled which we se out above but are worth repeating here if the subtleties of the law are to be understood clearly. They are: ©The defendant had a duty of car to the lammant ‘There was a breach ofthe duty of care which caused harm or damage, That damage must have been foreseeable There must be proximity betwoon the partes. itis fa, just and reasonable or the court t impo oa In these negligence ca! angs on whether a dary of cae is owed a al because ifthe auditors did awtowe dur cfcare oe ae pe it and 0 cannot be able for damages fr aggre, amos cae Teena any eines bave been cxzblished and st has he oP ee anco with al the vane cavied out a proper audit in accordance with all the Clearly if they have not been negligent, i. hey bs jenpetent, cautious and careful auditor would then they have no case to answer as they have tors the failure is often all roo apparent. srowimiy ie. dd the auditors know about the third fn duty of care? the auditors might be generally aware of and others 19@ alabilty on the auditors J. asa reasonably racy of directors Jed in their duy a5 24 jestion of" Precepts of the ISAs and done all their wor

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