4 Auditors' Legal Duties and Liabilities

Question 1

What is insurance theory?

Answer 1

• For the insurance theory of auditing to work then auditors need to be found negligent by a court of law and then ordered to pay out
• This makes it one of the weaker theories
• For the hundreds of cases that make it to court there are thousands that don’t

Question 2

Who researched the expectation gap and what did they find?

Answer 2

• Porter found 85% of people think auditing giver a guarantee of accounting
• Expectations are essential for auditing to survive

Question 3

What is the structure of the expectation gap? (draw diagram)

Answer 3

• The largest gap is the gap between what society expects and what auditors deliver and this is the expectation gap
• There is a smaller gap between what is expected of auditors and what society expects and this is the reasonableness gap
• This model acknowledges that there are deficient standards where what is being imposed onto an auditor does not match their duties

Question 4

What are the major limitations of the law regarding auditing?

Answer 4

• Torte law is a predominantly reactive method of law
• But auditing is based on judgements of the auditors about the judgements of the accountants
• Therefore no two cases are the same and the law poorly contains the matter
• Mofitt judgement supports this

Question 5

Has the law defined “True and Fair”

Answer 5

No it is not possible

Question 6

What is material in the eyes of the law

Answer 6

There is no materiality threshold in the eyes of the law (major limitation)

Question 7

What happens if auditors detect a small immaterial fraud?

Answer 7

It has been ruled that they are duty-bound to tell management but as it is not material so not the outside world

Question 8

Who do auditors owe a duty of care to?

Answer 8

If it was a strong duty owed to the investors why have so few cases been awarded damages

Question 9

Are the auditing standards legally authoritative?

Answer 9

Accounting and auditing standards are not legally authoritative. Judges have said despite auditors following standards they still did the wrong thing. Standards do not control the courts

Question 10

What are the primary court cases against auditors?

Answer 10

• Almost all cases brought against auditors are about negligence
• There is of separate laws or audit negligence. Just the general common law that applies to all lawyers, doctors etc

Question 11

What is negligence?

Answer 11

• Any conduct which is careless or unintentional in nature and entails a breach of contractual duty of care in tort owed to another person or persons
• It does not entail deliberate wrongdoing
  o This is a criminal act
• Includes actions and failure to take action

Question 12

Who is responsible to detect fraud?

Answer 12

Main responsibility for fraud detection lies with management and those charged with governance, and not with the auditors

Question 13

What is the reasonable man?

Answer 13

Negligence is the omission to do something which a reasonable man, guided upon those considerations which ordinarily regulate the conduct of human affairs, would do or doing something which a prudent and reasonable man would not do

Question 14

What are the limitations of negligence?

Answer 14

• Negligence only works if there is a duty of care owed to the defendant
• No general duty of care so cant be sued for going about daily life
• Therefore, focus is on who auditors owe a duty of care to and are able to sue for negligence

Question 15

What was the ruling for no general duty of care?

Answer 15

“A man is entitled to be as negligent as he pleases towards the whole world if he owes no duty to them”

Question 16

What established the general duty of care?

Answer 16

• Donoghue vs Stevenson
• Established that if it is reasonable that any member of the public could be affected then a duty of care is owed

Question 17

What are the four essential elements that must be proven to claim negligence?

Answer 17

• That duty was owed to the plaintiff by the defendant
• That there was a breach of that duty
• A loss was suffered by the plaintiff
• That there was a relationship between the breach of duty and the loss

Question 18

Who has the burden of proof for negligence

Answer 18

Burden of proof rests on the plaintiff

Question 19

How many of the 4 elements of negligence must the plaintive prove?

Answer 19

All 4

Question 20

How many of the 4 elements of negligence must the defendant disprove?

Answer 20

Just 1

Question 21

How can legal actions of negligence be brought?

Answer 21

• Breach of contract actions, (but only if the plaintiff had a contract with the defendant)
• Tort actions (by any plaintiff who is owed a ‘duty of care’ by the defendant

Question 22

What is privity of contract

Answer 22

• A contract action can only be brought by a person who is party to the contract
• There is a assumed duty of care in professional contracts
• In audits the contract is between the public company and the auditor
• Therefore, only the company can sue the auditor

Question 23

Why can shareholders not sue the auditors

Answer 23

• No contract with the auditor and shareholders
• No breach of contract
• So, they and other third parties to contracts can only sue in tort

Question 24

Who do auditors owe a duty of care?

Answer 24

• It is well established that auditors do not owe a duty of care unless there was foreseeability and proximity at the time of the negligence
• No audit duty of care is owed to a third party unless, at the time the audit report is prepared, the auditor had knowledge of the third party and knew or should reasonably have known

Question 25

What was the nature of the Caparo case

Answer 25

• There is a difference between the company making a loss and it affecting the shareholder’s investments and shareholders making a loss from investing in the company
• Shareholders as a result of reductions in the market price of the company’s shares do not entail any losses to the company itself
• Shareholder losses arising from an auditor’s negligence can only be recouped if the company has also suffered a loss which it is able to recover, on behalf of its shareholders

Question 26

What was the results of the Caparo case?

Answer 26

• Verdict agrees with the companies act which details shareholders own shares to control the company
• Act does not assume they are held for profit
• Therefore, they cannot sue for the loss on the profit as it is not the objective
• This is a very contentious ruling as in reality shares are held for profit

Question 27

What are the standards of skill and care required of auditors

Answer 27

• When duty of care has been established the next point is to consider if they have breached that duty
• This is their careful, independent and professional opinion and if it shows a true and fair view

Question 28

What is true and fair

Answer 28

• “True and fair view”, is not defined anywhere in the Companies Acts, nor in any equivalent overseas legislation.
• This is for good reason; it is not susceptible to any precise legal definition.
• Therefore, in terms of the law, the truth and fairness of financial statements is inherently subjective, being always a matter of professional judgement, in the context of the circumstances of a particular business

Question 29

What is material

Answer 29

In practice, an item or items are regarded as being material only if they are considered to be of sufficient size or importance as to be likely to affect the opinions, and therefore the actions, of users of the financial statements

Question 30

Do courts expect auditors to detect fraud?

Answer 30

• Courts recognise practical limitations
• They do not necessarily require auditors to detect material fraud or errors merely because it exists
• Courts hold a realistic view in comparison to the public’s expectations
• However, they do expect auditors to exercise a high standard of skill and care

Question 31

Overview Pacific Acceptance

Answer 31

• Pacific Acceptance sued its auditors for A$3m, claiming that it had lost this amount because of the auditors’ negligent failure adequately to investigate or to report certain irregularities.
• The court upheld these complaints, ruling that the auditors had placed too much reliance on management and on a firm of solicitors in ensuring the loan documentation. To the extent that irregularities had been discovered, the judge held that the audit report had been inadequately qualified.

Question 32

What was the audit firms

Answer 32

1. They had complied with professional auditing standards.
2. The errors which they had discovered, had emerged in the course of audit work which was in excess of that required to be done in order to comply with statutory reporting requirements, and
3. Management should have informed them of certain matters of which it had knowledge, including the existence of irregularities in respect of transactions made with Mr Thompson.

Question 33

What are the effects of Pacific Acceptance?

Answer 33

• It is up to the courts to decide if they have complied with skill and care
• Even if you comply honestly with standards
• Have other auditors agree that you acted correctly
• The court can find it that you were negligent
• Worrying for auditors as they can do all they think it right and still get it wrong
• But it doesn’t expect auditors to detect fraud as it by its own nature is well hidden and is deception