Auditors liability 1

Auditors legal and professional liability

Introduction ................................................................................................................ 2 Cases ......................................................................................................................... 2 Ultramares Corporation v. Touche (1931)....................................................................3 Facts of the case......................................................................................................... 3 Judgment.................................................................................................................... 4 Arguments supporting for negligence..........................................................................4 Arguments against negligence....................................................................................4 Harold Tod Parrott v. coopers & Lybrand, LLP (1998)...................................................4 Facts of the case......................................................................................................... 4 Judgment.................................................................................................................... 5 Arguments supporting negligence...............................................................................6 Rusch Factors, Inc. v. Levin (1986)..............................................................................6 Facts of the case......................................................................................................... 6 Judgment ................................................................................................................... 7 Arguments in support of negligence............................................................................7 Arguments against negligence...................................................................................8 Auditing standards...................................................................................................... 8 ASA 240 the Auditors Responsibility to Consider Fraud in an Audit of a Financial Reports....................................................................................................................... 8 ASA 315 Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement ................................................................................................8 ASA 330 the Auditors Procedures in Response to Assessed Risks...............................9 Conclusions ..............................................................................................................10 Bibliography..............................................................................................................10

Auditors liability 2 Introduction Auditors are liable to third parties incase of negligence. They are liable in tort law and in contract law. Third parties such as investors and buyers suffer damages due to wrong audits done by auditors. Investors suffer damages in the secondary market and buyers make losses when buying shares. Liability of auditors to third parties can be described as liability for pure economic loss. Auditors are liable for negligence behavior if a misleading audit led to damages in the secondary market (Tubbs 1990, p.453). They are also liable for simple negligence in the case of primary market audit. The law of tort restricts and excludes the liability of an auditor for pure financial loss. However, contract law demands that pure economic losses must be compensated in the case of simple negligence. Damages that are caused to the shareholder, under an implied contract between the shareholder and the auditor, damages can be recovered because the auditor is liable for simple negligence. The auditor has violated a contractual duty to the shareholder negligently though the explicit contract was between the auditor and the company. These damages under the law of contract are recoverable under the law of tort. However, compensation cannot be given to simple negligence since the damages are considered to be pure economic losses under the law of tort. Under common law auditors are liable to third parties incase of ordinary negligence. This paper describes various cases that are related to the auditors liability due to negligence. It also describes the changes in audit standards that describe the auditors obligations to identify and assess risks of material misstatements due to fraud. It is the duty of an auditor to alert the audit team of any potential unsuitable behavior to facilitate the required planning and implementation of an effective audit (Holstrum et al, 1985, p.104). Cases

Auditors liability 3 Ultramares Corporation v. Touche (1931) This is a land mark case in common law that established the liability of auditors to third party beneficiaries for ordinary negligence (Toba 1975, p. 13). This case also denotes that auditors are liable to other third parties for gross negligence. The case between Ultramares Corporation v. Touche (1931) is a tort law case that was decided in the US for negligent misstatement by an auditor. The case was decided by Cardozo CJ who denoted that the law should not accept to a liability that involves an indeterminate amount for an indeterminate time and to an indeterminate class. The action is under the law of tort where damages were suffered due to misrepresentations by the accountants who were negligent and fraudulent. Facts of the case Touche, a firm of public accountants was employed by Fred Stern & Co to prepare and certify a balance sheet that would show its financial position at the end of 31st Dec 1923. Fred Stern & Co. was a company that was dealing with importation and sale of rubber and required finances that would enable it to continue running. The company decided to borrow money from various financial institutions. The defendants (Touche) knew that, they should prepare a balance sheet that would be accepted by the financial institutions and lent money to Fred Stern & Co. they made up a balance sheet for the financial year and distributed 32 copies certified with serial numbers as counterpart originals to stern company. The balance sheet was presented on Feb 26th 1924 with more assets of 2,550,671.88 than liabilities of 1,479,956.62 with a net worth of 1,070,715.26. It was certified by the accountants as having a true and fair view of the company. Stern company borrowed money from the plaintiff using the balance sheet. On the faith of the balance sheet the plaintiff advanced a loan to stern company and other loans were given without or inadequate security. The plaintiff used the audited balance sheet and suffered losses (Waller et al 1984).

Auditors liability 4 Judgment The audit was confirmed with negligence and fraud. The auditors did not communicate to the creditors of the wrong audit hence they were liable for negligence since they did not use reasonable and ordinary care. The judge Cardozo CJ held that auditors were not negligent to the plaintiff since they owe no duty of care to the plaintiff. The judge said that there was no sufficiently proximate relationship since the liability was for an indeterminate amount for an indeterminate time to an indeterminate class. The case laid down the privity of relationship and not for contract (Dye 1993, p. 889). Arguments supporting for negligence The defendants owe a duty of care to the plaintiff. Any information negligently provided for the guidance of others is subject to liability for pecuniary loss caused to them by use of such information. Auditors should not give wrong information for the benefit of the company. Arguments against negligence There is no contract relationship between the auditor and the plaintiff hence the auditor has no liability to plaintiff. Harold Tod Parrott v. coopers & Lybrand, LLP (1998) Harold Tod Parrot was the plaintiff in this case and demanded that the defendant Coopers & Lybrand were negligent through misrepresentation of facts and had a breach of fiduciary duty. It is a common law case that was decided at the supreme court of the state of New York (Coopers et all 1979). Facts of the case

Auditors liability 5 Pasadena was a private business providing investment advisory services. Pasadena employed Parrot and entered into a stock agreement. Parrot as a key employee would purchase 40,500 shares of Pasadenas common stock for $28.22 per share. Parrot was to sell the shares at the time of termination to Pasadena at their fair market value. Parrot was terminated in May 1996 and coopers were told to do valuation report for determining the fair market value of Pasadenas common stock. In the previous years coopers were producing valuation reports showing growth in stock. Coopers was influenced by Engelmann in 1996 to treat Pasadena as a company with hidden values. Tubbs (1990, p. 458) argues that, the change of methodology led coopers to produce inaccurate valuation of stock. Parrot accepted the price and sold he hares to Pasadena at the reduced price per share of $78.21. Coopers had issued inaccurate stock valuation report for Pasadena Capital Corporation. 40,500 shares were sold by parrot a former officer and director of Pasadena at a price that had been determined by the report. Parrot claims that, the price was undervalued. Parrot sold the shares back to the company in less than a year after buying. Pasadena then went into a merger with another company where the shareholders received a higher rate of $144 per share plus an additional payment of $22 per share from Pasadenas retained earnings.

Judgment The court decided that, there was no sufficient relationship between parrot and coopers upon which claims of negligence can be based by parrot. Coopers did not have any idea of parrots specific identity in Pasadenas shares. The court held that, accountants are only liable for negligence to non contractual parties who rely on untrue financial reports under the following conditions; the accountants should have been aware that the financial information was to be used for a particular

Auditors liability 6 purpose. Accountants must have been aware that the financial reports were to be used for a specific purpose. There must have been a witness available when the accountants were informed of the partys reliance. The court did not extend any liability to the accountants coopers (Cushing et al 1983, p. 32). Arguments supporting negligence Accountant must be aware of the relationship of the company and the plaintiff. Accountants should be given details that the reports are for a particular purpose. Auditors are required to demonstrate knowledge that the financial statements will be relied upon by a third party. Such a situation, the auditor will be held liable for negligence. Rusch Factors, Inc. v. Levin (1986) This was a common law case that found auditors liable for ordinary negligence to third parties who are not specifically identified to the auditors and the auditor were aware of the intentions of preparing the financial statements. According to Taylor (2000, p. 693) It is a litigation case.

Facts of the case Leston Nay emigrated from Hungary to US when he was 18 years old. At Chicago he found a job after which he was laid off during a depression. When the American economy was recovering Nay found a permanent employment with Ryan-Nychols & Company which was a brokerage firm. He was promoted as the companys president and he later owned 90% of the companys stock. The company was changed to First Securities Company of Chicago in 1945 and became a member of Midwest Stock Exchange. At that time Nay established his own customers and gave them an opportunity to invest in profitable fund that he managed by himself. The fund was known as

Auditors liability 7 escrow syndicate which was not an asset of First Securities of Chicago. Nay loaned the money from the syndicate to blue chip companies who would pay interests at a higher rate than the market rates. As advocated by Biggs et al (1983, p. 241), the fraud was revealed in June 4the 1968 after Nay had shot himself together with his wife. He had left a note declaring that he had stolen money from his customers for over thirty years. He also claimed that the escrow syndicate did not exist. The defrauded customers sued for the recovery of their investments from Midwest stock exchange and the first securities of Chicago. The customers claimed on the grounds that the stock exchange did not investigate Nays background before they admitted him as a member. Judgment The court dismissed the case due to unclear grounds and the customers did not succeed in their getting their investment. In addition, the customers did not succeed on the claim against first securities of Chicago. The court held that, Nays fraud was facilitated by the brokerage firm, however, the firm was bankrupt and the customers could not recover their money. Ernst & Ernst the public accounting firm was also sued by the customers since it was the auditing firm that audited the brokerage firms financial reports. The customers demanded that, the auditing firm helped Nay in defrauding the company by not detecting and revealing the mail rule that was only opened by Nay in secret (Turtle et al 2000, p. 42). Investors sued the auditing firm with negligence for not discovering the mail rule. They considered it as a violation to the rule 10b-5 of the securities Exchange Act of 1934. It was held that there was no enough evidence to maintain such accusations. The accounting firms decision did not control with the intention of deceiving hence the firm was not held liable. Arguments in support of negligence

Auditors liability 8 Ordinary negligence occurs when an auditor fails to exercise the degree of care expected of a reasonable person to exercise under the same conditions. Gross negligence is when an auditor fails to use the slightest care in the conditions. Failure to exercise care leads to fraud. Arguments against negligence Negligence cannot be qualified without a reckless disregard for the truth. Although the defendants were aware of the mail policy, they did not know the fraud made by Nay through the mail. Auditing standards The above described cases are related to auditors responsibility to assess risk of material misstatement in the financial statements of a firm that may lead to fraud. ASA 240 the Auditors Responsibility to Consider Fraud in an Audit of a Financial Reports This standard describes that, it is the responsibility of the auditor to judge the fraud in an audit in the financial reports. This standard applies to the case of Rusch Factors, Inc. v. Levin (1986). The auditors should maintain a professional attitude and recognize that materials misstatements in financial reports of the company may exist. The auditor must perform the required procedures to find information that can be used to identify the risks of material misstatement due to fraud. The auditor must identify and evaluate risks of material misstatement arising from fraud at both the financial and the declaration level. Auditors must ensure that the firms internal controls are in place and implemented. The auditor of a firms financial reports should be committed in designing and performing audit procedures in order to deal with the assessed risks of material misstatement due to fraud (Stewart et al 2007, p. 53). ASA 315 Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement

Auditors liability 9 The standard ASA 315 provides that auditors must practice professional competence and due care. It requires any person providing forensic services to maintain professional competence and ensure due care in the performance of their work. Auditors must have the required specialized training and experience before accepting any audit engagement to provide a forensic accounting service to a company. According to Dye (1993, p. 889), a company should apply professional judgment in the determination of whether the auditor is competent enough to provide a forensic accounting service. The auditor must perform risk assessment procedures that enable him to understand the entity and its environment including the internal control. The auditors in the case of Harold Tod Parrott v. coopers & Lybrand, LLP must have made enquiries with the management to get information that is helpful in identifying the risks of material misstatement due to fraud. The auditors should have used professional expertise to seek advice from a third party to establish the basis of preparing the valuation report. ASA 330 the Auditors Procedures in Response to Assessed Risks Auditors are required to determine generally responses that can be used to address risks arising from material misstatement due to fraud at the financial report level. The auditors in the case of Ultramares Corporation v. Touche (1931) were responsible for designing and performing audit procedures that would be able to respond to assessed risks arising from material misstatement at the declaration level. Auditors must be aware of the timing, nature and extend of further audit procedures that are required in the assessment of risks of the firm. They must identify areas where tests of control or substantive procedures are required. This will enable auditors to be able to determine the adequacy of presentation and

Auditors liability 10 disclosure by evaluating the completeness and appropriateness of the audit evidence acquired (Grobstein et al 1984, p. 11). Conclusions

Auditors are said to be liable to third parties in cases of ordinary and gross negligence and the party suffers damages. Auditors must act with due care and diligence to avoid breach of duty that may lead third parties to incur losses. Parties that can recover from ordinary negligence are third party beneficiaries, limited class of known or intended users and any third party whom the auditor may foresee as user. In order for an auditor to be liable for negligence, the plaintiff must prove that he or she suffered a loss due to auditors negligence. The plaintiff must have relied on the financial reports that led to incurrence of loss. In order to prevent litigation, auditors are required to emphasize on complying with GAAS and professional ethics. Auditors must maintain sufficient professional liability as well as examining potential clients carefully. They must have a complete knowledge of clients business and cautiously assess any risk mistakes and abnormalities together with the ones specified by weak areas in internal control. Bibliography Biggs, SF & Mock, TJ 1983, An Investigation of Auditor Decision Porcesses in the Evaluation of Internal Controls and Audit Scope Decisions, Journal of Accounting Research, Spring Vol. 2, pp.235-255. Coopers & Lybrand 1979, Theoretical Issues and Practical Methods of Auditing Solicitors' Trust Accounts Consultants Report to the N.S.W. Law Reform Commission.

Auditors liability 11 Cushing, BE & Loebbecke, JK 1983, Analytical approaches to audit risk: A survey and analysis, Auditing: A Journal of Practice and Theory, Fall, pp.23- 41. Dye, RA 1993, Auditing Standards, Legal Liability, and Auditor Wealth, The Journal of Political Economy, university of Chicago press, Vol. 101, No. 5, pp. 887-914. Grobstein, M & Craig, PW 1984, A Risk Analysis Approach to Auditing, Auditing: A Journal of Practice and Theory, Spring, Vol. 3, No. 2, pp.1-16. Holstrum, GM & Mock, TJ 1985, Audit Judgement and Evidence Evaluation, Auditing: A Journal of Practice and Theory, Fall, Vol. 5, No. 1, pp.101-108. Toba, Y 1975, A General Theory of Evidence as the Conceptual Foundation in Auditing Theory,The Accounting Review, pp.7-24. Tubbs, RM, Messier, WF & Knechel, WR 1990, Decency effects in the auditor's belief revision process, The Accounting Review , April, 452-460. Waller, WS & Felix, WL 1984, Cognition and the Auditor's Opinion Formulation Process; A Schematic of Interactions between Memory and Current Audit Evidence, Norman ton: University of Oklahoma Press. Stewart J & Munro, L 2007, The Impact of Audit Committee Existence and Audit Committee Meeting Frequency on the External Audit: Perceptions of Australian Auditors, International Journal of Auditing, pp.51-69.

Auditors liability 12 Taylor, MH 2000, The Effects of Industry Specialization on Auditors Inherent Risk Assessments and Confidence Judgments, Contemporary Accounting Research, Vol. 17, No. 4, pp.693712. Tuttle, B, Coller, M & Plumlee, RD 2002, The Effect of Misstatements on Decisions of Financial Statement Users: An Experimental Investigation of Auditor Materiality Thresholds, Auditing: A Journal of Practice and Theory, Vol. 3. No. 4, pp. 37-48.