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TOPIC 2
Auditors Legal Liability

Learning objectives
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1. 2. 3.

At the end of the lesson, students should be able to: Explain the key legal terms Explain auditors liability under statute and under common law Apply the relevant case law Relevant auditing pronouncements: ISQC 1 ISA 220 ISA 240

INTRODUCTION
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The increasing number of corporate misconducts among firms worldwide has caused a major breakdown from the economy perspective For example: in USA, the extreme cases and the collapsed of billion dollar firms such as Enron (2001), WorldCom; and Parmalat (2003) have provide evidences that financial irregularities could lead to the demise of big firms. The costs of such scandals have huge impact on the society and capital markets.

INTRODUCTION
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In relation to Enron case, Arthur Andersen, one of the then top five audit firm was forced out of business, resulting in the now top four firm. The professional accountants are facing increasing lawsuits due to change in legal environment Is auditing profession in Malaysia spared of such liability? Similarly, the accountant and external auditor of Kiara Emas Asia Industries Berhad had faced criminal prosecution due to fraud. They were charged under the Securities Industry Act 1983 and Section 409-Penal Code that stipulate that perpetrators of fraud would be fined not less than RM1 million and jail for not more than 10 years if convicted (K.Syakira, 2010)

Business failure, audit failure and audit risk

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One of the reasons for the increase of lawsuits is the lack of understanding between business failure, audit failure and audit risk Business failure occurs when the business is unable to repay its lenders due to economic or business conditions such as recession, stiff competition in the industry Audit failure happens when the auditor issues an erroneous audit opinion as the result of an underlying failure to comply with the requirements of established auditing standards (eg failure to exercise due care in the conduct of the audit) Audit risk the risk that the auditor will conclude that the FS give a true and fair view and an unqualified opinion can therefore be issued when, in fact, they are materially misstated

Explanation of terms
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Negligence absence of reasonable care that can be expected of a person in a set of circumstances.

Deep pocket syndrome - due to compulsory professional indemnity insurance, injured parties tend to perceive the auditors as having the most resources for compensation

Breach of contract failure of one or both parties in a contract to fulfill the requirements of the contract.

Fraud occurs when a misstatement is made and there is both the knowledge of its falsity and the intent to deceive

Explanation of termsctd

Gross Negligence lack of even slight care, tantamount to reckless behavior that can be expected of a person

Common Law laws that have been developed through court decisions based on negligence, gross negligence, or fraud.

Proportionate liability plaintiffs loss is divided among the defendants according to their share of responsibility

Statutory Law laws that have been passed by the Government, such as the Securities Commissions Act 1993 and Companies Act 1965 .

Expectation Gap
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Components of expectation gap

Unrealistic expectations on the part of the users

Users expect auditors to detect material misstatements due to fraud as well as to give absolute assurance on material misstatements

Performance Gap

a failure by individual auditors to comply with laid down standards, and a failure of the standards to meet the legislative needs of user

Expectation Gapctd
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Auditors believe that the conduct of an audit in accordance with the Generally Accepted Auditing techniques is all that can be expected of auditors. But users, believe that the auditors guarantee the accuracy of the FS and some users even believe that the auditor guarantees the financial viability of the business.

Auditors Liability
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Under Statute (CA 1965 & Securities Commission Act 1983) Civil Liability: Negligence Gross negligence Fraud

Under Common Law

Clients Breach of contract Negligence Gross negligence Fraud Third parties Negligence Gross negligence Fraud

Criminal liability : Violation of statues

Liability to clients Breach of contract

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Should an auditor fails to carry out his contractual arrangements with the client, he may be held liable for : Breach of contract when he fails to complete the services as agreed in the contract (Engagement letter represents a written contract) And /or negligence

Liability to clients and third parties Negligence

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When an auditor performs an engagement negligently, he can be held liable for an actionable tort in negligence.
To sue the auditor for negligence; the following need to be proven:

a. The auditor owes a duty of care to the plaintiff b. There is breach of duty of care to the plaintiff c. Plaintiff suffered actual financial loss or damage d. There is causal relationship or connection between the auditors negligence and the plaintiffs damage

Liability to clients and third parties Causal relationship

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Refers to the connection between the auditors negligence and the plaintiffs damage: To succeed in his claim, the plaintiffs must demonstrate that: The loss is the consequence of the breach in the duty of care and At the time the breach was committed the loss was reasonably foreseeable as a consequence. As such, an auditor could be liable for loss due to defalcation which could be prevented if the audit was carried out competently.
Failure to detect a fraud Loss (damage)

Liability to clients and third parties Causal relationship

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The reliance factor; Plaintiff needs to prove that he had relied on the accounts and suffered loss Simply being aware of the audited accounts not sufficient to show in court However, if information is prepared for specific purpose for a third party, then it will be a stronger case against the auditor (Haig v. Bamford) If the accounts is misrepresented, but not used by the plaintiff as its main purpose of reliance, the chance of success is rather remote as in the case of JEB Fastener. Here, the plaintiff s motive was to obtain the services of the two directors in the company acquired and the audited accounts has no impact his acquisition decision.

Case law: Liability to third

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parties
Third parties include: Actual and potential shareholders, vendors, bankers, other creditors, employees, and customers

A. Ultramares v. Touche et.al (1931) Ultrameres Corp lent money to an insolvent co relying on the FS prepared by the cos accountants. Subsequently they sued the accountants, alleging that they were guilty of negligence and fraudulent misrepresentation. The a/c receivable of approximately $650,000 had been falsified by adding to it another item of over $700,000.The a/cs payable contained similar discrepancy

A. Ultramares v. Touche et.al (1931)

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Judgement: Established the Ultrameres Doctrine. -an auditor could not be held liable to third parties due to lack of privity of contract Judge Cardozo stated that, If a liability for negligence exists, a thoughtless slip or blunder, the failure to detect a theft or forgery may expose accountants to liability in an indeterminate amount for an indeterminate time to an indeterminate class

B. Candler v. Crane Christmas & Co

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Plaintiff: Third party, investor, Mr Chandler invested in a co which became insolvent not long after. Claims: Relied on the audited accounts in making the investment decision . The audited accounts had been negligently prepared.

Judgement: The defendants owed no duty of care to the plaintiffs in the absence of any contractual relationship and negligence claim could not be sustained.

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C. Hedley Bryne v. Heller & Partners (1964) landmark case for professional liability to 3rd parties
-in the absence of a contract, a person who is expected to exercise due care in providing information or advice can be held negligent if : 1.he know or 2. ought to know that the inquirer is relying on him. Thus, a special relationship exists between the provider of information and the inquirer. (the defendants, however, escaped payment of damages because of a disclaimer included in the reference issued) -introduced the Concept of Proximity -extending the principle to the auditors work, it means that an auditor can be held liable for negligently audited FS if he know or ought to know that the FS would be relied upon by some non-clients, 3rd parties with whom he has no contractual relationship.

D. Jeb Fastener Ltd v Marks, Bloom & Co

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Duty of care of the auditor was extended to include unheard and unknown parties

Judgement: The court held that the defendant auditor owed a duty of care to the third party who was a prospective investor who had relied on the FS that were negligently prepared. However, no damages were awarded on the grounds that negligence of the defendants was not the cause of the plaintiffs loss, in that evidence before the court indicated that the plaintiff would have gone ahead with the takeover even had the true position of the accounts been known to him.
Other cases extending auditors liability to unknown third parties (Haig v. Bamford; Scott Group v. McFarlane ;)

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E. Caparo Industries pty v. Dickman & Others (1990)

a reversal of the principal found in cases such as Hedley Bryne and Jeb Fasterners -it was stated that the purpose of statutory accounts was for the company and the shareholders and not to assist investors making investment decisions. -accordingly, auditors do not owe a duty of care to investors making investment decisions on the strength of audited accounts. -it was held: unreasonable to establish a relationship of proximity between the auditors and third party who was not the intended recipient of the auditors report

Reaction to Caparos case

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-generally has been unfavorable -the verdict appears to treat auditors more favourably -consequences of negligent advice -diminish the value of auditors services

Duty of care to third parties - post Caparo

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Cases ruled in favour of the auditors 1. McNaughton Raper Group (1991) 2. R Lowe Lippman Figdor (1992) 3. 3. Essanda Fiance Cases ruled against the auditors 1. Columbia Coffee & Tea Pty Ltd (1993) 2. Royal Bank of Scotland plc (2005)

Breach of the standard of care

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Auditor is required to exercise reasonable skill and care in carrying out his duties. 1. Case: London and General Bank (1895) Judgement: An auditor is not bound to exercise more than reasonable care and skill. Even in a case of suspicion. Auditor is not an insurer, does not guarantee accuracy of accounts 2. Kingston Cotton Mill (1896) Jugement: Detection of fraud is beyond the auditor and should not be made responsible in particular carefully laid out schemes. Auditors are watchdog not bloodhound

Summary of cases
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Year 1895

Case London and General Bank

Judgment Not liable to 3rd parties

1896
1931 1951 1963 1981 1990

Kingston Mill
Ultrameres Chandler Hedley Byrne Jeb Fasteners Caparo

Not liable to 3rd parties

No liability to 3rd parties No liability to 3rd parties Liable to 3rd parties Liable to 3rd parties No liability to 3rd parties

Inconsistent outcomes & judges reasoning in many cases

Criminal liability
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These laws affect auditors in respect of criminal liability: 1.The Securities Commission Act 1993 2. Companies (amendment) Act 2007 Case: United States v. Andersen (2002)
The plaintiff, the government charged Andersen for destructing of documents related to the firms audit of Enron. Enron, the client alerted Andersen of inquiry by SEC into its accounting for special purpose vehicle. SEC served Andersen with a subpoena re Enron. Andersen shredded physical documentation as well as deletion of computer files. Judgement by court: Convicted with obstruction of justice.

Avoidance of litigation
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1.use EL for all professional services 2. Investigate prospective clients thoroughly 3. Comply fully with professional pronouncements

4. Establish and maintain high standards of QC

5. Maintain adequate professional indemnity cover

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Duties to report breaches of laws

Additional duties for the auditor to report breaches and irregularities (Whistle blow) CA 1965 S174(8) requires the auditor to report to CCM if encountered a breach or non-compliance with any provisions of the CA 1965 (whistle blowing duties)

Summary
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Refer words file