Third Party Liability in Audit

Topics: Audit, Financial audit, Negligence Pages: 10 (3568 words) Published: April 18, 2012

The liability of auditors to third parties has been the subject of much litigation. Litigation claims against accountancy firms have increased dramatically in the last thirty years. Previously, such cases were rare and were viewed with great interest. Nowadays, whereas still treated with great interest they are becoming all kind of common. The specific area of auditors' liability to third parties is an extremely complex area. As there is no contractual claim for recovery of losses, third parties take action in tort. Some time ago it was believed that recovery of losses from auditors for negligence was not possible, because there was no contractual relationship between the parties. But some time later Auditors in Australia were subject to a much higher level of liability to companies and third parties due to the wide scope of statutory obligations. (Nguyen, Rajapakse, 2008) In order to understand the impacts which litigation claims have had on the auditors, we have to examine the cases brought against auditors in the past 100 years. The grounds for these claims have often related to breaches of contract, professional negligence, and the contravention of statutory duties. The "traditional" third party cases all follow a very similar pattern. One entity (A) either invests in or lends money to another entity (B) under a contractual arrangement. Entity B is audited by a firm of auditors under a standard contractual arrangement. A of course has no contractual arrangement with the auditors. Entity A subsequently discovers its new investment is significantly over-valued or its loan is irrecoverable. Having no recourse to B, A then takes a case against the auditors claiming that the only reason it entered into its contract with B was because the audit report appeared to indicate B's state of affairs was fairly stated, whereas subsequent events show it to be significantly misstated. As the plaintiff A has no contract with the defendant auditors, a third party action under the tort of negligence is commenced. (O'Leary, 1998) Though it is still being thought and felt in some quarters that the scope and basis   of   auditor's liability has not changed since the 1896 case of Re Kingston Cotton Mills Co, there is no doubt however, that the standard of reasonable care   and   skill   bas   been   exacting   since   Re   Thomas   Gerrard   and   Sons   Ltd. Thus, if Re Kingston Cotton Mills Co. were to be decided again today, the case could no doubt be decided differently. It is important to note that in Re Kingstons Cotton Mills case, the auditors had relied on director's certificates, which turned out to be deliberately false. Curiously, the   Court   of   Appeal   held   that   it   was   not   the   duty   of   company   auditors   to   take   stock, and   they incurred no liability if they rely on directors certificates since a director was a person   whom the law adjudged as being competent and reputable.  Infact the current Austraian and UK auditing   standards   and   guidelines   prescribes   a   much   more   exacting   standard   than   the   Re   Kingston   Cottons   era. Therefore, it   appears   the   auditors   in   Re   Kingston   Cotton   Mill   would   have   been   required   to   perform   more   audit   testing   to   be   in   a   safe   position   to   either   rebut   or   confirm   the   certificate   of   dosing   stocks   prepared   by   the   enterprise’s management. (Asada, Danwanka, 2010). The next important case of Ultramares Corp v. Touche took place in US in 1931. Touché prepared a balance sheet for Fred Stern & Company upon their request. The balance sheet reflected that Stem had a large net worth when in reality the company was insolvent. A lender of the company, the Ultramares Corp,...
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