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Audit

By Shakil729 Aug 26, 2013 13592 Words
Part I: Understanding Auditor Responsibilities
Chapter 4
Professional Liability

Learning Objectives:

By studying this chapter, students should be able to:

1. Discuss the liability environment in which auditors operate, the factors that have led to litigation against auditors, increasingly including shareholder class actions, and the effects of lawsuits on audit firms.

2. Describe the causes of legal action against auditors and identify parties that may sue auditors.

3. Explain the impact of key court cases on the public accounting profession.

4. Describe auditor liability, discuss auditor responsibilities, identify possible auditor defences, and discuss possible remedies and sanctions available under both common law and statutory law.

5. Identify professional requirements that help assure audit quality and minimise auditor exposure to liability suits.

6. Describe defensive actions that audit firms can take to limit the effects of litigation on audit firms and individual auditors.

7. Apply the decision analysis and ethical decision-making frameworks to issues that could result in litigation.

Teaching Suggestions

Even though most audits are properly performed, a significant percentage of the gross revenue of public accounting firms is spent on professional liability insurance and litigation costs. Litigation costs and settlements caused Andersen, once the world’s largest public accounting firm, to declare bankruptcy. In today’s litigious environment, it is extremely important that auditors use due professional care to minimise such costs. Even when due professional care is exercised, the government, investors, and clients may still sue auditors. This chapter discusses the legal environment and concepts related to audits, and approaches to minimising exposure to liability. It also looks at several key court cases and their impact on the profession.

The challenge when teaching this material is to impart to students a genuine understanding of the legal environment in which auditors operate without overwhelming them with material to memorise that they are unlikely to remember. This challenge is heightened by the need to stress the importance of ‘liability avoidance’ without leaving the impression that it is the major focus of the audit process.

Begin by reviewing pertinent legal terminology. Then discuss the litigious climate for auditors and how that climate has changed over the past few decades. Reasons for the increase in litigation, often settled out of court include greed on the part of unscrupulous financial report users and preparers, ignorance and neglect on the part of auditors, and a volatile business climate characterised by numerous business failures. Public distrust adds to the problem. Stress the impact of litigation on the profession: (1) considerable resources expended to litigate, (2) some distrust and loss of credibility in the public accounting profession which is heightened by negative media coverage, (3) proliferation of new auditing standards, and (4) pressure from stock exchanges which has resulted in the establishment of audit committees and ‘comfort letters’ to underwriters.

It is helpful to go over the concept of due care found in tort law. Ask students how they view their liability if, as new employees, they are asked to complete a task that they do not feel qualified to do. Explain the imprecision of the ‘reasonable man’ concept and the problems that arise when ‘ordinary citizens’ sit on juries involving technical matters with which they are unfamiliar.

The text outline can be followed when discussing the specific legal concepts that affect the auditing profession including the auditors’ liability to clients and third parties. Stress that carefully following Auditing Standards and maintaining a healthy sense of professional scepticism with regard to client assertions can reduce legal problems. Emphasise that defensive auditing also plays an important role in liability avoidance. Describe the approaches used to improve the quality of public accounting: quality control standards, external quality/peer reviews and internal peer reviews. The various court cases mentioned in the text can be used to heighten student awareness of legal liability.

Suggested Homework Problems

|Learning Objectives|Review Questions |Multiple-Choice Questions |Discussion and Research Questions |Cases | |LO 1 |4-1, 4-15, 4-23 |4-2, 4-3 | |4-42 | |Pp 114-118 | | | | | |LO 2 |4-3 | |4-31, 4-32, 4-35, 4-39 |4-40, 4-42 | |Pp 118-119 | | | | | |LO 3 |4-8, 4-17, 4-18 | |4-28, 4-35, 4-39 | | |Pp 119-120 | | | | | |LO 4 |4-2, 4-4, 4-5, 4-6, 4-7, 4-9, |4-2, 4-3, |4-27, 4-28, 4-29, 4-30, 4-31, 4-32, |4-40, 4-41 | |Pp 120-130 |4-10, 4-11, |4-4, 4-5, |4-33, 4-34, 4-35, 4-36, 4-39 | | | |4-12, 4-13, 4-16 |4-6, 4-7, 4-8, 4-9, | | | | | |4-10, 4-11, 4-12 | | | |LO 5 |4-19, 4-20, |4-13, 4-14 |4-37, 4-38 | | |Pp 130-133 |4-21, 4-22, | | | | | |4-24, 4-25 | | | | |LO 6 |4-14, 4-20, |4-1 | | | |Pp 133-135 |4-23, 4-26 | | | | |LO 7 | | |4-36 |4-42. 4-43 | |Refer Ch 3 | | | | |

Chapter Outline

I. THE LEGAL ENVIRONMENT
A. Public accounting firms are sued for the conduct of audits of both large and small clients. Andersen, one of the world’s largest public accounting firms, in 2001 was forced into bankruptcy and out of business. The diverse group of litigants includes class action suits by small investors and suits by the regulator, ASIC. Legal liability cases are expensive, win or lose. B. The responsibility of public accountants to safeguard the public’s interest has increased as the number of investors has increased, as the relationship between corporate managers and shareholders has become more impersonal, and as government increasingly relies on accounting information. C. Even when an audit is properly performed, however, the public accounting firm may be sued and incur substantial legal costs to defend itself. Even if the public accounting firm wins the litigation, its reputation and that of those involved may be unfairly tarnished.

Teaching Note: Go over the factors that affect litigation against auditors. Explain that the actions to extend legal redress to persons who might otherwise not have the ability to sue have contributed substantially to the increased exposure to legal liability that accountants now face. Remind students that public accounting firms may get sued even when the audit is performed properly and that auditors are subject to contract law, common law, and statutory law.

D. Liability Doctrines
1. Proportionate vs Joint and Several Liability
i. Under Joint and Several liability, auditors may be apportioned all of the damages – even if they are only minimally at fault – if the other defendants are unable to pay. The effect of this doctrine has been a rise in ‘deep pockets’ suits against auditors. ii. After the HIH Insurance Ltd collapse in Australia, the Federal Government moved to a Proportionate Liability regime whereby auditors are responsible for only their share of damages.

E. Audit Time and Fee Pressures
1. Most auditors feel intense pressure to make their audits more efficient and competitive. The auditor should remember that the client exerting the most time and fee pressure might be the client who is attempting to hide something from the auditor and is thus the client whose pressure should be most resisted.

F. Audits Viewed as an Insurance Policy
1. An audit does not guarantee that an investment in the audited company is free of risk. Unfortunately, some investors mistakenly view the unqualified audit report as an insurance policy against any and all losses from a risky investment.

Teaching Note: Explain the expectations gap that leads some investors to believe that an unqualified audit report is an insurance policy against loss from risky investments.

G. Class Action Suits
1. These are designed to prevent multiple suits that might result in inconsistent judgements and to encourage plaintiffs to consolidate small individual claims. Damages in such cases, and thus fees for the lawyers, can be extremely large.

II. BASIC LEGAL CONCEPTS
A. Auditors must understand four important dimensions of liability: i. concepts of breach of contract and tort as they affect the auditor ii. parties who may bring suit against the auditor iii. legal precedent and statutes that may be used as a standard against which to judge the auditor’s performance, and iv. defences available to the auditor.

B. Causes of Legal Action
1. Plaintiffs usually allege that the auditors did not meet the standard of ‘due care’ in performing the audit. The broad concept of due care is implemented by the courts through the concepts of breach of contract, negligence and fraud. 2. Breach of contract occurs when a person fails to perform a contractual duty. 3. Negligence is the failure to exercise reasonable care. 4. Fraud is an intentional concealment or misrepresentation of a material fact that causes damage to those deceived. In an action for fraud, scienter must generally be proved. Scienter means knowledge on the part of the person making the representations, at the time they are made, that they are false.

C. Parties That May Bring Suit against Auditors
1. Anyone who can support a claim that damages were incurred based on reliance on a misleading financial report that was attested to by the auditor is in a position to bring a claim against the auditor.

III. LEGAL PRECEDENCE: LIABILITY TO CLIENTS AND THIRD PARTIES UNDER COMMON LAW AND STATUTORY LAW A. Liability that affects public accounting firms is derived from the following laws: 1. Common Law – Liability concepts are developed through court decisions based on negligence or fraud. Under common law, cases can be based on contract law whereby liability occurs where there is a breach of contract. 2. Statutory Law – Liability is based on legislation. The most important of these statutes to the auditing profession is the Corporations Act 2001. B. Auditors are expected to fulfil their responsibilities to clients in accordance with their contracts (usually an engagement letter). Auditors can be held liable to clients under contract law for breach of contract, and they can be sued under the concepts of negligence and fraud. C. Breach of Contract

1. Non-performance of a contractual duty.
2. Remedies for breach of contract include:
i. requiring specific performance of the contract agreement ii. granting an injunction to prohibit the auditor from doing certain acts, such as disclosing confidential information iii. providing for recovery of amounts lost as a result of the breach 3. Negligence

i. The client needs to show the auditor had a duty and breached it, a causal relationship, and actual damages. Auditing and Accounting Standards are often used to establish the auditor’s duty. 4. Misleading Financial Reports

i. Financial statements and/or notes containing material errors unknown to management that should have been discovered during the audit.

D. Common-Law Liability to Third Parties
1. Generally, the courts have held that the user, or at least the use to which the financial report might be put, must be known to the auditor in order to extend the auditor’s liability to these groups. To win a claim against the auditor, third parties must prove that: i. They suffered a loss.

ii. The loss was due to reliance on a misleading financial report. iii. The auditor knew, or should have known, that the financial report was misleading.

Teaching note: Explain that, by definition, a material misstatement is one that can influence the decisions of the users of the information. Unless the users (and their probable decisions) are known to the auditor, the auditor has no objective way to determine what constitutes a material misstatement of the financial report.

2. Foreseeability and Negligence: Common Law
i. The fundamental issue is how much negligence a third-party must prove to be successful in obtaining damages from an auditor. ii. Courts have varied the standard, or burden of proof by the plaintiff, depending on the likelihood that an auditor could reasonably foresee that a user might have relied upon the financial report or other attestation services provided by the auditor. 3. Important Third Party Cases

R. Lowe Lippman Figdor & Franck v AGC (Advances) Ltd (R.Lowe Lippman Figdor) [1992] 10ACLC 148 This case narrowed the opportunity for third-parties to claim auditors owe them a duty of care. It used the notion of proximity to require third parties to prove that there was a legally recognisable relationship between themselves and the auditor that would establish a duty of care.

R.Lowe Lippman Figdor was an Australian case that followed the principles as laid down in the Caparo[1] case. The court held the expression of interest by AGC (a creditor) in the audited accounts for the purpose of reviewing its position, did not create a special relationship with the auditor. The court felt that the preparation of the accounts was not for the special purpose of inducing the plaintiff to act in a certain way.

1 Columbia Coffee and Tea Pty Ltd v Churchill (Columbia Coffee) [1993] 9 ACSR 415 (NSW)

The court applied a proposition in Mutual Life & Citizens Assurance Co Ltd v Evatt That a duty of care is created where an auditor knows or ought to have known that a non-client would rely on the auditor’s report. In this case the audit firm’s own audit manual included a statement acknowledging that interested third parties might read and rely on the audit report issued at any time. The court departed from the rigid interpretation of the use of audited accounts used in Caparo and R.Lowe Lippman Figdor among others. The judges considered that in reality people in the business world review and rely upon audited accounts in making investment decisions, whether they are legally advised to or not. The court held that the auditor could owe a duty of care to a purchaser of shares who relied on the audited accounts and audit report; and suffered economic loss as a result.

Esanda Finance Corp. Ltd v Peat Marwick Hungerfords (Esanda Finance) [1997] 188 CLR 241 The court endorsed the reasoning applied in R.Lowe Lippman Figdor. It is necessary to have both foreseeability of harm plus a relationship of proximity for a duty of care to arise. A duty of care is difficult to establish unless the auditor intends to induce reliance on his work product by a non-client or a limited class. Other factors besides intent to induce reliance may establish proximity. Numerous policy factors that should be weighed in deciding whether a duty of care arises were outlined. This case severely restricted the application of third-party liability to auditors, holding that the decision in Columbia Coffee was incorrect. Brennan, CJ, stated that for a third party to rely on the report prepared by the auditor, the following would have to be established: • The report was prepared on the basis that it would be conveyed to a third party. • The report would be conveyed for a purpose that was likely to be relied upon by that third party. • The third party would be likely to act in reliance on that report, thus running the risk of suffering the loss if the statement was negligently prepared.

IV. MINIMISING LIABILITY EXPOSURE
A. Quality work can mitigate legal exposure. Tort reform if successfully implemented, may also reduce auditors’ liability exposure.

i. Remember that the needs of end-users are paramount. ii. Do quality work.
iii. Document the work done and the audit reasoning process.

B. Policies to Help Assure Auditor Independence
1. Partner Rotation
i. Periodic rotation of partners helps bring a fresh approach to audits and minimises bias that may result from long-term contacts with client management. The CLERP 9 Act requires that the partner in charge of the audit of a listed company and the quality control engagement partner be rotated at least every five years.

C. Restricted Provision of Non-Audit Services
1. To help assure auditor independence, the CLERP 9 Act restricts public accounting firms from performing certain services for public interest entity and other audit clients

D. Restrictions on Non-Audit Services for Audit Clients 1. The CLERP 9 Act requires that the board of directors, usually through the audit committee where one exists, be responsible for assessing whether the provision of non-audit services has compromised an audit firm’s independence. 2. The Accounting Professionals Ethical Standards Board (APESB) APES 110 Code of Ethics for Professional Accountants (Code) allows public accounting firms to perform services not specifically prohibited (see above) for audit clients if the firm determines that independence will not be compromised. The firm should also establish an understanding with the client that the client is responsible to: i. Designate a management-level individual(s) to be responsible for overseeing the services being provided ii. Evaluate the adequacy of the services performed and any resulting findings iii. Make management decisions related to the service.

E. Auditor Independence Program
1. One of the elements of a public accounting firm’s quality control program (covered in the next section) is establishing policies and procedures to provide reasonable assurance that personnel maintain independence in fact and in appearance when performing audits. Such a program may include the following: i. Firm training programs that emphasise factors that can impede independence ii. Firm review of all relationships that may affect auditor independence and individual reporting of all potential relationships that might impair independence iii. On-the-job review of performance emphasising the need for scepticism, objectivity, and the need to corroborate management’s explanations.

V. Quality Control Programs
A. Quality Control Standards
1. The most important ingredient for mitigating liability exposure is for firms to implement sound quality control policies and procedures. B. External Inspections/Peer Reviews
1. ASIC has established rules that it will conduct quality reviews for public accounting firms. 2. Firms that perform audits and/or reviews are required by the professional accounting bodies to undergo an external peer review periodically. C. Internal Peer Review

1. There are two kinds of internal peer review programs – engagement quality control partner reviews and interoffice reviews. i. Engagement Quality Control Partner Review • A partner not otherwise involved in the audit performs an engagement quality control review near the end of each audit to ensure that documented evidence supports the audit opinion. Analytical procedures at this stage of the audit help identify unexpected relationships and trends for which sufficient evidence should be documented. ii. Interoffice Review

• An interoffice review is a review of one office of the firm by professionals from another office to ensure that the policies and procedures established by the firm are being followed.

D. Continuing Education Requirement
1. Membership of the professional accounting bodies requires that members in public practice take a stipulated amount of CPE every three years.

VI. Defensive Auditing
A. Defensive auditing means taking special actions to avoid lawsuits. These actions include establishing good quality controls and submitting the firm to quality/peer reviews.

B. Issuing Engagement Letters
1. The engagement letter should clearly state the scope of the work and describe the degree of responsibility the auditor takes with respect to discovering fraud and misstatements.

C. Screening Client
1. It is important to screen out undesirable clients.

D. Evaluating The Firm’s Limitations
1. Avoid engagements the firm is unqualified to handle.

E. Maintaining Accurate and Complete Audit Documentation 1. The audit team should document everything done on the audit. Audit documentation should clearly show evidence of supervisory review, particularly in those areas with the greatest potential for improprieties, such as inventories, revenue recognition, and accounting estimates. The documentation should clearly reflect the identification and investigation of related-party transactions.

F. Maintaining Appropriate Insurance Coverage
Many public accounting firms carry professional liability insurance to protect themselves from the full financial impact of lawsuit damages.

G. Organising as Limited Companies
1. The CLERP 9 Act did permit for the first time the incorporation of audit firms. Solutions for Chapter 4

Professional Liability

Multiple Choice Questions Online

*4-1 (LO 6) The cornerstone of any defensive audit practice program is the engagement letter. Which of the following most likely would be included in an auditor’s engagement letter to the client? a.A list of issues discovered during the prior-year audit. b.The specific procedures that the auditor plans to use. c.A description of the auditor’s responsibilities to evaluate the going-concern assumption. d.A statement that limits the auditor’s responsibility to detect errors and frauds.

4-2 (LO 1, 4) In a common-law suit for damages, the jury awards the plaintiffs $1 million. The jury also determines that management is 80% at fault, the auditors are 15% at fault, and management’s counsel is 5% at fault. Assume that management is unable to pay any damages. Under joint and several liability, the auditor would be responsible for damages of: a.$1 million

b.$750,000
c.$270,000
d.$150,000

4-3 (LO 1, 4) Use the same facts as in Question 4-2. Under proportionate liability, the auditor would be responsible for damages of: a.$1 million
b.$750,000
c.$270,000
d.$150,000

*4-4 (LO 4) Nast Ltd orally engaged Baker & Co., public accountants, to audit its financial report. Nast management informed Baker that it suspected the accounts receivable were materially overstated. Although the financial statements audited by Baker did, in fact, include a materially overstated accounts receivable balance, Baker issued an unqualified opinion. Nast relied on the financial statements in deciding to obtain a loan from Century Bank to expand its operations. Nast has defaulted on the loan and has incurred a substantial loss. If Nast sues Baker for negligence in failing to discover the overstatement, Baker’s best defence would be that: a.Baker did not perform the audit recklessly or with intent to deceive. b.Baker was not in privity of contract with Nast.

c.Baker performed the audit in accordance with Auditing Standards. d.Baker had not signed an engagement letter.

*4-5 (LO 4) If a shareholder sues a public accountant for false statements contained in the financial report audited by that public accountant, which of the following, if present, would be the accountant’s best defence? a.The shareholder lacks privity to sue.

b.The false statements were immaterial.
c.The public accountant did not benefit financially from the alleged fraud. d.The client was guilty of contributory negligence.

4-6 (LO 4) In a common-law action against an accountant, lack of privity is a viable defence if the plaintiff: a.Is the client’s creditor who sues the accountant for negligence. b.Can prove the presence of negligence that amounts to a reckless disregard for the truth. c.Is the accountant’s client.

d.Bases the action upon fraud.

4-7 (LO 4) Under common law, which of the following statements most accurately reflects the liability of a public accountant who fraudulently gives an opinion on an audit of a client’s financial report? a.The auditor is liable only to third parties in privity of contract with the auditor. b.The auditor is liable only to known users of the financial report. c.The auditor probably is liable to any person who suffered a loss as a result of the fraud. d.The auditor probably is liable to the client, even if the client was aware of the fraud and did not rely on the opinion.

*4-8 (LO 4) Which one of the elements is necessary to hold an auditor liable to a client for negligently conducting an audit? a.Acted with due diligence.
b.Was a fiduciary of the client.
c.Failed to exercise due care.
d.Executed an engagement letter.

*4-9 (LO 4) Which of the following, if present, would support a finding of criminal liability on the part of an auditor? a.Privity of contract
b.Reliance by third parties
c.Reckless disregard
d.Negligence

*4-10 (LO 4) Which of the following penalties is usually imposed against an auditor who breaches contract duties owed to a client in the performance of audit services? a.Re-registration as a company auditor with ASIC

b.Punitive damages
c.Specific performance
d.Continuing education requirements

*4-11 (LO 4) A public accountant usually will not be liable to a purchaser of shares who relied on the audited financial report: a.If the purchaser is contributorily negligent.
b.If the public accountant can prove due diligence.
c.Unless the purchaser can prove privity with the public accountant. d.Unless the purchaser can prove criminal liability on the part of the public accountant.

*4-12 (LO 4) Under common law, which of the following must be proven by a purchaser of a security taking legal action against an auditor for negligence? Reliance on theFraud by
Financial Report the auditor
a.YesYes
b.YesNo
c.NoYes
d.NoNo

*4-13 (LO 5) Quality control for a public accounting firm, as referred to in ASQC 1, Quality Control for Firms That Perform Audits and Reviews of Historical Financial Information, and Other Assurance and Related Services Engagements applies to: a.Auditing services only

b.Auditing and consulting services
c.Auditing and tax services
d.Auditing and accounting and review services

*4-14 (LO 5) Which of the following policies help to assure auditor independence? a.Partner rotation
b.Restrictions on permitted non-audit services
c.Auditor independence programs
d.All of the above

*All questions marked with an asterisk are adopted from the Uniform CPA Examination.

Multiple Choice Answers:

4-1.d (LO 6, pp 133-135)
4-2.b. (auditor and legal counsel share damages ¾ and ¼ under joint and several liability) (LO 1, pp 116-118; LO 4, pp 120-130) 4-3.d. (LO 1, pp 116-118; LO 4, pp 120-130)
4-4.c.( LO 4, pp 120-130)
4-5.b.(LO 4, pp 120-130)
4-6.a. (LO 4, pp 120-130)
4-7.c. (LO 4, pp 120-130)
4-8.c. (LO 4, pp 120-130)
4-9.c. (LO 4, pp 120-130)
4-10.c . (LO 4, pp 120-130)
4-11.b . (LO 4, pp 120-130)
4-12.b. (LO 4, pp 120-130)
4-13.d. (LO 5, pp 130-133)
4-14.d. (LO 5, pp 130-133)

Review Questions:

4-1.(LO 1, pp 116-118)
A variety of factors seems to be causing so many lawsuits including:

• General public awareness of the possibilities and rewards of litigation. Our society has developed expectations that damages can be appropriately addressed in courtrooms. • Joint and several liability statutes that permit a plaintiff to recover the full amount of a settlement from a public accounting firm even though that firm is found to be only partially responsible for the loss (often referred to as the deep pocket theory: sue those who can pay). Joint and several liability may be argued to encourage lawsuits because the potential to receive awards for damages is increased. In addition a defendant has to be only partially to blame to bear responsibility for (potentially) all losses. Note that CLERP 9 proposes to introduce proportionate liability for auditors in Australia. • Increased complexity of audits caused by computerisation of businesses, new types of business transactions and operations, more international business, and more complicated accounting standards. The increased complexity creates more opportunity for errors to take place, as well as for users to misunderstand financial statements. • More demanding auditing standards for detection of errors and fraud. Users, including clients, expect auditors to find fraud. When damage is incurred through fraud, the party damaged looks to the auditor to have identified the fraud so that corrective action could have been taken. • Pressures to reduce audit time and improve audit efficiency in the face of increased competition among public accounting firms. Sometimes such pressures can lead auditors to be less sceptical and demanding in their audit work. • A misunderstanding by the general public who may mistakenly believe that an unqualified audit opinion is an insurance policy against investment losses. The public often has a difficult time distinguishing between a business failure and an audit failure. Many businesses fail, but the auditor’s unqualified report does not insure against failure. The auditor’s role is limited to an expression of an opinion on the fairness (or truth and fairness if a Corporations Act 2001 audit) of financial statement presentations.

4-2.(LO 4, pp 120-130) Common law is developed through court decisions, such as the Donoghue vs Stevenson [1932] AC 562, UK case. Statutory law is created by legislation, such as the Corporations Act 2001. Only those parties specifically subject to the Act may have action taken pursuant to it.

4-3.(LO 2, pp 118-119) The potential causes for action against the auditor for breach of contract include: • Violating client confidentiality
• Failing to provide the audit report on time
• Failing to discover a material error or employee fraud.

4-4.(LO 4, pp 120-130) Settlements against the auditors include: • Requiring specific performance of the audit agreement • Granting an injunction to prohibit the auditor from performing certain acts, such as disclosing confidential information • Providing for recovery of amounts lost as a result of the breach. Under common law, a client may receive punitive damages as well as compensatory damages.

4-5(LO 4, pp 120-130) The client has the burden of proving the following: • The auditor deviated from the usual professional standards or the professional standards are substandard, based on the prudent person criterion. • The client sustained a loss.

• The auditor’s actions caused the client’s loss.

4-6 (LO 4, pp 120-130)
a.The auditor can use the following as defence against a breach of contract suit: • Auditing Standards were followed.
• The client was contributorily negligent.
• The client’s losses were not caused by the breach. b.Defences under tort law are:
• The auditor was not negligent, or fraudulent.
• The financial statements were not materially false or misleading. • The audit did not cause the client’s loss.
• The client was contributorily negligent.
Courts are often reluctant to allow the defence of contributory negligence because the auditor has special skills that most clients do not have. However the AWA case established that this defence can be successful in particular circumstances.

4-7.(LO 4, pp 120-130)A due care or due diligence defence requires that auditors prove both that they applied reasonable procedures and that they reasonably believed that the financial report was true and fair. Auditors will attempt to prove that the audit followed Auditing Standards and that the financial statements and notes comply with Accounting Standards. In other words, the auditor had exercised all the care that a skilled professional in the field of public accounting could be expected to exercise in the conduct of the audit.

4-8.(LO 3, pp 119-120) The Ultramares case set the precedent for auditor liability to third parties. The court concluded that auditors are liable to third parties for fraud, and negligence; however, auditors are liable for negligence only to third-party beneficiaries. Judge Cardozo was concerned that any other standard would hold the auditor responsible to an indeterminate number of users for an indeterminate amount of time for indeterminable levels of damages because he was concerned with concepts of negligence that would include a ‘careless’ slip in judgement. The judge was concerned that auditors be held responsible for audits to a large group of third parties only when it is very clear that the auditors had been quite negligent in the conduct of the audit work. The four primary tests that have been utilised by the courts include these: • a duty of care is owed to the plaintiff (reasonable foreseeability and proximity) • the audit is negligently performed or the opinion negligently given (reasonable care and skill not exercised by the auditor) • the plaintiff relied on the auditor

• the plaintiff has suffered quantifiable economic loss as a result of the auditor’s negligence (causation).

4-9.(LO 4, pp 120-130) The three primary tests that have been utilised by the courts include these: • Identified user test
• Foreseen user test
• Foreseeable user test.

The class of potential users, and thus the number of users, increases as one moves from the identified user test to the foreseeable user test as described below.

The identified user test states that the auditor has a liability for ordinary negligence only to those third parties known by the auditor to require the audit before making a specific economic decision, such as to lend money to the audit client. These third parties either have privity of contract or are acknowledged third-party beneficiaries.

The foreseen user test states that the auditor is liable for negligence to intended or known third-party users and to any individually unknown third parties who are members of a known or intended class of third-parties. Under this test, the client must have informed the auditor that a third party or class of third parties intends to use the financial statements for a specific economic action, such as to lend money to the client.

The foreseeable user test states that the auditor can be held liable to all those whom that auditor should reasonably foresee being recipients of the company’s statements for proper business purposes, provided that the recipients rely on the statements pursuant to those business purposes.

4-10.(LO 4, pp 120-130) The administrative sanctions the ASIC can bring against auditors under s.1292 of the Corporations Act 2001, are that the CALDB may cancel or suspend registration, admonish or reprimand and/or require an undertaking to engage in, or refrain from engaging in specified conduct. Under s.1294, registration must not be cancelled or suspended unless the person being disciplined is given the opportunity to appear at a hearing held by the CALDB.

The major purpose of giving the ASIC power to implement administrative sanctions against auditors without a court hearing is that action can proceed quickly, while litigation conducted in court can be protracted and permit the auditor to continue signing audit reports until the case comes to completion.

4-11.(LO 4, pp 120-130)

a.The primary purpose of the CALDB is to create a vehicle under ASIC which can discipline registered company auditors. The intent of administrative sanctions is to improve the performance of all parties who practice as registered company auditors by allowing disciplinary action against them. Under s.1292 of the Corporations Act 2001, the CALDB may cancel or suspend registration, admonish or reprimand and/or require an undertaking to engage in, or refrain from engaging in specified conduct. Under s.1294, registration must not be cancelled or suspended unless the person being disciplined is given the opportunity to appear at a hearing held by the CALDB. Traditionally there has not been cooperation between the CALDB and the professional accounting bodies. However, CLERP 9 proposal 34 proposes that the institutional arrangements for taking disciplinary action against registered company auditors will be strengthened to: • provide a majority of members of the CALDB, with appropriate skills, who are non-accountants • allow the CALDB to sit in more than one Division simultaneously and provide for the appointment of a deputy chairman of the CALDB, and • enable the CALDB to provide information obtained in the course of a disciplinary proceeding to the investigation and disciplinary committees of the ICAA, CPAA and NIA (National Institute of Accountants) to facilitate the disciplinary procedures of those bodies. b.The primary purpose of the professional accounting bodies’ disciplinary processes is to ensure their respective bylaws are upheld and maintained. For instance the ICAA bylaws (paragraph 40) provide the following as grounds for disciplinary action. If the member or practice has: (a)in the opinion of any of the Committees referred to in By-law 41, failed to observe a proper standard of professional care, skill or competence in the course of carrying out his or its professional duties (b)before any court of law in any jurisdiction in Australia or elsewhere pleaded guilty to, or been found guilty of, any criminal offence which has not been set aside on appeal (c)in any civil proceedings before any court of law in any jurisdiction in Australia or elsewhere been found to have acted dishonestly and such finding has not been set aside on appeal (d)pleaded guilty to, or been found guilty of, any statutory or other offence by a court of law, professional body, statutory or other regulatory authority in any jurisdiction in Australia or elsewhere which is not a crime but which, in the opinion of any of the Committees referred to in By-law 41, brings, or is likely to bring, discredit upon him or it, the Institute or the profession of accountancy and any such finding has not been set aside on appeal (e)been the subject of an adverse finding in relation to his or its professional or business conduct or competence by any court of law, professional body, statutory or other regulatory authority in any jurisdiction in Australia or elsewhere (f)committed any breach of the Supplemental Charter, the By-laws or the Regulations (g)failed to comply with any reasonable and lawful direction of any officer or organ of the Institute acting within the powers conferred by the Institute’s Supplemental Charter, the By-laws or the Regulations and which relates to a matter concerning the good order and management of the Institute (h)become a bankrupt or has signed an authority authorising a registered trustee to call a meeting of his creditors and to take over control of his property or has authorised a solicitor to call a meeting of his creditors or has executed a deed of assignment or a deed of arrangement or a composition has been accepted by his creditors (i)had a resolution for the voluntary winding-up of such practice has been passed by its creditors or a winding-up order has been made in respect of it by a court of law or a compromise or scheme of arrangement between such practice entity and its creditors or a class of creditors has been agreed to or has been approved by a court of law or a receiver has been appointed of it or any of its assets or undertakings (j)committed any act, omission or default which, in the opinion of any of the Committees referred to in By-law 41 brings, or is likely to bring, discredit upon himself or itself, the Institute or the profession of accountancy.[2]

4-12.(LO 4, pp 120-130) Remedies for breach of contract include the following: • requiring specific performance of the contract agreement • granting an injunction to prohibit the auditor from doing certain acts, such as disclosing confidential information, and • providing for recovery of amounts lost as a result of the breach.

4-13.(LO 4, pp 120-130)
R. Lowe Lippman Figdor & Franck v AGC (Advances) Ltd (R.Lowe Lippman Figdor) [1992] 10ACLC 148 This case narrowed the opportunity for third parties to claim auditors owe them a duty of care. It used the notion of proximity to require third parties to prove that there was a legally recognisable relationship between themselves and the auditor that would establish a duty of care.

R.Lowe Lippman Figdor was an Australian case that followed the principles as laid down in the Caparo[3] case. The court held the expression of interest by AGC (a creditor) in the audited accounts for the purpose of reviewing its position, did not create a special relationship with the auditor. The court felt that the preparation of the accounts was not for the special purpose of inducing the plaintiff to act in a certain way.

2 Columbia Coffee and Tea Pty Ltd v Churchill (Columbia Coffee) [1993] 9 ACSR 415 (NSW)

The court applied a proposition in Mutual Life & Citizens Assurance Co Ltd v Evatt that a duty of care is created where an auditor know or ought to have known that a non-client would rely on the auditor’s report. In this case the audit firm’s own audit manual included a statement acknowledging that interested third parties might read and rely on the audit report issued at any time. The court departed from the rigid interpretation of the use of audited accounts used in Caparo and R.Lowe Lippman Figdor among others. The judges considered that in reality people in the business world review and rely upon audited accounts in making investment decisions, whether they are legally advised to or not. The court held that the auditor could owe a duty of care to a purchaser of shares who relied on the audited accounts and audit report, and suffered economic loss as a result.

Esanda Finance Corp. Ltd v Peat Marwick Hungerfords (Esanda Finance) [1997] 188 CLR 241 The court endorsed the reasoning applied in R.Lowe Lippman Figdor. It is necessary to have both foreseeability of harm plus a relationship of proximity for a duty of care to arise. A duty of care is difficult to establish unless the auditor intends to induce reliance on his work product by a non-client or a limited class. Other factors besides intent to induce reliance may establish proximity. Numerous policy factors that should be weighed in deciding whether a duty of care arises were outlined. This case severely restricted the application of third-party liability to auditors, holding that the decision in Columbia Coffee was incorrect. Brennan, CJ, stated that for a third party to rely on the report prepared by the auditor, the following would have to be established: • The report was prepared on the basis that it would be conveyed to a third party. • The report would be conveyed for a purpose that was likely to be relied upon by that third party. • The third party would be likely to act in reliance on that report, thus running the risk of suffering the loss if the statement was negligently prepared.

4-14.(LO 6, pp 133-135)
Investors might become concerned with auditors’ defensive actions related to limiting auditor liability. These actions include the move from joint and several liability to proportionate liability and lobbying to create a cap on liability. Some investors may view these types of changes with concern about whether the reduction in auditor liability would reduce audit firm accountability and provide an incentive for the auditors to take shortcuts, and therefore reduce overall audit quality. Those promoting such reforms often counter such concerns by noting that these reforms are not intended to provide auditors with a ‘free pass’ in situations where the auditor does low quality audit work.

4-15.(LO 1, pp 116-118) The intent of this question is to demonstrate that there are negative effects associated with any lawsuit even if the auditor is successful in defending the suit. a.The negative effects of losing a lawsuit include monetary loss through legal fees, fines, penalties, compensatory damages, and punitive damages; loss of productive time of personnel assisting in the defence; loss of reputation; loss of clients; loss of personnel who may be jailed in criminal cases; loss of public practice certificate; and restriction of a public accounting firm from accepting new and/or serving existing clients. b.Even winning a case has negative effects: loss of reputation because of publicity, loss of productive time of personnel assisting in the defence, and the expense of legal fees.

4-16.(LO 4, pp 120-130) Yes, there is a conceptual difference between an ‘error’ and ‘negligence’. Errors in judgement can, and do, occur on almost every audit or assurance engagement such as when the auditor may have misinterpreted a response to a confirmation, or did not follow up on all responses, but did exercise ‘reasonable care’ in the performance of all duties. Negligence, on the other hand, implies that the auditor did not exercise the standard of care expected by all professionals in the field of auditing and assurance. Thus, proving negligence requires more than proving that an auditor made an error in an accounting or auditing judgement. Therefore, many lawsuits against auditors involve expert witnesses testifying as to the reasonable standard of care that auditors would be expected to exercise in similar situations. The codified auditing and assurance standards are the main standard reference for due care. CLERP 9 proposes these standards receive the backing of the Corporations Act 2001 and be made into disallowable instruments. If the legislation is passed, a statutory breach of the standards will occur if it can be established they are not followed.

4-17.(LO 3, pp 119-120) The Caparo case is a UK House of Lords case that established that an auditor of a public company, in the absence of special circumstances, owes no duty of care to an outside investor or an existing shareholder who buys stock in reliance on a statutory audit. A three-pronged test for a duty of care is applied: (a) foreseeability; (b) proximity; (c) it must be just and reasonable on a policy basis to impose a duty. Auditor liability for negligent misstatements is confined to cases in which it can be established that the auditor knew his or her work product would be communicated to a non-client, either individually or as a member of a limited class, and the third party relied on the work product in connection with a particular transaction. This case severely restricted the application of liability to third parties.

4-18(LO 3, pp 119-120)
The Columbia Coffee case is particularly important because it emphasised the importance of internal public accounting firm manuals and other materials. In the case, the audit firm’s own audit manual included a statement acknowledging that interested third parties might read and rely on the audit report issued at any time. Even though the Esanda case later held that the decision in Columbia Coffee was incorrect, the significance for courts of words used in internal pronouncements was highlighted and the need for great care in this type of internal material has been subsequently better practised.

4-19.(LO 5, pp 130-133) The professional accounting bodies require that their members undertake a certain amount of continuing education to maintain their accreditation/membership. Students can find information about continuing education requirements for each of the professional accounting bodies through their websites. http://www.cpaaustralia.com.au/

http://www.charteredaccountants.com.au/
http://www.publicaccountants.org.au/.

4-20.(LO 5, pp 130-133)
Defensive auditing means taking special actions to avoid lawsuits. Some of these actions are targeted towards improving overall quality in the audit and review opinion formulation process. These actions include establishing good quality control, submitting the firm to quality reviews, requiring engagement letters for all engagements, carefully screening clients, ensuring that the personnel are competent, and maintaining accurate and complete audit documentation.

4-21.(LO 5, pp 130-133) The purpose of the professional accounting bodies’ peer review program is to monitor audit quality with a view to enhancing it.

4.22(LO 5, pp 130-133)
The three main elements of any audit firm’s program to assure auditor independence include: • Firm training programs that emphasise factors that can impede independence • Firm review of all relationships that may affect auditor independence and individual reporting of all potential relationships that might impair independence • On-the-job review of performance emphasising the need for scepticism, objectivity, and the need to corroborate management’s explanations.

4-23.(LO 1, pp 116-118; LO 6, pp 133-135)

With proportionate liability, a public accounting firm that is found partially responsible would only have to pay that proportion of damages, regardless of the other defendant’s ability to pay. Under joint and several liability the auditor often got stuck paying the full amount of damages to the plaintiff.

4-24.(LO 5, pp 130-133)
In an engagement quality control review, a partner from the same firm (usually in the same office) intervenes near the end of the audit to ensure that documented evidence supports the audit opinion. In an interoffice review, professionals from another office ensure that the policies and procedures established by the firm are being followed. In that way, interoffice reviews are much broader in nature while engagement quality control reviews are at the individual audit level.

4-25.(LO 5, pp 130-133) Every three years.

4-26.(LO 6, pp 133-135) ASIC has been approved to undertake public accounting firm inspections on behalf of regulators from the US and Europe.

DISCUSSION AND RESEARCH QUESTIONS

4-27.(Liability for Negligence ) (LO 4, pp 120-130)
a.The issue is whether proximity and reasonable foreseeability existed. It appears clear that foreseeability is satisfied since the auditor knew that the financial institution was a primary beneficiary of the audit report. However, proximity may be harder to establish. Esanda reinforced the decision in the AGC case that the auditor must take some action to induce the plaintiff to act in reliance. If the audit is being conducted solely for the purpose of a loan application to the financial institution, it could be argued that the financial institution is being induced by the auditor to rely on the audit report for this purpose. As such, the condition of proximity would be satisfied and the auditor would owe a duty of care to the bank. This would be especially so if the financial institution had requested a privity letter (see AGS 1014). However, it is unclear whether the audit is being conducted solely for this purpose. b.The auditor would not be liable to individual shareholders under Caparo where it was held that the auditor owed a duty to shareholders as a body and not to individual shareholders or potential investors. However the auditor may also have a potential liability under the Trade Practices Act or Fair Trading Act. c.The auditor would not be liable since proximity and reliance are insufficiently proven. Esanda Finance demonstrated that for a third party to rely on the report prepared by the auditor, the following would have to be established: 1. The report was prepared on the basis that it would be conveyed to a third party. 2. The report would be conveyed for a purpose that was likely to be relied upon by that third party. 3. The third party would be likely to act in reliance on that report, thus running the risk of suffering the loss if the statement was negligently prepared.

4-28.(Responsibility for Negligence) (LO 3, pp 119-120; LO 4, pp 120-130) a.The Columbia Coffee case in Australia rejected this narrow view and held that the auditor has a duty of care to users that the auditor knows are relying on the financial reports. However, other Australian cases such as R. Lippmann Figdor & Franck Vs AGC Advances and Esanda have supported the narrow Caparo view and have held that the auditor must have induced the third party to rely on the audit report for there to be a duty of care.

The Esanda case held that the decision in Columbia Coffee was incorrect. In the High Court, Brennan, CJ, stated that for a third party to rely on the report prepared by the auditor, it would have to be established that the report was prepared on the basis that it would be conveyed to a third party, the report would be conveyed for a purpose that was likely to be relied upon by that third party and the third party would be likely to act in reliance on that report, thus running the risk of suffering the loss if the statement was negligently prepared.

This does not mean case law has established the auditor no longer owes a duty of care to third parties, but rather that the duty is limited to those meeting the conditions specified in Esanda. The difference is that the Caparo case found the auditor cannot be relied on by third parties, whereas in the Esanda case, it was established that reliance by third parties on the audit report could apply if certain criteria in relation to foreseeability and proximity are established.

However, the impact of the Trade Practices Act or State Fair Trading Acts is important also when considering third-party liability.

b.Opinions will vary widely on this question. Points to be sure are discussed include: • Should all likely users financially injured because of the auditor’s carelessness be able to recover their losses from the auditor? Does this encourage frivolous lawsuits that waste a lot of time and money? • Does society benefit from the rash of litigation against auditors and other professionals who are negligent? Or does this tie up time the professionals could better spend performing their normal duties? • Public accounting firms shy away from auditing high-risk companies such as start-up companies, high-technology companies, and financial institutions. Many of these need audited financial statements to help them raise capital to grow. • To what extent does the threat of litigation cause auditors to be more careful? • Litigation costs of public accounting firms are usually passed on to their clients. However, in some cases, the firm cannot survive (e.g. Andersen). • Potential litigation causes some public accounting firms, particularly small firms, to avoid accepting audit clients. • Lawyers may benefit more than the injured parties from litigation.

4-29.(Recoverability of Damages) (LO 4, pp 120-130)
The creditor might claim that the auditor was negligent and that the creditor is a foreseen user or that the auditor was negligent because of a reckless disregard of due care and skill.

4-30.(Defence against an Investor) (LO 4, pp 120-130)
The auditor could try to prove that the audit did not cause the investor’s loss. The investor knew of the errors in the financial statements and the decline in the price of stock is likely to have been caused, at least in part, by the operating losses in the subsequent period and the general decline in stock market prices. The auditor could also try the defence that the investor was not an identified or foreseen user but only a foreseeable user.

4-31.(Identified user test) (LO 2, pp 118-119; LO 4, pp 120-130) a.The issue is whether proximity and reasonable foreseeability existed. Esanda reinforced the decision in the AGC case that the auditor must take some action to induce the plaintiff to act in reliance. If the audit is being conducted solely for the purpose of a loan application to First Bank, it could be argued that First Bank is being induced by the auditor to rely on the audit report for this purpose. As such, the condition of proximity would be satisfied and the auditor would owe a duty of care to the bank. This would be especially so if First Bank had requested a privity letter (see AGS 1014). However, it is unclear whether the audit is being conducted solely for this purpose.

4-32.(Interpreting the Negligence Doctrine) (LO 2, pp 118-119; LO 4, pp 120-130) a.An error. It would be difficult for the auditor, without advance suspicion, to note a forgery on a confirmation form. This most likely would not be considered negligence. b.Negligence. This is a careless disregard for the audit process. Confirmations are intended to seek independent outside evidence. If the client mails the confirmation, the client has complete control as to whom the confirmations are delivered and thus can forge the confirmations to make the receivables appear to be valid. c.An error. There was no previous evidence that the new model would result in warranty obligations different from those for previous years. Only if the auditor had knowledge that a different model should be used in estimating the warranty liability for the new product would the auditor be held liable for negligence. d.Negligence. Auditors are expected to determine the validity and collectibility of loans. It is customary auditing procedure to review loan documentation, including the assessment of the adequacy of collateral. e.Negligence. The auditor had evidence that the account was materially different from previous years but undertook no auditing procedures to determine the cause. A jury would review the surrounding circumstances to determine whether it was negligence. A careless disregard for the audit – which might be indicated here – would support a negligence claim. f.Negligence. The auditor clearly failed to exercise due professional care. The account is material and had risen faster than sales (and presumably production), but the auditor performed no detailed investigation. g.Negligence. The auditing firm has not exercised reasonable care and skill by failing to supervise the new employee. The lack of knowledge of the industry and the client’s policies raises questions that may lead to establishing negligence.

4-33.(Corporations Act 2001) (LO 4, pp 120-130)
a.True. It deals with fundraising through a prospectus. b.True. Caparo established that the auditor owes a duty of care to shareholders as a whole. If the audit was negligent, and from the facts it appears to be, the shareholders can take action against the auditor. c.True. This constitutes a material misstatement.

d.False. The standard is one of negligence, not one of fraudulent conduct of the audit. e.True. This is one of the defences the auditor may assert. f.False. Contributory negligence is not an issue with the ASIC. g.False. The standard is whether the exercise of due care would have detected the fraud, not that management had engaged in a clever fraud.

4-34.(Auditor Defences) (LO 4, pp 120-130)
| | | |Allegation |Auditor Defences | | | | |a. Auditor knew the statements were misleading – fraud. |Auditor did not know. | | |Misstatements were not material. | | | | |b. Auditor was negligent and should have known the |Due care and skill defence – did what a prudent auditor would have | |statements were misleading. |done, followed GAAS. | | | | |c. Statements were materially false and misleading. |Statements were in accordance with GAAP and were not materially | | |misstated. | | | | |d. Damage was due to false/misleading financial |Damage was due to the decline in general share market prices, the | |statements. |downturn in the economy, and reduced company profitability subsequent | | |to the time the plaintiff purchased the shares. The audit was not | | |causal of the investor’s loss. | | | | |e. Auditor has a duty to the plaintiff because they are a|Auditor does not have a duty because the plaintiff is not an | |foreseeable user. |identified or foreseen user. |

4-35.(Recent Common Law cases) (LO 2, pp 118-119 LO 3, pp 119-120; LO 4, pp 120-130) This project presents an opportunity for the auditing students to utilise the resources of your library such as LEXIS/NEXIS computerised data services.

4-36.(Research) (LO 4, pp 120-130; LO 7, Chapter 3)
a.This project presents an opportunity for the student to read the ASIC/CALDB releases. (See www.sec.govb) Taking action against firms could trigger the collapse of that firm (e.g. Enron and Andersen) and if it was a Big 4 firm, leave inadequate competition in the market for assurance services. b.CLERP 9 in Part 1 Schedule 8 contained reforms to the Companies Auditors and Liquidators Disciplinary Board (CALDB) and its processes.

4-37.(Mitigating Exposure to Liability) (LO 5, pp 130-133)

a.Partner rotation helps bring a fresh approach to audits and minimise bias that may result from long-term contracts with client management. However, the disadvantage is that every five years, a partner who does not have the client and industry knowledge will have to take over, and the quality of the audit could suffer. b. An auditor’s independence can be impaired by providing tax services if the revenues provided for the services are a significant amount such that the audit team is not as willing to give anything but a clean opinion for fear of losing the non-audit revenue.

Preparing the client’s tax returns may provide better evidence about the proper amounts of tax expense, tax accruals, and deferred taxes.

4.38(Peer Review) (LO 5, pp 130-133)

| | | | | |a. Objective |b. When required. | | | | | |(1) Internal partner |To assure the documented evidence supports|No legal requirement although it is considered best practice | |review |the audit opinion before the opinion is | | | |issued | | | | | | |(2) Interoffice review |To help assure that each office is |It applies to multi-office public accounting firms as part of the | | |following the policies and procedures of |monitoring element of the firm’s quality control standards that | | |the firm |will become a part of an external peer review | | | | | |(3) External peer |To help improve the accounting and |It is required as part of the practice monitoring program by CPAA | |review |auditing practice of public accounting |and the ICAA as one of their membership requirements for public | | |firms |practice certificate holders |

c. External peer review reports are issued to the client, by the CPAA or the ICAA, if applicable. They are not made available to the public and are used to educate practices in respect of quality control. Some believe the outcomes of peer review should be made public.

4-39Court Influence on Auditing Standards) (LO 2, pp 118-119; LO 3, pp 119-120; LO 4, pp 120-130) a. Generally speaking, Auditing Standards identify a very high standard of conduct. However, Auditing Standards may not cover every instance that an auditor may face. Courts may find that an average prudent person in the position of the auditor would have investigated the circumstances more thoroughly than the auditing and assurance standards may have required. Thus, the prudent person concept is applicable. Additionally, the courts are influenced by the spirit of the authoritative standards, not literal interpretations in a narrow context. When applying their trade, auditors cannot be required to be automatons, narrowly following specific authoritative pronouncements but must be attuned to the audit situations and the overall purpose for the professional standards. b. The court’s major reference is the requirement for ‘fairness’ or ‘truth and fairness’. Auditors cannot hide behind a narrow definition of GAAP if adherence to the narrow interpretation hides full and fair disclosure. What might have been acceptable in earlier times in terms of financial statements being fairly presented when they omitted important disclosures, today we accept as mandatory disclosures. The primary court emphasis serves as a reminder to auditors that it is the overall quality of presentation that is important.

Courts are more concerned with the spirit of the accounting and auditing standards rather than a literal interpretation of them in a specific context. If evidence exists that a literal interpretation of a standard does not fairly present the financial picture of a company or if management is using accounting principles as a tool to develop inflated earnings, the auditor should be willing to step back and make a statement about the overall fairness of financial presentations.

Auditors have to walk a fine line between keeping clients and risking financial statement presentations that may technically conform to GAAP but not necessarily present a ‘full and fair picture’ of the company’s financial position or results of operations. Cases

4-40.(Statute and Common Law) (LO 2, pp 118-119; LO 4, pp 120-130) Crea is not likely to be liable to the purchasers of shares based on Crea’s negligence. Audited financial statements must be prepared pursuant to S301 of the Corporations Act 2001 by all companies except small proprietary companies. Under Chapter 6D of the Corporations Act 2001 Companies involved in fundraising must issue a prospectus, which is not the same as annual financial statements. Caparo Industries Pty Ltd v. Dickman (1990) 1A11 ER 568 narrowed reliance on audited accounts to existing shareholders that the auditors knew their report would be sent to and relied upon. Potential shareholders subscribing to a seasoned offering are unlikely to be able to prove reliance on the company’s audited financial statements because of the role of the Prospectus in fundraising under the Corporations Act. Many sources of information are available to potential shareholders and proving reliance on the audited financial statements alone is likely to be extremely difficult to do. In Australia, the judgement in Esanda rejected the notion that liability could be based on foreseeability of reliance alone. The High Court established that there had to be a relationship of proximity between the auditor and the third party before a duty of care could be said to exist. The auditor has to be part of a real relationship with the third party for liability to arise rather than just having knowledge of the third party’s existence as a theoretical possibility. Establishing this relationship is much more likely in relation to Safe Bank than the purchasers of shares.

Crea is likely to be held liable to Safe Bank based on Crea’s negligence despite the fact that Safe is not in privity of contract with Crea. For Safe Bank to establish a cause of action for negligence against Crea, Safe Bank must establish to the satisfaction of the court that: 0. Crea owed a legal duty of care to Safe Bank.

1. Crea breached the legal duty by failing to perform the audit with the due care or competence expected of members of the profession. 2. Crea’s failure to exercise due care proximately caused Safe Bank to suffer damage. 3. Safe Bank suffered actual losses or damages.

To owe a duty of care the following has to be established (Esanda Finance on appeal to the High Court 1997): • The report was prepared on the basis that it would be conveyed to a third party. • The report would be conveyed for a purpose that was likely to be relied upon by that third party. • The third party would be likely to act in reliance on that report, thus running the risk of suffering the loss if the statement was negligently prepared.

In this case, it seems that the audit was conducted and the audit report prepared on the basis that it would be conveyed to Safe Bank for the purpose of the Bank’s reliance in deciding whether or not to extend the loan to Dark. Despite the New South Wales Supreme Court in Columbia Coffee & Tea (1992), finding it unnecessary to prove that the audited financial statements were prepared for the purpose of the plaintiff or the class of persons intended to rely upon the audit, the Lowe Lippman Figdor & Frank v. AGC (1992), and Esanda Finance Corp Ltd v. Peat Marwick Hungerfords (1994) cases endorsed the decision in the Caparo case that this is necessary. On the facts it would seem that the audited financial statements were prepared for the purpose of Safe Bank.

Crea appears to have failed to perform the audit with the due care or competence expected of members of the profession. Cases such as Kingston Cotton Mill and London and General Bank have suggested that the auditor will have exercised due care if he or she exercises the skill and care of a reasonably competent member of the profession. Pacific Acceptance established that courts consider whether the auditor followed the appropriate professional standards in determining whether he or she had acted with due care. It seems Crea failed to exercise due care in detecting the president’s embezzlement, which resulted in Safe’s loss, that is, Dark’s default in repaying the loan to Safe. The auditor’s defence will include due diligence in conducting the audit or the claim that the audit did not cause Safe’s loss.

4.41.(Legal Liability) (LO 2, pp 118-119; LO 4, pp 120-130) Part A
Peters will not prevail. The Caparo case (UK House of Lords) established that an auditor of a public company, in the absence of special circumstances, owes no duty of care to an outside investor or an existing shareholder who buys stock in reliance on a statutory audit. A three-pronged test for a duty of care is applied: (a) foreseeability; (b) proximity; (c) it must be just and reasonable on a policy basis to impose a duty. Auditor liability for negligent misstatements is confined to cases in which it can be established that the auditor knew his or her work product would be communicated to a non-client, either individually or as a member of a limited class, and the third party relied on the work product in connection with a particular transaction.

Despite the New South Wales Supreme Court in Columbia Coffee & Tea (1992), finding it unnecessary to prove that the audited financial statements were prepared for the purpose of the plaintiff or the class of persons intended to rely upon the audit, the Lowe Lippman Figdor & Frank v. AGC (1992), and Esanda Finance Corp Ltd v. Peat Marwick Hungerfords (1994) cases endorsed the decision in the Caparo case that this is necessary.

Part B
a. Ira is likely to prevail and recover damages from Baker.

b. He will base his action on the liability imposed on experts, including accountants, whose opinions appear in a prospectus. The experts are liable to all those who in relying on their opinions, purchase securities in a public offering. Ira does not have to prove that Baker was negligent in auditing Able. All he needs to allege and prove is that there is a material false statement or omission of a material fact in the prospectus and Ira suffered a loss. The only defence that Baker may use is that he exercised the degree of care that would be exercised by public accountants in similar circumstances. This is commonly referred to as the due diligence defence. Negligence by Baker makes Baker liable to Ira for damages.

4-42.(LO 1, pp 116-118; LO 7, Chapter 3)

a. While individual answers will of course vary, we present a potential approach to moving through the seven steps in resolving the difficult, but realistic, ethical issue encountered by the staff member.

1) Identify the ethical issue. The ethical difficulty is that the audit staff is being pushed to do a high quality job and not accurately record the time it took OR do a low quality job (which would require fewer hours) and report the hours accurately. Either alternative has undesirable aspects.

(2)Determine who are the affected parties and identify their rights. Affected parties include shareholders (right to receive a quality audit at a fair price), the audit committee and board of directors (right to receive a quality audit at a fair price), client management (right to receive a quality audit at a fair price), the Firm (the right to expect payment for services), the individual staff auditors on the engagement (the right to have their professional opinions respected and followed; the right to not be pressured to do the wrong thing), the manager on the engagement (the right to be made aware of the situation), the auditing profession (the right to expect that a quality audit will be performed at a fair price), future engagement team members (the right to have accurate information when making budgeting and fee decisions in the future). Note that the audit senior does not have the right to expect the staff members to under-report time.

(3)Determine the most important rights. In this case the most important rights relate to most of the affected parties and include the right to provide a quality service for a fair price.

(4)Develop alternative courses of action. The staff auditors could do all the work necessary and under-report the hours actually worked; the auditor could do a minimal job working only the hours already budgeted; the auditor could bring the matter to the attention of the manager, appealing to her to ask the client for additional hours in the fee budget to accomplish the analysis in a high-quality manner.

(5)Determine the likely consequences of each proposed course of action. Doing the necessary work, but under-reporting the hours will lead to an appropriate level of quality but inappropriate measures of engagement profitability. This would result in poor budgeting decisions for future audits, and thus the problem will continue. Further, if the audit staff member stays under budget it is likely that the staff member will be positively evaluated.

Doing a minimal job will result in lower audit quality, but staying on budget while doing lower quality work will appease the audit senior and manager and could have possible implications for the evaluation of the staff member. However, if some aspect of the audit ‘blows up’ in the future, the staff auditor’s actions will be scrutinised.

Having the audit manager appeal to the client will allow the audit to be performed in a high-quality manner while having the actual hours worked being recorded. However, without knowing the personality of the audit manager it is difficult to know how she might react to this suggestion.

(6)Assess the possible consequences, including an estimation of the greatest good for the greatest number. When assessing the consequences, the greatest good for the greatest number would suggest that a quality audit be performed for a fair price, based on audit hours actually worked.

(7)Decide on the appropriate course of action. The third option, or some variant whereby the audit fee is adjusted upward with the client’s consent, seems preferable.

a. The most important thing to achieve in this scenario is good communication between engagement team members and the client. In pilot testing of this case in an ethics symposium, practicing auditors noted the importance of involving the client immediately in the decision process in terms of alerting them to the problem and the need for additional budgeted hours and associated increased engagement fees. Practitioners agreed that the longer the engagement team waited to notify the client or senior members of the engagement team, the worse the outcome was likely to be, in terms of audit quality, ethical decisions, and monetary compensation for the audit firm.

Note: The authors acknowledge the insights of Ira Chaleff, author of The Courageous Follower, for his help in generating ideas for the above case, which was used during an ethics symposium at the University of Wisconsin – Madison.

4-43.(LO 7, Chapter 3)

a) While individual answers will of course vary, we present a potential approach to moving through the seven steps in resolving the difficult, but realistic, public policy issues.

1)Identify the ethical issue. The issue is whether public policy should be changed so that ASIC ‘names and shames’ audit firms in its inspection reports, as does the PCAOB.

2)Determine who are the affected parties and identify their rights. Affected parties include shareholders (right to receive a quality audit at a fair price, right to a competitive market for audit services), the audit committee and board of directors (right to receive a quality audit at a fair price, right to a competitive market for audit services), client management (right to receive a quality audit at a fair price, right to a competitive market for audit services), the Firm (the impact on its reputation and competition in the market – but naming individual auditors may still lead to loss of Firm reputation), the individual auditors at all levels on the engagement (the right to have their professional opinions respected and followed; the right to not be pressured to do the wrong thing, the right for their firm not to be tarnished because of the actions (or lack of action) of individual auditors, the right for the named auditor to be treated with fairness), the auditing profession (the right to expect that a quality audit will be performed at a fair price; the right to retain the public trust), future engagement team members (the right to work for a firm that has a respected reputation), regulators (the right to design and implement public policy in the interests of the public as a whole).

3)Determine the most important rights. This is always a matter of opinion, but the fear of one of the Big 4 auditors collapsing if Firms are named and a consequential lack of competition in the market for assurance services is a legitimate fear of regulators worldwide.

4)Develop alternative courses of action. The alternative courses of action are for public policy to name just the individual auditors involved in sub-standard audits and/or to name the Firm as performing a sub-standard audit(s).

5)Determine the likely consequences of each proposed course of action. Naming and shaming the firm: The firm, whether one of the Big 4 or not, may not survive. Naming and shaming individual auditors: The auditor may leave and not be re-employed.

6)Assess the possible consequences, including an estimation of the greatest good for the greatest number. Because of the potential market consequences of triggering the collapse of an audit firm when it is a member of the Big 4 (e.g. Andersen and Enron), naming only individual auditors is arguably the appropriate public policy.

7)Decide on the appropriate course of action. Maintaining the status quo is arguably the appropriate action.

b) While individual answers will of course vary, we present a potential approach to moving through the seven steps in resolving the difficult, but realistic, public policy issues.

1)Identify the ethical issue. The issue is whether auditors of private sector entities should be employed by the regulator or remain as a private enterprise undertaking.

2)Determine who are the affected parties and identify their rights. Affected parties include shareholders (right to receive a quality audit at a fair price, right to a competitive market for audit services), the audit committee and board of directors (right to receive a quality audit at a fair price, right to a competitive market for audit services), client management (right to receive a quality audit at a fair price, right to a competitive market for audit services), the Firm (the impact on its remuneration and competition in the market, the right to attract and retain skilled staff), the individual auditors at all levels on the engagement (the right to have their professional opinions respected and followed; the right to not be pressured to do the wrong thing, the right for competitive remuneration and a career path), the auditing profession (the right to expect that a quality audit will be performed at a fair price; the right to retain the public trust), future engagement team members (the right to work for an employer that has a respected reputation and pays competitively, the right to a career path), regulators (the right to design and implement public policy in the interests of the public as a whole), existing public sector auditors (the right to competitive remuneration and a career path).

3)Determine the most important rights. This is always a matter of opinion, but the fear of failing to attract the best and brightest if private sector auditing became a public sector activity is often cited as a drawback of such a policy. There are implications for audit quality arising from this issue.

4)Develop alternative courses of action. The alternative courses of action are for public policy to leave private sector auditing in the hands of private enterprise or to deem that for the public good it must change to a public sector activity.

5)Determine the likely consequences of each proposed course of action. Status quo – some audits will fail, auditors/audit firms will continue to be dependent on clients for remuneration. Move to public sector – auditors/audit firms will not be dependent on clients for their remuneration. Attracting and retaining skilled staff may become a greater problem that it already is. Profession would lobby aggressively to retain status quo.

6)Assess the possible consequences, including an estimation of the greatest good for the greatest number. Nationalising auditing could be justified because of the ‘public interest’ nature of auditing, but it could create more problems than it solves.

7)Decide on the appropriate course of action. Maintaining the status quo is arguably the appropriate action.

-----------------------
[1] The Caparo case established the principle that an auditor of a public company, in the absence of special circumstances, owes no duty of care to an outside investor or an existing shareholder who buys stock in reliance on a statutory audit. A three-pronged test for a duty of care is applied: (a) foreseeability; (b) proximity; and (c) it must be just and reasonable on a policy basis to impose a duty. Auditor liability for negligent misstatements is confined to cases in which it can be established that the auditor knew his or her work product would be communicated to a non-client, either individually or as a member of a limited class, and the third party relied on the work product in connection with a particular transaction. This case severely restricts the application of liability.

[2] Extracted from ICAA Members’ Handbook, A2 Bylaws.
[3] The Caparo case established the principle that an auditor of a public company, in the absence of special circumstances, owes no duty of care to an outside investor or an existing shareholder who buys stock in reliance on a statutory audit. A three-pronged test for a duty of care is applied: (a) foreseeability; (b) proximity; (c) it must be just and reasonable on a policy basis to impose a duty. Auditor liability for negligent misstatements is confined to cases in which it can be established that the auditor knew his or her work product would be communicated to a non-client, either individually or as a member of a limited class, and the third party relied on the work product in connection with a particular transaction. This case severely restricts the application of liability.

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