Professional Documents
Culture Documents
This source of compensation (insurance) creates a perception that auditors have deep pockets and, arguably, contributes to the extent of claims filed against them There have been major changes in the legal environment concerning auditor liability in the last few years
Duke Group case over an independent experts report prepared by Nelson Wheeler resulted in $32 million in damages was paid In April 2002, Arthur Andersen settled with Southern Equities (formerly Bond Corporation) a $1 billion damages claim for an undisclosed amount and an estimated $30 million in legal costs In the United States, a substantial number of claims as indicated by the following Table
Number of claims defended by the Big Four in the United States over a 6-year period
It can be seen from the data that the litigation crisis may have reached its peak between 2002 and 2003
The bill does this through the Commonwealths Trade Practices Act 1974, the Australian Securities and Investments Commission Act 2001 and the Corporations Act 2001
The following key points relate to subsequent state-based legislations to enact the Commonwealth based reforms:
Limitation caps are calculated with reference to a multiple of fees charged The cap does not apply to liability arising from claims for death, personal injury or any conduct involving a breach of trust, fraud or dishonesty A minimum cap of $500 000 applies but can vary within and between occupational groups
9
10
To determine the required insured amount, ASIC proposes the following formula:
If the maximum engagement fee is estimated to be less than $50 000, the insured amount will be $500 000, for any one claim and in the aggregate; or If the maximum engagement fee is estimated to be more than $50 000, the insured amount will be ten times the estimated maximum engagement fee up to a maximum figure of $20 million for any one claim and in the aggregate 11
12
The following issues, therefore, need to be considered and each is dealt with separately:
Due care Negligence Privity of contract Causal relationship Contributory negligence Damages
13
Due care
The development of the concept of due care, as applied to the performance of an auditors duties, is considered by referring to cases decided in UK and Australian courts Consideration is also given to the relevance of the professions auditing and accounting standards
14
The auditor did not physically observe stock or attempt to verify the valuation of individual items Also, did not reconcile stock with the opening balance and purchases and sales during the year Finding The Kingston Cotton Mill case laid down some fundamental auditing principles such as the watchdog role and the notion of taking reasonable skill and care
16
17
The auditor made a full report to the directors in respect of the valuation of these loans and the need for a provision for bad debts against both the loan and the accrued interest However, in his report to the shareholders, the auditor merely qualified his opinion with the following sentence: The value of the assets as shown on the balance sheet is dependent upon realisation 18
Finding The duty of an auditor is to convey information, not to arouse enquiry Although an auditor might infer from an unusual statement that something was seriously wrong, it by no means follows that ordinary people would have their suspicions aroused by a similar statement
19
Implications of the Kingston Cotton Mill and the London and General Bank cases These two cases have formed the basis for most subsequent decisions as to the determination of auditor negligence The auditor is not necessarily answerable for an error of judgement, provided he or she exercises the skill and care of a reasonably competent and well-informed member of the profession
20
In Thomas Gerrard & Son Ltd (1967), the judge concluded that the standards of reasonable care and skill are, on the expert evidence, more exacting today than those which prevailed in 1896 (as in the Kingston Cotton Mill case)
21
The narrow interpretation of the Kingston Cotton Mill Co. case concerning some audit practice was finally laid to rest by the Pacific Acceptance case The Pacific Acceptance case showed the changing expectations in respect of the auditors responsibility, with the standards of reasonable care also being raised
22
23
Numerous auditing deficiencies were alleged, such as the assignment of inexperienced audit staff, lack of adequate supervision, excessive reliance on management representations instead of examination of documentary evidence Findings Reasonable skill and care calls for changed standards to meet changed conditions or changed understanding of dangers, and in this sense standards are more exacting today than in 1896 (Kingston Cotton Mill case)
24
Stanilite Pacific Ltd & Anor v. Seaton and Ors (2005) (trading as Price Waterhouse)
the judgement referred to an extension of the duty to exercise reasonable skill and care in giving consent for their report to be included in a prospectus
26
Negligence
Negligence has been defined as any conduct that is careless or unintentional in nature and entails a breach of any contractual duty or duty of care in tort (that is, to those who the auditor could reasonably foresee would rely on the auditors report), owed to another person or persons
27
If the auditor has been negligent, then the client may sue the auditor for breach of an implicit term of the contract to exercise reasonable care and skill, so as to recover any consequential loss suffered The client may also sue the auditor in the tort of negligence to obtain damages sufficient to restore the client to its original position
28
Subsequent to the Pacific Acceptance case, the Australian accounting bodies issued more comprehensive and specific auditing standards and practice statements concerning the conduct of the audit Disputes may still arise as to whether, in a specific engagement, an auditor has complied with the standards and thus has a good defence against an action for damages on the grounds of negligence
29
In the 1992 AWA case, for example, the court considered whether the auditor had complied with a paragraph in the standards that the auditor should make management aware on a timely basis of material weaknesses which have come to his/her attention
30
10
Auditors are now subject to an increasing amount of scrutiny by regulatory bodies such as ASIC For example, recent media releases by ASIC include:
On 28 April 2005, a Brisbane auditor was reprimanded by the Companies Auditors and Liquidators Disciplinary Board for failing to conduct an audit in compliance with Australian Auditing Standards
31
On 12 May 2005, a Sydney auditor was fined for breaching auditor independence provisions relating to charges of acting as auditor of a listed company while, at the same time, acting as the company secretary
32
Privity of contract
The term privity of contract refers to the contractual relationship that exists between two or more contracting parties An audit is assumed to be performed in accordance with professional standards unless the contract (engagement letter) contains specific wording to the contrary
33
11
Under contract, only the directors (on behalf of the company) or, more commonly, the liquidator or receiver, may sue the auditor in respect of losses incurred by the company arising from the auditors negligence
34
Causal relationship
A causal relationship exists between the breach of duty by the defendant and the loss or harm suffered by the plaintiff This relationship must have been reasonably foreseeable and it must be proven that the loss suffered is attributable to the negligent conduct of the auditor in a negligence case
35
12
Contributory negligence
Contributory negligence relates to the failure of the plaintiff to meet certain required standards of care Together with the defendants negligence, it contributes to bringing about the loss in question
37
AWA Ltd v. Daniels t/a Deloitte Haskins & Sells & Ors (1992)
The auditor was held to have been negligent in failing to warn the appropriate level of management and to implement follow-up actions to rectify internal control weaknesses, even though that was not the main purpose of the audit An important development, however, was that the company was held to be guilty of contributory negligence through not establishing adequate controls in the first place
38
The court accepted that the directors of AWA had a duty to establish a sound system of internal control to safeguard the companys assets Their failure to do so was held to be contributory negligence
39
13
Damages
Where auditors fail in their duty to act with reasonable care and skill, whether under contract or in tort, a plaintiff is entitled to recover any economic loss arising out of such a breach of duty Two issues need to be considered
Firstly, what is the purpose of statements that may give rise to reliance reasonably being placed on them? Secondly, to what extent may responsibility for any loss be assigned on the one hand to the auditors negligence and, on the other, to other 40 causes and other parties?
To illustrate, Cambridge Credit Corporation failed in 1974 and it was determined that the audit of the 1971 accounts had been negligently performed Had the auditors report been appropriately qualified, the amended view of the companys financial position would have required the trustee for the debenture holders to appoint a receiver It was alleged that the company, through the auditors negligence, was allowed to remain in business for a further 3 years, incurring further losses before a receiver was finally appointed in 1974
41
Damages were claimed in the amount of losses incurred by virtue of the company being liquidated in 1974 instead of 1971 However, the auditor appealed on the grounds that he could not have foreseen the economic downturn that caused the losses to reach the level they did
42
14
The Hedley Byrne case involved a bank, that supplied a reference without making a careful check of its records The verdict was in favour of the defendant on the grounds that the disclaimer of liability was a good defence, notwithstanding that a duty of care existed
44
15
Proximity is held to arise through the fact that where a companys financial condition is such that it is a likely takeover target, auditors should be aware that potential suitors will rely on the accounts and that a duty of care thus arises
46
A number of cases have addressed third party liability over the years and include the following:
Mutual Life and Citizens Assurance Co. Ltd v. Evatt (1968) Shaddock & Associates Pty Ltd v. Parramatta City Council (1981) JEB Fasteners Ltd v. Marks, Bloom & Co. (1981) Twomax Ltd v. Dickson, McFarlane & Robinson (1983) Caparo Industries Pty Ltd v. Dickman (1990)
47
The House of Lords in the Caparo case argued that the purpose of the financial statement on which auditors express an opinion is to assist the shareholders in their collective function of scrutinising the companys affairs It would be unreasonable, therefore, to hold the auditors responsible for their use, by shareholders or others, for any other purpose
48
16
There is concern that Caparo appears to reverse what is seen as a socially desirable development in law of holding experts liable for the consequences of negligent advice Post Caparo cases include:
Morgan Crucible Co. PLC (1991) Lowe Lippman Figdor & Franck (1992) Columbia Coffee & Tea case (1992) Esanda Finance Corporation (1994) Royal Bank of Scotland PLC (2002)
49
In Australia, the common law concerning the nature and extent of an auditors duty of care to third parties remains complex because judgements contain differences of judicial opinion and interpretation However, the judgement in the Esanda case was a positive development for auditors because the Court rejected the contention that liability could be based on foreseeability of reliance alone
50
The High Court found that there had to be circumstances establishing a relationship of proximity between the auditor and the third party before a duty of care could be said to exist
51
17
Avoidance of litigation
The following precautions may be taken by auditors wishing to avoid or minimise the consequences of litigation: Use engagement letters and investigate prospective clients thoroughly Comply fully with professional pronouncements Establish and maintain high standards of quality control and insurance cover
52
53
Investors can also make use of the Trade Practices Act (TPA) to take actions under common law for deceit and negligence Litigation under the TPA does not require the various factors of foreseeability and proximity as do cases under tort of negligence As all professionals are covered by competition laws, partnerships, audit companies or sole practitioners and their associations are subject to the competition provisions of the TPA
54
18
Consumer protection provisions include implied warranty provisions of Section 74 of the TPA that require a professional service to be rendered with due care and skill Section 87AB of the Trade Practices Act allows the professional standards legislation (PSL) referred to earlier to be applied to damages claims for misleading and deceptive conduct under Section 52 of the Trade Practices Act 1974 55
The PSL was part of the response of the Commonwealth and the States to curb large damages payouts and to ensure adequate protection is in place for those who rely on professional indemnity insurance cover The trade-off for consumers and the community in capping the liability of professionals is the implementation of statutory schemes that aim to improve professional standards
56
19