Legal Liability

Week 5

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The Legal Environment

Increased litigation, especially in the US. The effect of litigation on the profession. Limitation of auditors liability incorporation of audit firms. Joint and several liability v. proportionate liability.

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Key legal terms

Privity Breach of contract Tort Ordinary negligence Gross negligence Fraud Joint & several liability Proportionate liability
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Summary of types of actions

Types of Liability Accountant's Actions Resulting in Liability Common law Breach of contract, negligence, clients gross negligence, fraud Common law - third Negligence, gross negligence, parties fraud Civil Liability under Negligence, gross negligence, statutes fraud Criminal Liability Willful violation of statutes under statutes
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Breach of contract
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Auditors failure to complete the agreed services in the engagement letter. If client breaches its obligations, then auditor is excused from his contractual obligations. If auditor discontinues audit without adequate cause, may be liable for economic loss suffered by client. Other possible issues late audit report, failure to detect fraud
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Negligence proving it:

The accountant had a duty to the plaintiff to exercise due care, The accountant breached that duty by not following professional standards, The accountant's breach of due care was the proximate cause of the third party's injury, and The third party suffered an actual damage as a result.
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Duty of care
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Obligation to perform duties with skill & care required, under the circumstances What other professional accountants would have done, under the similar circs

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Privity

The traditional view held that auditors had no liability under common law to third parties who did not have privity with the auditor. Privity of contract means that the obligations that exist under a contract are between the original parties to the contract, and failure to perform with due care results in a breach of that duty only to those parties. The landmark decision in this area, Ultramares v. Touche (1931) auditor not liable to 3rd parties who relied on a negligently-prepared report
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Privity Various cases

Candler v. Crane Christmas & Co (1951) Judgement same as Ultramares, but the judge was of the view that accountants owed a duty of care to persons, other than their clients, whom they know would rely on their accounts Hedley Byrne v. Heller & Partners (1963) Duty of care owed, although no contractual relationship Haig v. Bamford (1976) Duty of care owed although identity of plaintiff not known to auditor

4-9

Privity Various cases (Contd.)

Scott Group v. McFarlane (1978) foreseeability JEB Fasteners v. Marks, Bloom & Co (1982) reasonable foreseeability Caparo v. Dickman (1990) privity rule reaffirmed McNaughton Paper Group v. Hicks Anderson (1991) R Lowe Lippman Figdor & Fank v. AGC (Advances) Ltd (1992) Esanda Finance v. Peat Marwick Hungerfords (1997) Rulings similar to Caparo case

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Breach of standard of care

Standard of care reasonably skill & care of another skilled person carrying out the same assignment But does not include a guarantee Watchdog not bloodhound Professional skepticism, not suspicion Over the years, the standard of care has evolved Physical stock observation Communication to client in instances of fraud are now part of standard auditing procedure.

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Duty to detect fraud

Usually considered by reviewing auditors approach to suspicious circumstances Re Kingston Cotton Mill auditors not responsible for detecting fraud schemes Thomas Gerrard, Revelstoke Credit Union v Miller & Berry (1985) auditors suspicion should have been aroused and fraud should have been detected Cenco, Inc v. Seidman & Seidman auditor has no duty to uncover fraud committed via collusion
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Causal relationship

Loss is the consequence of the breach of duty, must be reasonably foreseeable Reliance must have relied on the FS, casual perusal or awareness not enough If FS prepared for the purpose of an investment decision, and no other source of info available stronger reliance connection can be drawn JEB Fasteners plaintiffs loss not caused by auditors negligence Contributory negligence clients loss may not be entirely due to auditors negligence could be partly due to employee of client AWA Limited v. Deloitte Haskins & Sells (1992)
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Damages
Common claims loss of investment, overpayment of investment, loss due to fraud, overpayment of dividends Awards usually monetary, and usually puts the plaintiff in the same position had the negligence had not occurred No award if plaintiff has not suffered real measurable loss Scott Group v. McFarlane Overstatement of shareholders funds by NZ$38,000 Would not necessarily result in an overpayment for the acquired company hence no real damage was suffered

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Auditor liability for fraud

A false representation by the accountant, Knowledge or belief by the accountant that the representation was false, The accountant intended to induce the third party to rely on the false representations, The third party relied on the false representation, and The third party suffered damages.

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Statutory Liability
Companies Act 1965 Securities Commission Act 1993 Securities Commission (Amendment) Act 2000 s.57 negligence/misrepresentation in financial info in public issues s.153 right to civil proceedings by person/s suffering damage S.155 SC has power to take civil actions on behalf of investors who suffer loss

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Criminal liability
Companies Act 1965 s.174(8) must report to CCM if breach/non-compliance encountered in the course of audit S.132A insider trading is an offence

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Approaches to minimising legal liability at the professional level

Pushing for tort reform. Limitation of auditor liability, e.g. proportionate liability Establishing stronger auditing and attestation standards. Continually updating the Code on Professional Ethics and sanctioning members who do not comply with it. Educating users on expectation gap.

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Approaches for minimising legal liability at the firm level

Instituting sound quality control and review procedures. Ensuring that members of the firm are independent. Following sound client acceptance procedures. Being alert for risk factors that result in lawsuits. Diligently performing and documenting work.

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