AUD 610

TOPIC 2 Legal Liability

By:
Aida Hazlin Ismail
&
Kamaruzzaman Muhammad
Shah Alam

Topics to discuss

Areas to be cover
Liability under statutory law

Liability to clients (Directors of the company) Under

companies Act 1965
Duties to report breaches of laws under different acts

Liability under Common Law

Liability to clients. Due to breach of contract,

negligence and fraud
Liability to third parties (Shareholders, bankers,
government and investor). Due to negligence and
fraud

Introduction

Lawsuits against auditors relatively uncommon before the 1970s,

but not now auditors profession face greater exposure to legal
action, especially in US, Canada, U.K. and Australia.

In U.S., approximately 4,000 each year (in 1960s, only a few

hundred a year) claims against auditors. Example, as table below:Auditors

Company Audited

Settlement Amt
(USD)

EY

Cendant

335 million

Andersen

Waste Management

75 million

Andersen

Sunbean

110 million

PWC

Microstrategy

51 million

EY

Saving & Loan

400 million
Source: text book

Introduction Key Legal Terms

Privity A contractual/trust relationship, lack of privity means the

accountants may not owe a duty of care to an injured third party.

Breach of contract Occurs when the contracting parties fails to meet the
terms and obligation established in the contract. Example: Failure of a CA
to deliver a tax return on the agreed-upon date. Parties who have
relationship that is established by a contract are said to have privity of
contract.

Tort A wrongful act other than a breach of contract but not criminal
action and can held liable under the civil court. Example: Negligence and
Fraud.

Negligence means some act or omission which occurs because the

person concerned has failed to exercise that degree of professional care
and skill, appropriate to the circumstances of the case, which is expected
of accountants and auditors (ICAEW).

Ordinary negligence An absence of due care in the conduct of an

assignment. For auditors, in terms of what other auditors would have done
in the same situation.

Introduction Key Legal Terms

Due care - is evaluated in terms of what other professional

accountants would have done in similar circumstances.

Gross negligence An extreme departure from professional

standards of due care. Lack of even slight care, totally reckless that
can be expected of a person.

Fraud Actions taken with the knowledge and intent to deceive

(make someone believe on something not true) Example: auditors
has made false representation and the auditor has the knowledge
that the representation is false.

Third-party beneficiary A third party who does not have privity of

contract but is known to the contracting parties and intended to
have certain rights and benefits under the contract. E.g. Bank. The
company has a large outstanding loan and the bank requires
audited financial statement as parts of its loan agreement.

Introduction

Statutory Law: Written law enacted by the legislative arm of

the government that establish certain course of conduct that
must be adhered to by covered parties.

Example: Under the Companies Act 1965, the auditors are

liable to express their opinion on the financial statements of
the clients.

Auditors also has reporting duties under various other statues

such as under BAFIA, SCA and AMLA.

These duties require the auditor to report to the relevant

authorities violation of laws or regulations they encounter in
the course of performing their duties.

Introduction

Auditors can be sue by clients, shareholders, bankers investors,

creditors and government for failure to perform professional
services adequately. Auditors can be held liable under two classes
of law; i.e. common law and statutory law.

Common law: Case law developed over time by judges who

issues legal opinion when deciding a case. The legal principle
announced then become precedent for judges deciding similar
case in future. Under the common law: Auditor held liable to client: for breach of contract,
negligence and fraud.
Auditor held liable to third party: for negligence and fraud.

The outcome of application the common law for the third party
is subjective, inconsistent and sometimes depend on the
location where the case is tried.

Introduction Why??

Increase legal action against auditors, why??

Many accounting and legal professional believe that a major cause of

lawsuit against auditors is because lack of understanding by financial
statements user of the difference between a business failure and an
audit failure and between an audit failure and audit risk.

Business failure occur when business fail financially and as a result,

will be unable to pay its financial obligations and unable to meet the
expectations of its investors due to poor management, economic
conditions etc..

Audit failure occur when the auditor issues an erroneous audit

opinion as the result of failure to comply with the requirement of
auditing standards. E.g. Assigned unqualified staff to perform audit,
he unable to detect material misstatement that qualified auditors
would discover.

Audit risk is the risk that the auditor will conclude that the financial
statements are fairly stated and an unqualified opinion can therefore
be issued when in act they are materially misstated. This because
the auditors gather information on test basis

Introduction Why??

Increase legal action against auditors, why??

When there is a business failure due to unable to pay its debt, it

is common for the user of the financial statement to claim that
there was an audit failure, even if the audited financial
statements in actual fact is fairly stated and it was correctly
reported by the auditors.

The user argue, if the auditor perform their job with due care
the auditor should be able to detect misstatement and advise
their client accordingly. In other word, the auditors can prevent
the business to fail by implementing proper audit job.

This conflict we called Audit Expectation Gap.

Introduction Why??

Audit of Expectation Gap:

Is the difference that exists between what the public expects

of auditors and what the auditors believe their responsibilities
should be.

The users believe, unqualified audit opinion provides an

assurance that an entity is well managed, financially sound
and there is no fraud.

On the other hand, auditors argue that the user is lack an

understanding of the limitations of the financial reporting or
the auditors examination of the financial statements, i.e. base
on sample and materiality.

Introduction Why??

Audit of Expectation Gap:

Thus, the public has unreasonable expectations on the auditors and

financial statements.

However, the gap is also due to auditors inadequate performance.

This is due to either the auditor not performing up to the standard
OR the standards itself are not drawn up to the required
benchmark.

An understanding of the gap enables the profession to address the

relevant issues and maintain confidence of the users of the financial
statements in providing the services.

So, Component of audit expectation gap:

Unrealistic expectations on the part of users

Performance gap
By auditor to comply the standards
By standard to meet the need of users

Introduction Why??

Implications of Audit Expectation Gap:

Loss confidence on auditors

Audit report less reliable
Bad reputation of auditors
Increase of lawsuits

Action to be taken to narrow the gap

Expanded audit report (more explanation or disclaimer clause)

Increase public awareness and education in respect of the nature

of audit work and its inherent limitations

Educate client and audit committees

Educate client and public on the word reasonable assurance.

Due to inherent limitation, auditor unable to give absolute
assurance.

Introduction Why??

Action to be taken to narrow the gap

Influence public opinion and changing professional standards

to ensure an audit is designed to provide reasonable
assurance that materials errors, irregularities and
misstatement in the financial statement will be detected
(Example: developed good audit program to enable to detect
fraud).

Auditors strictly adhere to auditing standards.

Auditors should be more sensitive to possible existence of

fraud in every audit they conduct.

Introduction Why??/

In U.S., factors that contribute to the high incidence to lawsuit:

Evolution of the legal system: Professional Indemnity is
mandatory to auditor. The client who facing the business
failure or injured parties tend to get compensation from the
auditor as the auditor is covered with the large insurance
coverage. This so-called deep pocket syndrome.

The practice of contingency legal fees: no legal fee when the

case is lost and the fee will charged on the percentage of
damages awarded when the case is successful. Plaintiffs have
no risk of paying legal fee from their own pocket.

Jury system: members of public as a jury will apply laymans

standard in judging professional negligence and most in cases
the decision is favour to the injured parties.

Measures to reduce exposure to

lawsuits

At the profession level:

Research in auditing
Establish stronger auditing and assurance standards
Set requirement to protect auditor. E.g. developed a
sample of engagement letter and letter of representation
to be followed by all auditors
Establish peer review (auditing the auditors) requirement
Lobby for changes in the law to protect the auditors
Education of users to the meaning of auditors opinion and
scope of audit work
Continually updating the code on professional ethic and
sanction (official order to stopping trade) members for
improper conduct and performance

Measures to reduce exposure to

lawsuits

At the individual firm level

Deal only with clients possessing integrity and investigate

prospective clients thoroughly

Hire qualified personnel and train them properly

Follow the standards of the profession

Understand the clients business

Maintain independence

Perform high standard of quality audits

Documented the work properly

Obtain clear engagement letter and representation letter

Maintain confidential relations

Carry adequate insurance coverage

Alert to risk factors that may result in lawsuit

Exercise professional scepticism..

AUD 610
TOPIC 2 Legal Liability
LIABILITY OF AUDITORS:
UNDER THE STATUTORY LAW

Liability Under the Statue

Statutes in Malaysia: Company Act 1965 (CA), SCA 1993, BAFIA

1989 are intend to safeguard the interest of shareholders,
depositor, investor and public. Companies Act 1965 govern the
auditors in Malaysia of which auditor has specific duties and
responsibilities under the following sections:
Sec 9 Qualification as auditors

Sec 172 Appointment and remuneration of auditors

Sec 174 Power and duties of auditor

Besides the above provision, the liability of the auditor also came
from the legal reporting liabilities imposed under the various
statutes. The auditor has the duty to report but not to detect any
violation of law that came to the auditors attention during the
course of the audit.

Example

Companies Act 1965: Duty to report companys financial

statement (CA 1965) and become whistle blower, i.e. to
report a breach or non-compliance with any provision of the CA.

Liability Under the Statue

Example

Securities Industries Act 1983: (Governed the trading of

securities on the stock exchange). The auditors need to report
breach of securities law to authorities such as SC.

BAFIA 1989: (licensing and regulation of banking institution).

Any violation of BAFIA by the bankers, the auditor need to report
to the central bank (Bank Negara) immediately.

AMLA 2001: (dealing with law and penalties of money

laundering and measure for preventing such activities). AMLA
imposes a legal duty on a reporting institution including auditor
to report unlawful transaction to the Financial Intelligent Unit of
Bank Negara.

SCA 1993: (Establish SC as approving and registering body for

prospectus issued in connection with public securities offering).
The auditor is responsible to report non-compliance of the Act by
the company or borrower in the case of issuing debenture.

AUD 610
TOPIC 2 Legal Liability
LIABILITY OF AUDITORS:
UNDER THE COMMON LAW

Liability Under Common Law

Auditors has liability to clients and third parties under the common
law.
Liability to clients due to Breach of contract, Negligent and Fraud
Liability to third party due to Negligent and Fraud
Under the both liability, plaintiff must prove the following in order to
bring any legal action against the auditors:
Duty of care: The auditor owed a duty of due care to the plaintiff.
Extensively discussed with cases

Breach of duty of care: The auditor has failure to act in

accordance with due care. The standard of care is that of the
reasonable skill and care of another person carry in the same
assignment.

Casual relationship: There is casual relationship or connection

between the auditors negligence and the plaintiff damage.

Damage: The plaintiff suffered actual loss or damage.

Liability Under Common Law

Liability to clients (Due to Breach of contract, Negligent and

Fraud):

When the auditors accepts appointment, he actually enters

into a contract with client which then indirectly impose
certain obligation on him. These obligations may clearly
stated (express term) or unstated (implied terms) in the
contract:

Express terms: Provision stated in the contract (e.g.:

engagement letter) and these terms shall NOT override the
statutory law but they may be go beyond the statutory law.
Example: Clearly stated auditors responsibilities and client
responsibilities which are not stated in the Companies Act
1965 and also the deadlines.

Liability Under Common Law

- Liability to Clients

Implied terms: The terms which parties in concert have left

unstated because they consider too obvious to express.
Example: Auditors have a duty to exercise reasonable care,
work with reasonable expediency (with normally in the
engagement letter) and auditors have the right to reasonable
remuneration.

Under the common law, the auditor may liable to clients for
breach of contract, negligence and fraud.

Breach of contract for example, the auditors failure to

complete the job as stated in the engagement letter (the
duties, the fee and time line should be clearly stated in the
letter).

The auditor also is required to perform the professional service

with due care (same degree of skill, knowledge and judgment
with the other members of the profession).

AUD 610
TOPIC 2 Legal Liability
LIABILITY OF AUDITORS:
UNDER THE COMMON LAW TO THIRD
PARTY

Liability Under Common Law

Liability to Third Party (due to Negligence and Fraud)

As discussed above, plaintiff must prove the following:

Duty of care: The auditor owed a duty of due care to the
plaintiff. Extensively discussed with cases

Breach of duty of care: The auditor has failure to act in

accordance with due care. The standard of care is that of the
reasonable skill and care of another person carry in the same
assignment.
Casual relationship: There is casual relationship or connection
between the auditors negligence and the plaintiff damage.
Damage: The plaintiff suffered actual loss or damage.

Liability Under Common Law

Duty of Care to the third party:

The auditor under the law has
responsibility to perform his duty with skill and care required under the
circumstances.

Legal action by third party often involve allegation of

misrepresented financial statements and inaccurate audit
reporting. However, this area of liability is complex and court ruling
are always inconsistent. The main difficulty faced by the plaintiff is
to prove negligence of the auditors.
Until the 1960s, view under U.K. common law was that accountant
would not be held liable to a third party outside the contractual
relationship which is based on the doctrine of privity of contract.
Privity of contract means the obligation exist under the contract
are between the original parties to the contract and failure to
perform with due care results in a breach of contract only to those
parties.

The evolution of liability under

common law based on case (Duty of
care)

First landmark case: Ultramares v Touche. Et. Al (1931)

Fact of the case: The plaintiff (Ultramares Corporation) was

approached for a loan. The plaintiff asked the borrower to
provide the audited financial statement of which audited
by the defendant (Touche). The borrower were bankrupt
after obtained the loan from the plaintiff. The plaintiff
alleged that the auditor has been negligent in their report
for failing to detect or report deceptive accounting entries
that hide the borrowing companys problem.

Judgment: The auditors did not owe a duty of care to the

plaintiff due to not in contractual privity.
Explanation: In this case the court held that although the
auditor (Touche) was negligent, they were not liable to third
party (Ultramares) because Ultramares was not deemed to be
primary beneficiaries (i.e. a known third party was informed
before the audit)

The evolution of liability under

common law based on case (Duty of
care)

Case 1 : Chandler v Crane, Christmas and Co. (1951)

Fact of the case: The plaintiff (Mr Chandler) in this case was invest
in a company based on audited accounts of the company, which is
negligently prepared by the auditor. The company subsequently
became insolvent. Mr. Chandler sue the auditor and the auditors did
not deny their negligence in performing the audit and they also
aware that the account would be used by the plaintiff in investment
decision.

Judgment: It was held by the majority of the Court of Appeal in

England that in absence of a contractual relationship between the
parties, the auditor did not owe a duty of care to the plaintiff (Mr.
Chandler).

Why: view under the U.K. common law was that a professional
accountant would not be held liable to a party outside the
contractual or fiduciary relationship based on doctrine of privity of
contract.

Referring case: Ultramares V. Touche, et. Al (US 1931)

The evolution of liability under

common law based on case (Duty of
care)
Auditor-Crane
Christmas

Chandler
Shareholder

Prepare account
negligently

Company

Purchase share based on

the Accounts and suffer
losses
Judgment: The auditor did not owe duty of care in
the absence of a contractual relationship.

The evolution of liability under

common law based on case (Duty of
care)

The privity doctrine was again tested in another important

English case: Hedley Byrne v. Heller and Partner (U.K. 1963).

Case 2: Hedley Byrne vs Heller & Partners (1963)

Fact of the case: The case did not involve auditor but a
merchant bank, Heller & Partners, was approached by Hedley
Byrne, an advertising company for credit reference on a
potential client, Easipower Ltd., who was also a customer to
the bank. The reference was supplied by the bank without
making a careful check of the records. Based on this
reference, Hedley Byrne provided a credit to Easipower Ltd.,
which subsequently went into liquidation before the debt
were recovered by Hedley Bryne.

Hedley Bryne sue the bank and the bank denied

responsibility on the ground that it owed no duty of care to
the plaintiff in absence of contractual relationship. According
to privity doctrine, Chandler case and Ultramares case.

The evolution of liability under

common law based on case (Duty of
care)

Case 2: Hedley Byrne vs Heller & Partners (1963)

Judgment: House of Lord held that the bank owed a duty of care
to the plaintiff on the ground that the bank is responsible to
give information with due care once he knew or ought to have
known that Hedley will rely on its information to make credit
decision.

This judgment eroded the precedent ruled in the Ultramares

and the Chandler case and the privity standard is no longer
strictly used as a defense measure.

However, Heller & Partners escaped liability because it had

inserted a disclaimer of responsibility in the certificate of credit
references. On the strength of the disclaimer, the bank did not
have to pay any compensation to the plaintiff.

Example of disclaimer: We must emphasize that this report has

been prepared solely for your own records/information and no
responsibility nor warranty will be accepted by our firm to any
third party who may use this report for any purpose.

Hedley Byrne & Co v Heller and

partner (1963) -- Duty of care
Asked about companys
credit worthiness from
banker

Hedley ByrneAdvertising Agent

Provide
information
without proper
Banker - Heller
checking

Company
Want to be advertised in
media

Judgment: bank owed a duty of care to the plaintiff on the

ground that the bank is responsible to give information with due
care once he knew or ought to have known that Hedley will rely on
its information to make credit decision.

The evolution of liability under

common law based on case (Duty of
care)

Since the Hedley case, a number of court decision have

demonstrated the extension of auditors liability to third party
base on the Hedley principle.

As long as the auditor knew the identity of third party which would
rely on the audited account to make a decision, the courts are
more ready to establish the existence of a duty of care.

The evolution of liability under

common law based on case (Duty of
care)

Case 3: JEB Fasterners Ltd v. Marks, Bloom & Co (1981)

Fact of the case: JEB Fasteners Ltd was acquired the entire
shares of BG Fasterners which was facing liquidity problems.
Marks, Bloom & Co were the auditors of BG Fasterners Ltd.

In performing the audit of BG, the auditor did not verify the net
realizable value (NRV) of the inventory but accepted the
companys own figure of NRV. The accounting policies is
Inventory will be valued at lower of cost and NRV. In actual
fact that the cost of the inventory is far less than NRV and to
comply with an accounting standards, the amount of the
inventory is should be based on cost not based on NRV.

If inventory carried at cost, the company would shown

substantial loss instead a small profit as reported. The plaintiff
brought an action against auditors claiming that the account
negligently audited and they had rely on the audited account
when acquiring the companys shares.

The evolution of liability under

common law based on case (Duty of
care)

Case 3: JEB Fasterners Ltd v. Marks, Bloom & Co (1981)

Fact of the case (Continued):

The auditor contended that they did not owe a duty of care to
plaintiff and if a duty of care existed, it was only to persons
who made a specific request for information. In this case, JEB
Fasterners was not officially request for the information, they
just use the information available for public at large, i.e. the
audited accounts.

Judgment: The court held in favour of plaintiff on the ground

that the auditors knew at the time the accounts were prepared,
the company needed outside financial support and ought
reasonably to have foreseen that a take over was a solution to
financial problem faced by BG. The auditor owed the JEB
Fasterners a duty of care in the preparation of audited
accounts.

The evolution of liability under

common law based on case (Duty of
care)

Effect to profession: Make accounting profession more risky as

the court had broadened the auditors liability to the extent
that they could potentially owe a duty of care to almost anyone
who relying on their audit opinion.

JEB Fasteners vs Marks Bloom Duty

of care
Company
BG Fasteners
Aware co having
liquidity problems.
Prepare Account so
that co get financial
support from
outside

Auditor

By shares in
the company
based on
audited
account.
I

JEB Fasteners

Judgment: The auditors could have been liable to the third

party because he knew or ought to have reasonably
foreseen that the accounts, which he audited were to be
relied on upon for the purpose of making investment
decision.

Liability under Common Law Duty

of care

From the cases so far, a few terms that need further explanation.
Example ought reasonably to have foreseen in the JEB case.
Basically this is a type of relationship between plaintiff and the auditor
to be established by the court before enter the judgment for the case.

There are 4 types of relationship between plaintiffs and the auditor:

1.
Privity relationship as discussed above.
2.
Primary Beneficiary relationships
3.
Foreseen Party relationships
4.
Foreseeable party relationship

Privity relationship refers to the contractual relationship that exists

between two or more contracting parties. (i.e. the auditor and the
client)

Liability under Common Law Duty

of care

Primary Beneficiary relationships

Non-client could have this relationship. A known third party.

Auditor knows that the audit is specially for the identified third
party.

Example: Carried out due diligence review for a specific third party
to take over a company.

Hedley Bryne is a known third party to Heller & Partner

Foreseen Party relationships

Non client relationship. (In the case of JEB Fasterner)

Known to or reasonably expected to be known and rely on auditors

work in making decisions.

Foreseen party is a member of limited class of user whom auditor

is aware that they will rely on the financial statement and to be
treated the same as a known third party.

Example: a bank that has loans outstanding to a client may be a

foreseen user.

Liability under Common Law Duty

of care

Foreseeable party relationship

Users who are not specifically known to or identified to the

auditor. Often called an unlimited class of third party.

Reasonably be expected to see the auditors report and

financial statements. Example: Public or market who make
investment decision based audited accounts.

Explanation: Many courts allowed third parties whom having Primary

Beneficiary relationships and Foreseen Party relationships the right
to bring legal action against auditors, BUT not for the parties which
considered under foreseeable party relationship.

In other word, third party such like potential buyer of the company
(who asked the auditor to perform due d), bankers and creditors as
at balance sheet date are the parties who have right to take action.
Potential shareholders, creditors and bankers is foreseeable party of
which does not have legal right to take action against auditors.

This called Test of Proximity. i.e. testing to identify the primary and
foreseen relationship.

The evolution of liability under

common law based on case Duty of
care

Case 4: Caparo Industries Pty Ltd v. Dickman & Others

(1990)

The fact of the case: In 1984, relying on the audited

account, Caparo purchased Fidelity plc shares in the open
market on staged basis until finally acquired control of the
Fidelity. The audited accounts of Fidelity showed a profit of
1.2m. After take over, Caparo discovered that the result
would have been a loss of 400,000. Caparo alleged that
the auditor had been negligent in auditing the account.

The main issue here whether the auditor owed a duty of

care to the plaintiff.

The evolution of liability under

common law based on case Duty of
care

Case 4: Caparo Industries Pty Ltd v. Dickman & Others (1990)

Judgment: House of Lord (reversing the Court of Appeal). The decision

gave substantial comfort to the auditing profession as it held that:1. the auditor owed no duty of care to the potential investors

making investment decision on the strength of audited accounts.

2. Duty of care should only to the intended recipient of the auditors

report, i.e. primary beneficial third party and foreseen third party
(Proximity relationship) where the account were prepared
specifically for a third party for a particular purpose and the
intention was made clear to the auditor at the time of the audit
engagement.

The Caparo decision seems to reaffirm the privity rule in the earlier
Ultramares and Candler case where individual shareholders,
prospective investors, lenders or other third parties who suffer
financial loss by relying on negligently audited account would have
no claims against the auditor.

The evolution of liability under

common law based on case Duty of
care

Case 5: Royal Bank of Scotland v. Bannerman Johnston Mc

Clay and Others (2002)
Fact of the case: This case has an impact on the auditors
report in Malaysia. The plaintiff (Royal Bank) claimed on
misleading audited account in disburse loans and investing in
equity of a company that had to go into receivership. As a
result, the plaintiff suffered loss and sue the auditors.
Judgment: The Scottish Court, in reference to the Caparo case,
held that when the auditors did not stated the disclaimer
statement in the auditor report and did not disclaim their
responsibility, they could be held owing a duty of care to a
third party if they knew (or ought to have known) that the
third party would rely on the audited account for lending or
investment decision.

The evolution of liability under

common law based on case Duty of
care

Case 5: Royal Bank of Scotland v. Bannerman Johnston Mc

Clay and Others (2002)
Effect to profession: Modification on the audit report to
include the following clause:
It is our responsible to form an independent opinion, based
on our audit, on the financial statements and to report to you
as a body in accordance with Section 174 of the Companies
Act 1965 and for no other purpose. We do not assume
responsibility to any other person for the content of this
report.
This statement serve as disclaimer statement for the auditor,
i.e. the responsible of the auditor is to report the accounts to
the shareholders as a body as required by CA 1965 and the
auditor do not accept any other responsible.

Summary of Cases for Duty of Care

Case

Summary of the case

Judgment

Ultramar
es(1931)

Plaintiff was approached for a loan by a

company which went bankrupt after
receiving loan.

Auditors
Privity
Doctrine

Chandler
(1951)

Plaintiff invest in a company which became

insolvent. Investment made based on the
audited account

Auditors
Privity
Doctrine

Hedley
(1963)

Plaintiff asking the bank (Heller & Partner)

about the credit worthiness of a client
which went into liquidation subsequently.
Certificate given by bank without proper
checking on the record.

Plaintiff but
auditors
escaped due
to disclaimer
sttmt

JEB
Fastener
(1982)

Plaintiff take over a company which having

a financial difficulties. The financial
statement was negligently prepared (show
small profit instead of substantial loss).

Plaintiff
Auditor
should know
account to be
used by 3rd

Summary of Cases for Duty of Care

Case

Summary of the case

Judgment

Caparo
(1990)

Plaintiff take over a company shares on

stages until having control in the company
based on financial statement which shown
profit Rm1.2 whereas in actual fact it
should loss RM400k.

Auditors no
duty of care
to
unidentified
party
(Doctrine of
proximity)

Royal
Bank of
Scotland
(2005)

Plaintiff give a loan and invest in a

company which go into receivership
subsequently. Investment made based on
the audited account

Plaintiff
Absent of
disclaimer
Statement

The evolution of liability under

common law based on case

Significant to the profession: Based on example cases above, lawsuit

exercise against auditors has give significant changes in the
profession in particular:

Many find judgment in caparo case difficult to accept raises

questions about the role of the auditor and the value of the
auditors service.
New audit standard were developed from time to time
Auditors are encourage to obtain clear engagement letter
Clarified the certain concept so that more clear. Example concept
of contributory negligence: Relates to the failure of the plaintiff to
meet certain required standards of care that also contributed to
the negligence such as the directors fail to establish a sound
internal control to safeguard the companys assets.
Rise on litigation cost and the cost of professional liability
insurance and become the second largest cost after the cost of
human resources for the auditing profession.

Liability Under Common Law

The plaintiff also must prove the following:

Breach of duty of care: Second condition in a tort negligence is
to establish by the plaintiff that the auditor has failure to act
in accordance with due care.

The standard of care is that of the reasonable skill and care of

another person carrying the same assignment. Under common
law, an auditor has the duty to perform an audit using the
same degree of care that would be used by an ordinary,
prudent member of the public accounting profession.

Liability Under Common Law (Breach

of Duty of Care)

Two classic statement have often been referred to in defining

the auditors responsibility to perform with due care:-

First statement by Lindley LJ in Re London and General Bank

(1895):
An auditor is not bound to do more than exercise reasonable
care and skill in making inquiries and investigations.

He is not an insurer, he does not guarantee that the books do

correctly show the financial position BUT auditor must be
honest, not certify what he does not believe to be true and he
must take reasonable care and skill before he believes that
what he certifies is true.

Where suspicion is arose, more care is necessary. In absent of

the above, auditor may be said as breach of duty of care.

Liability Under Common Law (Breach

of duty of care)

Second statement is by Lopez LJ in Re Kingston Cotton Mill

(1896):
the auditor had relied on a managers certificate as the basis
for ascertaining the amount of inventory stated in balance
sheet. As a result the inventory is misstated and inflate the
profit (at that time stock take is not normal auditing practice).
The judge conceded that it was not the auditors duty to take
stock and that he must rely on some skilled person to record
the proper value of stock.
However, to respond to the auditors responsibility relating to
detecting fraud, the judge stated that it is auditors duty to
perform with reasonable skill, care, competent, careful and
caution of which depend on particular circumstances of each
case but he is not bound to detect the fraud.

Conclusion: Reasonable skill and care is not static concept. The

standard of reasonable care will go inline with current expectation.

Liability Under Common Law

(Causal Relationship)

The plaintiff also must prove the following:

Causal Relationship: Third condition in a tort negligence is the proof
of connection between the plaintiff loss and the act of negligence.

The plaintiff must demonstrate that the loss is the consequence of

the breach in the duty of care and at the time the breach was
committed, the loss was reasonable foreseeable as a consequence.

Example: To proof of connection between auditors failure to detect

(not carry more care when suspicion arose) a fraud and the loss
(damage) arising from the fraud.

Plaintiff has to proof that if the audit had been carried out
competently, the auditor can detect the weakness of internal
control and able to prevent the fraud and accordingly the loss from
the fraud can be avoided.

Liability Under Common Law (Causal

Relationship)

The plaintiff also must prove the following:

Causal Relationship: Example Legal Case: Galoo Ltd Vs Bright
Graham (1994). The plaintiff claimed the auditor were liable
for its trading losses for a number of years during the audited
account materially misstated. Plaintiff alleged that if the
financial position was known earlier, the entity may
discontinued its business operations, thus avoiding the huge
trading losses.

Court: Causal relationship not exist, because an entity

operations decision and result depend on many factors such as
management and market forces. Accordingly, the plaintiff
claims against the auditor was denied.

In the case of Haig Vs Bamford, the plaintiff was able to

satisfy the court on the issue of relationship by showing that he
had discussed the account with bankers and auditor regarding
the intention of the investment.

Liability Under Common Law

(Damages)

The plaintiff also must prove the following:

Damages: The forth element in the tort of negligent is the
proof the plaintiff suffered actual loss or damage.

Type of damages are loss of investment, overpayment for

investment, loss due to defalcation by management or
employee and overpayment of dividends.

The measurement of damages is dependent on the

circumstances and the courts typically attempt to
approximate monetary equivalents that the plaintiff will get if
the auditors discharged his duties properly. Award of damages
would not be granted if the plaintiff had not suffered real or
measurable loss.

AUD 610
TOPIC 2 Legal Liability
AUDITORS DEFENSE MEASURES
AGAINST LEGAL ACTION :
BY CLIENT
BY THIRD PARTY

Auditors Defenses Against Legal

Action

Legal Action by Client: Defenses Measures by Auditors:

Lack of duty to perform: Auditors would claims that there was no

implied or express contract. E.g. The misstatement due to fraud
was not uncovered because the obligation of prevent fraud is on
the management, not on the auditors. Must clearly stated in the
engagement letter.

Non negligent performance: auditors would claims that the audit

was performed in accordance with auditing standards.

Absence of causal connection: The succeed client need to prove

that the damaged suffered by them mainly due to auditors
negligence. E.g. client alleges that the bank not granted the
bank facilities to the company due to the auditor unable to
complete the audit on the agreed-upon time, which cause
damages to the company. The auditor may defence is that the
bank refuse to give the loan for other reason such as weakening
financial condition of the company. This defense is called an
absence of causal connection.

Auditors Defenses Against Legal

Action

Legal Action by Client: Defenses Measures by Auditors:

Contributory negligence: Auditors would claims that the clients

own actions and interfering were resulted in the loss that is rge
basis for damages. E.g. Client have to pay penalty for late filling of
tax return due to auditor unable to complete the job on time. The
auditors defense is that the audit job unable to complete within the
time due to lack of corporation from the management in providing
appropriate audit evidence and explanation.

Legal Action by Third Parties: Defenses Measures by Auditors

The first three defenses measures above also available in third

parties lawsuit. Contributory negligence is not available because
the third parties are not contribute to misstated of financial
statement.

The most preferred defense measure could be Non Negligent

Performance. The auditors had perform the job according to
auditing standards. The other defenses measures: Lack of duty to
perform (lack of privity of contract) and lack of causal connection

END OF TOPIC 2

EXAMPLE QUESTIONS
QUESTION 1
Range Bhd. went into receivership in 2004 after incurring a deficiency in
shareholders funds over RM117 million. The deficit was mainly due to
trading losses in the past 5 years and the writing off in 2000 of some nonexistent investments and receivables. The liquidator of Range Bhd. is now
suing the former auditor of the company for the breach of contract and
negligence. The auditors conceded that they had not carried out adequate
procedures to verify the investments and receivables and had relied
mainly on the Chief Executives written representations and assurance.
However, the auditors claimed that they are not liable for the loss because
the loss was not caused by their negligence.
Required:
How can the liquidators of Range Bhd. establish that the auditors
negligence has resulted in the loss of the company?
(6 marks)

EXAMPLE QUESTIONS
QUESTION 2
Negligence on the part of the auditor could be so willful so as to
constitute a conspiracy with management to defraud the company or
other parties. The auditors could be brought to court on criminal fraud
charges, (Gill, G.S. & Cosserat, G.W.,2000).
Required:
a) What elements must a plaintiff prove to be successful in action against
an auditor for negligence? (4 marks)
b) What is the significance of the Caparo case with respect to auditors
liability to a third party? (4 marks)
c) Identify steps that can be taken at the professional and individual level
to minimise legal liability against the auditors.
(6 marks)

EXAMPLE QUESTIONS
QUESTION 3
Halim & Co has been the auditor of Berkat Bhd., a public listed company
for several years. Halim & Co issued an unqualified audit report on the
financial statements for the year ended 30 June 2006. Halim & Co did not
detect a material misstatement in the financial statements as a result of
negligence in the conduct of the audit. Based on the audited financial
statements, Fortune Bhd purchase substantial amount of shares in Berkat
Bhd which subsequently has a drastic downturn. Berkat was place under
receivership and Fortune Bhd began proceeding against Halim & Co for
damages caused by his negligence.
Required:
a) Discuss the factors which might substantiate Halim & Cos liability
towards Fortune Bhd. Support your answer with relevant cases. (9 marks)
b) State, if any, Halim & Cos defences against the action. (3 marks)

SUGGESTED ANSWER
ANSWER 1
To establish that the auditors negligence has caused the loss of
the company, liquidators of Range Bhd. can claim that if the
auditor had performed their work with due care, the company
would have caused a receiver to be appointed earlier, instead of
carrying on the business until 2004. It can claim that the
overstatement in investments and receivables had presented a
very misleading picture of the true financial position of the
company. If the company has appointed a receiver earlier, the
company would have avoided the subsequent trading losses and
the increase in the deficiency in the shareholders funds can also
be avoided.
6 marks

SUGGESTED ANSWER
ANSWER 2a
Element must a plaintiff prove to be successful in action against
an auditor:1. Duty of care: The auditor owed a duty of due care to the
plaintiff.
2. Breach of duty of care: The auditor has failure to act in
accordance with due care. The standard of care is that of the
reasonable skill and care of another person carry in the same
assignment.
3. Casual relationship: There is casual relationship or connection
between the auditors negligence and the plaintiff damage.
4. Damage: The plaintiff suffered actual loss or damage.
4 marks

SUGGESTED ANSWER
ANSWER 2b
The Caparo case seems to be a reversal of the principle found in
cases such as Hedley Byrne, Haig v. Bamford, and JEB Fasteners.
In the case, it was stated that the purpose of statutory accounts
was for the company and the shareholders and not to assist
investors making investment decisions. Accordingly, the auditors
do not owe a duty of care to investors making investment
decisions on the strength of auditor accounts. It was held in the
case that it was unreasonable to establish a relationship of
proximity between the auditors and the third party who was not
intended recipient of the auditors report.
4 marks

SUGGESTED ANSWER
ANSWER 2c
The following steps can be taken to minimize legal liability
against auditors:
1. Establishing stronger auditing and assurance standards
2. Continually updating the code of professional conduct on ethics
and sanctioning members who do not comply with it
3. Educating users
4. Instituting sound quality control and review procedures
5. Ensuring that members of the firm are independent
6. Following sound client acceptance and retention procedures
7. Being alert for risk factors that may result in lawsuits
8. Performing and documenting work diligently
9. Pushing for tort reform

SUGGESTED ANSWER
ANSWER 3a
Factors that might substantiate Halim & Cos liability to Fortune
Bhd are:1. Duty of care: The auditor owed a duty of due care to the
plaintiff.
2. Breach of duty of care: The auditor has failure to act in
accordance with due care. The standard of care is that of the
reasonable skill and care of another person carry in the same
assignment.
3. Casual relationship: There is casual relationship or connection
between the auditors negligence and the plaintiff damage.
4. Damage: The plaintiff suffered actual loss or damage.

SUGGESTED ANSWER
ANSWER 3a
Court held for the following cases are in favour of Plaintiff:Case

Summary of the case

Judgment

Hedley
(1963)

Plaintiff asking the bank (Heller &

Partner) about the credit worthiness of a
client which went into liquidation
subsequently. Certificate given by bank
without proper checking on the record.

Plaintiff but
auditors
escaped due
to disclaimer
sttmt

JEB
Fastener
(1982)

Plaintiff take over a company which

having a financial difficulties. The
financial statement was negligently
prepared (show small profit instead of
substantial loss).

Plaintiff
Auditor
should know
account to
be used by
3rd party

SUGGESTED ANSWER
ANSWER 3a
Whereas in the following cases, court held are in favour of
auditor:Case

Summary of the case

Judgment

Ultramares Plaintiff was approached for a loan by a

(1931)
company which went bankrupt after
receiving loan.

Auditors
Privity
Doctrine

Chandler
(1951)

Auditors
Privity
Doctrine

Plaintiff invest in a company which

became insolvent. Investment made
based on the audited account

SUGGESTED ANSWER
ANSWER 3b
Halim & Co defenses measures include:1. That there is no duty of care to Fortune Bhd. Audited account is
for shareholders NOT for investment decision making.
2. No proximity relationship as his liability towards Fortune Bhd
would mean that the auditor is exposed to liability in an
indeterminable amount for an indeterminate time to an
indeterminate class of person, under Caparo case
3. Halim & Co has carried audit due care and diligence. Not
breach duty of care..
4. Contributory negligence by the Berkat Bhd.