LECTURE 8 – AUDIT LIABLITY
The Legal Environment
Auditors liable for negligence and/or breach of contract if fail to provide services or not exercise ‘due care’
The responsibility of auditors to safeguard the public’s interest has increased as:
o The number of investors has increased
o The relationship between corporate managers and stockholders has become more impersonal
o The government increasingly relies on accounting information.
Auditor liability to clients and third party user groups developed from the following laws:
o Contract law: Liability from breach of contract. The origin of auditors responsibility. Client sued the
auditor for not properly performing an audit.
o Common or tort law: expansion of liability to third parties that rely on auditor reports concepts
developed through court decisions based on auditor negligence, gross negligence or fraud.
o Statute: Liability based on statutes, such as the, Trade Practices Act 1974,Crimes Act 1914, Queensland
Criminal Code 1899 and Corporations Act 2001.
Factors leading to increased litigation against auditors
More demanding audit standards for detection of errors and fraud.
User awareness of the possibilities and rewards of litigation.
Deep pockets: auditors have professional indemnity insurance and have been jointly and severally liable.
Recently changed to proportionate liability.
Increased audit complexity- computerised systems, new transactions and operations, more complicated
accounting standards, more international business.
Pressures to reduce audit time and improve audit efficiency.
Misunderstanding by users that an unqualified opinion is an insurance policy against misstatements
Auditors liable for others work
Class action lawsuits:
defendants combined into one legal action
To understand the potential liability, the auditor must understand:
o Concepts of breach of contract and tort
o Parties who may bring suit
o Legal precedence and statutes that may be used as a standard against which auditor performance may
o Auditor defences.
Reasonable Person Concept
Auditor not guarantor or insurer of financial statements
Auditor compliance with standards
Auditor compelled to exercise reasonable care and skill Causes of Legal Action
Causes of legal action from not using reasonable care and skill in completing an audit
o Breach of contract
Breach of contract occurs when auditor fails to perform a contractual duty.
Breach actions include
Failing to complete the engagement within the agreed-upon time
Withdrawing from the engagement without sufficient justification
Violating client confidentiality
Failing to provide professional quality work.
Parties to the contract can file suit.
Court remedies for a breach include:
Ordering auditors to fulfill the contract (specific performance)
Issuing an injunction to prohibit the auditor from continuing the breach
Ordering auditor to pay compensatory damages.
Auditor’s defenses include:
The auditor did not breach the contract.
The client was contributory negligent.
The client’s losses were not caused by the breach.
Auditor used due professional care & skill
o Negligence: failure to exercise a reasonable level of care that causes damage to another
Any conduct that is careless or unintentional in nature and entails a breach of any contractual
duty or duty of care in tort owed to another person or persons
Errors of judgment are not negligence.
o A/r confirmations were mailed by client not auditor
o Auditor failed to discover material misstatements in sales and A/R – unusual
increase in sales near year-end found but auditor failed to conduct further test
o Clients allowance for doubtful debts materially understated – auditor failed to
investigate audit work.
To recover damages through legal action for negligence, a plaintiff must generally prove four
Duty of care owed – reasonable person test
Breach of that duty
o Fraud: intentional concealment or misrepresentation of material facts that cause damages to those
Major Cases Involving Liability to Clients
London and General Bank Ltd 1895
o Interest on loans accrued but not received –
o BUT dividends pay out of profits
o Auditors made full report to Directors
o Qualified audit opinion to shareholders
o HELD Auditor had not fulfilled his duty to report the true state of affairs to shareholders
o Auditor did not guarantee; was not an insurer.
o Must be honest and use reasonable care and skill.
Kingston Cotton Mill Co 1896
o Manager KCM overstated inventory
o KCM unable to pay debts – true position revealed
o Auditor relied on certificate signed by manager & agreed to inventory in A/Cs
o HELD auditor not liable as doing stocktake not part of auditor’s job
o Auditor requires skill, care & caution – depending on circumstances
o The famous words: ‘…he is a watchdog not a bloodhound’.
o Auditors are not investigators; they only provide assurance. Australian Pacific Acceptance v Forsyth 1970 – important Australian case
o PAC advanced substantial loans to individual for joint venture
o Secured by mortgages on property – which were worthless
o Alleged intention to defraud company
o Claim against auditors – failure to discover fraudulent activities – negligence in conducting audit
o HELD – Auditor was liable – negligent in failing to confirm execution & registration loan documents
o Judgement set out auditors’ responsibilities. Auditors:
Must report and audit using due care and skill
Must promptly report fraud or warn of suspicion
Cannot avoid reporting in the pretext that some detriment would arise
Must audit the whole year, not just end-of-year balances
Must not consider fraud in isolation
Adequate planning of audit
Timing – interim work
Must consider the possibility of fraud in planning and carrying out an audit
Must not rely on the reputation of others; must carry out audit procedures
Must properly supervise and review work of inexperienced staff
Must document procedures in an audit program that must be amended to changed
Must understand internal control and test its operation using sufficiently competent audit staff.
Cambridge Credit Corporation Ltd