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Lecture 8

Lecture 8 - Audit Liablity.docx

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Queensland University of Technology

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 (expectations gap).  Auditors liable for others work  Class action lawsuits:  defendants combined into one legal action  contingent-fee-based compensation Potential Liability  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 be evaluated 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.  Examples: 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 things:  Duty of care owed – reasonable person test  Breach of that duty  Causation  Actual damages. o Fraud: intentional concealment or misrepresentation of material facts that cause damages to those deceived. 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 circumstances  Must understand internal control and test its operation using sufficiently competent audit staff.  Cambridge Credit Corporation Ltd
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