1. Topic 3 Legal Environment
Since many students are interested in a career in public accounting, we normally spend some time covering the items in this section. In particular, we like to go over the status of auditing as a profession and the role of government and professional associations in the auditing and assurance services environment.
You should outline the learning objectives for this chapter, and also walk them through how this chapter fits into the flowchart of the overall auditing and assurance framework.

2. Learning objectives
define negligence and indicate the elements which need to be proved for a claim to be successful;
explain the concept of ‘due care’ including auditor’s duties in regard to the prevention, detection and reporting of irregularities;
explain the auditor’s legal liability to clients;
describe the concept of contributory negligence;
evaluate the extent to which a duty of care may be owed to third parties;
demonstrate an understanding of the interrelationship between the auditing standards and case law; and
describe alternative proposals to limit auditors’ liability. .

3. Regulation of auditing and of the subject matter of audits
Figure 2.2 Professional and statutory regulation of auditing
To help students gain a deeper understanding of assurance, this section looks at the structure of assurance standards and pronouncements. The slides provide a diagrammatic depiction of the structure of assurance standards and pronouncements in Australia and internationally, which can be found on page 8 of the textbook.
This section also reviews the two different types of assurance: reasonable assurance engagements (an audit) and limited assurance engagements (a review). This synopsis of audits and reviews will be useful for students to compare and contrast.
Additionally, this section outlines the difference between attest and direct reporting.

4. Registered company auditor (RCA)
In order to be appointed as a company auditor under s 1280 of the Corporations Act 2001, a person must:
be ordinarily resident in Australia
be a member of an approved accounting body
be a graduate of a prescribed university or other prescribed institution in Australia, and have passed a course in accounting and commercial law acceptable to ASIC
have sufficient auditing experience
be a fit and proper person.
Auditors are required to fill out a logbook to demonstrate on-the-job experience and have this certified by a current RCA.

5. Internationalisation of auditing
Increased international trade has contributed to the development of international auditing practices.
Multinational organisations wish to ensure the quality of financial information from subsidiaries and related entities.
The International Organization of Securities Commissions (IOSCO) (including SEC in the USA and ASIC in Australia) supports the harmonisation of international auditing standards.
Most countries consider International Standards on Auditing (ISAs) carefully when developing their own standards Continued
Business is now conducted globally and this has contributed to the development of international auditing practices. Introducing students to the importance of the global environment at this early stage prepares them for considering this aspect of client business risk later on.

6. Internationalisation of auditing (continued)
Key groups:
International Federation of Accountants (IFAC): guides efforts to develop technical (accounting and auditing) and ethical standards. Members include 179 accounting bodies (including ICAA, CPA Australia and the IPA) in 130 countries.
International Auditing and Assurance Standards Board (IAASB): an independent body supported by IFAC that develops standards and guidance for audit and assurance services Continued

7. Internationalisation of auditing: Key groups (continued)
Transnational Auditors Committee (TAC): executive committee of the Forum of Firms (FOF) that performs auditing across national boundaries. In 2014 there were 25 full members (international auditing firms) and one affiliate member. Subject to FOF standards and global peer review.
International Forum of Independent Audit Regulators (IFIAR). Independent regulators including ASIC in Australia and PCAOB in USA. In 2014 there were 50 members. Shares information and undertakes inspections of audit firms.

8. Profile of the auditing profession and of audit firms
There are three primary professional accounting organisations in Australia:
Chartered Accountants Australia and New Zealand
CPA Australia
The Institute of Public Accountants (IPA).
Membership of these bodies by public accounting practitioners is voluntary.
However, membership of one of these bodies is necessary in order to become a registered company auditor.
We review the three key professional accounting bodies that dominate the auditing profession in Australia. We then briefly review the structure of firms (e.g. sole trader, partnership or authorised audit company), the categorisation of firms (e.g. Big Four, national firms, regional firms and local firms) and the types of services (e.g. audit, tax, management consulting, internal audit, accounting and insolvency services) that are offered by public accounting firms. Also, students are interested in the internal structure of an audit firm.

9. Audit firms There are three levels of audit firms in Australia:
international (including the Big Four and other firms that are members of Forum of Firms)
national firms
regional or local firms.
The largest international firms are known as the 'Big Four'. They are:
PricewaterhouseCoopers EY
KPMG
Deloitte
The Big Four dominate the practice of public accounting, especially for large listed clients.

10. Quality control
Quality controls (QCs) are implemented at both the audit firm level and at the audit engagement level.
ASA 220 (ISA 220) requires the audit engagement team to implement QC procedures.
ASQC 1 and APES 320 (ISQC 1) requires the audit firm to implement QCs.
ASA 220 (ISA 220) acknowledges that the engagement team may rely on the audit firm’s system of QC.
Students should be made aware at this stage that quality control procedures are essential to ensure auditors meet their responsibilities. We discuss the overall requirements of ASA 220 (ISA 220), ASQC 1 (ISQC1) and APES 320 and the key quality control procedures used by the professional accounting bodies, including practice reviews and professional development.

11. APESB standards Two APESB standards relate to QC.
APES 210 establishes auditors’ responsibilities in relation to compliance with Australian auditing and assurance standards.
APES 320 establishes basic principles and essential procedures and provides guidance concerning the firm’s responsibilities for its system of quality control.
The AUASB issued ASQC 1,(based on ISQC 1), with similar requirements to APES 320. ASQC 1 applies only to firms undertaking assurance engagements, whereas APES 320 applies to all accounting firms and all parts of the practice.

12. Other quality control procedures
Other key quality control procedures employed include:
Internal review (engagement quality control review)—auditor subject to review by another partner in the practice
Periodical rotation of auditors (partners and staff) to limit length of time spent on one client
Peer reviews—independent periodic review by another firm of public accountants
Continuing professional development requirements.

13. Reasonable care and skill, and negligence
An auditor has a duty to exercise the reasonable care and skill expected of a professional.
Requires adherence to regulatory and professional standards in all aspects of an audit.
‘The professional man owes a duty to exercise that standard of skill and care appropriate to his professional status’ (Caparo, 1990).
When discussing the concept of reasonable care and skill we use the quote from Lord Bridge in the Caparo case.

14. Negligence
Negligence can be 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 owed to another person or persons’.
When discussing the auditor’s liability under common law for negligence, we discuss the elements for establishing auditor liability for negligence: (1) the duty to conform to a required standard of care; (2) failure to act in accordance with that duty; (3) actual loss or damage to client; and (4) a causal connection between the auditor’s negligence and the client’s damage.

15. Claims for Negligence
To be successful in a claim for negligence, a plaintiff must prove that:
duty was owed to the plaintiff by the defendant (duty of care)
a breach of the duty of care (negligent conduct) occurred
loss or damage was suffered by the plaintiff
a causal relationship existed between the breach of duty by the defendant and the harm suffered by the plaintiff.

16. Liability to clients
Liability to clients arises both in contract and in the tort of negligence. Key cases include:
London & General Bank Ltd (1895)
Kingston Cotton Mill (1896)
Thomas Gerrard & Son (1967)
Pacific Acceptance (1970)
Kirby v Centro Properties (2012)
We point out that the auditor’s liability for breach of contract arises from the obligations included in the engagement letter. It is important that students realise that an auditor’s liability to clients can arise both in contract and in the tort of negligence. We discuss the main cases that have led to the development of the auditor’s liability to clients. Particular emphasis is placed on the Pacific Acceptance case, as this was the first time the court gave a decided indication of what was expected under reasonable care and skill.
We also discuss the development of the concept of contributory negligence here.

17. Pacific Acceptance (1970)
Auditors’ duties and responsibilities are to:
use reasonable care and skill
check and see for themselves
audit the whole year
appropriately supervise and review work of inexperienced staff
properly document procedures
rely on satisfactory internal controls
warn and inform the appropriate level of management
take further action where suspicion is aroused
structure plans and procedures so that discovery of material error or fraud is reasonably expected
be guided by professional standards (but not determinative).

18. Liability to third parties
A number of cases have considered the auditor’s liability in relation to persons other than the immediate client.
It was believed from early cases (e.g. Donoghue v Stevenson (1932)) that the recovery of losses by third parties from auditors for negligence (in the absence of fraud) was not possible.
Continued
It is important for students to know that auditor liability to third parties for negligence is very complex and court rulings are not always consistent. We believe it is important for students to be aware of the history of the development of the current position regarding auditors’ liability to third parties. Therefore, we go through some of the major cases, beginning with Donoghue and Stevenson through to Esanda, and discuss the concepts of special relationship, reasonable foreseeability and proximity. The amount of time spent here will depend on how much of this material students have already covered in business law subjects.

19. Liability to third parties (continued)
Early test: special relationship
A duty is owed to any third party to whom the auditor shows accounts or to whom the auditor knows the client is going to show accounts, so as to induce some action.
Candler (1951) (per dissenting judgement of Lord Denning)
Hedley Byrne (1963)
Continued

20. Liability to third parties (continued)
Next test: reasonable foreseeability
A duty is owed to a specific third party of whom the auditor was not aware, but who was part of a class of persons who they should have been aware would rely on their audit opinion.
Scott Group (1978)
Continued

21. Liability to third parties (continued)
Current test: proximity
Was there a sufficient degree of proximity between the auditor and third party? To answer this question, courts examine whether the report by the auditor was meant to induce the third party to undertake specific actions.
Caparo (1990)
R. Lowe Lippmann Figdor & Franck v AGC (1992)
Columbia Coffee (1992) (very wide interpretation, later overturned in Esanda)
Esanda (1997)

22. Summary of situation: liability to third parties
A general conclusion is that it would be hard to show that audits on general purpose financial reports were ever intended to induce third parties to undertake a specific course of action. (Auditors would strongly argue that this was never the intention.)

23. Privity letters
A privity letter is a letter from the auditor acknowledging a third party’s reliance on an audited report. The third party requests the privity letter from auditor.
Purpose: to establish a relationship with the requisite foreseeability and proximity and thereby establish a duty of care by the auditor to the third party.
We also point out to students that legal decisions have resulted in third-party requests for privity letters.

24. Liability to third parties: Competition and Consumer Act 2010
Consideration needs to be given to the provisions of the Commonwealth Competition and Consumer Act and relevant state Fair Trading Acts:
Acts prohibit misleading and deceptive conduct.
It is possible that, in issuing an inappropriate auditor’s report, an auditor might be guilty of conduct that is misleading or deceptive.
Students should also be made aware of the fact that although the auditor’s liability to third parties under the tort of negligence now seems very narrow and limited to situations where the auditor induced the third party to rely on the auditor’s report, the auditor may also have a potential liability under the Commonwealth Competition and Consumer Act 2010 or the relevant State Fair Trading Act and under the ASIC Act.

25. Limitation of liability
Prior to CLERP 9, audit firms were required to operate as sole traders or in partnerships—still the dominant form of organisation for audit firms.
Therefore, auditors are personally liable for damages arising from failure by either themselves or their partners to exercise reasonable skill and care.
Spiralling litigation costs and court-awarded damages.
Professional indemnity insurance is difficult to obtain and prohibitively expensive (claimed to be about 14% of audit revenues).
We find that a useful way of introducing this topic is to refer to the substantial litigation against auditors over the past fifteen years or so and refer to the claims made in cases in Australia, such as Tricontinental and the State Bank of South Australia, of the problems of operating as a partnership and of obtaining satisfactory professional indemnity insurance.
We then discuss the arguments for and against limiting the auditor’s liability and the different schemes introduced through CLERP 9.

26. Changes to auditor liability
Changes to the Corporations Act 2001 as a result of CLERP 9 allow:
Introduction of Professional Standards legislation to provide a statutory cap to auditor's liability
Auditors to incorporate and form authorised audit companies with adequate and appropriate professional indemnity insurance
Apportionment between the plaintiff and defendant according to blame, and proportionate liability if there are two or more defendants. (Note: Centro lawsuit was settled May 2012 for $200 million, with PwC’s share being $67 million, but no admission of liability.)

27. Summary Auditing profession regulates itself through:
the regulatory environment dominated by the Corporations Act 2001, the AUASB and ASIC , with the accounting bodies (CPA Australia, Chartered Accountants ANZ and IPA) contributing to regulation
the effect of globalisation of business and the need for the internationalisation of auditing. IFAC, IOSCO and IFIAR have major roles to play in the internationalisation process Continued
We provide a summary slide of the main learning takeaways in this chapter.

28. Summary (continued)
Self-regulation is enhanced by the accounting bodies’ ability to enforce their requirements on members. Structure of the auditing profession is dominated by the Big Four international audit firms.
Auditors are facing an ever-increasing amount of litigation.
Unlimited liability of auditors has now been removed through statutory cap, incorporation of auditors and removal of joint and several liability.