1. Topic 2: Ethical decision making and the legal liability of auditors -

2. Topic learning outcomes
Explain the concept of reasonable care and skill and define negligence and assess their impact on an auditor’s legal liability to clients
Describe the concept of contributory negligence
Indicate to what extent a duty of care may be owed to third parties
2.1
2.2
2.3
2.4
Analyse the arguments for and against limiting liability
Apply the ethical rulings of the accounting bodies using ethical decision-making
techniques
2.5 1

3. Topic 2: Legal liability of auditors and ethical decision making Outcomes 2.1 & 2.2

4. Establishing the auditor’s duty
2.1
Establishing the auditor’s duty
Society imposes a duty to exercise reasonable care and skill in two ways:
contractual (including statutory) relationship
special relationship between two parties. 3
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5. Reasonable care and skill
2.1
Reasonable care and skill
An auditor must exercise the reasonable care and skill expected of a professional.
Requires adherence to professional standards in all aspects of an audit.
Pacific Acceptance (1970) comprehensively set out the duties and responsibilities, established multiple legal principle and gave notice that the standards of care and skill will change over time.
APES110 s100.5(c) Professional competence and due care
APES110 s130
‘The professional man owes a duty to exercise that standard of skill and care appropriate to his professional status’ (Caparo, 1990) – though note this case relates to liability to third parties. 4
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6. 2.1
Negligence
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 (Godsell 1993).
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 defendant and harm suffered by the plaintiff. 5
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7. 2.1
Liability to clients
Liability to clients arises BOTH in contract and in the tort of negligence.
Early cases include:
London & General Bank Ltd (1895)
Kingston Cotton Mill (1896)
Thomas Gerrard & Son (1967)
More recent significant cases:
Pacific Acceptance (1970)
Centro (2012)
Other cases:
Cambridge Credit Corp. Ltd & Anor v Hutcheson & Ors (1985) 9 ACLR 545
Segenhoe Ltd v Akins & Ors (1990) 8 ACLC 263
Galoo Ltd v Bright Graham Murray (1994) BCC 319 6
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8. Contributory negligence
2.2
Contributory negligence
Exists where the plaintiff fails to exercise the required standard of care, thus contributing to its own loss.
Prior to AWA (1995), such a defence by auditors was unsuccessful. 7
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9. Contributory negligence: AWA (1995)
2.2
Contributory negligence: AWA (1995)
AWA: the company suffered losses due to internal control weaknesses over foreign exchange.
Auditor liable for failure to report to board of directors.
Company found to contribute to loss by officers failing to report to board of directors and failing to put in place adequate internal control system.
Defence of contributory negligence therefore upheld. 8
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10. Topic 2: Ethical decision making and the legal liability of auditors Outcome 2.3

11. Liability to third parties
2.3
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 such as Donoghue v Stevenson (1932) that the recovery of financial losses by third parties from auditors for negligence (in the absence of fraud) was not possible. 10
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12. Liability to third parties (cont.)
2.3
Liability to third parties (cont.)
Early test: special relationships
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 judgment of Lord Denning)
Hedley Byrne (1963)
MLC v Evatt (1971)
Shaddock & Associates (1979). 11
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13. Liability to third parties (cont.)
2.3
Liability to third parties (cont.)
Next test: reasonable foresight
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 of whom they should have been aware:
Scott Group (1978)
JEB Fasteners (1981)
Twomax (1983). 12
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14. Liability to third parties (cont.)
2.3
Liability to third parties (cont.)
Current test: reasonable 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)
AGC (1992)
Columbia Coffee (1992) (very wide interpretation, later overturned in Esanda)
Esanda (1997).
The proximity test—that is, that a statutory audit is not intended to advise or induce potential investors or lenders to either act or refrain from acting in a particular way—was considered and upheld by the full High Court in the Esanda case. 13
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15. Current situation: liability to third parties
2.3
Current situation: liability to third parties
A general conclusion is that based on Esanda 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. 14
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16. Liability to third parties: Trade Practice Act
2.3
Liability to third parties: Trade Practice Act
Consideration needs to be given to the provisions of the Commonwealth Trade Practices Act and State Fair Trading Acts:
Acts prohibit misleading and deceptive conduct.
It is possible that, in issuing an inappropriate audit report, an auditor might be guilty of conduct that is misleading or deceptive.
I am unaware of any successful claims using the Trade Practices Act. 15
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17. Criminal liability of auditors
2.3
Criminal liability of auditors
Auditors can be subject to criminal prosecution.
It is an offence under s 1308(2) of the Corporations Act 2001 to knowingly make or authorise false and misleading statements. A penalty of $22,000 and/or five years’ imprisonment exists.
Criminal actions against auditors are rare. 16
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18. Topic 2: Ethical decision making and the legal liability of auditors Outcome 2.4

19. Limitation of liability
2.4
Limitation of liability
Prior to CLERP 9, audit firms were required to operate as sole traders or in partnership form.
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.
Professional indemnity insurance is difficult to obtain and prohibitively expensive (claimed to be about 14 per cent of audit revenues). 18
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20. Methods adopted to limit auditors’ liability
2.4
Methods adopted to limit auditors’ liability
Imposition of a statutory cap on auditors’ liability
Introduced 1 July 2009
Incorporation of auditors
Permitted from 1 January under CLERP 9
Removal of joint and several liability and replacement with proportionate liability
Changes to Corporations Act 2001 as a result of CLERP 9 Bill 2004 allow:
Auditors to incorporate and form authorised audit companies with adequate and appropriate professional indemnity insurance
Apportionment between plaintiff and defendant according to blame, and proportionate liability if there are two or more defendants 19
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21. Arguments for limiting auditors’ liability
2.4
Arguments for limiting auditors’ liability
Inability of auditors to restrict the scope of their operations and/or resign
Inequitable position of the auditing profession compared with other professions and service provider
Inability of auditors to rely on representations of management
Auditors carry a heavier burden than other professionals with respect to the amount of damages assessed 20
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22. Arguments against limiting auditors’ liability
2.4
Arguments against limiting auditors’ liability
Auditors should accept full responsibility for their work.
Auditors are only successfully sued when not performing their duties competently.
If there is a limit, the auditor’s share of liability passes on to the public.
A precedent for other professions 21
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23. Topic 2: Ethical decision making and the legal liability of auditors Outcome 2.5

24. Accounting bodies’ code of ethics
2.5
Accounting bodies’ code of ethics
Code of ethics: formal, systematic statement of rules and principles developed by the community to promote its well-being and punish undermining behaviour.
APES 110 sets out main ethical pronouncements that relate to the undertaking of an audit.
ASA 200 requires that auditors comply with relevant ethical requirements.
There are also a number of APES standards and miscellaneous Professional Statements promoting ‘competence’. 23
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25. 2.5 Applying ethics Sound ethical decision making is dependent on:
Knowledge of the basic principles on which moral values and rules are based
Competence in decision making
The ability to choose appropriate policies and decision procedures in different situations.
The main ethical model used is the American Accounting Association Model
7 steps to be used as a framework
7 steps:
Determine the facts
Define the ethical issues
Identify major principles, rules & values
Specify the alternatives
Compare values, rules, principles (from Step 3) and the alternatives – see if there is a clear decision
Assess the consequences of single alternative (based on Step 5) or all alternatives
Make your decision
Other models include:
Mary Guy Model
Laura Nash Model.
Spiral Model. 24
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26. Developments in auditor independence
2.5
Developments in auditor independence
Ramsay Report (Aust): issued October 2001
IFAC independence rules: adopted conceptual approach using a framework for identifying, evaluating and responding to threats to independence
APES 110: based on IFAC independence rules
Sarbanes-Oxley Act (USA): 2002
Joint Committee of Public Accounts and Auditors (Australia): 2002
HIH Royal Commission: 2003
Corporate Law Economic Reform Program (CLERP 9) (Australia): 2002–4 25
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27. Developments in auditor independence
2.5
Developments in auditor independence
Some relevant areas in the Corporations Act 2001
PART 2M.3 FINANCIAL REPORTING
Division 3 Audit and auditor's report
s300(11) (B) disclosure of non-audit services provided by auditor
s307C independence declaration (furnished to the directors before their report is signed off)
PART 2M.4 APPOINTMENT AND REMOVAL OF AUDITORS
Division 3 Auditor independence
s324CA breaches of independence must resolved immediately or ASIC is to be notified within 7 days
s324CD defines a conflict of interest and the types of relationships that give rise to a conflict of interest
s324CI limits on auditors becoming directors of clients
Division 5 Auditor rotation for listed companies
s324DA rotation of audit partners after five years 26
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28. The importance of auditor independence
2.5
The importance of auditor independence
The Independence is a key characteristic of an audit or assurance service provider.
In order for auditors to add credibility to financial reports or other subject matter, they need to remain independent.
Test for independence is a reasonable person test: would a reasonable person having access to all facts consider that the auditor was independent?
APES 110 s290 (s291 for other engagements)
emphasises both:
Independence in appearance — how others will view the auditor
Independence of mind — state of mind of the auditor.
other relevant sections include s200 – 220, s260, s280 27
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