In what circumstances is an auditor potentially liable for negligence under common law to a third party?

THE AUDITOR’S LIABILITY

“They [Arthur Andersen] can never clear their name. In the court of public opinion, they have been tried, convicted and hanged. After WorldCom, there was just nothing you could say."

Lynn Turner, Former Chief Accountant, Securities and Exchange Commission (US), in June 2002

1.0       The auditor is accountable to those who appointed her of his conduct while making his report on the audit .She has to assess whether management to the entity has carried out its fiduciary responsibility in a manner acceptable to owners the business and to improve the accountability in the manner acceptable to the owners of the business.

1.2       The auditors liability is in two folds”

• Under statute where by the auditor is criminally liable for publishing her report or similar statements while knowing that these are misleading, false or deceptive;
• Under application of the principle of common law to establish the standards of work and reporting expected the auditor. Thus as a failure to exercise due care and skill in conduct of an audit.

The former is owed to state and the other to individuals who have suffered loss as a result of audit shortcomings.

1.3       Generally

• An auditor may fail to discover a material fraud or error and deliver unqualified opinion on set of accounts, which in reality is significantly misstated.
• An auditor may fail to recognize that the going concern assumption is not appropriate. Some time after the year-end the company may go into liquidation and question may be asked about absence of any warning in the auditor’s report.

1.4       Liabilities to the state are likely to be “fixed in terms of penalties whereas the liabilities to the clients or third parties have been proven to be open –ended.

1.5       The auditors are seeking to have the courts allocate blame for the corporate collapse on the basis of actual responsibility rather than the present system where by the deepest pocket carries the heaviest (usually the only) burden.

1.6       In summary:

                                                            Contract                  client-mgt investors       

Auditor

                                                            No formal contract                    third parties    

                                                                                                            users

1.7       Whilst an auditor has various statutory duties to perform. There are also non –statutory dutiesto consider the most important of these being the duty to exercise reasonable care and skill in conduct of an audit examination. This duty was clearly expressed in the of cited Re-Kingston Cotton Mill (1986) and Re- London and General bank (1895). The auditor’s duties may be summarized as follows:

• The duty to be aware of relevant statutes
• The duty to be aware of requirement of those statutes
• A duty to be aware of the written constitution the enterprise under audit

1.8       auditor of a limited company are bound to know (ie required to know ) or make themselves acquitted with their duties under the articles of the company, whose accounts they are appointed to audit, and under the companies Acts for the time being in force.

1.9       Auditors of enterprise such as nationalized industries or local authorities would also be subject to these duties and other duties

• A duty to abide by any express terms in the contract
• Specially for non-statutory appointments
• Basing on companies Act

2.1       As a self-protection exercise the prudent auditor should always explain any limitation through the medium o the audit report and should always clarify in advance the nature of the work to be undertaken. This can vary from a full “audit “ engagement (where the auditor express opinion as to the truth and fairness of the financial statements to a “review engagement” (where only limited assurance is provided)

• A duty to abide to any implied term of the audit appointments
• An implied duty to carry out the audit task within a reasonable period
• An implied duty to exercise reasonable careaand skill in conduct of the audit.

2.2       Reasonable care and skill

The more the specialized the work undertaken, the higher the degree of skill and care expected. Generally in the Re-London and General Bank, the duty of reasonable care and skill; she must be honest ie she must not certify what she does not believe to be true and she must take reasonable care and skill before she believes what she certifies is true, what is reasonable care in any particular case must depend upon the circumstances of that case.

2.3       In Re- Kingston Cotton Mill (1896) gives one hint on how the profession should set about determining the meaning of “reasonable care and skill; it is a duty of an auditor to bring to bear on the work she has to perform that skill, care and caution which a reasonably competent, careful and cautious auditor would use.

2.4       An auditor is not bound to be detective or to approach his work with suspicion or with forgone conclusion that there is something wrong .She is a watchdog and not a bloodhound.

2.5       This anticipates by more than half a century the Maultz and Sharaf (1962) auditing postulates which states that; as a working assumption;’ the financial statements and other information submitted for verification are free from collusive and other unusual Irregularities.

2.6       Auditors must not be made liable for not tracking out ingenious and carefully laid schemes of fraud where they’re nothing there to arouse their suspicion.

2.7       But when suspicions is aroused the auditor who does not respond by following through the suspicious circumstances in order to full resolve the matter may be liable for negligence ( Thomas Gerrard case).

2.8       Auditing standard and guidelines do not carry statutory power but they must be considered to be persuasive evidence” as to which and auditing procedures constitute best practice. Auditors should institute quality control measures to ensure that their audits (of whatever size) live up to the description of best practices such procedures include

• Proper audit planning
• The use of analytical review procedures
• The use of audit programs
• The use of checklists
• A suitable review procedures

2.9       Adherence to accounting (as opposed to auditing) standards raises the further possibility of debate over what constitute “reasonable care and skill”, the proof of compliance with generally accepted (accounting principles (GAAP;s ) as persuasive but not conclusive evidence’ the financial accounts show a true and fair view. Thus the auditors who simply ensure compliance with GAAPs and fail to examine the broader question of the truth and fairness may not be carrying out their duty with reasonable degree of skill and care.

3.0       The auditor’s liability in contract (privity of contract) for negligent work will depend on client’s ability to (firstly) prove negligence and (Secondly ) prove actual loss. Auditors negligence will be judged according to accepted standards of reasonable care and skill and these in turn will be judged according to the extend to which the audit or followed according to the extent to which the audit or followed accepted best practice (approved auditing standards) YET NEVERTHERLESS RETAINED A professional independence and flexibility which ensured that the ultimate slavish compliance with published professional guidance.

3.1       Generally the auditor will be liable whenever

• A formal contractual relationship exists
• Negligence by the auditor can be proved
• A loss by the other party of the to contract is established

3.2       But if some one less closely to the auditor and with whom no formal contractual relationship can be said to exist, but such cases is where the auditor duty of care takes place. In more remote third parties such as ;

• Trade creditors who fail to recover their outstanding debts if the debtor company goes into liquidation
• Bankers who have advanced loans or overdraft facilities
• Debenture or loan stock holders
• Investor who subsequent to issue of audited accounts have purchased shares in the company or purchased the company itself. There investment may be reduced or wiped out completely if the company accounts are later discovered to be materially incorrect.

3.3       Factors for liability to third party by auditor may established

• It must be shown that a duty of care exists
• The auditor must know , or should have known , that the financial statements where likely to be relied for the purpose claimed by the plaintiff
• The plaintiff must be of a class or category likely to rely upon the material concerned. The criteria is often referred as to use of proximity
• There must be actual reliance on negligently prepared financial statements where contributory negligence on the part of plaintiff can be established damages against a negligent auditor may be greatly reduced.
• The plaintiff must show that she would have acted differently had the financial statements on which they relied been correctly prepared.g. if a set of accounts had shown a true loss; rather than false profit , would the plaintiff still have gone ahead and purchased the company.

3.4       Cases law for doctrine of auditor third party liabilities

3.4.1.Candler V Crane, Christmas and Co (UK, 1951)

In this case it was held that there could be no auditor liability for negligence in absence of contractual relationship. Lord Denning delivered a dissenting opinion based on the argument that actual fore knowledge of the specific use to which the accounts would be put created a duty of care even in the absence of a formal contract between the accountant and the third party.

3.4.2     .Hedley Byrne V Heller and partners ( UK, 1963)

in this non- accounting case a reference was issued in the for knowledge that it would be relied upon by third party, for loan or investment purposes. The reference proved “unreliable “ and the issues of the reference were proved unreliable and the issuers of the reference were sued. It was held that because of that very foreknowledge a duty care existed towards and third party. Despite the absence of any formal contract

Thus Lord Denning’s dissenting decision in Candler V Cranes Christmas and Co was vindicated.

The relevance of this case for accountants (rather than as auditors),they often prepare special reports for a client in full knowledge that those reports or accounts are going to be used to persuade and identifiable third part ( a bank or prospective purchaser) to adopt a certain cause of action .The Hedley Byrene is often used to represent very narrow view of auditors liability to third parties – Actual knowledge of possible reliance being a necessary condition.

3.4.3.Caparo Industries Vs Dickman and others (1990)

In 1984 Caparo industries purchased 100,000 Fidelity shares in the open market .On June 12,1984, the date which the accounts (audited by Touch Ross) were published, they purchased a further 50,000 shares relying on information in the accounts, further shares where acquired. On September 4, Caparo made a bid for remainder and by October had acquired control of Fidelity. Caparo alleged that accounts on which they had relied where misleading in that an apparent pre- tax profit of the some $1.3 m should in fact be reported as a loss of $ 400,000. The plaintiff argued that Touch owed a duty of care to investors and potential investors

Held:

• The auditors of a public company’s accounts owed no duty of care to members of the public at large who relied upon the account sin deciding to buy shares in the company.
• A purchaser of further shares, while relying upon auditor’s report a shareholder stood in the same position as any other investing member of public to whom the auditors owed no duty.
• The purpose of the audit was simply that of fulfilling a statutory requirements of the companies Act 1985
• There was nothing in the statutory duties of company auditors to suggest that they were intended to protect the interest of investor in the market. In particular there was no reason why any special relationship should be held to arise simply form the fact that the affairs of the company rendered it susceptible to takeover bid.

Conclusion: though the above seems to lessen auditors duty to use skill and care because auditors are still fully liable in negligence to the companies they audit and their shareholders collectively.

3.4.4. Utramares Corpn V Touche (USA, 1930)

The auditors should not be made liable for an indeterminate amount to an indeterminate class of people ,for indeterminate period of time.

Some aspects of this view seem to be more acceptable than others. For example most people would agree that, as time passes after the publication of a set of audited accounts, less and less reliance can be placed of audited accounts, less and less reliance can be placed on them by the users because under lying economic factors may have changed significantly. Thus in determining the auditor’s liability the question the time reliance was placed would be a material consideration.

With respect to the likely classes of users there are three possible schools of thought:

• When reporting on statutory accounts, the auditor reports to the members of the company and them only. There can be no duty of care to anyone else unless the auditor has been specifically informed of their existence and the intention to provide them with accounts for a stated purpose.
• When reporting on statutory accounts the auditor reports to members of the company but may be aware that there exists certain identifiable third parties whom it is reasonable to assume will place reliance the auditor’s opinion. The duty of care should thus extend to cover third parties who can be identified at the time the audit opinion is delivered.

When reporting on the statutory accounts the auditor reports to the members of the company but the audit reports to the members of the company but the audit report enters the public domain and becomes an important source of assurance to any third party considering entering into financial arrangement with the client company. The auditors duty of care should thus extend beyond shareholders and identifiable third parties who belong to a class likely to rely on financial statements for a purpose which can justifiably be argued to be a reasonable purpose for a person of that class. All this is within timing constraints.

Conclusion

The ultramares case suggests the need for some limitation of liability but does not itself provide precise criteria .The concept has been reinforced by Caparo case. Caparo has taken Ultramares decision one step further by placing strict limits on the perceived purpose of the auditors report itself, in turn limiting the opportunity for third parties to establish that a duty of care exists between the auditor and themselves.

In many ways, auditors liability is not materially different concept from manufacturer liability for products(DonoghueV stephnson( UK ,1932)

3.4.5.    JEBB Fastener’s Vs Mark Bloom

Despite the fact that the auditors were not aware of a bid for the client company at the time they signed the audit report they would have been liable to the acquirer for the losses suffered had it not been accepted by the court that the plaintiff would have gone ahead and bought the company whatever he picture provided by financial statements. Clearly, in the view of the court prospective purchasers constituted a “reasonably foreseeable group of users, and the auditors would have been well advised to bear them in mind when programming their audit and considering the overall truth and fairness of accounts.

It is a case where the “reasonable foresight’ test was accepted and auditors, as a result found themselves liable to third parties who where complete strangers to them at the time the audit took place.

Whether the defendant auditors knew or reasonably should have foreseen sat the time the accounts for the purpose of deciding whether or not to take over the company, and therefore could suffer loss if the accounts were inaccurate.

3.4.6.    Two-max Ltd and Goode V Dickson, Mc Farlane and Robinson( UK,1982)

This case provided an immediate reinforcement of the judge’s decision in the JEBB Fasteners. The only deferent being that of judge believed that the plaintiff would not have acquired the company under consideration had the accounts actually shown a true fair view .

The judge in this case commended JEBB Fasteners decision on the grounds that it “combined the simplicity of the proximity or neighbor principle with a limitation which has regard to the warning. ( see Ultra mares V Touche) against exposing the accounts to interminable liability. Without disagreeing with the basic principle that the auditors had a duty to exercise “reasonable foresight” in carrying out their work.

3.4.7. Al Saudi Banque ( and others ) Vs Clarke Pixley ( UK ,1989)

In this case it was held that :

The auditors of a company owe no duty of care to a bank who lends money to the company, regardless of whether the bank is an existing creditor ( at the time of the audit report signed) making further advances or is only a potential creditor of the company, since either case even if it is foreseable that the bank might request a copy of company’s accounts and rely on them when making an advance to the company there is not a sufficiently close relationship between the auditors and the bank to give rise to the degree of proximity necessary to establish a duty of care

Conclusion

When suing an auditor for negligence it is first has to be established that a duty of care exists. The JEBB Fastener case had appeared to widen the proximity circle by holding auditors liable to the unknown third parties on the basis of a “ reasonable foresight’. The Al Saudi Banque , case and the Caparo case rejects this approach as being to open ended .They proceed to the precedents established in both the crane Christmas and the Hedley Byrne cases. That actual knowledge of an intention to rely on the accounts should constitute the primary test of Proximity”

With regards to the banks who were limited class the judge commended ‘they were limited class , and their identity and the amount of their exposure was know to defendants when they signed their reports. But their position is not all comparable with that of the members. They played no part in appointing the defendants auditors.

The defendants were under no statutory obligation to report to them, nor did they send them to the company with the intention or in the knowledge that they would be supplied to them.

The judge added that in order to establish sufficiently proximate relationship between parties

• What needs to be shown is not knowledge of an intention that the information will be provided to them

The basic ground rules for establishing a duty of care owed to a third party are;

• It must be reasonably foreseeable that a statement will be relied upon
• This relevant degree of proximity between parties
• It must be, just and reasonable in all the circumstances to impose a duty of care.

3.5       Liability for negligence may either ordinary or gross . Ordinary negligence refers to lack of reasonable care, eg an auditor who fail together sufficient competent evidence to support the figure of stock in the balance sheet might be accused of ordinary negligence by an injured party if all other phase of the audit conformed to generally accepted auditing standards (GAAS). On the other hand, gross negligence refers to lack of even the slightest care or reckless disregard of duty (constructive fraud i.e misrepresentation of facts). For example where the auditor fails substantially to comply with GAAS , the auditor may be charged by an aggrieved party.

The auditors protects themselves by using

• Professional standards
• Taking professional indemnity insurance

3.6       Further consideration of potential liability

• Civil liability

This is a result of breach of trust (Misfeasance), which is improper execution of some lawful act. It arises where the auditor fails to do something, which is correct (e.g. failure by the auditor to discharge his fiduciary duty under contract)

Conditions to be met for this liability

• the auditor must have owed a duty of care to plaintiff
• the plaintiff must have suffered a loss as a result of auditors negligence.

Relevant cases 

• Re-Kingston Cotton Mill Co and Re-London and General Insurance.(auditor as and officer of the company)
• Companies Act No. 12 of 2002
• Westminster Road construction and Engineers Ltd (1932)

• Criminal Liability

In companies Act No.12 of 2002, the auditor may be sued under miscellaneous offences. if the auditor , in a nay turn, report or certificate or balance sheet , willfully make a statement false in any material particular , knowing it to be false , he shall be quilt of an offence and shall be liable on conviction for not more than 3 years with or without hard labour and shall also be liable to fine in lieu of or in addition to such imprisonment as aforesaid

• Penal code – An auditor may be sued for criminal offenses as provide under the Tanzania penal code
• Theft Act

The auditor can be guilt of a criminal offence under this Act if she aided or abetted management to publish false statements with intent to defraud stakeholders

• Prevention of fraud

Any person, by statement, promise or forecast, which he knows to be misleading, false or deceptive or by dishonesty concealment of material facts, or by reckless making of any statement, promise or forecast which is misleading, false or deceptive induces or attempt to induce others for acquiring, disposing , subscribing for, or underwriting security shall be guilty of an offence and liable to penal servitude for a term not exceeding seven years.

Also see the prevention of corruption Act No. 6 of 1971 for corrupt practices (this will be studied in Frauds topic)

3.7       Liability under professional misconduct

• Code of ethics for Professional Accountant

( disciplinary Actions)

• They are set out by NBAA and TAA

1. Consider TTCL, Tritel and the NBC Ltd case when the auditor’s reports differed during the time of acquisition ( To be discussed in class). Assume investors had invested money without further inquiry what was the position of auditors?

1. Republic V James Makuri Nyakyoma and others(1986)

In this case it was reported by a local daily that the company has suffered losses of over Tzs 60,000,000/-(sixty million)in local and foreign currency during the period of 10 months, through forgery and under pricing of crops. The auditors (TAC) were appointed to establish the correctness of the newspaper report. TAC appointed a team headed by prosecution witness to carry out the audit. The exercise culminated into an audit report confirming Irregularities reported by press.

The case is relevant to study because if the Audit report was to be proved unreliable in that it was negligently prepared in course of investigation, then there could have been auditors liability

In the special audit report the honorable judge said the special report was unprofessional and failed to comply with accounting standard (TSSAPs)-TFAS-IFAS

4.0       AUDITORS LIABILITY, EXPECTATION GAP AND DEEP POCKET SYNDROME

4.1       The public opinion has become very important in determining what is expected by auditor’s day-to-day practice. Aggressive litigation is a strong driving force behind changes in professional recommendation is to what constituter ‘best practice’. The expectation gap, which is expected to exist, is instrumental in leading to legal actions against auditors. The gap lies between interpretations of their duty as independent auditors and client/shareholders interpretation of that duty.

4.2       The gap can either be liability, performance or standards gap depending on circumstances.

4.3       Anti- Auditor litigation is also blamed on the ‘deep pocket syndrome’. This means that in the wake of a corporate collapse or significant audit failure, creditors or plaintiffs often look to see which professional advisors involved have the deepest pocket’ in terms of professional indemnity insurance.

They may then launch an action against those advisors despite an absence of any good evidence that the advisor was actually negligent.

4.4       Auditors duty of confidentiality

Is an implied term of an accountant’s contract with a client.

For this reason an accountant should not, as a general rule, disclose to the other persons, against the clients wishes, information about the client’s affairs acquired during and as a result of their professional relationship.

An accountant or auditor who becomes aware that a client has committed default or an unlawful act is normally under no obligation to disclose what she knows to external authorities.

But some circumstance may allow eg. Terrorist actions and money laundering as required by statute.

The auditors have no direct statutory responsibility to detect and reporting fraud, error and other irregularities but the ISA suggest that “audit procedures should be designed to give an auditor a reasonable chance of detecting any material misstatement .The standard goes on to suggest how the auditor should approach the design of the audit work through adequate planning.

• Maintain high quality control audit standards
• Personnel with necessary qualification, professional as well as academic ability and willingness to learn
• Regular performance appraisal
• Compulsory on job training and a wide range of exposure and circumstances including attendance to CPD programs.
• Adequate remuneration to audit personnel
• Full documentation of audit work for regular reviews by superiors, including review of audit working papers and programs.
• Close supervision of delegated work including staff competence in specific assignment with adequate guidance.

• Maintaining high quality Audit Controls and procedures
• Ensure all registered members adhere to the professional standards
• Obtain public confidence in the profession by demonstration concern for high standard of work.
• Demonstrating to the public authorities and other instrument that the profession is discharging its fiduciary responsibilities
• Instituting quality controls within firms eg peer reviews

• Encouraging audit firms to become limited liability companies
• Setting maximum limits of claims against auditors e.g fixed liability as a factor of the audit fee
• Setting claims and damages in proportion to respective responsibilities e.g where there is a contributory negligence on party other than the auditor , such party should be made to bear part of the claim
• Use of sound and complete audit standards and guidance appropriate to circumstances of the specific audit
• Regular client screening to weed out difficult clients
• Understanding the client’s business well together associated customers including the integrity of its shareholders
• Use of carefully drawn engagement letters and where necessary letters of clarification and signing contracts which clients specifying the remedies for each party.
• Exercising extra caution when dealing with clients with financial difficulties e.g. clients with pending litigation or impending threat of insolvency.
• Maintain professional independence and integrity all times irrespective of having an assignment with your client
• Use of sound and complete audit standards and guidance appropriate to circumstances of specific audit.

NB: SEE THE ATTACHMENT B ON ENRON CASE AND LESSON LEARNED

Questions

See addition multiple choice questions from

http://www.kaplancpareview.com/resources/practice_questions.php

1. How does the professional Board for Auditors helps to prevent auditors Liability
2. Why auditors are willing to settle their legal cases outside the court of Law

Under what circumstances might the auditor be liable to the third party?

What are the legal liabilities of auditors under common law?

What are the policy reasons for holding accountants liable to third parties with whom they are not in privity?

How an engagement letter might affect an auditor's liability to clients under common law?