Learning Outcome
Topic 3
Legal Environment
Learning Outcome
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.
.
Outcome
Regulation of auditing and ofLearning
the subject
matter of audits
Figure 2.2 Professional and statutory regulation of auditing
Learning Outcome
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.
Learning Outcome
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
Learning Outcome
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
Learning Outcome
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.
Learning Outcome
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.
Audit firms
Learning Outcome
• 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.
Quality controlLearning Outcome
• 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.
APESB standardsLearning Outcome
• 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.
Learning Outcome
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.
Learning Outcome
•
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).
Negligence
Learning Outcome
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’.
Learning Outcome
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.
Liability to clients
Learning Outcome
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)
Learning Outcome
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).
Learning Outcome
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
Learning Outcome
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
Learning Outcome
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
Learning Outcome
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)
Learning Outcome
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.)
Privity letters
Learning Outcome
• 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.
Liability to third parties: Learning Outcome
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.
Learning Outcome
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).
Learning Outcome
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.)
Summary
Learning Outcome
• 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
Summary (continued)Learning Outcome
• 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.