Auditor's Legal and Professional Liability - Essay Example

Auditor’s legal and professional liability The term auditor’s responsibility and auditor’s legal liability often are confused by non auditors. The distinction is subtle and yet it must be drawn in order for auditors and non auditors to communicate with each other. One of the most ideal ways in which to understand the relationship between responsibility and liability is to think of responsibilities as being professional duties and legal liabilities as relating to society’s means of enforcing adherence to those professional duties. What this basically means is that these are ways in which compliance with professional standards and providing compensations to victims of wrongful conduct (Grubbs and Ethan, 2007). The concept of auditor’s responsibility usually arises in relation to two basic contexts: responsibility in relation to what, and responsibility in relation to whom. Answers to both of these questions can be gauged primarily in the technical and the ethical standards of the public accounting profession; occasionally these are specified in state and federal statues and court decisions. All of these sources provide guidance to auditors on how to conduct audits with due professional care and thus meet professional responsibilities and on other duties that auditors owe their clients and parties. There have been hundreds of accounting liability cases that have been litigated over the past few years and the flow of this litigation does not seem to be likely to stop anytime soon. Accountants perform an increasingly diverse variety of functions for their clients from traditional accounting services to full range of management consultation functions. Negligence has been 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 (that is, to those who the auditor could reasonably foresee would rely on the auditor’s report), owed to another person or persons”, (Liability of Auditors). Duty of care arises in cases where a contract is involved or when there is a tort of negligence involved. The conditions that are required or a case of negligence to hold ground include negligence with respect to a duty of care, there is a loss or damage suffered or when the loss is quantifiable. It is true that the numbers have been increasing over the years; there are few landmark cases that can be observed in details in order to create an outline of the existing trend in this kind of jurisdiction and how it has evolved. The first case that one can take a look at is the Caparo Industries vs. Dickman, [1990] 2AC 605, House of Lords, which was centered round the liability of the auditors to the purchasers of shares.  In the case the plaintiff’s company commenced to purchase shares after its Directors had publicly announced the year's results based on the defendant audit (Sahu, 2001). Following the posting of the audit to share holders and the shareholders meeting, the plaintiff purchased more shares and eventually made a successful claimant bid. It was however found that the stock was over valued, and the auditors were sued by the plaintiff or negligence. The claim was that the auditors had been negligent in basing their audit on what was allegedly deceptive misrepresentation by the Directors of the Company. The plaintiffs, by virtue of the fact that they were already directors on the Board had access to the report that was prepared by the auditors and relied on the audited accounts in buying more shares. This however turned out to be false the profits were not as high as projected leading to a fall in the share prices and an overall economic loss for the plaintiffs. The case dealt with important issues in the law of tort (Hicks and Goo, 2007). In the context of company law, the jurisdiction refuses to extend the liability of the auditors to third parties. The underlying principle was that an auditor making a negligent statement is liable only if a duty of care is owed to the person who relied on it thereby suffering loss, or if there was in place a relationship of sufficient proximity between the plaintiff and the defendant i.e. the auditor knew that the statement would be passed to the defendant individually or as a member of a class of persons in connection with a particular transaction or type of transaction, and that the plaintiff would be very likely to rely on it while making a decision bout whether or not to go through with the transaction in question. Third, it was also decided that the court must consider be sure that the imposition of duty is fair and reasonable. It was also recognized in the case that such tests are overlapping and are therefore a little more than labels thus being inapplicable to the process of accurately defining whether or not liability is to be established. The second case that can be discussed as being a landmark was the judgment in the AWA Ltd v. Daniels [ (1992) 10 ACLC 933] case (Campbell and Houghton, 2005). The judgment was given by Chief Judge of the commercial division of the NSW Supreme Court, Rogers J. The point of contention in the case was that the foreign exchange program in AWA, at one time a profit making process became the cause for a $50 million loss to the company which was concealed by a number of methods which included making number of unauthorized borrowings from banks on behalf o AWA (Campbell and Houghton, 2005). The defendant audit firm in question was that of Deloitte Haskins and Sells, engaged by AWA for drawing up two audits- a statutory audit and a non statutory audit. The problems relating to real exchange were not revealed to a full extent in either of the audits. The reason cited ultimately was a breach of contract claiming that the losses that had been suffered were a result of the failure on part of the auditors to draw attention to these deficiencies within the company’s accountancy practices. The claim was that auditors are responsible for the detection and reporting of faults and inadequacies. Auditors on their part denied the charge and claimed contributory negligence on the company’s end. The judgment found that the auditors had indeed been negligent but the auditor’s claim for contributory negligence was also upheld. The AWA responsibility for negligence was 20% while the auditor was found to be 80% responsible. The reasoning behind the judgment was that “an auditor’s duty has to be evaluated in the light of the standards of today”. The auditors should figure out whether or not proper financial records have been maintained-the auditors were found to have failed in this. There is also a duty in relation to the process of the gathering of information the auditors were under an obligation to enquire about the true nature and extent of the authority that was vested in the officer dealing with foreign exchange management. The third point was that the auditors have a responsibility to bring matters of doubt to the notice of the management and this duty persisted for the entire duration of the process of the audit. Finally, there is also their duty to Follow-up i.e. when it was found that the management had failed in its responsibility to act adequately, the matter should have been reported to the board. On appeal by the auditors, the judgment was upheld (Daniels v. Anderson [1995] 13 ACLC 614). The apportionment of damages was reduced however to one third but the responsibility of the auditors after the discovery of problems was stressed. The third case under consideration is the Waxman v. Waxman In Waxman v Waxman (2004 OJ No 1765). In the case it was adjudged by the Ontario Court of Appeal that auditors shall not be held legally responsible to individual stakeholders of their corporate patrons until and unless it has been specifically clarified that the range of work to be done by the auditor is to be expanded beyond a certain degree or scope (Appellate Court Jurisdiction, 2007). The basic case was that the firm of I Waxman & Sons was owned and run jointly by two brothers Chester and Morris Waxman, both of whom were each 50% shareholders and joint directors in the firm. There was a firm that had been used by the family over a number of years. Problems arose when after selling his shares in the firm to Chester in 1983 Morris later made an allegation that the sale was unintended and harmful to his interests. On consultation with auditors the advice he got was seek legal counsel. This however was postponed till 1988. a claim of negligence was filed against the auditors on the ground that they did not inform him about the bonuses paid to Chester and his family or the tariffs that were being charged by Chester's sons' trucking companies on account of which he did not become suspicious and could not avoid the sale. The problem was that Morris never went through the financial documents made by the auditors which meant that he could not claim negligent misrepresentation. The allegation was that the auditors failed to warn him about a transaction that was not to his advantage. They thereby owed him a personal duty based on a longstanding relationship with IWS and company The trail lasted over 200 days and the judge found the auditors to have been negligent in failing to include a related-party note on the company’s fiscal records and their failure to warn Morris about them. The ruling was however over turned at the appeal where it was held that the auditors did not take the matter to Morris because they were not asked to. Moreover their functions were restricted the permitting the overseeing of management decisions and not assisting the management while actually taking them. Moreover, such an action would have put the auditors in a conflict of interest position. Finally, the appellate court held that the auditors did not have a personal responsibility to Morris by virtue of the fact that they did not possess authority or the discretion regarding his personal interests. Morris had never asked the auditors for personal or business advice; in fact, Morris and Chester had typically made decisions about the business without consulting the auditors. Changes in Audit Standards and Requirements One can look at the various audit standards that have been applied in the ASA in order to get a clearer understanding of the exact definition of the roles which auditors are supposed to fill and responsibilities that they are supposed to shoulder in order to prevent the risks of material misstatement due to fraud that could in turn prevent claims of audit negligence by alerting the audit team to the identification potential inappropriate behavior the facilitation of the appropriate planning and execution of an effective audit. Section 240 of the ASA for example makes a differentiation between fraud and error, while requiring an attitude of professional skepticism (ASA 240). It also clearly lays down the exact term of the authority of the auditor which includes the identification of the risks of misstatement, evaluation of the implementation of an entity’s design and also establishes the requirement of communication and written documentation. Auditing Standard ASA 315 meanwhile establishes mandatory requirements and provides explanatory guidance on obtaining an understanding of the entity and its environment, including its internal control, and on assessing the risks of material misstatement in a financial report audit (ASA 315). Also there are in place other considerations like the Accounting Standard ASA 330 and APES 215 which deal with the other intricacies of auditing standards and liabilities (APES 320 Quality Control for Firms). These are inclusive of appropriate documentation and monitoring procedures along with records of evaluation of proof of adherence to professional standard. Based on these regulatory principles along with the cases that have been observed above what becomes clear is that there is a definite shift if one was to consider the exact duty and scope of responsibility of audit firms and the suit process. While it is true that there has been a trend towards a stricter vigilance about whether or not the there is an adherence with the principles of auditing with respect to auditing firms it is also true that in most cases, the onus to prove that there was in fact an act of negligence committed by the auditors lies with the plaintiff or the party making the allegation. This can be related to the ruling in Caparo Industries vs. Dickman, [1990] 2AC 605, House of Lords where the underlying principle was that an auditor making a negligent statement is liable only if a duty of care is owed to the person who relied on it thereby suffering loss. There is also an inordinate importance that is placed in the knowledge provide to shareholders and the on whether or not the auditor could actually have prevented a wrong loss by bringing a misstatement to the fore. Beside this the terms already agreed upon are import as is the agreement to an expansion of the auditor mandate. Framing a claim as a 'failure to warn', or trying to distinguish the situation because the company is closely held, or the auditor-client relationship is of long standing, will not exempt a plaintiff from this burden of proof. The three cases that have been stated above are wide in their discretion and the choice of judgments that were pronounced in each regard. In the Caparo v Dickman judgment and the judgment in the Waxman case the idea of proximity plays a big part in the decision about whether or not the auditors are found to be in negligence of their duties. It also becomes clear that the process by which information is gathered along with bringing doubts to the fore in front of the management is considered important and it is accepted now that this needs to be done in case there are misstatements that are discovered at any point during the auditing process. ASA 240 and ASA 315 are concerned with process of audit and an outlining of the duties of the auditors. Both function within a framework that outlines first, definition of fraud and the need to identify and report fraud and second, the fact that each audit has to be put in context and environment of the company for which the audit is being produced. In AWA Ltd v. Daniels[ (1992) 10 ACLC 933] it has been clearly stated that the auditors have a duty in relation to the process of the gathering of information the auditors and are under an obligation to enquire about the true nature and extent of the authority that was vested in the officer dealing with foreign exchange management. The idea here is simple. Producing an audit does not just mean the identification of abnormalities in account in the regular sense, it would also mean taking up the initiative to inform the responsible management and the ones affected by the discrepancies. This would also then mean that the auditors have to engage in the process keeping in mind an attitude which is that of a skeptic thereby allowing no room for errors. This however odes not mean that the auditors take it upon themselves to question matters that are intrinsically management oriented as long as the decisions are based principally on legal and accepted lines. As stated in Waxman v Waxman (2004 OJ No 1765), functions of auditors are restricted to the permitting of an oversee of management decisions and not assisting the management while actually taking them.  Conclusion: In conclusion it can therefore be stated that the process of audit is now as important an element as the result of the audit itself. There is a requirement from the auditors that the statement be without a bias and that the basic modus operandi in the entire process has to be in keeping with a spirit of skepticism and doubt. Finally, it can also be said that the process of audit now finds itself in a better and more challenging scope of work due to the immense possibilities that the urge to prevent fraud opens up in front of it. Reference: Grubbs and Ethridge, 2007, Auditor negligence liability to third parties revisited, Journal of Legal, Ethical and Regulatory Issues, Business Service Industry, accessed May 29, 2009, Hicks A and Goo S H, 2007, Cases and Materials on Company Law, Edition: 6, revised Published by Oxford University Press, p534, accessed May 29, 2009, Legal liability of Auditors, PPT, Chapter 3, accessed May 23, 2009, Shau R, The Laws Relating to Auditor’s Liability, accessed May 23, 2009, Campbell and Houghton, 2005, Ethics and Auditing, Australian National University E Press, Published by ANU E Press, p12-14, accessed May 23, 2009, Appeal Court Confirms Limited Auditor Liability for Economic Negligence, accessed May 23, 2009, http://www.fmc-law.com/upload/en/publications/archive/638901_Appeal_Court_Confirms_Limited_Auditor_Liability_for_Economic_Negligence_Frank_Bowman.pdf ASA 240 The Auditor’s Responsibility to Consider Fraud in an Audit of a Financia, accessed May 23, 2009, < http://www.charteredaccountants.com.au/A119285292?z_d=iov> APES 320 Quality Control for Firms, paragraphs 106-129, accessed May 23, 2009, < http://www.apesb.org.au/Document/Whats_New/APES%20320%20Quality%20Control%20for%20Firms-Revised.pdf> Australian State Territory and Local governments, accessed May 23, 2009, < http://www.gov.au/> Auditing Standard ASA 240, The Auditor's Responsibility to Consider Fraud in an Audit of a Financial Report, accessed May 23, 2009, < http://www.auasb.gov.au/admin/file/content102/c3/ASA_240_28-04-06.pdf> Auditing Standard ASA 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement, accessed May 23, 2009, < http://fedlaw.gov.au/ComLaw/Legislation/LegislativeInstrument1.nsf/previewlodgmentattachments/2F34EABFD705089CCA25716B007DC2B8/$file/ASA_315_28-04-06.htm> Read More