Auditing 1Lecture 4

Auditors Legal framework/The Liability of the Auditor

Litigation against auditors is virtually unknown in Ghana.

However, most of the major cases brought against auditors in the other countries have arisen because of alleged failure of auditors to detect fraud resulting in company failures and leading to loss of investment by creditors, shareholders and other investors.

Introduction

Introduction The serious effect of litigation against

auditors lies in the fact that audit firms have traditionally been sole traders or partnerships with unlimited liability status.

Firms guilty of causing loss to their clients may have damages awarded them and all the partners and are held jointly and severally liable up to the limit of the partners’ personal estates.

This led to the firms taking PII policies to cover possible damage claims.

Relationship between the auditor and the company/3rd parties.The auditor has no direct contract with

shareholders but with the company ( the company acts through them)

Shareholders are relegated to a 3rd party status.

(Directors, Creditors and officers are all 3rd parties to a large extent)

Any relationship between auditor and the public at large?Auditors have no connection with the public

unless the individual becomes user of the audited Financial Statement.

As agent of the shareholdersMay be looked at as an agent of the members

who appointed him for the purpose of (audit)Can only bind the members only for the

purpose of the auditCase: Spackman V Evans in the 19thCentury

by eminent Judge, Lord Gramworth

As officer of the companyAlthough not mentioned in the definition of

officers in the Company’s legislations, auditors can be regarded as officers of the company for determining liability in the case of winding up of a company resulting from any loss occasioned by misfeasance or breach of trust.

In civil and criminal cases in company’s legislations, auditors may be held liable.

Auditors liabilityAuditors liability can be categorised under

the following;(a) Liability under statute (civil or criminal)(b) Liability arising from common law to;

(i) Clients under contract law (and possibly law of tort),

(ii) Third parties under law of tort

Civil or Criminal liabilityCivil;Some of the circumstances under which the

auditor may be held liable are;(a) 3rd parties who suffer loss as a result of relying

on a negligently prepared audit report; and (b) Cases of tax fraud which comes to the notice

of the auditor.Criminal liability;The auditor, in the course of his audit

engagement, is subject to various legislations which hold citizens to criminal action.

Common law:Liability under contractThere is a contractual relationship between

the auditor and his client. When carrying out his duties, the auditor should exercise reasonable care and skill.

The degree of skill and care required will depend principally on the nature of the work undertaken.

The fundamental principles require that the auditor carries out his professional work with skill, care, diligence and expedition and with proper regard for the technical and professional standards expected of him as member of the profession.

Liability under contractThe Act also requires the auditor to act in such manner as

faithful, diligent, careful and ordinarily skilful.The Courts, when considering the adequacy of the work of

the auditor, is likely to take into account any pronouncements or publications of the accountancy profession including ISAs.

A guiding statement; In the “Professional Liability of Accountants and Auditors” issued in UK & Ireland, states that unless an express agreement is made between the parties, the standard of work required is defined by section 13, Supply of Goods and Services Act 1982, that the supplier will carry out the service with reasonable due care and skill.

All contractual arrangements should be clarified in a letter of engagement.

Auditors’ Guiding PrincipleAs an expert providing personal service and

an agent, he should exercise reasonable due care and skill in discharging his duties (the guiding principle)

Failure to exercise reasonable due care and skill in the execution of duties is guilty of negligence and can be held liable for damages resulting for that negligence.

Liability under Tort to a clientA tort is a wrong, not based on the

agreement of the parties, for which the remedy is unliquidated damages.

There are a number of distinct torts of which negligence is one. Negligence refers to a breach of duty to take care.

Auditor can be charged with negligence where some act or omission occurs because the auditor fails to exercise that degree of professional care and skill, appropriate to the circumstances of the case.

For a client to be successful in action against the auditor, he must satisfy the court in three areas that;(i) The auditor owes a duty of care enforceable

at law under statute or common law.(ii) The auditor has been negligent.(iii) The client has suffered damages/loss

Liability under Tort to a client

As a general rule, liability in negligence to a third party may only arise in circumstances where the auditor carries out work for an entity knowing;

(a) That his work will be relied upon by a third party;

(b) The purpose for which that third party intends to rely on it; and

(c) That the third party may suffer financial loss if the report is relied on having been negligently prepared

Liability under tort to 3rd parties

Disclaimer of liabilityAn express disclaimer of liability normally

provides protection against an unforeseen liability to a third party.

It would be a defence by the auditor to an action for negligence to show;

(a) That no negligence has occurred;(b) That the auditor owed no duty of care to

the plaintiff; and(c) No damage of financial loss was suffered

by the plaintiff.

Liability under tort to 3rd partiesCIRCUMSTANCES:There should be a clear case of negligenceFinancial loss has resulted from reliance on the

negligently prepared FS (document)It is clear that the financial loss is attributable

to reliance upon the negligently prepared document and to no other cause

The party issuing the document knows the purpose for which it was being prepared and knew that it was to be relied upon in that particular content.

Factors for duty of care is owedLord Justice Neil in the James McNaughton

case identified the following;The purpose of the statement madeThe purpose for which it was communicatedThe relationship between the advisor, advisee

and the third partyThe size of the class to which the advisee

belongsThe advisee’s state of knowledge; and The degree of reliance the advisee placed upon

the statement.

Test casesIn the cases below, state what the rulings of

the judges were;Caparo Industries v Dickman (1990) Gps 1 &

10Hedley Byrne & Co v Heller & Partners

Limited (1963) Gps 2 & 9Jeb Fasteners v Marks Bloom and Co. (1981)

Gps 3 & 8Twomax Ltd and Goode v Dickson (1983) Gps

4 & 7Hedley Byrne and Ultramares Gps 5 & 6

Unlawful acts or defaults by appointed auditor’s clientsAuditor is likely to come across certain

private and very sensitive matters, which may reveal certain unlawful acts and defaults by his clients

Implied confidentiality should be strictly observed.

Unlawful acts or defaults by appointed auditor’s clientsAppointed auditor should not disclose actual

or intended civil wrong or crime except:A. Cases of treason, legally obliged to discloseB. Where disclosure is expressly authorized by

clientC. Interest of appointed auditor requires

disclosureD. There is public duty because non-disclosure

will result in some damage to the public E. Compelled by court

Auditing 1Lecture 5

Engagement processACCEPTING /REJECTING AN OFFERCompanies or individuals extend an invitation

to auditors for appointment as an auditor or to offer certain professional services.

Before accepting, the auditor must comply with professional etiquette, respect and strictly adhere to them within the profession

He must communicate to existing auditor (if any) about the invitation.

Purpose of such communicationProfessional courtesy and comply with ethical rulesEnquire if there are professional reasons why

prospective auditor should not take up the appointment (Reason for the change)

Enquiry to the would-be client as to whether he objects to contacting the old auditor.

If objects to, don’t accept.If no objection, write to existing auditor for

(professional/ other reasons) for the proposed change.Existing auditor upon receiving the request should

seek the consent of the client to discuss client’s affairs freely with the auditor

Purpose of such communicationIf authority is refused existing auditor should

inform the new auditor accordingly, who should decline the appointment.

If authority is given, new auditor will decide to accept or decline

If existing auditor could not reply, go ahead for the offer.

Letter of EngagementClient and auditor should understand fully

the statutory obligations of both parties under company’s legislations so as to eradicate from their minds any misconceptions on the conduct of the audit.

Auditor should explain his statutory duties under the company’s legislations or as agreed between them.

Such explanation is given in a letter of engagement.

Letter of EngagementA letter of engagement is a letter which the

auditor sends to his client on his appointment.The letter sets out the extent of the work the

auditor will undertake for the client, and reminds the client of the liability of both parties.

It is a follow up of the verbal discussions/arrangements, and other agreements entered into at the preliminary interview with the client, and seeks to affirm the terms of the appointment.

Main points in a Letter of Engagement1. Functions of Auditor and

Responsibility of the management (Directors).

Statutory obligation with special emphasis of primary responsibilities of the auditor.

That the preparation of the accounts rests on the directors.

Main points in a Letter of Engagement2. Discovering fraud and defalcationsThat the audit will be planned to enable

auditor express opinion and should not be relied upon to detect all defalcations or other irregularities.

The disclosure of frauds would be as a result of effective audit planning and tests applied

Main points in a Letter of Engagement3. Details of other servicesOther services requested by the client and agreed upon by

the auditor should be specified. Eg tax computations should be separately charged for.

Inform client in the letter about services he can offer.4. Fees / RemunerationBasis for charging fees be indicated (ISA 240)Fees charged should be based on;(i) Degree of responsibility(ii) Skills involved(iii) Time expectedIt is unethical to charge contingent fees or fees based on

turnover

Main points in a Letter of EngagementConclusionClient to acknowledge receipt by signing a

copy as having read and understood the contents of the letter.

Signed copy is returned to the auditor. Client to state his comments if contents are

not in accordance with his understandingENGAGEMENT LETTER ISA 210