AUD 689

LEGAL LIABILITY

1
BEFORE WE START….

Name some laws / acts

that auditors will have
to know and comply
with

2
ALSO…. LET’S PONDER

If a bank approved a huge loan to

our audit client and the bank’s
decision to approve was based on
our audit report, are we liable to
the bank if the audit client is not
able to repay the loan?

3
Learning Objectives

•To understand auditor’s exposure to legal

liability
•To differentiate between statutory law and
common law
•To relate the understanding of common law to
prominent law cases

4
Coverage
• Expectation Gap
• Liability under the Statutory Law
• Liability under the Common Law
• Ultramares Corporation vs Touche et al
• Candler vs. Crane, Christmas and Co
• Hedley Byrne vs. Heller and Partners
• JEB Fasteners vs. Marks Bloom and Co
• Caparo Industries plc vs. Dickman and Others
• Royal Bank of Scotland vs. Bannerman Johnston Maclay and
Others (2002)
• Breach of Contract and Negligence
• Statutory Cap (Limited Liability Partnership)

5
6
 Introduction
• In the U.S., approximately 4,000
each year claims against auditors
(in 1960s, only a few hundred a
year). Example, as table below:-
Auditor Company Audited Settlement
Amount
(USD)
EY Cendant Corporation (1998) 335 m
https://www.econcrises.org/2016/11/29/cendant-corporation/
Arthur Andersen Waste Management Inc. (2001) 75 m
https://www.wsj.com/articles/SB992971291203974783
PWC MicroStrategy (2001) 55 m
https://www.washingtonpost.com/archive/politics/2001/05/09/
microstrategy-auditor-to-settle-investor-suit/dd74e519-6285-
4e28-a4bc-5629270c5a79/
EY Savings & Loan (1992) 400 m
https://www.latimes.com/archives/la-xpm-1992-11-24-mn-
1128-story.html 7
 Introduction
• Auditors can be sued by clients, shareholders,
bankers investors, creditors and government for
failure to perform professional services
adequately. Auditors can be held liable under
two classes of law; i.e. common law and
statutory law.
• “Deep pocket” syndrome.
• Professional indemnity is mandatory to auditors.

8
9
Introduction
• Statutory Law:
• Written law enacted by the legislative
arm of the government
• Must be adhered to.
• Example: Under the Companies Act 2016, the
auditors are liable to express their opinion on the
financial statements of the clients.
• Auditors also has reporting duties under various
other statutes such as under FSA, SCA and AMLA.
• These duties require the auditor to report to the
relevant authorities any violation of laws or
regulations they encounter in the course of
performing their duties.
10
Introduction
• Common law:
• Case law developed over time by judges who issues
legal opinion when deciding a case.
• The legal principle announced then become
precedent for judges deciding similar case in future.
• Auditors may be held liable to client for breach of
contract, negligence and fraud.
• Auditors may be held liable to third party for
negligence and fraud.
• The outcome of application the common law for the
third party is subjective, inconsistent and sometimes
depend on the location where the case is tried.
11
Introduction
Major cause of lawsuit against auditors may be due to lack of understanding by
financial statements users of the difference between a business failure and an
audit failure; and between an audit failure and audit risk.

Business failure occurs when business fail Audit risk is the risk that
financially and as a result, will be unable to pay its the auditor will conclude
financial obligations and unable to meet the that the financial
expectations of its investors due to poor statements are fairly stated
management, economic conditions etc. and an unqualified opinion
can therefore be issued
when in act they are
Audit failure occurs when the auditor issues an materially misstated. This
erroneous audit opinion as the result of failure to because the auditors gather
comply with the requirement of auditing information on test basis
standards. E.g. assigned unqualified staff to
perform audit, he unable to detect material
misstatement that qualified auditors would
discover.
12
Audit Expectation Gap
• When there is a business failure due to inability to pay debts, it is common for
the users of the financial statement to claim that there was an audit failure,
even if the audited financial statements in actual fact is fairly stated and it was
correctly reported by the auditors.

• Users argue, if the auditor perform their job with due care the auditor should
be able to detect misstatements and advise their client accordingly. In other
word, the auditors can prevent the business to fail by implementing proper
audit job.

• This conflict we called “audit expectation gap”, i.e. the difference between
public expectation of auditors and what the auditors believe their
responsibilities should be.

• The users believe, unqualified audit opinion provides an assurance that an

entity is well managed, financially sound and there is no fraud.

• On the other hand, auditors argue that the user is lack an understanding of
the limitations of the financial reporting or the auditors’ examination of the13
financial statements, i.e. base on sample and materiality.
Audit Expectation Gap
• However, the gap may also be due to auditor’s inadequate performance where
auditor is not performing up to the standard OR the standards itself are not
drawn up to the required benchmark.
• An understanding of the gap enables the profession to address the relevant
issues and maintain confidence of the users of the financial statements in
providing the services.

• Components of audit expectation gap:-

• Unrealistic expectations on the part of users
• Performance gap
• By auditor to comply the standards
• By standard to meet the need of users

• Implications of audit expectation gap:-

• Loss of confidence on auditors
• Audit reports less reliable
• Bad reputation of auditors
• Increase in lawsuits
14
Actions to Narrow Expectation Gap

• Expanded audit report (more explanation or

disclaimer clause, key audit matters (KAM))
• Increase public awareness and education in respect
of the nature of audit work and its inherent limitations
• Educate client and audit committees
• Educate client and public on the word “reasonable
assurance” which is not absolute assurance due to
inherent limitation
• Auditors strictly adhere to auditing standards.
• Auditors should be more sensitive to possible
existence of fraud in every audit they conduct.
15
Measures to Reduce Exposure to Lawsuits
At the profession level
• Research in auditing
• Establish stronger auditing and assurance standards
• Set requirement to protect auditor. E.g. developed a sample of
engagement letter and letter of representation to be followed by
all auditors
• Establish peer review (auditing the auditors) requirement
• Lobby for changes in the law to protect the auditors
• Education of users to the meaning of auditor's opinion and scope
of audit work
• Continually updating the code on professional ethic and sanction
(official order to stopping trade) members for improper conduct
and performance

16
Measures to Reduce Exposure to Lawsuits
At the individual firm level
• Deal only with clients possessing integrity and investigate
prospective clients thoroughly
• Hire qualified personnel and train them properly
• Follow the standards of the profession
• Understand the client’s business
• Maintain independence
• Perform high standard of quality audits
• Documented the work properly
• Obtain clear engagement letter and representation letter
• Maintain confidential relations
• Carry adequate insurance coverage
• Alert to risk factors that may result in lawsuit
• Exercise professional scepticism…..
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Key Legal Terms
Privity
• A contractual/trust relationship
• Lack of privity means the
accountants may not owe a duty of
care to an injured third party.
Tort
• A wrongful act other than a breach
of contract but not criminal action
and can held liable under the civil
court. Example: Negligence and
Fraud.
Due care
• Evaluated in terms of what other
professional accountants would
have done in similar circumstances.
Third-party beneficiary
• A third party not having privity of
contract but is known to the contracting
parties and intended to have certain
rights and benefits under the contract.
• E.g. the bank in which the company has a
large outstanding loan and the bank
requires audited financial statement as
parts of its loan agreement.

Breach of contract
• Contracting parties fails to meet the terms and obligation in a contract.
• Example: Failure of a CA to deliver a tax return on the agreed-upon date.
• Parties who have relationship that is established by a contract are said to have
privity of contract. 18
Key Legal Terms
Negligence
• Act or omission which occurs because the person concerned has failed to
exercise that degree of professional care and skill, appropriate to the
circumstances of the case, which is expected of accountants and auditors”
(ICAEW).

Ordinary negligence
• An absence of due care in the conduct of an assignment.
• For auditors, in terms of what other auditors would have done in the same
situation.

Gross negligence
• Extreme departure from professional standards of due care.
• Lack of even slight care, totally reckless that can be expected of a person.

Fraud
• Actions taken with the knowledge and intent to deceive
• Example: auditors has made false representation and the auditor has the
knowledge that the representation is false. 19
STATUTORY LAW: LIABILIY UNDER THE STATUTE
• Liability of the auditor also came from other legal reporting liabilities
imposed under various statutes. The auditor has the duty to report any
violation of law that came to the auditor’s attention during the course of the
audit.

• Examples:
• Companies Act 2016
• Duty to report company’s financial statement and to report a
breach or non-compliance with any provision of the CA.

• Securities Industries Act 1983

• Governed the trading of securities on the stock exchange. The
auditors need to report breach of securities law to authorities such
as SC.

• Financial Services Act 2013

• Licensing and regulation of banking institution. Any violation of FSA
by the bankers, the auditor need to report to the central bank
(Bank Negara) immediately. 20
STATUTORY LAW: LIABILIY UNDER THE STATUTE

• Anti-Money Laundering and Anti-Terrorism Financing

(Amendment) Act 2014
• Dealing with law and penalties of money laundering
and measure for preventing such activities. AMLA
imposes a legal duty on a reporting institution including
auditor to report unlawful transaction to Bank Negara.

• Securities Commission Act 1993

• Establish SC as approving and registering body for
prospectus issued in connection with public securities
offering. The auditor is responsible to report non-
compliance of the Act by the company.

21
COMMON LAW: LIABILIY UNDER COMMON LAW
• Auditors has liability to clients and third parties under the common
law.
• Liability to clients due to breach of contract, negligence and fraud
• Liability to third party due to negligence and fraud

• Under both liability, plaintiff must prove the following in order to bring any
legal action against the auditors:-
• Duty of care
• The auditor owed a duty of due care to the plaintiff. Extensively
discussed with cases.
• Breach of duty of care
• The auditor has failure to act in accordance with due care. The
standard of care is that of the reasonable skill and care of another
person carry in the same assignment.
• Causal relationship
• There is causal relationship or connection between the auditor’s
negligence and the plaintiff damage.
• Damage
• The plaintiff suffered actual loss or damage. 22
Liability Under Common Law: Liability to Clients
Due to breach of contract, negligence and fraud
• When an auditor accepts appointment, he actually enters into a contract
with client which then indirectly impose certain obligation on him.
• These obligations may be clearly stated (express term) or unstated (implied
terms) in the contract
• Express terms
• Provision stated in the contract (e.g.: engagement letter) and these
terms shall NOT override the statutory law but they may be go beyond
the statutory law.
• Example: Clearly stated auditors responsibilities and client
responsibilities which are not stated in the Companies Act 2016 and also
the deadlines.
• Implied terms
• The terms which parties in concert have left unstated because they
consider too obvious to express.
• Example: Auditors have a duty to exercise reasonable care, work with
reasonable expediency (with normally in the engagement letter) and
auditors have the right to reasonable remuneration.
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Liability Under Common Law: Liability to Clients

24
Liability Under Common Law: Liability to Clients

Breach of Negligence Fraud

contract
If an engagement If an auditor has acted
Liability is is performed with knowledge and
based on the without due intent to deceive the
auditor’s failing care, the auditor client, he or she can
to complete the may be held be held liable for
services agreed liable for an fraud.
to in the actionable tort in
contract with negligence.
the client

25
Liability Under Common Law: Liability to Clients

Client Must Prove Auditor’s Defence:

1. A duty was owed to the 1. No duty was owed to the

client. client.
2. Failure to act in 2. The client was negligent.
accordance with that 3. The auditor’s work was
duty. performed in accordance
3. A causal connection with professional
between the auditor’s standards.
negligence and the 4. The client suffered no loss.
client’s damage. 5. Any loss was caused by
4. Actual loss or damage to other events.
the client. 6. The claim is invalid because
the statute of limitations
has expired. 26
Liability Under Common Law: Liability to Third Parties

Negligence Fraud

If an engagement is If an auditor has acted with

performed without due knowledge and intent to
care, the CPA may be held deceive a third party, he or she
liable for an actionable tort can be held liable for fraud.
in negligence.

27
Liability Under Common Law: Liability to Third Parties
Third Party Must Prove Auditor’s Defense

1. The auditor had a duty to 1. No duty was owed to the

the plaintiff to exercise 3rd party
due care. 2. The 3rd party was negligent.
2. The auditor breached that 3. The auditor’s work was
duty and was negligent in performed in accordance
not following the with professional standards.
professional standards. 4. The 3rd party suffered no
3. The auditor’s breach of loss.
due care was the direct 5. Any loss was caused by
cause of the 3rd party’s other events.
injury. 6. The claim is invalid because
4. The 3rd party suffered an the statute of limitations has
actual loss as a result. expired.
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Liability Under Common Law: Liability to Third Parties
(Duty of Care)
Privity

Near Privity
A known third party.
Third parties whose relationship with the
Four legal CPA approaches privity.
principles
for third Foreseen Third Parties
parties Third parties whose reliance should be
foreseen, even if the specific person is
unknown to the auditor.

Reasonably Foreseeable Third Parties

Third parties whose reliance should be
reasonably foreseeable, even if the
specific person is unknown to the auditor.

29
Liability Under Common Law (Duty of Care)
First landmark case: Ultramares v Touche et. al. (1931)
• Facts of the case
• The plaintiff (Ultramares Corporation) was approached for a loan.
• The plaintiff asked the borrower to provide the audited financial
statement of which audited by the defendant (Touche).
• The borrower was bankrupt after obtaining the loan from the plaintiff.
• The plaintiff alleged that the auditor has been negligent in their report
for failing to detect or report deceptive accounting entries that hide the
borrowing company’s problem.
• Judgment
• The auditors did not owe a duty of care to the plaintiff due to the fact
that they were not in contractual privity.

• Explanation
• Although the auditor (Touche) was negligent, they were not liable to
third party (Ultramares) because Ultramares was not deemed to be
primary beneficiaries (i.e. a known third party – was informed
before the audit)
30
Liability Under Common Law (Duty of Care)
(Loan)
Ultramares Borrower

Audited FS of Borrower
Auditor

• Borrower bankrupt and not able to pay the loan

• Ultramares sued the auditor

• Judgment
• The auditor did not owe duty of care in the absence of a contractual
relationship.

31
Liability Under Common Law (Duty of Care)
Candler v Crane, Christmas and Co. (1951)
• Facts of the case
• The plaintiff (Mr Candler) invested in a company based on the audited
accounts of the company, which is negligently prepared by the auditor.
• The company subsequently became insolvent.
• Mr. Candler sued the auditor
• The auditors did not deny their negligence in performing the audit and
they also aware that the account would be used by the plaintiff in
investment decision.
• Judgment
• It was held that in absence of a contractual relationship between the
parties, the auditor did not owe a duty of care to the plaintiff (Mr.
Candler).
• Why
• The view under the U.K. common law was that a professional
accountant would not be held liable to a party outside the contractual
or fiduciary relationship based on doctrine of privity of contract.
• Referring case
• Ultramares V. Touche, et. Al (US 1931) 32
Liability Under Common Law (Duty of Care)
(Invest
Candler based on FS) Company

Auditor
Sued auditor for negligence in
(negligence in
auditing the FS
auditing FS)
• Auditor admitted negligence
• Auditor was not aware that the audited FS was used as basis for an
investment by Candler

• Judgment
• The auditor did not owe duty of care in the absence of a contractual
relationship.
• Lacked privity of contract
33
Liability Under Common Law (Duty of Care)
Hedley Byrne vs Heller & Partners (1963)
• Facts of the case
• The case involved a merchant bank, Heller & Partners, who
was approached by Hedley Byrne, an advertising company
for credit reference on a potential client, Easipower Ltd., who
was also a customer to the bank.
• The reference was supplied by the bank without making a
careful check of the records.
• Based on this reference, Hedley Byrne provided a credit to
Easipower Ltd., which subsequently went into liquidation
before the debt were recovered by Hedley Bryne.
• Hedley Bryne sued the bank and the bank denied
responsibility on the ground that it owed no duty of care to
the plaintiff in absence of contractual relationship.
34
Liability Under Common Law (Duty of Care)

Hedley Byrne vs Heller & Partners (1963)

• Judgment
• The House of Lord held that the bank owed a duty of care to the
plaintiff on the ground that the bank is responsible to give information
with due care once he knew or ought to have known that Hedley will
rely on it’s information to make credit decision.
• This judgment eroded the precedent ruled in the Ultramares and the
Candler case and the privity standard is no longer strictly used as a
defense measure.
• However, Heller & Partners escaped liability because it had inserted a
disclaimer of responsibility in the certificate of credit references and
thus, the bank did not have to pay any compensation to the plaintiff.
• Example of disclaimer: We must emphasize that this report has been
prepared solely for your own records/information and no responsibility
nor warranty will be accepted by our firm to any third party who may
use this report for any purpose.

35
Liability Under Common Law (Duty of Care)
Hedley Byrne (provided
credit)
Easipower Ltd.
Advertising Co.

Customer

Credit reference of Easipower Heller & Partners

without careful check (Bank)

• Easipower was liquidated and Hedley Byrne not able to recover the credit.
• Hedley Byrne sued Heller & Partners

• Judgment
• Bank owed a duty of care to the plaintiff
• Bank is responsible to give information with due care once he knew or
ought to have known that Hedley will rely on it’s information to make
credit decision (near privity).
• Bank escaped due to disclaimer in the credit reference. 36
Liability Under Common Law (Duty of Care)
JEB Fasterners Ltd v. Marks, Bloom & Co (1981)
• Facts of the case
• JEB Fasteners Ltd acquired the entire shares of BG
Fasterners which was facing liquidity problems.
• Marks, Bloom & Co were the auditors of BG Fasterners Ltd.
• In performing the audit of BG Fasteners, the auditor did not
verify the net realizable value (NRV) of the inventory but
accepted the company’s own figure of NRV.
• The accounting policies is “Inventory will be valued at lower
of cost and NRV”.
• In actual fact, the cost of the inventory was far less than
NRV and to comply with an accounting standards, the
amount of the inventory should be based on cost not NRV.
• If at cost, the company would have shown substantial loss
instead a small profit as reported.
37
• ASSETS – (LIAB. + EQUITY) = NET WORTH OF BUSINESS

• PURCHASE CONSIDERATION TO ACQUIRE ANOTHER

COMPANY IS BASED ON THIS NET WORTH OF BUSINESS

38
Liability Under Common Law (Duty of Care)
JEB FasternersLtd v. Marks, Bloom & Co (1981)
• Fact of the case (Continued):
• The plaintiff brought an action against auditors claiming that the
accounts were negligently audited and they had relied on the audited
accounts when acquiring the company’s shares.
• The auditor contended that they did not owe a duty of care to the
plaintiff and if a duty of care existed, it was only to persons who made a
specific request for information.
• JEB Fasterners did not officially request for the information, they just
use the information available for the public i.e. the audited accounts.

• Judgment
• The court held in favour of plaintiff on the ground that the auditors
knew at the time the accounts were prepared, the company needed
outside financial support and ought reasonably to have foreseen that a
take over was a solution to financial problem faced by BG.
• The auditor owed JEB Fasterners a duty of care in the preparation of
audited accounts.
39
Liability Under Common Law (Duty of Care)
(acquired) BG Fasteners
JEB Fasteners
(Had liquidity problem)

Sued auditor Marks, Bloom & Co.

(Investment was overstated & (Auditor)
BG actually suffered loss)

• The FS of BG’s should show losses instead of small proit

• Judgment
• The auditor owed duty of care to the third party (JEB)
• Auditors knew at the time the accounts were prepared, the company
needed outside financial support and ought reasonably to have
foreseen that a take over was a solution to financial problem faced by
BG. 40
Liability Under Common Law (Duty of Care)

• Effect on profession from JEB case:

• Accounting profession becoming riskier as the
court had broadened the auditors’ liability to the
extent that they could potentially owe a duty of
care to almost anyone who relied on their audit
opinion.

41
Liability Under Common Law (Duty of Care)
Caparo Industries Pty Ltd v. Dickman& Others (1990)
• Facts of the case
• Relying on the audited accounts, Caparo purchased Fidelity
plc shares in the open market in stages until finally it
acquired control of Fidelity.
• The audited accounts of Fidelity showed a profit of £1.2m.
• But, after take over, Caparo discovered that the result
would have been a loss of £400,000.
• Caparo alleged that the auditor had been negligent in
auditing the account.

• Judgment
• House of Lord (reversing the Court of Appeal) held that the
auditor owed no duty of care to the potential investors
making investment decision on the strength of audited
accounts. 42
Liability Under Common Law (Duty of Care)

Caparo Industries Pty Ltd v. Dickman& Others (1990)

• Duty of care should only to the intended recipients of the
auditors’ report, i.e. primary beneficial third party and foreseen
third party (Proximity relationship) where the accounts were
prepared specifically for a third party for a particular purpose
and the intention was made clear to the auditor at the time of
the audit engagement.

• The Caparo decision seems to reaffirm the privity rule in the

earlier Ultramares and Candler cases where individual
shareholders, prospective investors, lenders or other third
parties who suffer financial loss by relying on negligently
audited account would have no claims against the auditor.

43
Liability Under Common Law (Duty of Care)
(bought shares on open
Caparo Industries Fidelity plc
market & eventually
acquired 100%)

Auditor

Sued auditor
(FS showed GBP1.2m but actually GBP400K loss) Dickman & Others

• Judgment
• House of Lord (reversing the Court of Appeal) held that the auditor owed no
duty of care to the potential investors making investment decision on the
strength of audited accounts.

44
Liability Under Common Law (Duty of Care)
Royal Bank of Scotland v. Bannerman Johnston Maclay and Others (2002)
• Facts of the case
• APC Ltd. submitted to Royal Bank of Scotland (RBS) audited accounts
audited by Bannerman Johnston Maclay & Others (Bannerman)
• RBS approved overdraft facilities and term loans to APC.
• APC subsequently went into receivership
• RBS claimed Bannerman was negligent in issuing the audit opinion and
in breach of the duty of care it owed to RBS.
• Bannerman defended that they did not owe RBS a duty of care.

• Judgment
• Referring to Caparo case, the court held that when the auditors did not
state the “disclaimer statement” in the auditor report and did not
disclaim their responsibility, they could be held owing a duty of care to
a third party if they knew (or ought to have known) that the third party
would rely on the audited account for lending or investment decision.

45
Liability Under Common Law (Duty of Care)
Royal Bank of Scotland v. Bannerman Johnston Maclay and
Others (2002)
• Effect on the profession
• Modification on the audit report to include the following
clause:
• “It is our responsible to form an independent opinion, based
on our audit, on the financial statements and to report to
you as a body in accordance with Section 174 of the
Companies Act 2016 and for no other purpose. We do not
assume responsibility to any other person for the content of
this report.”
• This statement serves as a disclaimer statement for the
auditor, i.e. the responsibility of the auditor is to report the
accounts to the shareholders as a body as required by CA
2016 and the auditor does not accept any other
responsibility 46
Liability Under Common Law (Duty of Care)
Supplied audited FS
Royal Bank of Scotland Fidelity plc
Approved loan

Auditor

Sued auditor
(Claimed auditor was negligent in issuing audit Dickman & Others
opinion and in breach of the duty of care it owed
to RBS)
• Judgment
• The court held in favour of RBS on the basis that the auditors knew the identity
of the third party, the use to which the information would be put and that the
bank intended to rely on it for the known purpose
• RBS might not extend the company’s lending agreements, if they had known
about the misstatements in the accounts (due to fraud) that had not been
detected by the auditors.
• Significantly, the judge commented that, having become aware of the details of
the requirements of the lending agreement, the auditors could have disclaimed
responsibility to the bank. 47
Summary of Cases for Duty of Care

48
Summary of Cases for Duty of Care

49
Liability Under Common Law (Duty of Care)
From these cases, it can be summarized that there are four types
of relationships between plaintiffs and the auditor:
• Privity relationship
• Refers to the contractual relationship that exists between
two or more contracting parties. (i.e. the auditor and the
client)
• Near privity relationship / Primary relationship.
• Non-client could have this relationship. A known third
party.
• Auditor knows that the audit is specially for the identified
third party.
• Example: Carried out due diligence review for a specific
third party to take over a company.
• Hedley Bryne is a known third party to Heller & Partner
50
Liability Under Common Law (Duty of Care)

• Foreseen party relationship

• Non client relationship. (In the case of JEB Fasterner)
• Known to or reasonably expected to be known and rely on auditor’s
work in making decisions.
• Foreseen party is a member of limited class of user whom auditor is
aware that they will rely on the financial statement and to be treated
the same as a known third party.
• Example: a bank that has loans outstanding to a client may be a
foreseen user.

• Foreseeable party relationship

• Users who are not specifically known to or identified to the auditor.
Often called an unlimited class of third party.
• Reasonably be expected to see the auditors report and financial
statements. Example: Public or market who make investment decision
based audited accounts.

51
Liability Under Common Law (Duty of Care)

• Many courts allowed third parties whom having primary

beneficiary relationships and foreseen party relationships the
right to bring legal action against auditors, BUT not for the
parties which considered under foreseeable party relationship.
• In other words, third party such like potential buyer of the
company (who asked the auditor to perform due diligence
audit), bankers and creditors as at balance sheet date are the
parties who have right to take action.
• Potential shareholders, creditors and bankers is foreseeable
party of which does not have legal right to take action against
auditors.
• This is called ‘Test of Proximity’. i.e. testing to identify the
primary and foreseen relationship.

52
Liability Under Common Law (Duty of Care)

• Based on example cases above, the lawsuits against auditors

have give significant changes in the profession in particular:-
• Many find judgment in Caparo case was difficult to accept,
raising questions about the role of auditors and the value of
the auditors’ service.
• Clarified certain concept to become clearer.
• Example: concept of contributory negligence
• Relates to the failure of the plaintiff to meet certain
required standards of care that also contributed to the
negligence such as the directors fail to establish a sound
internal control to safeguard the company’s assets.
• Rise in litigation cost and the cost of professional liability
insurance and become the second largest cost after the
cost of human resources for the auditing profession.
53
Liability Under Common Law (Breach of Duty of Care)

• Breach of duty of care

• Plaintiff to establish that the auditor has failed to act in accordance
with due care.
• The standard of care is that of the reasonable skill and care of another
person carrying the same assignment.
• Two classic statement have often been referred to in defining the auditor’s
responsibility to perform with due care:-
• First statement by Lindley LJ in Re London and General Bank (1895):
• An auditor is not bound to do more than exercise reasonable care
and skill in making inquiries and investigations.
• He is not an insurer, he does not guarantee that the books do
correctly show the financial position BUT auditor must be honest,
not certify what he does not believe to be true and he must take
reasonable care and skill before he believes that what he certifies is
true.
• Where suspicion is arose, more care is necessary.

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Liability Under Common Law (Breach of Duty of Care)
• Second statement by Lopez LJ in Re Kingston Cotton Mill (1896):
• The auditor had relied on a manager’s certificate as the basis for
ascertaining the amount of inventory stated in balance sheet. As a
result, the inventory is misstated and inflated the profit .
• The judge accepted that it was not the auditor’s duty to take stock
and that he must rely on some skilled person to record the proper
value of stock.
• However, to respond to the auditor’s responsibility relating to
detecting fraud, the judge stated that it is auditor’s duty to perform
with reasonable skill, care, competent, careful and caution of
which depend on particular circumstances of each case but he is
not bound to detect the fraud.

• Conclusion
• Reasonable skill and care is not a static concept.
• The standard of reasonable care will go inline with current expectation.

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Liability Under Common Law (Causal Relationship)

• Causal Relationship is the proof of connection between the

plaintiff’s loss and the act of negligence.
• The plaintiff must demonstrate that the loss is the consequence
of the breach in the duty of care and at the time the breach
was committed, the loss was reasonable foreseeable as a
consequence.
• Example:
• To prove the connection between auditor’s failure to detect
a material misstatement (fraud or error) and the loss
(damage) arising from the fraud.
• Plaintiff has to prove that if the audit had been carried out
competently, the auditor can detect the weakness of
internal control and able to prevent the fraud and
accordingly the loss from the fraud can be avoided.
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Liability Under Common Law (Causal Relationship)
Examples of legal cases:
• GalooLtd Vs Bright Graham (1994).
• The plaintiff claimed the auditor were liable for its trading losses for a
number of years during which the audited accounts were materially
misstated.
• Plaintiff alleged that if the financial position was known earlier, the
entity may discontinued its business operations, thus avoiding the huge
trading losses.
• Court judgment
• Causal relationship does not exist, because an entity operation’s
decision and result depend on many factors such as management
and market forces. Accordingly, the plaintiff claims against the
auditor was denied.

• Haig Vs Bamford (1976).

• The plaintiff was able to satisfy the court on the issue of relationship by
showing that he had discussed the account with bankers and auditor
regarding the intention of the investment.
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Liability Under Common Law (Damages)
• The plaintiff must prove that they suffered actual loss or
damages.
• Types of damages:
• Loss of investment
• Overpayment for investment
• Loss due to defalcation by management or employee
• Overpayment of dividends.
• The measurement of damages is dependent on the
circumstances
• Courts would attempt to approximate monetary equivalents
that the plaintiff would get if the auditors discharged his duties
properly.
• Award of damages would not be granted if the plaintiff had not
suffered real or measurable loss.

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Auditor’s Defences Against Legal Action
Legal action by clients
• Lack of duty to perform
• Auditors would claim that there was no implied or expressed contract.
• E.g. the misstatement due to fraud was not uncovered because the
obligation of prevent fraud is on the management, not on the auditors.
• Must be clearly stated in the engagement letter.
• Non negligent performance
• Auditors would claim that the audit was performed in accordance with
auditing standards.
• Absence of causal connection
• The client needs to prove that the damaged suffered by them mainly
due to auditors’ negligence.
• E.g. client alleges that the bank did not grant the bank facilities due to
the auditor’s inability to complete the audit within the agreed-upon
time, which caused damages to the company.
• The auditor may defend that the bank refused to give the loan for other
reason such as weakening financial condition of the company.
• This defence is called an absence of causal connection. 59
Auditor’s Defences Against Legal Action
• Contributory negligence
• Auditors would claim that the client’s own actions and interference
were the causes of the loss which was the basis for damages.
• E.g. the audit job unable to complete within the time due to lack of
corporation from the management in providing appropriate audit
evidence and explanation.

Legal action by third parties

• The first three defense measures above may also be used in third party's
lawsuit.
• Contributory negligence is not available because the third parties do not
contribute to misstated financial statement.
• The most preferred defence measure could be ‘Non-Negligent Performance’,
where the auditors have performed the job according to the auditing
standards.
• The other defense measures are lack of duty to perform (lack of privity of
contract) and absence of causal connection
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PYQ: June 2018; Question 2 (B)
Emilia & Partners has been appointed by Teras Construction Bhd (TCB) to audit Gabungan
Bina Sdn Bhd (GBSB). Sharifah the most senior manager with the firm is assigned to do the
audit of GBSB. TCB is in the process of acquiring GBSB. Sharifah was informed by the CEO
of TCB that they need reliable and good financial report of GBSB before they proceed with
the aquisition. The audited financial statement would be used to determine the purchase
price of the GBSB .

Sharifah performed her examination in a negligent manner. As a result of her negligence,

she failed to discover substantial fraud committed by Salim the finance manager of GBSB.
Based on the audited financial statement perfomed by Sharifah, TCB acquired GBSB. TCB
would not had acquired if they knew about the fraud committed by the CFO. After TCB
discovered the fraud, TCB sold all their shares in GBSB at a loss of RM250,000. TCB then
sue Emilia & Partners for negligence and seek to recover their RM250,000 loss.

Required:
Discuss whether Teras Construction Bhd (TCB) able to recover its loss from Emilia &
Partners.
(8 marks)

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