Explain the factors which have contributed to the increased number of lawsuits against auditors from third parties in recent years.
- Non-compliance to standards
- Increased consciousness of information from regulators e.g. CMA Changes in law replacing auditors responsibility as watchdogs.
- Changes in ICT making it impossible to deny especially if there is evidence against them Increased awareness of responsibilities placed on public accountants.
- Judges having difficulties in interpreting technical accounts and audit information.
Identify three parties to whom the auditor could be held liable to.
- The client company under the law of contract – To third parties under the tort of negligence.
- To the government under criminal law.
(a). Describe five circumstances under which an auditor’s criminal liability might arise.
- If the auditor alters, mutilates, destroys or is privy to allegation, falsification, mutilation or destruction of any books or accounts, vouchers or statements.
- If the auditor makes a statement which is false in material terms knowing it to be false.
- If the auditor makes or is privy to making of a fraudulent entry in the company’s accounts.
- If the auditor willfully contravenes any provision of the Companies Act which under normal circumstances is supposed to be followed in the course of his audit work.
- If the auditor is aware of a material misstatement that has been omitted in the report, accounts, statements or even prospectus but does not reveal this fact. – Practicing as an auditor when he is not eligible.
- One of the leading cases in the duty of care owed by an auditor to third parties is that of Caparo Industries PLC v Dickmav and others. This case established the criteria for determining the duty of care owed by an auditor to third parties.
However, in the case of a prospectus, the auditor’s liabilities are open since if there is negligence on the part of the auditor, any party who suffers loss can sue the auditor.
With reference to the above statement, suggest five ways of limiting third party liability with respect to prospectuses.
- Auditors should withdraw consent in writing before a prospectus has been registered and circulated for public use.
- After registration of the prospectus but before the issue of shares, auditors canwithdraw the consent before allotment of shares
- Screening clients before acceptance of engagement – Taking an insurance cover
- Joint audit i.e. sharing responsibility of litigation.
- Quality control reviews .
- An auditor should ensure manageMent issue letters of representation as a reasonable ground to support his statement.
- When circumstances dictate an auditor should attach a disclaimer to his report that he was unable to form an opinion.
- The auditor should caution third parties not to rely on his report.
- The auditor should always use reasonable care and skill during the course of his work by for instance following international standards on Auditing.
Discuss the factors that have led to increased litigation against auditors.
- The competence needed that is of high standard.
- Increased audit complexity caused by computerised systems.
- More complicated accounting standards
- More complicated business involving foreign operations.
- New types of transaction and operation affecting client e.g. internal operation.
- Negligence cases on the work done.
- Joint and several liability statute that permit the plaintiff to collect the full amount of the settlement from any dependent even though he is liable partially for the losses sustained.
- Corporate governance requirements.
- Changes in the laws and regulations governing the audit.
- More demanding auditing standard for detecting errors and frauds.
- Increased regulation e.g. Capital Markets Authority regulation.
- Pressure to reduce audit time and make the audit efficiency.
- Awareness by the users of financial information of the possibilities and rewards of ligation.
- Misunderstanding by the users that an unqualified opinion is an insurance policy against misstatement.
- Class-action law shifts which allow the law firms to combine the dependants into one legal action.
You are the auditors of Pickley Ltd. a company quoted on the stock exchange. Your audit reports for the company for the last three years have been unqualified, including the report for the current financial year ended 30 April 2011.
On 15 May 2011 a potential investor in Pickley Ltd.’s shares sent a registered letter to you which contained the following:
We wish to advise you that we intent to make substantial investment in Pickley Ltd. of which we understand you are the auditors. We shall .place material reliance on the audited accounts of the company in making decision relating to our contemplated investment. We note in particular the earnings per share of the company have been quite impressive.”
Thereafter, the potential investor purchased substantial shares in Pickle), Ltd. The investment turned out to be unprofitable since the market value of the shares of Pickley. Ltd. dropped by over 60%. The investor has asked your audit firm to admit liability for the loss since the investor relied on financial statements which were later confirmed to contain material errors..
Citing relevant cases under common law, discuss the liability of the auditors of Pick ley Ltd.
Liability of the auditors
Decided legal cases have not been consistent on the issue of auditor’s liability. Discussed below are few, of the decided cases on auditors liability
– Candler V Crane Christmas & Co.
Majority (Lord Denning dissenting) decided that there could be no liability in the absence of a contractual relationship. The decision was reached despite Candler having been induced to invest money in the company on the strength of the accounts which were negligently prepared by the company’s auditors.
– Hedley Bryne & Co Ltd V Heller 4 Partners Ltd
The judges took differed with the above Judgment. They were of the view that the ease had been wrongfully decided. They held that a certificate issued in the ordinary course of a bank’s business would be relied upon by the party to whom it is issued and the absence of a contract did not constitute a valid defence in negligence claim against the bank.
The Counsel of the Institute of Chartered accountants in England and Wales (ICAEW) on their part maintained that no third party liability would attach auditors if the financial statements they have audited under the Companies Act are used without their knowledge or consent by outsider’s ill the investment context.
However it is importance to note that any loss traceable: to negligence of auditors would not be easy to defend .
Jeb Fasteners Ltd V Marks Bloom & Co
In this case it was held that;
- A duty of care was owed by defendant auditors (Marks Bloom & Co.) to the plaintiff.
- The plaintiff in realizing the takeover decision had relied on the financial statements and unqualified report of the auditors.
- The accounts did not show a true and fair view of the company and were negligently prepared.
- Judgment would be given for the defendant auditors, but by reason only of the fact that on the evidence before the court the plaintiff would have acted no differently and would still have gone ahead to take over the company. – Caparo industries Plc. V Dickman & Others
it was unanimously concluded by the five lords that the question of auditor’— duty of care to third parties does not extend to investors and individual shareholders acting on Stewardship accounts. conclusion
The auditors of Pickley Ltd would rely on some of the cages decided by the court while at the same time legal liability may arise based on the interpretation of the case in the question. The auditors can mitigate against legal liability by writing to the potential investor on the issue raised
Explain the factors which have contributed to the increased number of lawsuits against auditors from third parties in recent years.
- Regulators such Capital Markets Authority (CMA) have become more conscious of their responsibility in protecting investors interest.
- Increasing size of businesses coupled with globalisation has led to complexity of auditing and accounting functions.
- Growing awareness of the responsibilities of public accountants by users of financial statements. iv. Judges encounter hardships in understanding and interpreting technical accounting and auditing matters.
- Changes in accounting standards and legislation.
Outline measures that could be taken by practicing auditors to minimise their legal liability
- Undertaking measures to ensure that all assignments are performed to the highest quality standards. The auditor should ensure that the requirements of the International Standards on Auditing are adhered to in ill assignments;
- Proper planning of the audit work to ensure that all potential risks that could affect the financial statements are identified and appropriate audit procedures performed;
- Be independent
A lot of litigation has arisen from a too willing acceptance by an auditor of a client’s representation or of a client’s pressures. The auditor must maintain an attitude of healthy scepticism.
- Putting in place appropriate quality control policies and procedures and monitoring their effectiveness;
- Limit access to his work or reports, where possible;
- Include a disclaimer of liability clause in the relevant document or report. Example of such a clause would be while every care has been taken in the preparation of this document, it may contain errors for which we cannot be held responsible”
- When submitting un-audited accounts or other un-audited financial statements (where the auditor prepares accounts on behalf of the client) the auditor should ensure that the purpose for which the statements or reports have been prepared is properly explained on the face of the report.
- Obtaining proper terms of engagement such that the auditor’s roles and responsibilities are clearly bid out and the client understands his role in the engagement.
- Concentrate on clients who have integrity
There is an increased likelihood of having legal problems when a client lacks integrity ill dealing with auditors, employees, units of government, a firm needs procedures to evaluate the integrity of clients and should dissociate itself from clients found lacking integrity.
An auditor may be liable for damages for material misstatements in published accounts on which he has expressed an audit opinion in the following circumstances: –
- His failure to detect error and fraud;
- Carelessness or dishonesty on his part or by his audit assistants.
However, he may avoid liability by;
Planning and carrying out audit procedures that will provide him with a reasonable expectation of detecting all material misstatements. Again, it may be a defense to show;
- There was no negligence
- That no duty of care was owed to the plaintiff in the circumstances
- In the case of actions in tort, that no financial loss has been suffered by the plaintiff. (b) A successful, legal claim be brought against the auditor by: –
- His client, whom he owes a primary duty of cane
- To third parties under the law of tort to assess the value of damages, the tort will consider the following:-
- i) It must be proved that the auditor was actually negligent ii) That out of his negligence the plaintiff suffered a financial loss. iii) That the auditor owed a duty of care to the plaintiff. iv) Whether the financial lo§s is material to warrant redress.
Ways of limiting an auditors liability; –
- Incorporation of the audit practice
This has already been done in the United Kingdom. For example, KPMG incorporated its UK practice. However in Kenya, this is prohibited by law.
These arrangements create a “firm within a firm”. KPMG audit plc is a limited liability company wholly owned by the partnership. This is done in order to protect partner’s from the crushing effects of litigation. Thus, KPMG Audit plc fences the personal assets of each partner, protecting them from the negligence of a colleague working on an audit.
Under this arrangement, partners involved directly in an audit can still be sued, but incorporation should prevent other partners from losing everything they own simply because they work with someone who has been negligent.
Incorporation will however impose statutory disclosure required on accountancy firms, which have been able in the past to avoid producing published accounts because of their partnership status.
This greater degree of openness can be seen in a more positive light. Clients will be able to see the first position of one of their most important service providers.
- Limited liability partnerships
An alternative means of limiting the risks faced by the accountancy profession is allowing partnerships limited liability.
If such a law is passed, the change in law would protect partners, personal assets from negligence claims against another partner. The firm’s assets and those of the allegedly negligent partner would still be- exposed to liability.
- Avoiding or disclaiming liability to third parties (non-statutory works)
A duty of care to a third party may arise when an accountant does not know that his work will be relied upon by a third party, but only knows that this work of a kind which is liable in the ordinary course of events to be relied upon by a third party.
Conversely, an accountant may sometimes be informed before he carries out certain work that a third party will rely upon the results. An example is a report upon the business of a client, which the accountant has been instructed to prepare for the purpose of being shown to a potential purchaser or potential creditor of that business. In such a case, an accountant should assume that he will be held to owe the same duty of care to the third party as to his client.
One way that the accountants may seek to avoid liability to third parties is to limit access to his work or reports. For example:
- When publishing documents generally an accountant may find it advantageous to include in the document a clause disclaiming liability. For example; “while every care has been taken in the preparation of this document, it may contain errors for which we cannot be held responsible”
- When submitting unaudited financial statements or reports to the client, an accountant should ensure that any special purpose for which the statements or reports have been prepared is recorded on their face and in appropriate cases should introduce a clause providing that the report or statement is confidential and has been prepared solely for the private use of the client. For example; – “This report (statement) has been prepared for the private use of X (the client) only and on condition that it must not be .disclosed to any other person without the written consent of Y (the accountant)
- There are areas of professional work (for example when acting as an auditor under the Companies Act), where it is not possible for liability to be limited, or excluded. There are other areas of professional work (for example when preparing reports on a business for the purpose of being submitted to a potential purchaser) where although such a limitation or exclusion may be included, its effectiveness will depend on the view which a court may subsequently form of its reasonableness.
- The investor’s view of the reliability of the audit opinion may be attended by the limiting of an auditors liability. The investors may be of the opinion that an auditor’s opinion may be given recklessly because his liability is limited, thus, they may not consider it as reliable as when the auditors liability was not limited. There will be no effect on the work to be performed by the auditor. This is because the auditor’s work is governed by statutes, auditing standards and professional guidelines that have not changed with the limited auditor’s liability.
Therefore the auditor’s opinion will still be as reliable as before.
- It is practical for the auditor’s liability to be limited. However, the extent of liability can only be determined by a court of law in the case of a legal suit.
- There will be not effect see (d) (ii)
Yes. I agree that the auditor’s liability should be limited. Why? Because the public as a result of misunderstanding the role of the auditor have been bringing cases of negligence against them indiscriminately