On 17th December 2018, the Competition and Markets Authority (CMA) published an update paper outlining serious competition concerns and proposing changes to legislation to improve the audit sector for the benefit of savers and investors alike.

Week2c_Auditorsliability.pdf

Home >Business & Finance homework help >Management homework help >On 17th December 2018, the Competition and Markets Authority (CMA) published an update paper outlining serious competition concerns and proposing changes to legislation to improve the audit sector for the benefit of savers and investors alike.

Advanced Audit &

Assurance

Week 2c – Auditors’ liability

Use with Auditing 10e by Alan Millichamp and John Taylor

ISBN 9781408044087

Legal liability

▪ Liable under contract to client – based on Engagement

Letter.

▪ Auditors have to complete audit to best of ability – failure

to complete or negligently prepared report will trigger

liability.

▪ Must remain up to date and professionally competent

▪ If comply with latest auditing standards will not be

considered negligent.

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Liability in tort (third parties) –

negligence

◼ Could be liable to third parties, e.g. bank, potential investors

◼ Employed under contract – duty of care

◼ Need to prove

 Duty of care owed

 Duty of care breached

 Loss suffered

Under Kingston Cotton Mill guidelines must use reasonable skill and

care (an auditor ‘is a watchdog but not a bloodhound’)

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ISBN 9781408044087

Post Caparo

A duty of care exists when there is a special relationship between

the parties, i.e. where the auditors knew, or ought to have known,

that the audited accounts would be made available to, and would be

relied upon by, a particular person (or class of person).

The injured party must therefore prove:

▪ that the auditor knew, or should have known, that the injured party

was likely to rely on the financial statements

▪ that the injured party has sufficient ‘proximity’, i.e. belongs to a

class likely to rely on the financial statements

▪ that the injured party did in fact so rely, and

▪ that the injured party would have acted differently if the financial

statements had shown a different picture.

Use with Auditing 10e by Alan Millichamp and John Taylor

ISBN 9781408044087

Case law

Key cases – contractual duty of care

Kingston Cotton Mill (1896) – as mentioned reinforced London &

General Bank case (1895)

Thomas Gerrard (1968) – discovery of falsified invoices should have

alerted auditors- couldn’t rely on directors and were therefore negligent

Liability to third parties

Caparo Industries v Dickman (1989)

Use with Auditing 10e by Alan Millichamp and John Taylor

ISBN 9781408044087

Caparo

Fidelity acquired Caparo Industries and discovered that the accounts

they claimed to have relied on in fixing the price were overstated

Held – auditors (Touche Ross) were not liable to potential investors

they were not aware of. There has to be proximity, i.e. Auditors must be

aware of existence of third party and possibility they might rely on

accounts.

Auditors role is to protect company itself from errors etc not owners

and to provide shareholders with info so they can scrutinise the conduct

of directors.

Their role is not to aid investment decisions.

See also Peach Properties – assurances on unaudited accounts.

Use with Auditing 10e by Alan Millichamp and John Taylor

ISBN 9781408044087

Contrast – ADT

ADT purchased Brittania Securities group (BSG) for £105m in 1990

Worth only £40m

During negotiations BDO Binder Hamlyn audit partner had meeting with

ADT and confirmed that they stood by their audited accounts

Held: This created a relationship with ADT – BDO had duty of care –

ADT awarded £40m against BDO

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ISBN 9781408044087

Future developments

Royal Bank of Scotland v BJM (Bannerman) 2002

RBS sued auditors after the collapse of APC.

Auditors claimed no duty of care as didn’t know bank was relying on

accounts (after Caparo)

Held – auditors aware of agreements between client and bank

therefore should have known RBS might rely on accounts .

Proximity was established even if auditors had no actual knowledge

of use accounts were to be put to.

Use with Auditing 10e by Alan Millichamp and John Taylor

ISBN 9781408044087

Minimising potential liabilities

▪ Observe client acceptance procedures – screen clients and review existing

clients

▪ Have Engagement Letter explaining responsibilities of directors and

auditors

▪ Perform audit work properly – use documents only for intended purpose

▪ Document work and decision and review processes

▪ Have quality control system – hot/cold reviews

▪ Take legal advice

▪ Use disclaimers where appropriate in audit report

▪ PII cover

▪ Agree with company to limit liability in respect of their audit (Companies Act

2006)

▪ Use of corporate form – Limited Liability Partnerships

Use with Auditing 10e by Alan Millichamp and John Taylor

ISBN 9781408044087

Disclaimers

Auditors have duty of care where they know report may be

relied on by third party

Since Bannerman many audit forms have included a

disclaimer in audit report – to protect them against claims

by lenders. Effectiveness not tested

ACCA’s view is that it is not appropriate as it may devalue

the audit report

Note statutory responsibilities cannot be disclaimed

Use with Auditing 10e by Alan Millichamp and John Taylor

ISBN 9781408044087

Professional Indemnity Insurance

Auditors sued for vast sums – e.g. Enron, WorldCom, Parmalat

Need insurance cover to protect assets of firm & for 6 years afterwards

Mandatory for auditors to have PII cover (ACCA rules)

For insurance against risk- akin to fire insurance or public

liability

could prevent bankruptcy

Against Can create ill founded claims

expensive

insurers will cover accountants mistakes

don’t agree with compulsion Use with Auditing 10e by Alan Millichamp and John Taylor

ISBN 9781408044087

Fidelity Guarantee insurance

Covers acts of dishonesty by partners,

directors and employees

Also required by ACCA rules

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Limiting liability by agreement

Under Companies Act 2006 auditors can agree cap on any

claims with client.

Any arrangement has to be approved by shareholders

Based on –

▪ a specific sum

▪ multiple of audit fee

▪ proportionate liability

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Incorporation

Partnerships don’t file accounts and don’t have same regulatory

burden as companies but carry exposure to risk for all partners

jointly and severally

Can now incorporate part or all of practice (CA 2006) e.g. KPMG

Audit plc is wholly owned by KPMG but will protect partnership from

excessive damages

Limited Liability Partnerships (LLP’s) – works as partnership but with

limited liability

Main disadvantage of incorporation or LLP status is disclosure of

information and requirements to file accounts.

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ISBN 9781408044087

Limited liability partnerships

The key features of an LLP include:

◼ It is a corporate body, i.e. a separate legal entity distinct from its

members. The LLP can own and hold property, employ people and

enter into contractual obligations. Debts incurred are the debts of the

LLP not of the individual partners.

◼ An LLP does not have any restrictions on its activities.

◼ An LLP has members but does not have directors or shareholders,

nor does it have share capital. Two of the members are classed as

‘designated members’ and are responsible for corporate legal

matters such as signing the accounts, appointing auditors, filing

returns, etc. at Companies House.

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ISBN 9781408044087

Limited liability partnerships

◼ The members of an LLP have limited liability. The LLP is liable for all

its debts to the full extent of its assets. Individual members are only

liable to the extent of their investment in the LLP

◼ There are no requirements for board or general meetings or

decision-making by resolution. An LLP does not have a

memorandum or articles of association.

◼ the LLP maintains accounting records, prepares and delivers

audited annual accounts to the Registrar of Companies, and submits

an Annual Return in a similar manner to companies. The

exemptions available to companies e.g. delivery of abbreviated

accounts and exemption from audit, also apply to LLPs.

Use with Auditing 10e by Alan Millichamp and John Taylor

ISBN 9781408044087