Summary OF KEY Auditor Legal Liability Cases PDF

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SUMMARY OF SOME KEY AUDITOR LEGAL LIABILITY CASES 1. LIABILITY TO THE CLIENT (i.e. The company & its existing shareholders) London & General Bank Ltd (1895) [UK case] Facts: This banking firm had many uncollectable debts = accounts receivable overvalued. Auditor only told Chairman of the Board who said he would raise the issue at the AGM so auditor gave an unqualified (clean) report. The Chairman did not properly deal with this at the AGM. The company subsequently collapsed and the liquidator sued the auditor. The Court’s decision: Auditor owed a duty of care to shareholders and was held responsible for the loss. No more than a reasonable level of skill expected from an auditor, but this includes proper reporting directly to shareholders. Kingston Cotton Mill Company (1896) [UK case] Facts: Company managers were involved in fraud by overstating the company’s inventory. The auditor accepted a “certificate” from the management about inventory values and checked no further. Auditors commonly accepted this form of evidence at the time. The company subsequently collapsed and the liquidator sued the auditor. The Court’s decision: Auditor not liable because accepting such evidence was normal audit practice at that time. The auditor should have investigated further if there was a reason to question the evidence, but no problem appeared to exist. It was not the auditor’s responsibility to go looking for fraud – auditor is a “watchdog not a bloodhound”. Pacific Acceptance Corporation Ltd (1970) [Australian case] Facts: This finance company made loans. The auditor did not identify a lack of documentation regarding insufficient collateral (security) for a number of the loans and relied heavily on management’s explanations. The auditor’s staff were inexperienced and were not adequately supervised. Large losses were incurred on the loans and the company sued the auditor. The Court’s decision: Auditor was liable for $1.5 million (a significant amount at that time) due to their deficient work. There was a lack of professional scepticism and not enough reliable evidence was collected to support the opinion given. Audit procedures should ensure that there is a reasonable chance of discovering any fraud or material error that might have occurred. This is the key Australian case that sets out in detail the more current expectations of the work of auditors. Many of today’s auditing standards came out of this decision. AWA Ltd (1995) [Australian case] Facts: The manager of the foreign exchange division of this Australian electronics manufacturing company was not qualified or experienced for the role. Internal controls were weak and he was not appropriately supervised. The auditor brought these concerns to the management of the company but they took no action, possibly because the manager was making significant profits from foreign currency trading at that time. The auditor did not notify the board of directors of the problems or that management had not addressed them. When the foreign exchange division made a $49.8 million trading loss, the company sued the auditor for not advising them earlier. The Court’s decision: Auditor was held liable for not reporting the deficiencies to the directors when he found that company management had failed to rectify them. The executive directors

were found to have contributed to the negligence by not meeting their obligation to have appropriate internal controls in place. The damages bill of $6 million ended up being split $4 million from the auditor and $2 million from the company for “contributory negligence”. The case lasted many years and the legal bill was $30 million. This case established the principle that company management could be at least partially responsible for financial loss if they played a part in (or contributed to) the loss by their action or inaction. Centro Properties (2011-12) [Australian case] Facts: This property development and management company improperly disclosed $1.5 billion of current liabilities as non-current liabilities and failed to disclose a further $1.75 billion of shortterm debt guarantees it had provided for an associated company. Although he did know about these matters the auditor from PwC did not properly identify them as significant breaches of accounting and reporting standards in his audit report. The company had difficulty obtaining refinancing for their loans and the share price fell significantly after the errors became known a few months later. Shareholders filed a class action claim against the auditor for $600 million for the lost share value. The Court’s decision: No judgment was made in this case because the case was settled out-ofcourt. The auditor had his company auditor registration suspended for three years and contributed about 1/3 of the $200mill settlement amount. Almost 1/2 came from the company for their contributory negligence, and the balance from insurance. Consequently, the concept of “contributory negligence”, first established in Australia in the AWA case, was affirmed in practical terms in the settlement split.

2. LIABILITY TO THIRD PARTIES (Typically potential investors or lenders who rely on the auditor’s report to make a financial decision about the client company). There is no contract between the auditor and a third-party (the company and the auditor are the two parties to the audit agreement) but a “duty of care” may still exist to those outside of the contract if they rely on the information provided by the auditor. This concept is based on the following UK cases that used the concept of reasonable “foreseeability”: [1] Donoghue v Stephenson (1932) where a soft-drink manufacturer was held financially liable for physical injury caused to a woman who drank a bottle of their ginger ale that had a snail in it. The manufacturer should have foreseen the potential for contamination and taken steps to ensure high product quality; and [2] Hedley Byrne (1963) where, without properly checking its records, a bank gave a good credit reference about one of its customers (Easipower Ltd) to a potential supplier to the customer (Hedley Byrne). Relying on the information Hedley Byrne gave credit to Easipower but was able to recover the debt when Easipower went into liquidation. The bank should have foreseen that Hedley Byrne would use the information to allow credit and taken steps to ensure the reference was accurate. Candler (1951) [UK case] Facts: Mr Candler relied on a negligently prepared audit report and invested money in a company that became insolvent. He sued the auditor for his loss. The Court’s decision: Auditors only owe a duty of care to those people that they show the accounts to and they know their client will show the accounts to in order to induce them to invest

money or take other action. That duty cannot be reasonably extended to include strangers that the auditor does not know. Mr Candler was not known to the auditor so no duty of care was owed to him. This case effectively removes any liability of auditors to third parties that they did not know will use the reports. Scott Group Ltd (1978) [NZ case] Facts: Scott Group relied on the audited accounts when they made a successful takeover offer for a company. It was subsequently found that the auditor had failed to identify a $38,000 overstatement of assets in the target company. Scott Group sued the auditor to recoup some of the purchase prices they had paid because of the lower asset values acquired. The Court’s decision: In this judgment the auditor was found liable. The reasoning was that auditors could “reasonably foresee” what types of people will rely on their audit report and the types of decisions they will make, so they owe them a duty of care. The decision widened the potential third parties that an auditor could be liable to, including those whom the auditor may not specifically know. Caparo Industries Pty Ltd (1990) [UK case] Facts: Caparo relied on the audited accounts when they made a successful takeover offer for a company. It was subsequently found that the reported profit of £1.2 million for the year was actually a £400,000 loss and Caparo sued the auditor for negligence. The Court’s decision: After some appeals this case reached the House of Lords, the highest court in the UK. In the end the auditor was found not liable because no duty of care was deemed to be owed. The reasoning followed that of the earlier Candler case. It was decided that there must be reasonable “proximity” (or a close relationship) between the auditor and the third party before a duty of care is owed. The auditor must be aware of the third-party group and the decisions they intend to make using the audit report. The decision again narrowed the potential third parties that an auditor could be liable to. The case also established that auditors owe a duty of care to shareholders as a group, and not to individual shareholders. AGC (Advances) Ltd (1992) [Australian case] Facts: AGC is a finance company. The client company sought to increase the loan they already had from AGC. After relying on the audited accounts AGC made the additional loan but the client company subsequently went into receivership and the loan was not repaid. It was found that the accounts included a material overstatement of the work-in-process that AGC said the auditor should have identified. AGC sued the auditor to recoup the loss. The Court’s decision: The auditor was not liable because no duty of care was deemed to be owed. The reasoning followed that of the earlier Candler and Caparo cases. It was decided that there must be reasonable “proximity” (or a close relationship) between the auditor and the third party, along with an “inducement” (or encouragement) from the auditor for the third party to take action, before a duty of care is owed. This decision confirmed the narrow view as to which third parties an auditor could owe a duty of care to. Columbia Coffee and Tea Pty Ltd (1992) [Australian case] Facts: Donyoke Pty Ltd relied on a negligently prepared audit report and bought shares in Columbia Coffee. The accounts materially understated accounts payable liabilities and, when

included, caused the shareholders’ funds to be negative. Donyoke sued the auditor for their proportion of the loss of share value. The Court’s decision: In this case the auditor’s own staff manuals stated that they need to audit properly because a wide range of users would be relying on the financial reports, including people beyond those to whom the audit report is addressed. Consequently, the court held that the auditor themselves accepted a wide potential responsibility existed and should be held accountable for the loss. This case is unusual because it seems to again widen the auditor’s responsibility to third parties BUT only on the basis of the auditor’s own words. The judge seems to have focussed on this one issue that had never been considered before. Esanda Finance Corporation (1997) [Australian case] Facts: Esanda is a finance company which made loans to various entities related to a company called Excel. The loans were made on the basis of Excel’s audited accounts and the guarantees provided by Excel that they would pay the loans if the other entities defaulted. Excel was subsequently placed in receivership and the loans were not repaid. Esanda sued the auditor for the loss claiming that the audit was deficient as the financial statements were not in accordance with accounting standards. The Court’s decision: After a number of appeals this case reached the Full High Court, the highest court in Australia. The decision in the earlier Columbia Coffee and Tea was rejected. In the end the auditor was found not liable because no duty of care was deemed to be owed. The reasoning followed that of the earlier Caparo and AGC cases. It was decided that there must be reasonable “proximity” (or a close relationship) between the auditor along with an “inducement” (or encouragement) from the auditor for the third party to take action, before a duty of care is owed. The decision again narrowed the potential third parties that an auditor could be liable to. The point was also made that audit reports are prepared for a certain purpose for a certain audience (i.e. reporting to shareholders on management’s performance), so no duty of care should exist where the audit report is used to other purposes....