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Week 2 Homework Solutions:

2.18

What are the three conditions that must be proven for an auditor to be found negligent under tort law? Based on a review of the legal cases discussed in the chapter, which conditions appear to be most difficult to prove?

A client may bring an action against an auditor under contract or tort law. The contract is between the client and the auditor. Damages under a breach of contract can only be claimed by a party to the contract.

Tort law allows any party to bring an action for negligence, provided the following three conditions are established:



a duty of care was owed by the auditor



there was a breach of the duty of care



loss was suffered as a consequence of that breach.

Therefore, tort law allows another party to bring an action (not just a party to the contract) if it can be shown that there was a duty of care to that party. This means that the client and other parties could potentially bring an action for negligence. The first condition appears to be the most difficult to prove.

For example in the HIH Royal Commission Report, it was noted that the auditor could owe a duty of care to the client and its shareholders. The report discusses the problems facing plaintiffs when seeking to establish that the client or shareholders had suffered a loss as a result of the auditor’s negligence. To ascertain a causal relationship between the negligent act and the loss suffered, reasonable foreseeability must be proven. This means that the auditor must have been aware that any negligence on their part could cause a loss to the client or their shareholders.

In Esanda (1997) the High Court of Australia ruled that for a third party to be able to establish that an auditor owes them a duty of care, they would need to show the following.



The report was prepared on the basis that it would be communicated to a third party.



The report was likely to be relied upon by that third party.



The third party ran the risk of suffering a loss if the report was negligently prepared.

1

The judgement in the Esanda case provided some relief for auditors as it made it far more difficult for a third party to establish that a duty of care was owed by the auditor. Today, it is advisable that a third party take steps to establish proximity before using an audited report to make a decision.

The plaintiff must also show that the auditor breached its duty of care, for example, by conducting a poor quality audit. Mere non-compliance with auditing standards may not be sufficient to show a breach of the duty of care. Finally, the plaintiff must establish that they suffered loss as a result of the breach of the duty of care. For example, the plaintiff must show that they relied on the audit report to make their investment which subsequently lost value.

2.22

Explain the difference between independence of mind and independence in appearance. Give an example of each.

If an auditor has independence of mind the auditor will act independently. Acting independently means that the auditors are free of the clients’ influence and will perform their duties as required by the auditing standards and codes of ethics, even if the clients do not agree. For example, an independent auditor will not be persuaded by the client to ignore a piece of evidence because of the auditor's friendship with the client. Acting independently is essential for a high quality audit. Independence in appearance is the perception of the auditor's independence. If outside parties believe that the auditor will not be unbiased because of a friendship with the auditor, the auditor will not appear independence. Despite how independently the auditors may act, the audit reports will not be credible if the outside parties do not believe that the auditors acted independently. That is, the outside parties do not believe the audit reports have any credibility because they believe that the clients have influenced the auditor. Therefore, the auditor must be seen to be independent by outside parties. That is, the auditor must be independent in appearance for the audit report to be believed. If the auditor is seen to be independent but is really not independent, then the audit reports will have credibility, but if later events reveal that the auditor did not act independently, the outside parties could suffer a loss from relying on an inappropriate audit opinion. Both independence of mind and independence in appearance are required for effective auditing. 2.25 Pringle and Partners Chartered Accounting firm has built up its audit work over the last five years. It has obtained new clients each year and many of its existing clients have grown in size. It has clients in many industries, but none of its clients are in the mining industry. At this month’s planning meeting, the audit partners will consider whether they will tender for audit work for a potential new client that has several divisions including oil and gas, gold mining and steel fabrication.

Required Explain whether Pringle and Partners should tender for the audit work for the potential new client. 2

There is nothing in the question to suggest that Pringle and Partners' independence would be compromised for the client. The issue is one of professional competence. When it comes to professional competence, members must attain and maintain knowledge and skills needed to ensure clients or employers receive competent professional activities reflecting up to date technical and professional standards and the law. The potential new client has an oil and gas division and a gold mining division. Both of these divisions are in industries that are mining or mining related. The question states that the audit firm does not have any existing clients in the mining industry. This suggests that the firm does not have the relevant expertise to audit clients that are in the mining industry. The partners need to consider whether, even though they have no existing clients in the mining industry, they would have sufficient expertise to take a client in mining. Some existing personnel could have the relevant expertise from previous work (with another audit firm), and that is why they are considering the tender. It could be possible to hire new personnel before the audit work is to be done (although they should already be in the audit firm so that they can evaluate the client acceptance decision).

SQ2.1 Cheddar Ltd was a large cheese products manufacturer that was considered a prime takeover target. Johnson and Associates completed the annual audit for 20X8 and issued an unmodified auditors report. Shortly afterwards Cheddar Ltd was taken over by Tasty Ltd, which used the audited financial report as the basis of takeover. After the takeover was completed Tasty Ltd found that the inventory of Cheddar was materially overstated. Johnson & Associates has relied on management representations about the quality of the cheese products. In fact, 20 per cent of cheese were adversely affected by fungus that rendered them worthless. In addition, Johnson and Associates only attended the Melbourne stocktake, as it accounted 65 percent of the stock. No work was completed on interstate locations. However, subsequent investigation showed significant shortage in these locations. Required: Explain whether Johnson & Associates is liable to Tasty Ltd for damages under the tort of negligence. Solution 1. Johnson % Associates was negligent, as it did not comply with the auditing standards, in relation to verification of inventory. Did not attend the stocktake for the 35percent of inventory held in other locations nor verified its existence by alternative audit procedures. It also accepted management representation concerning valuation of inventory, when other audit evidence could have reasonably have been expected to exist. 2. Tasty suffered a loss due to the inflated price paid for cheddar Ltd due to the overstatement of inventory. 3. Tasty limited relied on the financial reports, which caused it to suffer loss. 3

4. It was reasonable foreseeable that Cheddar Ltd would be taken over, as it was considered a prime take over target and the acquire would look at and rely on the financial report. 5. However, there is no proximity between Johnson and Associates and Tasty Ltd , as Johnson & Associates did not prepare its report for Tasty Ltd nor induce it to rely on it. Therefore, Johnson and Associates did not owe tasty Ltd duty of care and consequently would not be liable to it under tort of negligence, even though the other necessary conditions has been satisfied.

SQ2.2

Situation (a) Type of threat and explanation

(b) Action to

(c) Safeguard to reduce

eliminate threat

risk of threat in the future

(i)

Self-interest—the audit

The audit team

CBDL should put in place

team member holds

member should

policies and procedures

shares in the audit client

dispose of their

that prohibit employees

such that their

shares or should not

from owning shares in

independence and

be part of the audit

any audit client. Audit

objectivity may be seen

team

team members could also

to be impaired

be asked to sign an independence declaration prior to joining the team

(ii)

Self-review—Big Boss

An independent

A policy should be put in

previously provided

valuation should be

place disallowing the

valuations that are

sought for the

provision of valuation

disclosed on the

intangible assets

services to audit clients,

statement of financial

disclosed on the

and prior to acceptance

position and that will now

statement of financial

of any new audit

be audited by the same

position or Newport

appointment all existing

audit firm

should not be

relationships and

appointed as auditor

engagements should be

of CBDL

disclosed

SQ2.3 4

(a) Threats

Explanation

(b) Action RAP needs to implement

Familiarity

Bob and Owen (the CFO of

RAP should not make Bob the partner

EAL) are friends. Bob may be

on this audit

too sympathetic towards Owen’s interests and too accepting of his work Self-interest

Ralph’s wife is a prominent

RAP must ensure that any gifts of

jewellery designer and Ralph

jewellery offered by Ralph or his wife

has suggested that the audit

are refused by the audit team

team will be able to get some of her limited-edition jewellery. This could influence the audit team into making the audit ‘smooth’ for the client, rather than retaining their professional scepticism throughout. Given the nature of the jewellery, the value of any gifts is unlikely to be ‘trivial and inconsequential’ Self-review

Elspeth would find it hard to

RAP must remove Elspeth from the

maintain objectivity if she is

audit team

auditing work that she has prepared

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