AUD 689
ADVANCED AUDITING
TOPIC 2a
Auditors’ Legal Liability
YMI/AUD689/OCT2020
1
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
2
Introduction
Due to a slump in the
economy in the early
1970’s and the
Claims against
recession of the
auditors were
1980’s, it became more
relatively
uncommon before common for auditors
to be sued.
the 1970’s.
1970
1980
1990
The recession of
1990-1992 led to
another upsurge in
litigation against
auditors.
2002
Due to several
high-profile frauds,
Congress
refocused attention
on auditors in the
Sarbanes-Oxley
Act of 2002.
3
Introduction
 Lawsuits against auditors relatively uncommon before the
1970s, but not now auditors’ profession face greater
exposure to legal action, especially in US, Canada, U.K. and
Australia.
 In U.S., approximately 4,000 each year (in 1960s, only a few
hundred a year) claims against auditors. Example, as table
below:-
Auditors
Company Audited
Settlement Amt (USD)
EY
Cendant
335 million
Andersen
Waste Management
75 million
PWC
Microstrategy
51 million
EY
Saving & Loan
400 million
4
Introduction

In the U.S., factors that contribute to the high incidence to lawsuit:◦ Evolution of the legal system: Professional indemnity is
mandatory to auditor.The client who facing the business failure
or injured parties tend to get compensation from the auditor as
the auditor is covered with the large insurance coverage.This socalled “deep pocket” syndrome.
◦ The practice of contingency legal fees: no legal fee when the case
is lost and the fee will charged on the percentage of damages
awarded when the case is successful. Plaintiffs have no risk of
paying legal fee from their own pocket.
◦ Jury system: members of public as a jury will apply layman’s
standard in judging professional negligence and most in cases the
decision is favour to the injured parties.
5
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.
 Statutory Law:
◦ Written law enacted by the legislative arm of the government that
establish certain course of conduct that must be adhered to by
covered parties.
◦ 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 statues
such as under FSA, SCA and AMLA.
◦ These duties require the auditor to report to the relevant
authorities violation of laws or regulations they encounter in the
course of performing their duties.
6
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. Under the
common law: Auditor held liable to client: for breach of contract, negligence
and fraud.
 Auditor 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.
7
Introduction
Two Classes of Law
Common Law
Statutory Law
Case law
developed by
judges
Written law
enacted by the
legislative branch
of government
8
Introduction

Increase legal action against auditors, why??
◦ Many accounting and legal professional believe that a major cause
of lawsuit against auditors is because lack of understanding by
financial statements user of the difference between a business
failure and an audit failure and between an audit failure and audit
risk.
◦ Business failure occur when business fail financially and as a result,
will be unable to pay its financial obligations and unable to meet
the expectations of its investors due to poor management,
economic conditions etc..
◦ Audit failure occur when the auditor issues an erroneous audit
opinion as the result of failure to comply with the requirement of
auditing standards. E.g.Assigned unqualified staff to perform audit,
he unable to detect material misstatement that qualified auditors
would discover.
◦ Audit risk is the risk that the auditor will conclude that the
financial statements are fairly stated and an unqualified opinion
can therefore be issued when in act they are materially misstated.
This because the auditors gather information on test basis…
9
Introduction

Increase legal action against auditors, why??
◦ When there is a business failure due to unable to pay its debt, it is
common for the user 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.
◦ The user argue, if the auditor perform their job with due care the
auditor should be able to detect misstatement 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”.
10
Introduction

Audit expectation gap:
◦ Is the difference that exists between what the public expects 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 the financial statements, i.e. base on
sample and materiality.
11
Introduction

Audit expectation gap:
◦ Thus, the public has unreasonable expectations on the auditors
and financial statements.
◦ However, the gap is also due to auditor’s inadequate
performance.This is due to either the auditor 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.
◦ So, component 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
12
Introduction

Implications of audit expectation gap:◦ Loss confidence on auditors
◦ Audit report less reliable
◦ Bad reputation of auditors
◦ Increase of lawsuits

Action to be taken to narrow the 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”. Due
to inherent limitation, auditor unable to give absolute assurance.
13
Introduction

Action to be taken to narrow the gap
◦ Influence public opinion and changing professional standards to
ensure an audit is designed to provide reasonable assurance that
materials errors, irregularities and misstatement in the financial
statement will be detected (Example: developed good audit
program to enable to detect fraud).
◦ Auditors strictly adhere to auditing standards.
◦ Auditors should be more sensitive to possible existence of fraud in
every audit they conduct.
14
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
15
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…..
16
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.

Breach of contract– Occurs when the contracting parties fails to meet
the terms and obligation established in the 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.

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.

Negligence means “some 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.
17
Key Legal Terms

Gross negligence – An extreme departure from professional
standards of due care. Lack of even slight care, totally reckless that
can be expected of a person.

Due care - is evaluated in terms of what other professional
accountants would have done in similar circumstances.

Fraud – Actions taken with the knowledge and intent to deceive
(make someone believe on something not true) Example: auditors has
made false representation and the auditor has the knowledge that the
representation is false.

Third-party beneficiary – A third party who does not have privity of
contract but is known to the contracting parties and intended to have
certain rights and benefits under the contract. E.g. Bank.The company
has a large outstanding loan and the bank requires audited financial
statement as parts of its loan agreement.
18
STATUTORY LAW
Liability Under the Statue

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.

Example:
◦ 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
Liability Under the Statue

Example:
◦ AMLA 2001: 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
Liability 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.
23
Liability Under Common Law
- Liability to Clients
 Due to breach of contract, negligence and fraud:
◦ When the auditors accepts appointment, he actually
enters into a contract with client which then indirectly
impose certain obligation on him.These obligations may
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.
24
Liability Under Common Law
- Liability to Clients
Requires Due Care
Degree of Liability to the
Client
May be held liable
for breach of
contract or
negligence
Is liable for gross
negligence and
fraud ( acting with
knowledge and
intent to deceive)
25
Liability Under Common Law
- Liability to Clients
Breach of
contract
Negligence
Fraud
• Liability is based on the auditor’s
failing to complete the services
agreed to in the contract with the
client
• If an engagement is performed
without due care, the auditor may be
held liable for an actionable tort in
negligence.
• If an auditor has acted with
knowledge and intent to deceive the
client, he or she can be held liable for
fraud.
26
Liability Under Common Law
- Liability to Clients
Client Must
Prove
1. A duty was owed to the client.
2. Failure to act in accordance with that duty.
3. A causal connection between the auditor’s
negligence and the client’s damage.
4. Actual loss or damage to the client.
Auditor’s Defense
1. No duty was owed to the client.
2. The client was negligent.
3. The auditor’s work was performed in accordance with professional
standards.
4. The client suffered no loss.
5. Any loss was caused by other events.
6. The claim is invalid because the statute of limitations has expired.
27
Liability Under Common Law
- Liability to Third Parties
Negligence
• If an engagement is performed
without due care, the CPA may be
held liable for an actionable tort in
negligence.
Fraud
• If an auditor has acted with
knowledge and intent to deceive a
third party, he or she can be held
liable for fraud.
28
Liability Under Common Law
- Liability to Third Parties
Third Party Must
Prove
1. The auditor had a duty to the plaintiff to exercise due care.
2. The auditor breached that duty and was negligent in not
following the professional standards.
3. The auditor’s breach of due care was the direct cause of
the 3rd party’s injury.
4. The 3rd party suffered an actual loss as a result.
Auditor’s Defense
1. No duty was owed to the 3rd party (level of duty required depends on the
case law followed by the courts).
2. The 3rd party was negligent.
3. The auditor’s work was performed in accordance with professional
standards.
4. The 3rd party suffered no loss.
5. Any loss was caused by other events.
6. The claim is invalid because the statute of limitations has expired.
29
Liability Under Common Law
- Liability to Third Parties (Duty of Care)
Four legal
principles for third
parties
Privity
Near Privity
Foreseen
3rd Parties
Near Privity
3rd parties whose
relationship with the
CPA approaches
privity. A known 3rd
party.
Reasonably
Foreseeable
3rd Parties
Foreseen 3rd Parties
3rd parties whose reliance
should be foreseen, even if
the specific person is
unknown to the auditor.
Reasonably Foreseeable 3rd
Parties
rd
3 parties whose reliance
should be reasonably
foreseeable, even if the
specific person is unknown
30
to the auditor.
Liability Under Common Law
- Duty of Care
▪
First landmark case: Ultramares v Touche. Et. Al (1931)
◦
Fact 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 were bankrupt after
obtained 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 not in contractual privity.
Explanation:In this case the court held that 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)
31
Liability Under Common Law
- Duty of Care
▪
Candler v Crane, Christmas and Co. (1951)
◦
Fact of the case:The plaintiff (Mr Candler) in this case was
invest in a company based on audited accounts of the
company, which is negligently prepared by the auditor.The
company subsequently became insolvent. Mr. Candler sue the
auditor and 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 by the majority of the Court of Appeal
in England 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: 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
Auditor-Crane
Christmas
Candler
Shareholder
Prepare account
negligently
Company
Purchase share based on the
Accounts and suffer losses
Judgment: The auditor did not owe duty of care in the absence
of a contractual relationship.
33
Liability Under Common Law
- Duty of Care

The privity doctrine was again tested in another important
English case: Hedley Byrne v. Heller and Partner (U.K. 1963).

Hedley Byrne vs Heller & Partners (1963)
◦ Fact of the case:The case did not involve auditor but a
merchant bank, Heller & Partners, 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 sue 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: 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. On the strength of the disclaimer, 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 ByrneAdvertising Agent
Asked about company’s credit
worthiness from banker
Company
Provide
information
without proper
checking
Banker - Heller
Want to be advertised in
media
Judgment: 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 (near privity).
36
Liability Under Common Law
- Duty of Care
Since the Hedley case, a number of court decision have demonstrated
the extension of auditors’ liability to third party base on the Hedley
principle.
 As long as the auditor knew the identity of third party which would
rely on the audited account to make a decision, the courts are more
ready to establish the existence of a duty of care.


JEB Fasterners Ltd v. Marks, Bloom & Co (1981)
◦ Fact of the case: JEB Fasteners Ltd was 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, 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 that the cost of the
inventory is far less than NRV and to comply with an accounting
standards, the amount of the inventory is should be based on cost
not based on NRV.
37
Liability Under Common Law
- Duty of Care

JEB Fasterners Ltd v. Marks, Bloom & Co (1981)
◦ Fact of the case (Continued):
◦ If inventory carried at cost, the company would shown substantial
loss instead a small profit as reported.The plaintiff brought an
action against auditors claiming that the account negligently
audited and they had rely on the audited account when acquiring
the company’s shares.
◦ The auditor contended that they did not owe a duty of care to
plaintiff and if a duty of care existed, it was only to persons who
made a specific request for information. In this case, JEB Fasterners
was not officially request for the information, they just use the
information available for public at large, 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 the JEB Fasterners a duty of care in
the preparation of audited accounts.
38
Liability Under Common Law
- Duty of Care
Company
BG Fasteners
Aware co having liquidity
problems. Prepare
Account so that co get
Auditor financial support from
outside
By shares in
the company
based on
audited
account.
JEB Fasteners
Judgment: The auditors could have been liable to the third party because
he knew or ought to have reasonably foreseen that the accounts, which he
audited were to be relied on upon for the purpose of making investment
decision.
Effect to profession: Make accounting profession more risky as the court had
broadened the auditors’ liability to the extent that they could potentially owe a
duty of care to almost anyone who relying on their audit opinion.
39
Liability Under Common Law
- Duty of Care

Caparo Industries Pty Ltd v. Dickman & Others (1990)
◦ The fact of the case: In 1984, relying on the audited account,
Caparo purchased Fidelity plc shares in the open market on
staged basis until finally acquired control of the Fidelity. The
audited accounts of Fidelity showed a profit of £1.2m. 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.
40
Liability Under Common Law
- Duty of Care

Caparo Industries Pty Ltd v. Dickman & Others (1990)
◦ Duty of care should only to the intended recipient of the
auditors’ report, i.e. primary beneficial third party and foreseen
third party (Proximity relationship) where the account 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 case 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.
41
Liability Under Common Law
- Duty of Care
Royal Bank of Scotland v. Bannerman Johnston Mc Clay and Others
(2002)
 Fact of the case: This case has an impact on the auditors report in
Malaysia.The plaintiff (Royal Bank) claimed on misleading audited
account in disburse loans and investing in equity of a company
that had to go into receivership.As a result, the plaintiff suffered
loss and sue the auditors.


Judgment:The Scottish Court, in reference to the Caparo case,
held that when the auditors did not stated 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.
42
Liability Under Common Law
- Duty of Care
Royal Bank of Scotland v. Bannerman Johnston Mc Clay and Others
(2002)
 Effect to 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 serve as disclaimer statement for the auditor, i.e.
the responsible of the auditor is to report the accounts to the
shareholders as a body as required by CA 2016 and the auditor
do not accept any other responsible.
43
Summary of Cases for Duty of Care
Case
Summary of the case
Judgment
Ultramares Plaintiff was approached for a loan by a
(1931)
company which went bankrupt after receiving
loan.
Auditors –
Privity
Doctrine
Candler
(1951)
Plaintiff invest in a company which became
insolvent. Investment made based on the
audited account
Auditors –
Privity
Doctrine
Hedley
(1963)
Plaintiff asking the bank (Heller & Partner)
about the credit worthiness of a client which
went into liquidation subsequently. Certificate
given by bank without proper checking on the
record.
Plaintiff but
auditors
escaped due
to disclaimer
sttmt
JEB
Fastener
(1982)
Plaintiff take over a company which having a
financial difficulties. The financial statement
was negligently prepared (show small profit
instead of substantial loss).
Plaintiff –
Auditor should
know account
to be used by
3rd party
44
Summary of Cases for Duty of Care
Case
Summary of the case
Judgment
Caparo
(1990)
Plaintiff take over a company shares on stages
until having control in the company based on
financial statement which shown profit Rm1.2
whereas in actual fact it should loss RM400k.
Auditors – no
duty of care to
unidentified
party
(Doctrine of
proximity)
Royal
Bank of
Scotland
(2002)
Plaintiff give a loan and invest in a company
which go into receivership subsequently.
Investment made based on the audited
account
Plaintiff –
Absent of
disclaimer
Statement
45
Liability Under Common Law
- Duty of Care

From the cases, it can be summarised that the 4 types of relationship
between plaintiffs and the auditor entails:
(1) Privity relationship refers to the contractual relationship
that exists between two or more contracting parties. (i.e. the
auditor and the client)
(2) 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
46
Liability Under Common Law
- Duty of Care
(3) 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.
(4) 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.
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Liability Under Common Law
- Duty of Care
 Explanation: 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 word, 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.
 Based on example cases above, lawsuit exercise against auditors has give
significant changes in the profession in particular:◦ Many find judgment in Caparo case difficult to accept, raises questions about the role
of the auditor and the value of the auditors service.
◦ Clarified the certain concept so that more clear. 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 on 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.
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Liability Under Common Law
- Breach of Duty of Care
◦ Breach of duty of care: to establish by the plaintiff 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. Under common
law, an auditor has the duty to perform an audit using the same
degree of care that would be used by an ordinary, prudent
member of the public accounting profession.
◦ 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. In absent of the above,
auditor may be said as breach of duty of care.
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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 inflate the profit (at that time
stock take is not normal auditing practice).
 The judge conceded 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 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: the proof of connection between the plaintiff
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 proof of connection between auditor’s failure to detect (not carry
more care when suspicion arose) a fraud and the loss (damage) arising
from the fraud.
 Plaintiff has to proof 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
 Example legal case:
◦ Galoo Ltd Vs Bright Graham (1994). The plaintiff claimed the
auditor were liable for its trading losses for a number of years
during the audited account 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: 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
◦ Damages:The fourth element in the tort of negligent is the proof
the plaintiff suffered actual loss or damage.
◦ Type of damages are loss of investment, overpayment for
investment, loss due to defalcation by management or employee
and overpayment of dividends.
◦ The measurement of damages is dependent on the circumstances
and the courts typically attempt to approximate monetary
equivalents that the plaintiff will 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 Defenses Against Legal Action
Legal action by clients:
 Defense measures by auditors:-
◦ 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 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 need to prove that the
damaged suffered by them mainly due to auditors’ negligence. E.g.
client alleges that the bank not granted the bank facilities to the
company due to the auditor unable to complete the audit on the
agreed-upon time, which cause damages to the company.The
auditor may defence is that the bank refuse to give the loan for
other reason such as weakening financial condition of the company.
This defense is called an absence of causal connection.
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Auditor’s Defenses Against Legal Action

Defense measures by auditors:◦ Contributory negligence:Auditors would claim that the client’s
own actions and interference were resulted in the loss that is
the basis for damages. E.g. Client have to pay penalty for late
filling of tax return due to auditor unable to complete the job
on time. The auditors defense is that 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:

Defence measures by auditors
◦ The first three defense measures above also available in third
party's lawsuit. Contributory negligence is not available because
the third parties do not contribute to misstated financial
statement.
◦ The most preferred defense measure could be ‘Non-Negligent
Performance’.The auditors had performed the job according to
auditing standards.The other defenses measures: Lack of duty
to perform (lack of privity of contract) and absence of causal
connection
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END OF TOPIC 2a
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