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Topic 2. Introduction to audit

Audit regulation d n ey
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Structure of the profession
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Legal liability e c hn
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Client acceptance and continuance ersity
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© Dr Amanda White - University of Technology Sydney
© Dr Amanda White - University of Technology Sydney
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Module 1 – Topic 2.1 y d ne y

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Audit regulation Te ch n o l

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The CorporationschAct n o
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o o l o
• We alreadyerknow sity that auditors have to c h n
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• Follow
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• Maintain their independence p y r ig
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• Auditors will be inspected by ASIC

• Have been called to the parliamentary enquiry to testify on n ey
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audit quality, the independence of audit firms and the l og y
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• ASIC is moving to prosecute auditors for breaches iversity
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© Dr Amanda White - University of Technology Sydney
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Module 1 – Topic 2.2 y d ne y

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Structure of the audit profession Te ch n o l

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© Dr Amanda White - University of Technology Sydney
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All the players in the game
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Big 4
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Chartered
2nd Accountants
+ CPA n ey
tier Australia + l og y Sy d
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IPA e c
Small and medium sized firms o fT
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© Dr Amanda White - University of Technology Sydney
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What is the inside ofo l othe
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p y r ig Directors
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© Dr Amanda White - University of Technology Sydney
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yd ney
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s ity h n
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p y r ig ni v e r
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Module 1 – Topic 2.3 y d ne y

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Legal liability – part 1 Te ch n o l

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© Dr Amanda White - University of Technology Sydney
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yd ney
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TeAuditor’s
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How are auditorsc hexposed
n o to legal liability? S yd n
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of T o lo g
s ity h n
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p y r ig ni v e r
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© Dr Amanda White - University of Technology Sydney
 Reasonable Care and Skill
• Overall, an Auditor has a duty to exercise the
reasonable care and skill expected of a
professional.
• Requires adherence to regulatory and
professional standards in all aspects of an
audit.
• ‘The professional man owes a duty to
exercise that standard of skill and care
appropriate to his professional status’
(Caparo, 1990).

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia, 6e 10
 Negligence
Negligence can be defined as any conduct
that is “careless or unintentional in nature
and entails a breach of any contractual duty
or duty of care in tort owed to another
person/s”.

In the context of Auditing, an Auditor would

be deemed to have been “negligent” where
they made a judgement or error that a
normal, reasonable Auditor would not have
made in the same situation.

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia, 6e 11
 Claims for Negligence
To be successful in a claim for negligence, a
plaintiff must prove that:
1) A Duty of Care was owed to the plaintiff by the
defendant (i.e. the Auditor)
2) There was a breach of the duty of care as the Audit
was negligently performed
3) It resulted in an inappropriate Audit report which
was relied upon by the plaintiff
4) Financial Loss or damage was suffered by the
plaintiff as a result
Note: A causal relationship existed between the breach
of duty and the harm suffered by the plaintiff.
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 Liability to Clients
Liability to clients arises both in Contract and
under the Tort of Negligence.

Key cases include:

• London & General Bank Ltd (1895)
• Kingston Cotton Mill (1896)
• Thomas Gerrard & Son (1967)
• Pacific Acceptance (1970)
• Kirby v Centro Properties (2012)

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia, 6e 13
 Pacific Acceptance (1970)
Auditors’ duties and responsibilities are to:
– Use reasonable care and skill
– Check and see for themselves
– Audit the whole year
– Appropriately supervise and review work of inexperienced
staff
– Properly document procedures
– Rely on satisfactory internal controls
– Warn and inform the appropriate level of management
– Take further action where suspicion is aroused
– Structure plans and procedures so that discovery
of material error or fraud is reasonably expected
– Be guided by professional standards

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 Contributory Negligence
• Exists where the plaintiff fails to exercise
reasonable care, thus contributing to
the harm or loss suffered.
• The defence of “contributory
negligence” by Auditors was first
successful in the AWA case (1995)
which involved considerable negligence
by management which was recognised
and considered in the court proceedings.

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia, 6e 15
 16

yd ney
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Tec y S
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s ity h n
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p y r ig ni v e r
Co h t U
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Module 1 – Topic 2.3 y d ne y

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Legal liability – part 2 Te ch n o l

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© Dr Amanda White - University of Technology Sydney
 Liability to Third Parties
• A number of cases have considered the
auditor’s liability in relation to persons other
than the immediate client.
• For such a case to be successful, the Plaintiff
(third party) must establish and prove a
reasonable degree of proximity existed
between third party and auditor.
• Donoghue v. Stevenson [1932]
Established the precedent that a duty of care
could be owed to third parties.

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia, 6e 17
 Liability to Third Parties (continued)

Early test: Special Relationship

• A duty is owed to any third party to whom
the auditor shows accounts or to whom the
auditor knows the client is going to show
accounts, so as to induce some action.
– Candler (1951) (per dissenting
judgement of Lord Denning)
– Hedley Byrne (1963)

Continued
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 Liability to Third Parties (continued)

Next test: Reasonable Foreseeability

• A duty is owed to a specific third party of whom
the auditor was not aware, but who was part of a
class of persons who they should have been
aware would rely on their audit opinion – i.e.
where the party’s reliance on the client’s financial
report was reasonably foreseeable.
– Scott Group (1978)

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia, 6e 19
 Liability to Third Parties (continued)
Current test: Proximity
• For a duty of care to exist, there must be
circumstances establishing a relationship of
proximity between the auditor and third party – i.e.
The Auditor must have encouraged, enticed or
induced the party to rely on the report.
– Caparo (1990)
– R. Lowe Lippmann Figdor & Franck v AGC (1992)
– Columbia Coffee (1992) (very wide interpretation,
later overturned in Esanda)
– Esanda (1997)

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 Esanda (1997)
• The Australian High Court ruled that for a third party
to establish duty of care, they must show:
– 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; and
– The third party ran the risk of suffering a loss if
the report was negligently prepared

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia, 6e 21
 22

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Module 1 – Topic 2.3 y d ne y

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Legal liability – part 3 Te ch n o l

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Let’s talk about privity c hn o letters S yd n
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• Third g h tU
parties can send a Privity Letter to the Auditorrsseeking i ty
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formal acknowledgement of their reliance on the U
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report,
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• Should auditors respond to a privity letter?

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AGS 1014 Privity Letter Requests – no longer in circulation
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© Dr Amanda White - University of Technology Sydney
 Managing Legal Liability
Ø Deal only with clients possessing integrity
Ø Employ qualified personnel, and train and supervise them
properly
Ø Follow the Auditing Standards assiduously
Ø Maintain independence
Ø Understand the client’s business.
Ø Perform quality audits
Ø Document all work properly and thoroughly
Ø Obtain an engagement and a representation letter
Ø Carry adequate insurance
Ø Seek legal counsel.
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 Liability under Consumer Law:
Competition and Consumer Act 2010
Consideration needs to be given to the provisions of
the Commonwealth Competition and Consumer
Act and relevant state Fair Trading Acts:
Ø Acts prohibit misleading and deceptive
conduct.
Ø It is possible that, in issuing an inappropriate
auditor’s report, an auditor might be guilty of
conduct that is misleading or deceptive.
Ø Charges under this Act would often be brought
by the ACCC.
Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia, 6e 25
 Criminal Liability of Auditors
• Auditors can be subject to criminal prosecution under the
Crimes Act 1914.
• This Act requires Auditors to report any criminal
offences they discover the client has committed to the
appropriate authorities.
• If the Auditor fails to report the crime, they may be
deemed complicit in the act.
• Criminal actions against auditors are rare, but ASIC is
looking to pursue auditors legally for breaches of the
Corporations Act.
Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia, 6e 26
 Changes to Auditor Liability
• Changes to the Corporations Act 2001 as a result of CLERP 9
helped to limit Auditor liability in the following ways:
– Introduction of Professional Standards legislation to provide
a statutory cap to auditor's liability
– The ability for Auditors to incorporate and form company
structures with limited liability (rather than having to
operate as sole traders or in partnerships), with adequate
and appropriate professional indemnity insurance
– Apportionment between the plaintiff and defendant
according to blame, and proportionate liability if there are
two or more defendants.
(Note: Centro lawsuit was settled May 2012 for $200 million,
with PwC’s share being $67 million.)

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia, 6e 27
 Disciplinary Procedures
• Independent auditors are often mainly subject to the
disciplinary provisions of their professional accounting
bodies, either Chartered Accountants ANZ, CPA Australia
or the IPA.
• Sanctions can include:
– Exclusion from membership
– Suspension from membership
– Disbarment from practice
– Being fined a sum not exceeding $100,000
– Having to pay costs and expenses of any investigation
– Imprisonment (under Criminal Law).

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia, 6e 28
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Key take aways –chlegal n o liability S yd n
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o o l o
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• Auditorsg h t U are exposed to multiple sources of liability rsity
i
o pyr U n iv e
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• The best way to prevent getting sued is to p y r ig
conduct high
Co
quality audits

• Understand the concept of proximity in relation to auditor

liability to third parties ne y
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Module 1 – Topic 2.4 y d ne y

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Client acceptance and continuance Te ch n o l

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© Dr Amanda White - University of Technology Sydney
Quality Control Policies and Client Evaluation Procedures

• As part of Quality Control, audit firms must establish

policies for: Portfolio
Ø Investigating and evaluating potential new clients
approach
and acceptance of a new engagement
Ø Periodically reviewing continuance of clients.

• Policies and procedures for client acceptance and

continuance are important as an audit firm will want to
avoid association with a client who lacks integrity and
can expose us to legal liability!

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia, 6e 32
 Evaluation Procedures
• Procedures carried out before accepting a new client or
continuing with an existing client include:
– Obtaining and reviewing available financial information
regarding the client
– Making inquiries of third parties, such as solicitors
and bankers
– Communicating with previous auditor (only if client
permission is granted)
– Evaluating the firm’s independence and ability to serve the
client, including technical skills and knowledge of industry and
personnel
– Ensuring that accepting engagement will not violate the Code
of Ethics (APES 110/The Code).

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia, 6e 33
 Communication with the Previous Auditor
• This communication would allow the previous auditor to
advise the prospective new auditor of any professional
matters they should be aware of before accepting the
engagement.
• But it is important to note that APES 110/The Code
requires that:
– The nominated incoming auditor should request the client’s
permission to communicate with the previous auditor
– If the client refuses permission, normally decline nomination
– If permission is granted, the nominated auditor asks the
previous auditor in writing for all information necessary
to decide whether the nomination should be accepted.

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia, 6e 34
 Engagement Letter
• After accepting the audit appointment, ASA 210 requires
that the auditor and entity agree on terms of the
engagement in an Engagement Letter.
• This letter is from the auditor to the client and is intended to
record the arrangements made with the client and clarify
matters that may be misunderstood.
• Engagement letters should include the following:
– Objectives and scope of the audit
– Responsibilities of the Auditor
– Responsibilities of Management
– Identification of the applicable Financial Reporting
Framework (i.e. criteria to be used to evaluate whether the
subject matter is “true and fair”)

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia, 6e 35
 36

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Key take aways h n o
S yd n
Tec y
o f o lo g
s ity h n
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f Tec
U n y o
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• We y r ig
p must assess clients carefully ni v e r
Co h t U
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C opy
• Must consider the potential profitability

• Independence is still key y

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© Dr Amanda White - University of Technology Sydney