From the two definitions we can see that accountants produce financial information and auditors ascertain the validity of that information.
The Nature, Scope and Purpose of Auditing
Audits serve a vital economic purpose and play an important role in serving the public interest to strengthen accountability and reinforce trust and confidence in financial reporting. It was not until the Companies Act 1900, however, that a general legal obligation for annual audits was imposed on registered companies. (Institute of Chartered Accountants in England & Wales. (2005))
A UK company has a board of directors (the agents) and a body of shareholders (the principals). The directors have been delegated responsibility for managing the affairs of the company. Control of a company may be separated from its ownership. In effect, directors act as trustees for shareholders. They are bound by certain duties that are established in common law and under statute. The Companies Act 1985 prescribes clear statutory responsibilities for directors in respect of the company accounts and administration of the company. (Institute of Chartered Accountants in England & Wales. (2005))
The financial statements are the primary mechanism for shareholders to monitor the performance of directors. Shareholders have limited access to information about the operations of a company and may believe, therefore, that they are not getting the right information they need to make informed decisions or that the information being provided by way of the financial statements is biased. As such, shareholders may lack trust in the directors and in such a situation the benefits of an audit in maintaining confidence and reinforcing trust are likely to be perceived as outweighing the costs. (Institute of Chartered Accountants in England & Wales. (2005))
Under Section 235 of the Companies Act 1985 auditors are appointed by and report to the shareholders of the company. The auditors provide an independent report to the shareholders on the truth and fairness of the financial statements that are prepared by the board of directors. (Institute of Chartered Accountants in England & Wales. (2005)).This idea of audit purpose can be interpreted as Wallace’s (1980) Agency theory.
Another theory for the purpose of audit is seen in the ‘information hypothesis’ by Wallace(1980) which gives value to audited information in the sense that audited financial information is information of higher quality and therefore is sometimes the basis for investment decisions. Financial information which is audited helps detects errors and therefore motivates employees to be more careful in recording the information which in return improves the reliability of the recorded information.
Wallace’s (1980) suggests a third theory ‘insurance hypothesis’ suggesting that auditors are used to shift litigation onto them, reducing it for the management; this can be seen as management’s demonstration of exercising duty of care.
The auditor’s report is required to contain a clear expression of opinion on the financial statements taken as a whole.
The Audit Opinion (See appendix 1, page 4)
Reporting Requirements (See appendix 1, page 3-4)
Scope of an audit of financial statements (See appendix 1, page 2)
Stages in Audit Process
- Planning
- Determine audit approach – risk evaluation
- Ascertain system of accounting and internal controls
- Consider methodology to be used to obtain evidence
- Perform control and substantive tests
- Review Financial statements
- Report to management – management letter
- Report to members (in audit report)
(Cosserat & Rodda (2009))
Can a Legal Action Be Brought Against Auditors If They Make Mistakes?
Legal responsibilities of auditors
To tackle the aforementioned question we have to discuss the Auditors duty of care. Auditor’s duty of care is established by the Company Acts and case law. Auditors are expected to exercise reasonable skill and care with application of relevant professional standards and to come with an enquiring mind. Auditors would be guilty of negligence if they didn’t exercise a duty of professional care, having poor professional conduct and not abiding by the highest professional standards. (Boynton & Johnson (2006))
Liability to Shareholders
Boynton & Johnson (2006) state that auditors owe a duty of care to directors and shareholders because of a contract between them. Auditors are liable to pay compensation to the claimant if:
- Duty of care to claimant
- Audit negligently performed or
- Audit opinion negligently given
- Claimant has suffered a loss because of auditors negligence
- Loss is Quantifiable
To help understand the auditor’s liability, the following issues will be considered and dealt with separately:
• Due care
• Negligence
• Privity of contract
• Causal relationship
• Contributory negligence
• Damages
Due Care
The Key case which deals with the auditors responsibility (including detection of error and fraud) to shareholders is the Kingston Cotton Mill Case 1896 which says the duty of an auditor is to convey information, not to arouse enquiry. This case established the duty of care which an auditor owes which is that the auditor is not necessarily answerable for an error of judgement, provided he or she exercises the skill and care of a reasonably competent and well-informed member of the profession. (Cosserat & Rodda (2009))
Negligence
Negligence has been 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 (that is, to those who the auditor could reasonably foresee would rely on the auditor’s report), owed to another person or persons. (Cosserat & Rodda (2009))
If the auditor has been negligent, then the client may sue the auditor for breach of an implicit term of the contract to exercise reasonable care and skill, so as to recover any consequential loss suffered.
For example, On 12 May 2005, a Sydney auditor was fined for breaching auditor independence provisions relating to charges of acting as auditor of a listed company while, at the same time, acting as the company secretary.
Privity of contract
The term privity of contract refers to the contractual relationship that exists between two or more contracting parties. An audit is assumed to be performed in accordance with professional standards unless the contract (engagement letter) contains specific wording to the contrary. (Boynton & Johnson (2006))
Causal relationship
A causal relationship exists between the breach of duty by the auditor and the loss or harm suffered by the claimant. This relationship must have been reasonably foreseeable and it must be proven that the loss suffered is attributable to the negligent conduct of the auditor in a negligence case
An example of a causal relationship can be seen in the case of Segenhoe Ltd v. Akins & Ors (1990) where Segenhoe argued that it has suffered loss by wrongly paying an amount to its shareholders. It claimed the loss was due to negligence of the auditor. The auditor in this case was found liable (Boynton & Johnson (2006)).
Contributory negligence
Contributory negligence relates to the failure of the claimants to meet certain required standards of care, together with the auditor’s negligence.
An example of contributory negligence can be seen in the case of AWA Ltd v. Daniels t/a Deloitte (1992). The company suffered losses due to internal control weaknesses. The auditor was held liable for failure to report to board of directors and to rectify control weaknesses. Company found to contribute to loss by officers failing to report to board of directors. The court accepted that the directors have a duty to establish a sound system of internal control to safeguard company’s assets. Their failure to do so was held to be contributory negligence. The court upheld the notion of proportionate liability. Share of the loss: AWA mgt. 33.3% of the loss; Auditors liability 66.6% (Cosserat & Rodda (2009)).
Damages
Where auditors fail in their duty to act with reasonable care and skill, whether under contract or in tort, a plaintiff is entitled to recover any economic loss arising out of such a breach of duty. This can be seen in the 1995 High Court judgment against the auditing company BDO Binder Hamlyn who didn’t discover that the company that they were auditing overstated their value by £65 Million causing a loss for the company who wanted to purchase the audited company. (Boynton & Johnson (2006))
Liability to 3rd Party
Action for damages may be brought against an auditor under tort, outside of any contractual relationship. The Hedley Byrne & Co Ltd v Heller & Partners Ltd [1964] AC 465 case is a landmark case for professional liability to third parties and established the concepts of foreseeability and due care; both tests are essential elements in establishing auditor liabilities to third parties. The case of Donoghue v Stevenson [1932] AC 562 established that a third party is ‘one who is not in privity with the parties to the contract, but may, nevertheless, be a primary beneficiary or a beneficiary to the contract’. (Cosserat & Rodda (2009))
The concepts of foreseeability and due care are exemplified in the case of JEB Fasteners Ltd v. Marks, Bloom & Co. (1981) where JEB Fasteners sued the auditor on the grounds that the stock of the company they wished to acquire was overstated. JEB Fasteners paid more for the acquisition then it would have, had it know the true facts. In the judgement it was seen to be reasonably foreseeable that the company would use the audited financial statements when considering the takeover. It was held that there was sufficient proximity therefore a duty of care was owed to the claimant.
Auditors are liable to pay compensation to a third party if:
- The third party suffers an economic loss
- The economic loss can be quantified
- Duty of care to the third party
- Auditors knew that the third party would use and rely on the audited accounts.
(Cosserat & Rodda (2009))
Auditor professional ethics
Auditors also have to follow professional ethics when carrying our their job, one of the many ethics they have to follow is being independent from the company being audited whereby the auditor has no self interest and is free from influence. Audit firms engaging in Enron, WorldCom and Xerox failed to follow these professional ethics and have found themselves at the centre of audit scandals and litigation. (BBC News. (2003) PwC pays again in new audit scandal)
Conclusion
From the report it would be fair to say that there is an expectation gap in the minds of the public as to the role of the auditor and that hopefully this report has bridged the gap as to where the limitations of the auditors role lie and strengthens the idea the auditors role is to ascertain the validity of financial information. The issue of audit litigation shows that if audit operation is carried out negligently that auditor could see themselves facing legal action.
Bibliography
Appendix 1-The Auditing Practices Board (APB) (26 March 2009) Scope of an Audit of the Financial Statements of A United Kingdom Publicly Traded Company or Group [Online], the Auditing Practices Board (APB). Available at: < http://www.frc.org.uk/apb/scope/UKP.cfm>> [Accessed 20 Febuary 2010].
ASIC. (12 May 2005 ) Sydney auditor pleads guilty and is fined for breaching auditor independence provisions [Online], ASIC Available at: < http://www.asic.gov.au/asic/asic.nsf/byheadline/05-124+Sydney+auditor+pleads+guilty+and+is+fined+for+breaching+auditor+independence+provisions?openDocument> [Accessed 20 Febuary 2010].
BBC News. (2003) PwC pays again in new audit scandal, BBC [Online]. Available at: <http://news.bbc.co.uk/1/hi/business/2931250.stm> [Accessed 26 Febuary 2010].
Boynton, W, C. & Johnson, R,N.(2006) Modern Auditing: Assurance Services and the Integrity of Financial Reporting, 8th Edition. Wiley, Chichester
Cosserat, G.W. & Rodda, N. (2009) Modern Auditing, (3rd edn). Wiley, Chichester
Drury, C. (2008). Management and Cost Accounting. 7th ed. Cengage Learning.
Gray, I. & Manson, S. (2005) The Audit Process,: Principles and Practice, (3rd edn) Thomson, London
Hwang, D, B, K. & Staley A. B. (2000) ‘An analysis of recent accounting and auditing failures in the United States on US accounting and auditing in China: Managerial Auditing Journal, Vol. 20 No. 3, 2005, pp. 227-234
Institute of Chartered Accountants in England & Wales. (2005) Agency theory and the role of audit. Research Report.
Wallace, W, A. (1980) the Economic Role of the Audit in Free and Regulated Markets, New York: University of Rochester