Download 9.401 Auditing

9.401 Auditing
Chapter 4
Legal Liability
Auditors and the Law
Professionals must fulfill implied or express
contracts with reasonable level of care
 Powerful force exerted on auditors, getting
stronger
 Increased volatility, losses, complexity
 Deep pockets
 Out of court settlements
 “expectations gap”

Expectations Gap
Public believes a clean audit opinion means:
 F/S are free of error
 No fraud has occurred
 Business is in sound health
 Importance of clear audit reports,
engagement letters, public education, clear
GAAS

Sources of Auditor Liability

Auditors can have liability under:
 Statutory law
 Responsibilities under CBCA etc.
 Contract law
 Responsibility by virtue of contracts with
client
 Common law
 Law developed through past court decisions
 Criminal law
 Responsibility under Criminal Code of
Canada
Key elements of liability

To be successful:
 Duty of Care
 Breach of duty
 Loss
 Causal link between breach of duty and
loss
Auditor Liability to Clients
Generally through contract law.
 Client generally asserts auditor was
negligent in performance of duties

Defenses against Client Claims
Lack of Duty (eg. Review vs. Audit: see
next slide)
 Absence of Misstatement
 Absence of Negligence
 Contributory Negligence
 No damages
 Absence of Causal Connection

Audits vs. Review vs.
Compilation

Progressively lower levels of assurance, less
work done by auditor, less responsibility
 Audit: “f/s present fairly…”
 Review: “nothing has come to our
attention”
 Compilation: “we do not express an
opinion..”
Liability to Third Parties
Liability under common law
 Most common defense is that there is no
duty of care (=lack of privity)

Are auditors liable?

Smith v. London Assurance Corp (1905)


first American case involving an auditor : held liable
towards their client for failing to audit a branch office
as stipulated in the engagement contract and failing to
detect an embezzlement
Ultramares Corporation v. Touche (1931)
if negligence were so great as to constitute gross
negligence, might conclude that auditor had engaged
in constructive fraud and could be liable to third
parties
 actual fraud = intentional act to deceive, mislead or
injure the rights of another person.
 Auditors not liable for ordinary negligence in USA for
the next 35 years

Due Care to whom?




Foss v Harbottle (1842)
 no duty to financial stakeholders
Heaven v. Pender (1883)
 duty to 3rd parties for physical damage only
Ultramares v. Touche (1931)
 duty to 3rd parties for gross negligence but not
ordinary negligence
Headley Byrne v. Heller (1964)
 duty to 3rd party the auditor knows or should
know will rely
Due Care to whom?



Haig v. Bamford (1976) and Toromont v. Thorne
(1975)
 duty to known third parties or known limited
class of third parties
Dupuis v. Pan American Mines (1979)
 duty to recipients of prospectus
Caparo Industries Plc. V. Dickman (1989)
 duty only to known 3rd parties of sufficient
proximity if fair and reasonable
Recent developments: Auditors
Not Legally Liable to Investors,
Top Court Rules
Hercules Management Ltd v. Ernst and Young
 An auditor who signs a company's financial
statements has no legal liability to shareholders
or investors
 The court’s concern is to protect auditors (for
public policy reasons) from unlimited liability
to thousands of investors who may use the
audit opinion for many different purposes

Liability to 3rd parties: Causal
Connections

Causality may be disproved if:
 User did not rely on f/s to make decision
 Event gives rise to loss, not f/s
Liability to 3rd parties:
Confidentiality

Confidentiality may conflict with not associating
with false and misleading



Consolidata Services v. Alexander Grant
(1981) should have maintained
confidentiality
Fund of Funds v Auther Anderson (1982) should have
broken confidentiality to avoid misleading statements
Transamerica vs. Dunwoody (1996): auditor was
correct in maintaining confidentiality
Criminal Liability


Generally rare. Occurs if:
 Gross negligence
 Deliberate
Proceeds of Crime Legislation:
 Guilty if auditor accepts property if they know
or should know that property was obtained
illegally
 Participating in money laundering is illegal
Canadian Trends in legal liability







Ontario Securities Commission interested in
increasing auditors liability to shareholders by
revising securities legislation
Charter of Rights and Freedoms may move the
Canadian system closer to the USA
Class Action suits allowed in Quebec (1979),
Ontario (1993) and British Columbia (1995)
Contingency fees for lawyers being considered
PA firms are finding it difficult to acquire adequate
insurance
Limited liability partnerships
Proportionate liability
Is there an auditor liability crisis in
Canada?





Jury trials in USA - Judge in Canada
Punitive damages rare in Canada
Unsuccessful party must pay 50 to 60
% of the legal fees of the opposing
side and other costs in Canada
Class actions are rare in Canada
nothing comparable to SEC in
Canada